When valuing a controlling or non-controlling interest in a C corporation that owns only marketable securities, a common method to apply is the net asset value method under the asset approach. Under this method, the fair market value of liabilities is subtracted from the fair market value of assets. Included in the liabilities is a dollar-for-dollar reduction on the date of valuation for the built-in capital gains (BICGs) tax.
The 5th and 11th Circuits have accepted a dollar-for-dollar reduction in value for the BICG tax for both a controlling interest and a non-controlling interest (See Dunn v. Commissioner, U.S. Court of Appeals 5th Circuit, No. 00-60614, and Estate of Frazier Jelke, III v. Commissioner 11th Circuit U.S. Court of Appeals, No. 05-15549). However, in the tax court case heard in the 3rd Circuit, Estate of Helen P. Richmond, Deceased, Amanda Zerbey, Executrix, Petitioner v. Commissioner of Internal Revenue, Respondent, T.C. Memo 2014-26 (Richmond Case), this approach was not applied.
In the Richmond Case, the subject interest was a 23.44% non-controlling common stock interest in Pearson Holding Company, a family owned C corporation that held primarily marketable securities with significant built-in capital gains. The court record established that 87.50% of the $52 million market value of assets represented appreciation that, if triggered by a sale, would result in capital gains tax of approximately $18 million.
The estate’s expert relied on the income approach, whereas the IRS expert relied on the asset approach. Mr. Thompson, the IRS expert, quantified the BICG tax exposure by increasing the marketability discount by 15% based on his analysis of closed-end funds. Interestingly, the tax court criticized Mr. Thompson for his tax methodology and analysis but accepted his conclusion of the tax amount, which was approximately $7.8 million. This is about 43% of the full $18.1 million tax had the portfolio been liquidated, or had the dollar-for-dollar reduction in value been applied.
The court justified its $7.8 million reduction in value by performing a present value calculation of the full capital gain tax assuming it would be incurred ratably over a 20-year and 30-year period. They used this as a proxy for the portfolio turnover rate. They calculated a range of present values for the BICG tax, from $7.5 million to $9.5 million using discount rates ranging from 7.0% to 10.27%, and concluded that $7.8 million was “reasonable in this case”.
This is a disappointing ruling given the 5th and 11th Circuits’ dollar-for-dollar reduction in value rulings in other BICG tax cases using the net asset value method. The expectation is for consistency in the tax court that results in logical and reasonable conclusions. This decision, however, just muddies the waters.
By Cindy Andresen, ASA
Source: Business Valuation Review, Volume 34, Issue 3, Fall 2015, “Thoughts on Estate of Richmond Tax Court Case” by John M. Byrne, CPA/ABV