Marketability Discounts for Built-In Gains Post-Davis When the Guideline Method Is Not Used
In the Davis and Eisenberg cases described below, the Guideline Publicly-traded Company method was used by the valuation experts to determine the fair market value of the stock which was the subject of the proceedings. When the Guideline method is used, privately held stock is determined by reference to the value of publicly-traded stock of companies deemed to be comparable to the private entity being value. Once the value of the comparable company(ies) is determined, a Discount for Lack of Marketability (DLOM) is typically applied as one of the steps in arriving at the value of the private company. Therefore, prior to using built-in capital gains taxes as one element of a DLOM, the reader should be certain to understand the method used to arrive at the private company's value and whether a DLOM is appropriate given the valuation method.
Note: These cases expanded the allowability (or applicability) of discounts for built-in or trapped capital gains beyond those circumstances where liquidation was contemplated. Existing case law (to be cited) had already found capital gains tax discounts applicable where liquidation was contemplated.
Example
Consider the following example, which highlights the mechanics of the liquidation tax and the silly result which obtains if the built-in gains tax is not properly accounted for in the valuation.
| Basis | FMV No Tax | FMV With Tax | |
| Assets | |||
| Tangible | 10 | 20 | 20 |
| Intangible | 0 | 80 | 80 |
| Total | 10 | 100 | 100 |
|---|---|---|---|
| Built in Gain Tax | 0 | 0 | 36 |
| Net Worth | 10 | 100 | 64 |
If the entity is liquidated or the assets sold, a cash cost of $36 (40% of the $90 built-in gain) will be incurred, making the true value of what was purchased only $64, not the gross asset value of $100. When liquidation or sale is not presently contemplated, the potential for this tax may (should?) still influence the fair market value determination.
Recent court cases - Built-in Gains
In Davis (Estate of Davis v. Comm (110 TC No. 530), the issue was whether a discount should be allowed in arriving at the fair market value of C corporation stock where the underlying assets had trapped or built-in capital gains. Shannon Pratt, arguing for the taxpayer, applied a 15% discount due to built-in gains tax as part of the Discount for Lack of Marketability. Despite the testimony of its own expert at trial for a similar discount, IRS rejected it. The key arguments in support of the discount offered by Pratt were:
1. Electing S status to avoid built-in gains tax is not relevant to the determination of the discount since it would limit the willing buyer to those eligible to hold S stock. Eligible entities are limited to individuals, a grantor trust, certain testamentary trusts, electing small business trusts, a qualified subchapter S trust and certain exempt organizations, e.g., a qualified plan. An S can have only one class of stock and no more than 75 shareholders.
2. The 10 year wait post-S election before the built-in gains tax was eliminated creates additional marketability issues
3. The presence of C Corporation earnings and profits (E&P) could result in termination of the S election if only passive income were present, and he concluded that
4. "A hypothetical willing seller and a hypothetical willing buyer could not have agreed on that date (of gift) on a price for each of the blocks of stock in question that took no account of built-in capital gains tax."
In Eisenberg (Eisenberg v. Commissioner, T.C. Memo 1997-483), the key issue again was whether the potential capital gains tax inherent in low basis assets trapped inside a C corporation allowed for a discount if no liquidation was contemplated. Tax Court Judge Hamblen granted Summary Judgment for IRS, reasoning that no discount for such trapped capital gains was allowable in the absence of plan to liquidate. The Second Circuit overturned the summary judgment and remanded the case to the Tax Court for a determination of the discount. The IRS acquiesced to the Second Circuit's decision in January of 1999.
In Jameson (Estate of Jameson v. Comm (TCM 1999-43), a case decided after Davis, the Tax Court again allowed a discount for built-in capital gains tax. In this instance, the Court rejected not only the IRS' position that no such discount should be allowed, but also the taxpayer's computation of the discount. The corporation whose stock was the subject of the discount owned highly appreciated timber and had made an election under section 631(a) which required it to recognize (capital) gain upon the cutting of the timber, irrespective of when it was actually sold. The Court estimated the amount of timber that would be cut each year, based upon the testimony of the experts, and discounted the resultant capital gains tax back to the valuation date in order to arrive at the correct built-in capital gains discount.
The most significant aspect of this case, perhaps, is that the Court made its decision based upon the requirement of 631(a) to recognize gain currently, arguably similar to the recognition provisions associated with a C corporation converting to S. C corporations converting to S must recognize as corporate level income their built-in gains during the 10 year period after electing S. In addition, the discount applied without regard to whether the method of valuation was the income approach or market approach via the Guideline Publicly Traded Company method. In fact, the approach used by the Court to calculate the discount involved an income forecast.
There are now court decisions supporting a discount for capital gains taxes where liquidation is contemplated, and where no liquidation is contemplated as part of the DLOM if the Guideline Publicly Traded Company method is used. A question should arise as well whether a discount is warranted for a C Corporation versus an identical S Corporation when the stock is being valued (i.e., is the value of the stock of a corporation different assuming 1) it is a C and 2) it is an S). The present working of the built-in gain tax is such that a tax is imposed at the highest rate on any corporate income during the 10 year period after a C Corporation elects S status. Although this tax may be avoided by a new S Corporation, for example, through the process of paying out all taxable income as compensation for the first 10 years, it is certainly a far less desirable position economically than to have a pre-existing S corporation not subject to such a tax. The pay-out-as-compensation-strategy is reasonably defensible with respect to built-in gains stemming from zero-basis accounts receivable in a professional corporation. It is far more problematic if the source is recognized built-in gains is sales of capital assets such as intangibles, for example, or built-in gain in a non-service business where no rationale for paying such gains as compensation exists.
Assume that we establish a Discounted Cash Flow (DCF) model to value valuing the stock of two identical entities, one of which is a C and one of which is an S, and that the value before any discount related to built-in gains is the $100 in the example above. If we compare the successful arguments on behalf of the taxpayer in Davis when the Guideline method of valuation is used, do we find any reason that a discount of some sort is not indicated when a DCF is used?
1. Electing S status to avoid built-in gains tax is not relevant to the determination of the discount since it would limit the willing buyer to those eligible to hold S stock
This is argument holds true for an existing C irrespective of the valuation method, as an S election is only valid if all of the shareholders (including the hypothetical willing buyer), are S eligible.
2. The 10 year wait post-S election before the built-in gains tax was eliminated creates additional marketability issues
Again, there is no difference in the impact on the value of the stock where a buyer must confront the possibility of a corporate level tax, regardless of the valuation method used.
3. The presence of C Corporation earnings and profits (E&P) could result in termination of the S election if only passive income were present
This factor has limited if any relevance to the typical operating corporation which is unlikely to find itself at risk for termination of its S due to passive income.
4. "A hypothetical willing seller and a hypothetical willing buyer could not have agreed on that date (of gift) on a price for each of the blocks of stock in question that took no account of built-in capital gains tax."
In the real world of negotiating the sale or purchase of a business interest, this statement is inescapable. Tax considerations are major determinants of privately held business structure and, in turn, value. While publicly traded companies are almost uniformly C corporations, many small businesses are not and do not harbor intentions of becoming public.
The question is most simply stated as follows: Given the choice between acquiring stock in two identical entities, one of which is an S and one of which is a C, which would you choose? In the author's view, some form of a discount for the C Corporation is clearly indicated in this circumstance. (I note that the FIRST thing I look at when valuing an S is when the election was made and whether any built-in gain appears unrealized in the tax return on page 2.)
For many years the Courts steadfastly refused to recognize that the repeal of the General Utilities doctrine in the Tax Reform Act of 1986 radically altered the discounts associated with built-in gains. It now appears certain that a steady stream of cases will recognize the appropriateness of such discounts, and that the valuation community at large, whether preparing a valuation for tax purposes or otherwise, should take them into account as well.
