Money Matters: Discount for embedded capital gains and fair value standard

 Kristin S. Coffey, The Daily Record Newswire

For some time, the IRS position has been to reject the premise that embedded capital gains affect fair market value in all but very limited circumstances. Specifically, they have argued that unless a corporate liquidation is probable, there should be no adjustment in value for built-in taxes.

Until 1998, the courts agreed with the IRS, refusing to allow discounts for built-in capital gains. Beginning in 1998, however, the decisions in certain court cases began to signal a significant shift in the thinking of some courts. Some of the more notable cases that involved C-corporations and the fair market value standard (i.e. willing buyer and willing seller of the corporate stock) include:

• In Estate of Davis v. Commissioner (110 T.C. 530, 110 T.C. No. 35, 1998 U.S. Tax Ct.), the court held that even though no liquidation of the company or sale of the assets was planned or contemplated as of the valuation date, a hypothetical willing buyer and a hypothetical willing seller would not have agreed upon a price that did not take into account the company’s built-in capital gains tax liability.

• In Eisenberg v. Commissioner (155 F.3d 50, 1998 U.S. App. [2nd Cir. Aug. 18, 1998]) the court held: “The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the market value of the property he considers buying … We find that even though no liquidation was planned or contemplated on the valuation date, a hypothetical willing seller and a hypothetical willing buyer would not have agreed on that date on a price for each of the blocks of stock in question that took no account of the corporation’s built-in capital gains tax.”

• Estate of Richard R. Simplot (112 T.C., No.13) is noteworthy in that experts for both the taxpayer and the IRS took — and the court allowed — a full discount for built-in capital gains. This continued the trend begun in 1998 with the Davis and Eisenberg decisions; however, in those earlier cases, only a partial discount was allowed. Simplot, therefore, marked one of the first instances where the court allowed a full discount for built-in gains.

• In Dunn v. Commissioner (CA-5, 2002-2 USTC Para. 60,446, 301 Fsd 339) the Appellate Court stated: “Under the factual totality of this case, the hypothetical assumption that the assets will be sold is a foregone conclusion for purposes of the asset-based test. The process of determining the value of the assets for this facet of the asset-based valuation methodology must start with the basic assumption that all the assets will be sold.

“By definition, the asset-based value of a corporation is grounded in the fair market value of its assets, which in turn is determined by applying the venerable willing buyer-willing seller test. By its very definition, this contemplates the consummation of the purchase and sale of the property, i.e., the asset being valued.”

It is clear, through these cases, that the tax courts have recognized the economic reality that capital gains taxes are considered by both willing buyers and willing sellers of business interests in the real world.

Courts also struggle with how to interpret statutory fair value in shareholder disputes, including whether to discount business interests for built-in capital gains tax.

On June 13, 2011, in Dawkins v. Hickman Family Corporation , the U.S. District Court for the Northern District of Mississippi granted a dollar-for-dollar reduction for this tax liability. In Dawkins, several oppressed minority owners requested a judicial dissolution and buyout of their 35.7 percent combined interest in a family business. The corporation and its general chairman/general manager, Perry Hickman, countered with a petition to buy out the minority interests at fair value.

Like many states, Mississippi grants courts the authority to dissolve a corporation if the shareholders prove that the directors have acted (or will act) in an illegal, oppressive or fraudulent manner. It also allows the corporation or remaining shareholders to buy out the other shareholders at fair value in lieu of dissolution. The primary issue in Dawkins was the fair value of the oppressed shareholders’ interests.

According to the court, the plaintiffs never provided any independent appraisal evidence “other than arbitrary numbers without explanation or evidentiary support.”

The defendant hired a valuation professional who valued the entire business at $225,000. Accordingly, the expert concluded that each of the four petitioning shareholders owned a 7.143 percent interest worth $16,071.75.

The corporation operates farmland that doesn’t generate income. So the appraiser concluded it was akin to a real estate holding company and based his value solely on the asset-based approach. Under this methodology, fair value equals the difference between a company’s assets and liabilities.

By not challenging the appraiser’s methodology, the petitioning shareholders “appear to concede that this asset-based methodology is correct.” The court accepted the expert’s report and commended his thorough review.

Under the Mississippi Business Corporation Act, fair value specifically excludes discounts for lack of control and marketability. But MBCA is ambiguous about discounts for built-in capital gains taxes. Typically, capital gains tax is charged on the difference between the selling price of a company (or an asset) and its adjusted cost basis. For C corporations like Hickman, sales proceeds are taxed again on the personal level when the corporation distributes cash to shareholders.

Because the farmland had been purchased in the 1940s, it had less than $20,000 of tax basis and would incur significant built-in capital gains tax if sold. Citing Dunn v. Commissioner, the court noted that “the corporation cannot realize the fair market value of the assets without incurring this tax liability.” Accordingly, a dollar-for-dollar reduction for built-in capital gains tax was upheld, even though a sale was not imminent.

Most case law granting discounts for built-in capital gains tax has been estate tax–related. But in Dawkins, a dollar-for-dollar reduction for capital gains tax was permitted in a shareholder dispute. Because there have been few cases of this nature, Dawkins could be cited in dissenting and oppressed shareholder cases in other jurisdictions.

Additionally, this case underscores the importance of hiring a credentialed valuation professional to prepare a comprehensive valuation report. In Dawkins, the only valuation evidence provided at trial was from the defendant’s expert. Throughout its opinion, the court applauded the appraiser’s in-depth analysis. Accordingly, the judge accepted the appraiser’s conclusion in its entirety.


Kristin S. Coffey is the senior manager of Business Valuation Services with Mengel, Metzger, Barr & Co. LLP. She can be reached at