SCOTUS Reports

Tag: Closely Held Stock Valuation

  • Davis v. Commissioner, T.C. Memo. 1998-119: Valuation of Closely Held Stock and Discounts for Gift Tax Purposes

    Davis v. Commissioner, T.C. Memo. 1998-119

    In valuing closely held stock for gift tax purposes, discounts for built-in capital gains tax are appropriately considered as part of a lack-of-marketability discount, even if liquidation or asset sale is not planned, because a hypothetical willing buyer and seller would consider these potential tax liabilities.

    Summary

    Artemus D. Davis gifted two blocks of 25 shares of A.D.D. Investment & Cattle Co. (ADDI&C) stock to his sons. The IRS determined a gift tax deficiency based on their valuation of the stock. ADDI&C was a closely held investment company holding a significant amount of Winn-Dixie stock. The Tax Court addressed the fair market value of the ADDI&C stock, focusing on discounts for blockage/SEC Rule 144 restrictions, minority interest, lack of marketability, and built-in capital gains tax. The court found that while no blockage discount was warranted, a discount for built-in capital gains tax was appropriate as part of the lack-of-marketability discount, even without planned liquidation, because a willing buyer would consider the potential tax liability. Ultimately, the court determined a fair market value lower than the IRS’s but higher than the estate’s initial valuation, incorporating discounts for minority interest and lack of marketability, including a component for built-in capital gains tax.

    Facts

    On November 2, 1992, Artemus D. Davis gifted two blocks of 25 shares each of ADDI&C common stock to his sons. ADDI&C was a closely held Florida corporation primarily a holding company, with assets including Winn-Dixie stock (1.328% of outstanding shares), D.D.I., Inc. stock, cattle operations, and other assets. ADDI&C and Davis were affiliates concerning Winn-Dixie stock sales under SEC Rule 144. ADDI&C had not paid dividends historically, except for a shareholder airplane use treated as a dividend in 1990. No liquidation plan existed on the valuation date.

    Procedural History

    The IRS determined a gift tax deficiency. Davis’s estate petitioned the Tax Court to redetermine the fair market value of the gifted stock. Both the estate and the IRS modified their initial valuation positions during the proceedings.

    Issue(s)

    1. Whether a blockage and/or SEC rule 144 discount should be applied to the fair market value of ADDI&C’s Winn-Dixie stock.
    2. Whether a discount or adjustment attributable to ADDI&C’s built-in capital gains tax should be applied in determining the fair market value of the ADDI&C stock.
    3. If a discount for built-in capital gains tax is appropriate, whether it should be applied as a separate discount or as part of the lack-of-marketability discount, and in what amount.
    4. What is the fair market value of each of the two 25-share blocks of ADDI&C common stock on November 2, 1992?

    Holding

    1. No, because the estate failed to prove that a blockage and/or SEC rule 144 discount was warranted on the rising market for Winn-Dixie stock and given the dribble-out sale method likely to be used.
    2. Yes, because a hypothetical willing buyer and seller would consider the potential built-in capital gains tax liability, even without a planned liquidation.
    3. As part of the lack-of-marketability discount, because it affects marketability even if liquidation is not planned. The court determined $9 million should be included in the lack-of-marketability discount for built-in capital gains tax.
    4. The fair market value of each 25-share block of ADDI&C stock was $10,338,725, or $413,549 per share, reflecting discounts for minority interest and lack of marketability, including the built-in capital gains tax component.

    Court’s Reasoning

    The court relied on the willing buyer-willing seller standard for valuation, considering all relevant factors. For unlisted stock, net worth, earning power, dividend capacity, and comparable company values are considered (Rev. Rul. 59-60). The court evaluated expert opinions, giving weight based on qualifications and analysis cogency.

    Regarding the blockage discount, the court rejected it, finding that the rising trend of Winn-Dixie stock prices and the likely dribble-out sale method mitigated the need for such a discount. The court disagreed with expert Pratt’s view of private placement sale and found Howard’s Black-Scholes model unpersuasive for justifying a blockage discount in this context.

    On built-in capital gains tax, the court rejected the IRS’s argument that no discount is allowed if liquidation is speculative. The court distinguished prior cases, noting that in this case, all experts agreed a discount was necessary. The court emphasized that even without planned liquidation, the potential tax liability affects marketability and would be considered by hypothetical buyers and sellers. The court quoted Rev. Rul. 59-60, stating that adjusted net worth is more important than earnings or dividends for investment companies.

    The court determined that a full discount for the entire built-in capital gains tax was not appropriate when liquidation was not planned. Instead, it followed experts Pratt and Thomson in including a portion of the built-in capital gains tax as part of the lack-of-marketability discount. The court found $9 million as a reasonable amount for this component within the lack-of-marketability discount.

    For the overall lack-of-marketability discount (excluding built-in gains tax), the court considered restricted stock and IPO studies, finding IPO studies more relevant for closely held stock like ADDI&C. The court criticized Thomson’s limited consideration of IPO studies and his overemphasis on dividend capacity given ADDI&C’s history. Weighing expert opinions and relevant factors, the court determined a $19 million lack-of-marketability discount (excluding built-in gains tax), resulting in a total lack-of-marketability discount of $28 million (including the $9 million for built-in gains tax).

    Practical Implications

    Davis clarifies that built-in capital gains tax is a relevant factor in valuing closely held stock even when liquidation is not planned. It emphasizes that the hypothetical willing buyer and seller would consider this potential future tax liability, impacting marketability. This case supports the inclusion of a discount for built-in capital gains tax, particularly as part of the lack-of-marketability discount, in estate and gift tax valuations of closely held investment companies. It highlights the importance of expert testimony in valuation cases and the court’s discretion in weighing different valuation methods and expert opinions. Subsequent cases will likely cite Davis to support discounts for built-in capital gains tax even in the absence of imminent liquidation, focusing on the impact on marketability and the hypothetical buyer-seller perspective. This case reinforces that valuation is fact-specific and requires a holistic analysis considering all relevant discounts and adjustments.

  • Estate of Henrietta E. Holmquist, 1954 Tax Court Memo LEXIS 295: Valuing Closely Held Stock & Identifying Previously Taxed Property

    Estate of Henrietta E. Holmquist, 1954 Tax Court Memo LEXIS 295

    The fair market value of shares in a closely held corporation for estate tax purposes is not simply the liquidating value of the assets, and previously taxed property can be identified even when commingled in a bank account, provided withdrawals do not exceed subsequent deposits of non-previously taxed funds.

    Summary

    The Tax Court addressed two issues: the valuation of stock in a closely held corporation, Heberlein Patent Corporation, and whether certain funds in the decedent’s bank account could be identified as previously taxed property. The court held that the fair market value of the stock was $25 per share, not the IRS’s calculated $41.84 based on asset liquidation value. The court also ruled that $8,640 in the decedent’s bank account was identifiable as previously taxed property, as withdrawals never exceeded initial balances plus subsequent deposits of non-previously taxed funds. This allowed a deduction from the gross estate.

    Facts

    Henrietta Holmquist died owning shares of Heberlein Patent Corporation, a company exploiting textile patents. The company’s earnings had declined. The corporation held a portfolio of publicly traded securities. Holmquist also had a bank account containing funds that included principal payments from a note inherited from her deceased husband’s estate, who died within five years of her death. The IRS and the estate disagreed on the value of the Heberlein shares and whether the funds in the bank account qualified as previously taxed property for estate tax deduction purposes.

    Procedural History

    The case originated in the Tax Court of the United States, where the Estate of Henrietta E. Holmquist petitioned for a redetermination of estate tax deficiency assessed by the Commissioner of Internal Revenue. The Commissioner argued for a higher valuation of the stock and denied the previously taxed property deduction. The Tax Court reviewed the evidence and arguments presented by both parties.

    Issue(s)

    1. Whether the Commissioner properly valued the stock of Heberlein Patent Corporation at $41.84 per share for estate tax purposes.

    2. Whether the petitioner can deduct $8,460 from the decedent’s gross estate under Section 812(c) of the Internal Revenue Code as previously taxed property.

    Holding

    1. No, because the fair market value should consider factors beyond the liquidation value of the company’s assets, and the evidence, including a recent sale, indicated a lower value.

    2. Yes, because the previously taxed cash was identifiable, as withdrawals from the bank account did not exceed the sum of the balance at the time of her husband’s death plus deposits from sources other than previously taxed cash.

    Court’s Reasoning

    Regarding the stock valuation, the court rejected the IRS’s reliance on the corporation’s liquidation value, noting, “But it is obvious that this figure, which would be the liquidating value of the Heberlein Corporation under ideal circumstances and without cost, can not be said to be the fair market value of that corporation’s shares.” The court emphasized that the decedent’s shares didn’t provide control and the company wasn’t contemplating liquidation. The court found a sale of 100 shares at $25 per share a few months after the valuation date to be a more reliable indicator of fair market value. For the previously taxed property issue, the court relied on precedents like John D. Ankeny, Executor, 9 B. T. A. 1302 and Frances Brawner, Executrix, 15 B. T. A. 1122, stating that “the commingling in a common bank account of previously taxed cash with non-previously taxed cash does not necessarily make the previously taxed cash unidentifiable.” The court distinguished Rodenbough v. United States, noting its rejection by the Tax Court and limited application elsewhere.

    Practical Implications

    This case provides guidance on valuing closely held stock for estate tax purposes, emphasizing that liquidation value is not the sole determinant of fair market value. Other factors, such as lack of control, the company’s financial performance, and actual sales data, must be considered. The case also clarifies the rules for tracing previously taxed property in commingled bank accounts. Attorneys can use this case to argue for lower valuations of closely held stock and to support deductions for previously taxed property where proper tracing is possible. It reinforces the principle that the IRS’s valuation methods must be grounded in real-world economic conditions and that taxpayers can overcome presumptions against identification of commingled funds by demonstrating sufficient tracing.