SCOTUS Reports

Tag: lack-of-marketability discount

  • Estate of Davis v. Commissioner, 110 T.C. 530 (1998): When Built-in Capital Gains Tax Impacts Stock Valuation

    Estate of Artemus D. Davis, Deceased, Robert D. Davis, Personal Representative v. Commissioner of Internal Revenue, 110 T. C. 530 (1998)

    A built-in capital gains tax should be considered in determining the fair market value of stock, even if no liquidation is contemplated, as part of the lack-of-marketability discount.

    Summary

    In Estate of Davis v. Commissioner, the Tax Court addressed the valuation of two blocks of stock in a closely held investment company, ADDI&C, given as gifts by Artemus D. Davis to his sons. The key issue was whether to apply a discount for the built-in capital gains tax when calculating the stock’s fair market value, given that no liquidation was planned. The court ruled that, despite no planned liquidation, a discount for the built-in capital gains tax was warranted as part of the lack-of-marketability discount, as it would impact the hypothetical willing buyer and seller’s agreement on the stock’s price. The court determined the fair market value of each block of stock to be $10,338,725, reflecting a minority and lack-of-marketability discount, including $9 million attributed to the built-in capital gains tax.

    Facts

    On November 2, 1992, Artemus D. Davis, a founder of Winn-Dixie Stores, gifted two blocks of 25 shares each of ADDI&C common stock to his sons, Robert and Lee Davis. ADDI&C was a closely held Florida corporation, primarily a holding company for various assets, including a significant holding in Winn-Dixie stock. Each block represented 25. 77% of ADDI&C’s issued and outstanding stock. The valuation of these blocks was contested, with the estate arguing for a discount due to the built-in capital gains tax on ADDI&C’s assets, while the Commissioner argued against such a discount.

    Procedural History

    The estate filed a Federal gift tax return in 1993, valuing each block of stock at $7,444,250. The Commissioner issued a notice of deficiency, asserting a higher valuation of $12,046,975 per block. The estate petitioned the U. S. Tax Court for a redetermination of the deficiency, modifying its position to value each block at $6,904,886, while the Commissioner also modified its position to $13,518,500 per block. The Tax Court, after considering expert testimony and evidence, issued its decision on June 30, 1998.

    Issue(s)

    1. 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 each block of ADDI&C stock on the valuation date?

    2. If such a discount is warranted, should it be applied as a reduction to ADDI&C’s net asset value before applying minority and lack-of-marketability discounts, or should it be included as part of the lack-of-marketability discount?

    Holding

    1. Yes, because a hypothetical willing buyer and seller would consider the built-in capital gains tax in negotiating the price of the stock, even though no liquidation was planned.

    2. No, because the full amount of the built-in capital gains tax should not be applied as a direct reduction to ADDI&C’s net asset value; instead, it should be included as part of the lack-of-marketability discount.

    Court’s Reasoning

    The Tax Court applied the willing buyer and willing seller standard for determining fair market value, emphasizing that both parties would consider the built-in capital gains tax in their negotiations, even without a planned liquidation. The court rejected the Commissioner’s argument that such a tax could be avoided through tax planning, such as converting ADDI&C to an S corporation, as this was considered unlikely. The court also found that the full amount of the built-in capital gains tax should not be deducted directly from ADDI&C’s net asset value, as this approach would not reflect the market’s perception of the stock’s value. Instead, the court agreed with experts from both sides that a portion of the built-in capital gains tax should be included as part of the lack-of-marketability discount, reflecting the reduced marketability of the stock due to this tax liability. The court ultimately determined a $9 million portion of the lack-of-marketability discount should be attributed to the built-in capital gains tax.

    Practical Implications

    This decision has significant implications for the valuation of closely held stock, particularly in cases where built-in capital gains tax is a factor. It establishes that such a tax should be considered in determining fair market value, even absent a planned liquidation, by including it in the lack-of-marketability discount. This ruling affects how similar cases should be analyzed, requiring appraisers and courts to consider the impact of built-in capital gains tax on stock valuation. It also influences legal practice by emphasizing the importance of expert testimony and market-based approaches in valuation disputes. For businesses, this decision may affect estate planning and gift tax strategies involving closely held stock. Subsequent cases have applied this ruling, further solidifying its impact on tax and valuation law.

  • 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 Young v. Commissioner, 110 T.C. 297 (1998): Valuation of Joint Tenancy Property for Federal Estate Tax Purposes

    Estate of Young v. Commissioner, 110 T. C. 297 (1998)

    Joint tenancy property must be valued at its full value less any contribution by the surviving joint tenant for Federal estate tax purposes, and fractional interest and lack of marketability discounts are inapplicable.

    Summary

    The Estate of Wayne-Chi Young contested the IRS’s valuation of jointly held real property in California for estate tax purposes. The estate argued for a 15% fractional interest discount, citing Propstra v. United States. The Tax Court held that the property was held in joint tenancy, not community property, and thus subject to the valuation rules of IRC section 2040(a). The court rejected the estate’s attempt to apply fractional interest and lack of marketability discounts to joint tenancy property, affirming the full inclusion of the property’s value in the estate minus any contribution by the surviving spouse. Additionally, the estate was liable for a late filing penalty under IRC section 6651(a).

    Facts

    Wayne-Chi Young and his wife Tsai-Hsiu Hsu Yang owned five properties in California as joint tenants. After Young’s death, the estate filed a Federal estate tax return claiming the properties were community property and applying a 15% fractional interest discount. The IRS determined the properties were held in joint tenancy and disallowed the discount. The estate obtained a state court decree stating the properties were community property, but the IRS was not a party to that proceeding.

    Procedural History

    The estate filed a Federal estate tax return and later filed a petition with the U. S. Tax Court after the IRS disallowed the claimed discount and assessed a deficiency. The Tax Court heard the case and issued its opinion on May 11, 1998.

    Issue(s)

    1. Whether the properties were held as joint tenancy or community property under California law.
    2. Whether a fractional interest discount or a lack of marketability discount is applicable to the valuation of the joint tenancy property.
    3. Whether the estate is liable for the addition to tax for late filing under IRC section 6651(a).

    Holding

    1. No, because the estate failed to overcome the presumption of joint tenancy created by the deeds and the state court decree was not binding on the Tax Court.
    2. No, because IRC section 2040(a) provides a specific method for valuing joint tenancy property that does not allow for fractional interest or lack of marketability discounts.
    3. Yes, because the estate did not show reasonable cause for the late filing.

    Court’s Reasoning

    The court applied California law to determine the nature of the property interest, finding that the deeds created a rebuttable presumption of joint tenancy that the estate failed to overcome. The court held that the state court decree was not binding because the IRS was not a party to the proceeding. For valuation, the court interpreted IRC section 2040(a) as requiring the full inclusion of joint tenancy property in the estate, less any contribution by the surviving spouse, and found that Congress intended this to be an artificial inclusion that did not allow for further discounts. The court rejected the estate’s reliance on Propstra, which dealt with community property, as inapplicable to joint tenancy. The late filing penalty was upheld because the estate did not show reasonable cause, and the executor’s reliance on the accountant’s advice was not sufficient to avoid the penalty.

    Practical Implications

    This decision clarifies that joint tenancy property must be valued at its full value for estate tax purposes, minus any contribution by the surviving tenant, without applying fractional interest or lack of marketability discounts. Practitioners should advise clients that joint tenancy property will be valued differently than community or tenancy-in-common property for estate tax purposes. The ruling also emphasizes the importance of timely filing estate tax returns, as reliance on an accountant’s advice without further inquiry may not constitute reasonable cause to avoid penalties. Subsequent cases have followed this approach in valuing joint tenancy property, and it remains a key precedent in estate tax valuation disputes.