One of the questions that practitioners ponder is how to properly discount the value of stock in a closely held C corporation to reflect the future income tax liability on the corporation's unrealized built-in gains (BIGs). For transfer-tax purposes, this is known as the built-in gain discount (the “BIG discount”).
The proper computation of the BIG discount has perplexed courts and practitioners alike. Many had hoped that the Supreme Court would solve the mystery. But, on Oct. 6, 2008, the High Court denied the Internal Revenue Service Commissioner's petition for writ of certiorari in Estate of Jelke,1 a case that raised this very question. Perhaps the Supremes found the task of traversing this BIG unknown as daunting as lower courts have. Regardless, practitioners are now left to choose among conflicting precedent in navigating the uncertainty.
In the midst of this ambiguity, a few things are clear. Taxpayers subject to jurisdiction in the U.S. Court of Appeals for the Fifth or Eleventh Circuit can use a taxpayer-friendly “dollar-for-dollar” approach. Those in the Second Circuit, and probably those in the Sixth Circuit, will be forced to use a “present value” approach favored by the IRS. And all other taxpayers should be forewarned that if they venture outside the safety of a present value approach, they may be stepping into a costly battle with the IRS.
The BIG Discount
The BIG discount is the transfer tax valuation discount to be applied to stock in a closely held C corporation to account for the future tax liability on the unrealized BIGs in the corporation's underlying assets. The need for the discount arises from the fact that when a corporation sells any of its appreciated assets, the tax liability attributable to the gain recognition will be indirectly borne by the shareholders who own stock at the time the gain is recognized. If any of this appreciation is attributable to the period before the shareholder acquired the stock, the acquiring shareholder would bear the burden of the liability for income tax attributable to the previous shareholder's accession to wealth.
This result would be economically unfair to the acquiring shareholder. As the price the acquiring shareholder pays for the stock already reflects the appreciation in the corporation's assets, the acquiring shareholder would be forced to shoulder the economic brunt of the tax without a corresponding economic gain. Thus, whether done implicitly in the market or explicitly in private bargaining, both the acquiring and the previous shareholder must reallocate the incidence of this tax liability. They will discount the value of the stock to reflect the future tax liability that will be attributable to appreciation accrued during the period of the previous shareholder's ownership.
This reallocation of tax burdens between market participants makes its way into the transfer tax world via the “willing buyer and willing seller” test of fair market value (FMV) articulated by the estate and gift tax regulations.2 Because a hypothetical willing buyer and hypothetical willing seller would take into consideration the allocation of tax liability arising from a corporation's recognition of lurking BIGs, so too must estates and donors. Although the need to apply a BIG discount seems clear enough in theory, its practical application may be more onerous, at least when stock in certain closely held corporations is at issue.
The relative ease or difficulty with which the BIG discount can be determined is in large part a function of the valuation technique applied to the particular corporation in question. When a corporation can be valued under either an income or a market approach, the BIG discount is accounted for quite easily. Under an income approach, which determines a corporation's value by discounting to present value the stream of income the corporation is expected to produce, the BIG discount is implicit in the valuation, as the present value income stream is calculated on a net income (after tax) basis. Similarly, under a market approach, which determines a corporation's value by comparison to market sales of comparable entities, any BIG discount would be implicit in the market valuation as the actual willing buyer in the comparable sale would have already accounted for the future tax liability. Transfer tax valuation need not speculate about what course of action hypothetical parties might select when actual parties already have acted.
But when neither the income nor market approach is appropriate — as often happens with closely held corporations, particularly corporations that lack major operating components — a net asset value approach must be used. And under this approach, a corporation's value is determined by subtracting the corporation's liabilities from the FMV of its assets. Thus, it is appropriate to subtract some figure from the FMV of the corporation's assets on account of the tax liability that the corporation will incur upon recognition of the BIGs in those assets.
But determining whether a BIG discount is appropriate is the simple part. The significantly more complex question is how much of a discount should be applied.
Taxpayers are inclined to argue for a so-called “dollar-for-dollar” approach. This approach assumes that on the relevant valuation date, all of a corporation's BIGs are immediately recognized. Immediate gain (and presumably loss) recognition is premised on a hypothetical liquidation of all the corporation's assets. Because the BIGs are triggered immediately, the discount would reflect the entire tax liability that would be currently payable. This taxpayer-friendly method provides simplicity and absoluteness in the computation. But it's based on an admittedly arbitrary and sometimes erroneous assumption. Nevertheless, the Fifth and Eleventh Circuits have embraced it.
On the other hand, the IRS Commissioner has taken the position that the future tax liability must be discounted under a present value approach. Because the tax liability on the BIG will not be payable until gain is actually recognized, the discount should reflect that this liability will not be incurred until some point in the future. Although this approach may be more accurate than the dollar-for-dollar approach, it's also more complex. It requires courts to make factual findings comparing rates of return, determining turnover rates of the corporation's assets, and selecting present value discount rates. Such tasks are certainly within the capacity of courts, and the parties may even stipulate these values.
But even once these values are determined, questions persist as to how to calculate the BIG discount.
For example, though the BIG in a particular asset on the valuation can be computed quite easily — it's the asset's FMV less the corporation's adjusted basis in the asset — the BIG is not a constant. Once one concedes that the tax liability on a corporate BIG is a future liability, one must consider that the BIG may vary over time. For every dollar that the asset appreciates, the BIG will increase correspondingly, and depreciation may complicate matters even further. At the same time, because a dollar today is worth more than a dollar tomorrow, some adjustment may be required to account for the fact that the corporation will pay the future liability with future dollars. Additionally, the timing of gain recognition may be influenced by whether a shareholder owns sufficient voting control to effectuate corporate action.3
Finding a rule of law that can assemble these moving puzzle pieces has been a challenge for judges, particularly outside of the Tax Court. Courts have shown notable reluctance to wade through the complex mathematics necessary to reduce factually determined values into bottom-line discounts. The challenges associated with the proper computation of the BIG discount have left the issue often untouched and certainly unresolved.
Determining the BIG discount has not always been so complex. Before the 1986 repeal of the General Utilities doctrine, determining the BIG discount was straight forward. Courts were nearly unanimous in their treatment of BIGs: they denied the BIG discount altogether.
The simplicity lay in the General Utilities doctrine. Under this doctrine, a corporation recognized no gain or loss on the distribution of corporate property to shareholders with respect to their stock. The doctrine was first recognized in General Utilities & Operating Co. v. Helvering,4 when the Supreme Court held that distribution of corporate property as a dividend in kind did not constitute a sale or exchange because it was not being used to discharge corporate indebtedness. Thus, no gain or loss recognition was required on distribution. This non-recognition principle was later incorporated into the Internal Revenue Code under Sections 311, 336 and 337.5
Prior to the repeal of the General Utilities doctrine, when courts faced the question of whether a BIG discount should be permitted, the relevant inquiry lay in a “liquidation” analysis. In cases such as Estate of Piper v. Comm'r6 and Estate of Andrews v. Comm'r,7 courts considered “liquidation” from two perspectives. First, they examined whether a corporation had any plans to “liquidate,” meaning to sell, its underlying assets. If no such plans existed, then no foreseeable gain recognition would merit a BIG discount.
But courts also looked beyond a corporation's foreseeable gain recognition and predicted the future tax consequences of the corporation's BIGs. The second inquiry became the effect of a corporate “liquidation,” meaning an eventual winding up of the corporation's affairs. With the General Utilities doctrine in place, it was a foregone conclusion that tax liability on a corporation's BIGs could be completely avoided. A mere distribution in kind would wipe out the lurking BIG and any potential tax liability. The fact that BIGs could be eliminated in this manner led courts to repeatedly deny the BIG discount.8
Although the transfer tax treatment of BIGs under the General Utilities doctrine was well-settled, in the late 1970s and early 1980s, the doctrine's income tax consequences were becoming increasingly controversial. The income tax avoidance techniques blessed by the General Utilities doctrine eventually led to its demise. The doctrine was slowly eroded, and by 1986, Congress accomplished a full repeal of the General Utilities doctrine with amendments under IRC Sections 311 and 336.9
The repeal of the General Utilities doctrine meant that C corporations would recognize gain on distributions of corporate property to shareholders with respect to their stock. Because a corporation could no longer simply avoid income tax on its BIGs by distributing its assets, the outcome of the second inquiry under the courts' “liquidation” analysis would have to change. Nonetheless, it took courts some time to realize how the repeal of the General Utilities doctrine would require a shift in the analysis of the BIG discount — a shift that would eventually lead to the BIG unknown.
In part on account of courts' failure to recognize the importance of the General Utilities repeal and in part on account of a lack of docketed cases that would lend themselves to such recognition,10 it took over a decade from the 1986 repeal of the General Utilities doctrine for courts to give due acknowledgment to this new quandary. The two cases that first addressed the issue, and helped to create the current ambiguity, were Eisenberg v. Comm'r11 and Estate of Davis v. Comm'r.12
In Eisenberg, the Tax Court first grappled with the issue, placing significant weight on the historical denials of the BIG discount, albeit such denials had come during the General Utilities era. The IRS Commissioner argued that despite the repeal of General Utilities, alternative tax deferral and avoidance techniques, such as a transfer under a corporate non-recognition provision or an election of subchapter S status under IRC Section 1362(a), still could be used to avoid gain recognition. In his Tax Court memorandum opinion, Judge Lapsley W. Hamblen, Jr., agreed and denied any BIG discount.
But the same issue arose just one year later. This time, Judge Carolyn P. Chiechi of the Tax Court took a different approach. In Davis,13 the court considered the second inquiry established under the cases decided during the General Utilities era: specifically, whether gain recognition could be completely avoided through in-kind distribution of a corporation's assets. The Tax Court acknowledged the possibility of an IRC Section 1362(a) subchapter S election. But the court found that the 10-year waiting period required to avoid corporate-level recognition of pre-election BIGs, coupled with the fact that IRC Section 1361(b)(1)(A) restricts the number of permissible shareholders in an S corporation (to 35 at the time of Davis), would make the IRC Section 1362(a) election unattractive. Only a strategic buyer — not a hypothetical one — would pursue such an option. The Tax Court thus issued a groundbreaking opinion in Davis, establishing that a BIG discount should be applied in valuing stock in a closely held C corporation.
Permitting a BIG discount was quite a different matter from actually determining the extent of that discount. The Tax Court in Davis confronted this new problem. It returned in principle to the cases addressing the issue prior to the General Utilities repeal. Because the corporation being valued in Davis was not contemplating a sale of its underlying assets, the Tax Court held that a dollar-for-dollar discount was inappropriate. Instead, the court recognized that the liability would be incurred at some point in the future. But the Tax Court's analysis ended there, and it simply selected a discount between the two discounts the respective expert witnesses had proposed.
The Tax Court's opinion in Davis offered a timely resolution for the U.S. Court of Appeals for the Second Circuit to consider, as it had just heard oral arguments on the taxpayer's appeal of the lower Eisenberg decision. In light of the Tax Court's blessing of the BIG discount in Davis, the Second Circuit followed suit and vacated the Tax Court's previous opinion in Eisenberg, which had denied the BIG discount. The Second Circuit recognized the significance of the General Utilities repeal. Just as the Tax Court had done in Davis, the Second Circuit dismissed gain deferral and avoidance techniques that would obviate the need for a BIG discount. The Second Circuit also encountered the issue of how large of a discount to permit. But rather than confront this challenge head on, the court remanded the case, instructing that a discount less than the full dollar-for-dollar amount would be appropriate.
With the Tax Court and the Second Circuit in agreement that the dollar-for-dollar approach provided too large of a discount, it looked, at least for a time, that the present value approach might yield a resolution. Indeed, when the Sixth Circuit faced the issue,14 it rendered an unpublished opinion endorsing the ruling in Eisenberg.
But in 2001, when the issue arose in the Fifth Circuit, the court declined to follow Davis and Eisenberg, and again in 2002, the Fifth Circuit embraced the more taxpayer-friendly resolution. First, in Estate of Jameson v. Comm'r,15 the Fifth Circuit overruled the present value calculation of the BIG discount the Tax Court had allowed, requiring instead a dollar-for-dollar discount. The Fifth Circuit relied on proffered evidence concerning rates of return in the corporation's underlying assets vis-à-vis the return that the market would provide for an investment of similar risk and duration. The corporation's asset produced a 14 percent rate of return and the market would have produced a 20 percent rate of return. Therefore, the court held that a hypothetical willing buyer would liquidate the corporation's assets immediately upon acquisition of the stock to reinvest the proceeds at the higher market rate of return. The tax liability on the corporation's BIGs would be triggered immediately, and the immediate gain recognition would require a dollar-for-dollar discount.
Two years later, in Estate of Dunn v. Comm'r,16 the Fifth Circuit took the dollar-for-dollar approach one step further. Rather than rely on a factual inquiry into comparative rates of return as it had done in Jameson, the Fifth Circuit in Dunn held that the dollar-for-dollar discount was required as a matter of law. It ruled that an inquiry into a hypothetical willing buyer's incentive to liquidate was inappropriate; instead, liquidation of all the corporation's assets on the valuation date must be presumed. Thus, as the Dunn Court held, the dollar-for-dollar discount would always be the appropriate result.
Most recently, the dollar-for-dollar approach has spread to the Eleventh Circuit, where the court has sided with the Fifth Circuit. In Estate of Jelke v. Comm'r,17 the IRS Commissioner successfully convinced the Tax Court to adopt a present value approach. The Tax Court paid due regard to Jameson and Dunn, but, invoking the Golsen rule, asserted that Fifth Circuit precedent need not be followed, as an appeal by the Florida taxpayer would lie outside that court's jurisdiction. The Tax Court relied instead on Eisenberg and its still-valid Davis opinion to rule that the dollar-for-dollar approach was not required.
But the Eleventh Circuit reversed the Tax Court.18 Citing Dunn with express approval, the court adopted the “arbitrary assumption” that a hypothetical liquidation occur on the valuation date. The Eleventh Circuit favored this bright-line test, admitting that despite its “simplistic” and “dogmatic” nature, its clear resolution of the issue avoided entanglement in unnecessary complexity. Thus, the court granted a dollar-for-dollar discount.
The majority opinion did not sit well with Judge Edward Carnes, one of the Eleventh Circuit judges who heard the Jelke appeal. His biting dissent urged that resolving such complexities is the very end for which courts exist, and judges ought not shrink at the prospect of confronting a challenging issue. Judge Carnes cautioned that the “ignoble ease” the majority exhibited in selecting the expedient solution over the correct one would create a dangerous precedent.
Still, Judge Carnes' concern and the split among the circuits were insufficient to prompt Supreme Court review of the Jelke decision. The Court denied the IRS Commissioner's petition for writ of certiorari and has left practitioners wondering where we go from here.19
Proceed with Caution
In light of the split among the circuits and the Supreme Court's unwillingness to provide a resolution, how should practitioners proceed? One point is certainly clear: practitioners should not infer from the Supreme Court's readiness to let Jelke stand that the dollar-for-dollar approach will become widely accepted as well-settled law. If anything should be taken from Jelke, it is that the IRS Commissioner's petition for certiorari manifests an intention to continue fighting this issue. And the IRS Commissioner's pleas are well received in Tax Court, which has yet to allow a dollar-for-dollar discount and expressly stated its unwillingness to apply Jameson and Dunn to cases outside the Fifth Circuit's jurisdiction.
So while taxpayers in the Fifth and Eleventh Circuits can take refuge in the dollar-for-dollar approach, taxpayers in other jurisdictions should be wary. The Second Circuit, and likely the Sixth, will require taxpayers to use a present value approach in computing the BIG discount. Meanwhile, the state of the law in other jurisdictions is uncharted.
Certainly, any taxpayer claiming a dollar-for-dollar discount outside the Fifth and Eleventh Circuits must be prepared for a lengthy — and costly — fight. If jurisdiction in the first instance will lie in Tax Court, taxpayers claiming a dollar-for-dollar discount would be well-advised to anticipate an appeal to the circuit in which they reside, as the Tax Court will almost certainly deny a dollar-for-dollar discount. Moreover, taxpayers must keep in mind that in light of the complex mathematics involved, litigation over the BIG discount is highly expert intensive, raising litigation costs significantly. Taxpayers should exercise particular care in selecting an appraiser.
In the end, even those taxpayers with the fortitude and fortune required to pursue a dollar-for-dollar discount still may find themselves on the losing end of the battle. Although the arguments for judicial efficiency embraced by the Eleventh Circuit may resonate with its sister courts, taxpayers must overcome what is an admittedly arbitrary approach.
Instead, the arguably more accurate approach, and one that other courts will likely follow, is to employ some form of present value calculation. Of course, this will mean wading through complex computations that must take into account myriad variables to arrive at an equitable solution. Even if courts shy from this challenge, rough justice may yield a splitting of the difference between expert witnesses. And while we can make educated guesses that other circuits may find the Tax Court's approach and Judge Carnes' dissent more compelling, only one thing is truly certain: The future of the BIG discount remains unknown.
- Commissioner v. Estate of Jelke, 77 U.S.L.W. 3197 (2008).
- Treasury Regulations Sections 20.2031-1(b) and 25.2512-1.
- For a discussion of how to account for such concerns, see Scott Andrew Bowman, “Built-in Gain Discounts for Transfer Tax Valuation: A Resolution for the BIG Debate,” 24 Akron Tax J. __ (forthcoming 2009).
- General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935).
- See Internal Revenue Act of 1954, Pub. L. No. 83-591, 68A Stat. 3, 94-95, 106-107.
- Estate of Piper v. Comm'r, 72 T.C. 1062 (1979), superseded by statute, Tax Reform Act of 1986, Pub. L. No. 99-514 Section 631, 100 Stat. 2085, as recognized in Eisenberg v. Comm'r, 155 F.3d 50 (2d Cir. 1998).
- Estate of Andrews v. Comm'r, 79 T.C. 938 (1983), superseded by statute, Tax Reform Act of 1986, Pub. L. No. 99-514 Section 631, 100 Stat. 2085, as recognized in Eisenberg, supra note 6.
- See Andrews, supra note 7; Piper, supra note 6; Gallun v. Comm'r, 33 T.C.M. 1316 (1974), superseded by statute, Tax Reform Act of 1986, Pub. L. No. 99-514 Section 631, 100 Stat. 2085, as recognized in Eisenberg, supra note 6; Estate of Cruikshank v. Comm'r, 9 T.C. 162 (1947), superseded by statute, Tax Reform Act of 1986, Pub. L. No. 99-514 Section 631, 100 Stat. 2085, as recognized in Eisenberg, supra note 6; but see Clark v. United States, 36 A.F.T.R. 2d 75-6417 (E.D.N.C. 1975) (allowing BIG discount); Obermer v. United States, 238 F. Supp. 29, 35-36 (D. Haw. 1964) (same).
- Tax Reform Act of 1986, Pub. L. No. 99-514, Section 631, 100 Stat. 2085.
- See Gray v. Comm'r, 73 T.C.M. (CCH) 1940 (1997); Estate of Luton v. Comm'r, 68 T.C.M. (CCH) 1044 (1994).
- Eisenberg v. Comm'r, supra note 6, rev'g 74 T.C.M. (CCH) 1046 (1997).
- Estate of Davis v. Comm'r, 110 T.C. 530 (1998).
- Estate of Welch v. Comm'r, 208 F.3d 213 (6th Cir. 2000) (unpublished table decision).
- Estate of Jameson v. Comm'r, 267 F.3d 366 (5th Cir. 2001), rev'g 77 T.C.M. (CCH) 1383 (1999).
- Estate of Dunn v. Comm'r, 301 F.3d 339 (5th Cir. 2002), rev'g 79 T.C.M. (CCH) 1337 (2000).
- Estate of Jelke v. Comm'r, 89 T.C.M. (CCH) 1397 (2005).
- Estate of Jelke v. Comm'r, 507 F.3d 1317 (11th Cir. 2007), rev'g 89 T.C.M. (CCH) 1397 (2005).
- Comm'r v. Estate of Jelke, supra note 1.
Scott Andrew Bowman is an associate at Withers Bergman LLP in New Haven, Conn.