Tax Court holds that the discount for the tax on built-in gains should take into account both future appreciation on property and the present value discount for the projected capital gains tax

In Estate of Jensen v. Comm'r, T.C. Memo 2010-182 (Aug. 10, 2010), the question before the Tax Court was how to determine the discount for the built-in capital gains tax for property owned by a C corporation. Both the taxpayer and the Internal Revenue Service agreed that a discount for built-in capital gains was appropriate because a willing buyer would consider the built-in capital gains liability and demand a discounted purchase price. See Treasury Regulations Section 20.2031-1(b) (estate tax valuation is determined by a willing buyer/willing seller analysis). The taxpayer and the IRS, however, disagreed about the amount of the discount and how it should be calculated. Rejecting the approaches of both the taxpayer and the IRS, the Tax Court formulated its own methodology for determining the appropriate discount for built-in-capital gains: The discount for such future tax liability should be calculated by taking into account both future appreciation on the property and a present value discount for the projected capital gains tax.

The estate of Marie Jensen owned an 82 percent interest in Wa-Klo, a closely held C corporation, the principal asset of which was a 94-acre waterfront parcel of real estate that had appreciated significantly. The estate's appraiser calculated the tax on the gain that would be recognized currently to be $965,000.1 The appraiser then subtracted the built-in capital gains tax (a dollar-for-dollar discount) from the net asset value. The estate's interest was equal to 82 percent of the reduced net asset value (a pro rata share), subject to a further discount for lack of marketability.

On audit, the IRS determined that the appropriate discount for the built-in capital gains tax was $250,042, causing a deficiency of $334,245. The IRS' expert determined the discount by studying how the built-in capital gains in six closed-end funds, some of which held primarily real estate investments, affected their net asset values. The IRS' expert concluded that there was no correlation between capital gains tax liability and net asset value discounts where the capital gains liability was less than 41.5 percent of the net asset value. Therefore, a discount was justified only if more than 41.5 percent of the net asset value was subject to capital gains tax. In the Jensen estate, 66 percent of Wa-Klo would be subject to capital gains tax upon a sale, so the IRS multiplied 24.5 percent (the percentage in excess of 41.5 percent) by the net asset value of Wa-Klo and then used a combined federal and state tax rate of 40 percent. The result was a combined tax liability of 9.8 percent that, when rounded up to the nearest percentage point, led to a discount of 10 percent. Later, some adjustments to the net asset value were made that resulted in raising the discount to 13 percent.

The Tax Court didn't agree with either the estate's or the IRS' method. The estate argued for a dollar-for-dollar discount based on Estate of Jelke v. Comm'r, 507 F.3d 1317 (11th Cir. 2007) and Estate of Dunn v. Comm'r, 301 F.3d 339 (5th Cir. 2002). However, the Tax Court noted that the U.S. Court of Appeals for the Second Circuit, to which this case could be appealed, hadn't ruled on the matter and therefore determined its own method. In analyzing the IRS' method, the Tax Court concluded that the IRS' reliance on closed-end funds was misplaced because the funds' values are often attributable to supply and demand and manager performance, none of which would be relevant to the real estate owned by Wa-Klo. Moreover, closed-end funds that invest in real estate generally invest in a diversified portfolio of commercial real estate that wasn't similar to the property here.

Instead, the Tax Court reasoned that a willing buyer would account for the likelihood that the assets would appreciate further. So the Tax Court calculated a future value (in 17 years, based on the average useful or depreciable life of real estate being 16.6 years) of the land and improvements using appreciation rates of 5 percent and 7.725 percent, respectively, which were based on the estate's appraiser's estimates. The Tax Court calculated the long-term capital gains tax using a combined federal and state tax rate of 40 percent and then discounted the value of the tax to its present value, using the same rates of 5 percent and 7.725 percent. The resulting discount was slightly higher than the estate's calculation, so the Tax Court upheld the estate's discount. Interestingly, even though the Tax Court used a more complicated method, its ruling essentially results in a dollar-for-dollar discount because the rates used for the appreciation and the present value discount were the same. In light of the foregoing, for clients who aren't in the Eleventh or Fifth Circuits, appraisers should consider addressing the Tax Court's approach, along with a dollar-for-dollar discount for built-in capital gains.

Endnote

  1. In its brief, the estate adjusted its estimate for the tax on the built-in gain upwards to $1,133,283, but the reason for the adjustment isn't explained in the opinion.