Nov 4, 2010 12:24 PM

The valuation profession and Internal Revenue Service have been at odds for over 20 years regarding the impact of capital gains tax liabilities on the value of privately held companies that hold appreciated assets. This dispute has had its fair share of skirmishes that have made their way to the U.S. Tax Court and beyond. Slowly but surely, arguments for recognition of these contingent liabilities have begun to resonate with the IRS and judiciary. The origins of this dispute date back to the Tax Reform Act of 1986 (TRA 1986) and the repeal of the General Utilities doctrine.1

Doctrine Repeal

Prior to 1986, corporations could avoid recognition of capital gains taxes on appreciated assets if they distributed those assets directly to their shareholders. The shareholders recognized the receipt of the distributed assets on their personal tax returns at fair market value (FMV) and paid taxes accordingly. In addition, shareholders received a step-up in tax basis of the distributed assets to FMV, which mitigated capital gains taxes on subsequent sales of those same assets. This tax treatment is referred to as the General Utilities doctrine.

TRA 1986 repealed the General Utilities doctrine by requiring corporations to recognize gains on distributions of appreciated assets to shareholders. Essentially, TRA 1986 requires corporations to treat asset distributions as a sale of property and to recognize the appreciated value of the asset as a corporate level gain subject to corporate income taxes. Consequently, this tax treatment created corporate level tax liabilities for corporations that hold appreciated assets. This tax liability is referred to as the built-in gains (BIG) tax liability.

BIG Tax Liability

The capital gains tax provisions of TRA 1986 did little to affect the value of companies that principally employ operational assets (for example, machinery, equipment, workforce) to create an investment return for their shareholders. These operational companies are not in the business of buying, holding and selling assets to produce an investment return. Therefore, the BIG tax liability is typically not a significant factor for these types of companies.

TRA 1986 had an impact on the value of companies that operate as “asset holding companies” (that is, companies in the business of buying, holding and selling assets) or operational companies that hold non-operational assets (for example, marketable securities, vacant land). Consequently, many analysts began to reflect the BIG tax liability in their valuation of C corporations post-TRA 1986. (See

“Value Impact of the BIG Tax Liability,”  p. 48, which illustrates the thinking behind this valuation adjustment.)

As “Value Impact of the BIG Tax Liability” illustrates, a hypothetical willing buyer (HWB) has two po-tential investment alternatives: (1) purchase the stock of Old Corp, which holds assets with an FMV of $100,000 and a tax basis of $40,000, or (2) purchase the stock of New Corp, which holds assets with an FMV of $100,000 and a tax basis of $100,000.

If the HWB purchases the stock of Old Corp for $79,000 and then sells the assets, the transaction would be subject to corporate level gains taxes of $21,000 ($60,000 x 35 percent). If Old Corp dis-tributes the sale proceeds of $79,000 ($100,000 - $21,000) to its shareholders, the transaction proceeds would be equal to the tax basis of the stock and no capital gains taxes would be due. Consequently, the HWB would receive back his initial investment of $79,000.

Alternatively, if the HWB purchases the stock of New Corp for $100,000 and subsequently sells the assets for $100,000, the transaction wouldn’t be subject to corporate level capital gains taxes because the inside tax basis of the assets and the sale price are the same. If New Corp subsequently distributes the sale proceeds of $100,000 to its shareholders, the transaction proceeds would be equal to the tax basis of the stock and no capital gains tax would be due. Consequently, the HWB would receive back his initial investment of $100,000.

The two alternatives described in “Value Impact of the BIG Tax Liability” illustrate why the BIG tax liability is significant. Given the two alternatives discussed, the HWB would be unwilling to pay more than $79,000 for the stock of Old Corp even though the net asset value is $100,000. Consequently, the discount from the net asset value to reflect the BIG tax liability should be 21 percent ($21,000/$100,000).

Initially, the BIG argument didn’t resonate well with the IRS. Taxpayers and the IRS went back and forth on this issue for years prior to the Tax Court reaching decisions in Estate of Eisenberg v. Commissioner2 and Estate of Davis v. Comm’r.3 In Eisenberg, the Tax Court initially rejected the BIG tax liability adjustment; however, the U.S. Court of Appeals for the Second Circuit overturned that decision in 1999. After the Second Circuit decision, the IRS conceded that the BIG tax liability may be a relevant factor when valuing certain C corporations.

Today, analysts routinely consider the BIG tax liability when valuing relevant C corporations. The determination of when the adjustment is appropriate and how to estimate its magnitude can be con-troversial. The analysis can go from relatively simple to very complex depending on the following attributes, among others:

• Characteristics of the ownership interest being valued (for example, control/minority, pre-ferred/common, voting/non-voting, dividend preference);

• Nature of the subject company (for example, asset holding company, operational company, asset liquidation patterns);

• Nature of the assets (for example, operational, non-operational, income producing, tax basis, required rate of return);

• Valuation methods employed in the analysis (for example, asset approach, market approach, income approach).

Future Projections

In several relevant Tax Court decisions, analysts have estimated the BIG tax liability using the follow-ing analysis:

1. Estimate when the company will liquidate the subject assets.

2. Estimate the value of the subject assets as of the future liquidation date.

3. Estimate the capital gains tax obligation as of the future liquidation date and discount this number back to the present using the rate of return attributable to the subject assets. 

There are several problems with conducting the analysis in this manner, including:

• Estimating when a company will liquidate assets is typically a subjective exercise at best. Absent a repeatable pattern of asset liquidations or assertions by management, the determination of when the company will conduct future asset liquidations is difficult to determine with precision.

• Estimating the future value of an asset is a speculative exercise. Even if it were possible to determine the future value of an asset with precision, the exercise is probably not necessary. The future value of an asset discounted at the appropriate rate of return is equal to the value of the asset today. Consequently, the best indicator of the discounted future value of an asset is the value of that same asset today.

• If it were possible to estimate the future value of an asset with precision, it might also be possible to estimate the future BIG tax liability with precision. To determine the present value of the future BIG tax liability, it’s necessary to estimate and apply an appropriate discount rate. In several Tax Court cases, the analysis presented was based on a projected growth rate in the value of the asset to determine its future value. This future value was then used to determine the future BIG tax liability. A discount rate consistent with the required rate of return of the subject asset was then applied to determine the present value of the future BIG tax liability. This analysis is improper.

To demonstrate the problem discussed above, let’s assume the sole asset of a C corporation is a publicly traded stock that has an FMV of $100,000 and a tax basis of zero. Analysts expect this stock to increase in value by 5 percent per year over the next five years. The stock has a required rate of return of 15 percent. “Faulty Reasoning,” above, illustrates three potential analytical scenarios based on this fact pattern.

As column A illustrates, the BIG tax liability (that is, the corporate taxes on gain) as of the valuation date is $35,000 ($100,000 x 35 percent) and the BIG tax liability discount is 35 percent ($35,000/$100,000). No projections or present value analysis is necessary because the value of the stock and the BIG tax liability is valued as of the valuation date.

Column B illustrates an analysis whereby the value of the asset grows at 5 percent per year for a five-year period to a value of $127,628. Accordingly, the BIG tax liability also increases from $35,000 to $44,670 ($127,628 x 35 percent). The BIG tax liability is then discounted using the 15 percent required rate of return of the subject stock. This analysis concludes that the present value of the future BIG tax liability is $22,209 ($44,670 x 0.4972) and the BIG tax liability discount is 22.2 percent($22,209/$100,000). 

Column C demonstrates the same analysis as Column B

with the exception that the BIG tax liability is discounted at the rate of 5 percent as opposed to the required rate of return of 15 percent. Similar to Column A, this analysis concludes that the present value of the future BIG tax obligation is $35,000 and the BIG tax liability discount is 35 percent ($35,000/$100,000). Consequently, the assumed time horizon doesn’t change the value of the BIG tax liability discount as of the valuation date.

The analysis in Column B is incorrect because the 15 percent discount rate is inconsistent with the

5 percent growth rate used in the analysis. In this analysis, the stock has an expected future value of $127,628 based on capital appreciation of 5 percent per year over the course of a five-year period. If this expected future value is then discounted at the

15 percent rate of return, the present value of the stock is $63,454. This analysis is erroneous because the discounted future value of the stock is less than the value of the stock today. If this were the case, the investor would always sell the stock immediately rather than hold it, as the expected investment return is lower than the investment risk of holding the stock.

Generally, the analysis in Column C is proper, but not necessary. If the analyst uses the proper growth rate and present value discount rate in the analysis, the present value of the future BIG tax obligation will typically be the same as the value of the BIG tax liability as of the valuation date. Con-sequently, it’s not necessary to conduct a speculative exercise that attempts to determine (1) the fu-ture value of the asset, (2) when the asset will be sold, and (3) the appropriate discount rate. In other words, the best indication of value of the BIG tax liability is the value as of the valuation date.

C-to-S Conversions

S corporations don’t pay federal income taxes at the corporate level.4 These entities “pass through” their income to their shareholders who report it on their personal income tax returns on a pro rata own-ership basis. In addition, the distributions of S corporations are generally not taxable and the retained earnings increase the tax basis of its stock, which tends to mitigate capital gains taxes upon the sale of the company’s stock.

Given the tax attributes of S corporations, the 1986 Congress was concerned that the repeal of the General Utilities doctrine would encourage C corporations to convert to S corporations (C-to-S conver-sions), distribute appreciated assets and avoid the “double-taxation”5 concept of TRA 1986. To prevent this, Congress amended Internal Revenue Code Section 1374. 

Under IRC Section 1374, as amended, if an S corporation sells or distributes assets after a C-to-S conversion, the company will be subject to income taxes—at the highest C corporation income tax rate—on the BIG that existed as of the date of conversion. In addition, the S corporation shareholders will recognize their pro rata share of the gain—net of the gains taxes paid by the company—on their respective income tax returns. This tax treatment continues for a period of 10 years after the C-to-S conversion.6 Section 1374 refers to this 10-year period as the “recognition period.” “C-to-S Conversion” on p. 51 illustrates this tax treatment.

As “C-to-S Conversion” illustrates, prior to the C-to-S conversion, the C corporation held assets with an FMV of $100,000 and a tax basis of $40,000. The company converted to an S corporation and subsequently distributed or sold the assets for $100,000. The company recognized a gain at the corporate level and paid $21,000 ($60,000 x 35 percent) in taxes. In addition, the company reported a net gain of $39,000 ($60,000 less the $21,000 in taxes paid) that is “passed through” to the shareholders. Consequently, the shareholders pay income taxes of $15,600 ($39,000 x 40 percent) on their personal tax returns. In this situation, the company’s shareholders receive net proceeds of $63,400.

The BIG tax liabilities are avoidable if the shareholders wait for the 10-year recognition period to ex-pire. However, during the recognition period, the investor is subject to a lack of liquidity and holding period risk that may substantially impact the attractiveness of employing this strategy as well as the perceived value of the assets contained in the business.

From a valuation perspective, the length of time remaining in the recognition period affects the value of the stock of the S corporation. To demonstrate this concept, assume an asset holding company is operating as a C corporation and has the following attributes:

• FMV of assets of $100,000 with a tax basis of $40,000;

• Required investment rate of return of the assets is 10 percent;

• Corporate income tax rate is 35 percent; and

• Individual ordinary income tax rate is 40 percent.

The company conducts a C-to-S conversion and records a BIG tax liability of $60,000 ($100,000 - $40,000).

The corporate level and shareholder level BIG tax liability is $21,000 ($60,000 x 35 percent) and $15,600 ($39,000 x 40 percent), respectively. This total BIG tax liability continues at its full nominal amount of $36,600 ($21,000 + $15,600) until the expiration of the 10-year recognition period. 

Over time, the 10-year recognition period declines and the value effect of the BIG tax liability also declines. In other words, if there’s only one day left in the recognition period, the impact of the recognition period on the value of equity of the S corporation is essentially zero. Conversely, the impact on value may be substantial when there are 10 years remaining in the recognition period. 

At some point, the valuation discount associated with the risk of holding the assets for the remaining portion of the recognition period has a lower impact on value than the BIG tax liability. When this occurs, the appropriate valuation discount to use in the analysis is the holding period discount rather than the BIG tax liability discount. (See “BIG Tax Liability Discount vs. Holding Period Discount,” p. 52.)

As “BIG Tax Liability Discount vs. Holding Period Discount” illustrates, the valuation discount associated with the BIG tax liability is consistent, at approximately 37 percent, during the entire recognition period. This is because the BIG tax liability remains constant until the expiration of the 10-year recognition period. In contrast, the valuation discount associated with the holding period risk begins at approximately 60 percent—assuming a 10 percent required rate of return—when there are 10 years remaining in the recognition period. The holding period risk declines during the gradual expiration of the recognition period. This occurs because the holding period necessary to avoid the BIG tax liability declines as the recognition period gradually expires. When approximately four years remain in the recognition period, the holding period discount is less than the BIG tax liability discount. In other words, the investor is economically better off holding the asset than selling the asset and incurring the BIG tax liability. In this situation, the appropriate valuation discount should be the either the BIG tax liability discount or the holding period discount, whichever is less. 

Valuation Considerations

When estimating the valuation impact of the BIG tax liability, it’s important to understand (1) the tax and

economic characteristics of the equity interest being valued, (2) the nature of the subject assets, and (3) the nature of the subject company. Some of the relevant questions to ask when conducting a BIG tax liability analysis are:

• Is the company a C corporation, S corporation or a C-to-S conversion?

• If the company is a C-to-S conversion, how much time remains in the recognition period?

• Does the equity interest being valued have the unilateral ability to compel liquidation of the assets?

• Does the subject company primarily operate as an asset holding company or an operational company?

• Are subject company assets operational or non-operational in nature?

• What’s the expected asset turnover for the subject company?

• Do the assets produce sufficient income to support their value indication?

• What portion of the total investment return of the assets is attributable to capital gains returns and what portion is attributable to income returns?

• What valuation methods should be used to value the assets and how is the BIG tax liability reflected in these methods?

Potential for Controversy Remains

Tax Court decisions are interesting and worth consideration. However, it would be a mistake to as-sume that conclusions reached by the Tax Court—based on the facts and circumstances of each specific matter—are generally applicable to all situations. For example, the recent Litchfield v. Comm’r7 case involved the valuation of fractional equity interests in a C corporation as well as a recent a C-to-S conversion. The assets owned by these respective entities included marketable securities and low-income yield farmland. In addition, the taxpayer was able to demonstrate the need for a phased liquidation of assets to fund the stock redemptions of its aging shareholders. Other relevant attributes of this case may not be the subject of the published opinion.

The valuation impact of BIG tax liabilities can be complicated and requires an understanding of the income tax attributes of C corporations, S corporations and C-to-S conversions. In addition, the tax attributes of different valuation methods are an important consideration.

It’s encouraging to see the Tax Court continue to move in the direction of recognition of BIG tax liabilities when it’s appropriate to do so. Despite recent taxpayer victories on this issue, the complexity of the analysis necessary to support this valuation adjustment hasn’t diminished and the potential for controversy remains.

Endnotes

1. General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935).

2. Estate of Eisenberg v. Commissioner, 74 T.C. 1046 (1997).

3. Estate of Davis v. Comm’r, 110 T.C. 530 (1998).

4. Certain states assess income taxes on S corporations.

5. Double-taxation generally refers to the situation in which both the income of a C corporation and the dividends paid to shareholders are subject to income taxes. S corporations aren’t subject to double taxation because the distributions aren’t subject to income taxes.

6. On Sept. 16, 2010, the U.S. Senate adopted H.R. 5297, “Small Business Jobs Act of 2010.” Under Section 2014 of this bill, C-to-S conversions that occurred seven years prior to either 2009 or 2010 will not be subject to net realized built-in gains taxes in the event of a sale of assets. Also under this bill, any C-to-S conversions that occurred five years prior to 2011 will not recognize any net realized built-in gains taxes in the event of a sale of assets. New C-to-S conversions will continue to be subject to the 10-year recognition period.

7. Litchfield v. Comm’r, T.C. Memo 2009-21.

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