Estate Avoids Built-in Gains Tax Liability in Win Over IRS


	Kelly White

December 2010

Estate Avoids Built-in Gains Tax Liability in Win Over IRS

A Tax Court decision could have far-reaching implications for families owing estate tax after 2010

In a recent closely watched case, an estate was allowed to reduce the value of its interest in a corporation based on the full amount of a potential capital gains tax. This Tax Court decision (Estate of Jensen, TC Memo 2010-182) could have far-reaching implications for families owing estate tax after 2010.

Background. For estate tax purposes, the value of a business is generally determined by finding the price at which the assets would change hands between a willing buyer and a willing seller, with both having reasonable knowledge of all the relevant facts.

If the business interest is represented by stock in a closely held C corporation, the value of the stock is generally determined by an appraisal. The appraisal may take into account various factors that will reduce or “discount” the value of the stock. One such factor is the amount of built-in gains (BIG) tax that a willing buyer would have to pay upon liquidation of the corporation.

Facts. Marie Jensen owned 82% of the stock in Wa-Klo, Inc., a closely held C corporation. The principal asset was a 94-acre parcel of waterfront real estate used as a youth summer camp. In 2003, Jensen created a revocable trust that held her Wa-Klo shares. She died in 2005.

In assessing estate tax, the IRS determined there was a tax deficiency of $333,245. While Ms. Jensen’s estate and the IRS agreed that the value of the 82% interest was subject to a 5% discount for lack of marketability, they disagreed on the amount of the BIG tax liability: The estate deducted the full amount of capital gains tax that would be due upon the sale of the parcel, since a buyer would likely demand this amount as a discount. The IRS argued that the discount should be less than 100% because there are several ways that potential buyers of the stock could avoid or defer the tax.

At trial, the Jensen estate’s valuation expert applied a dollar-for-dollar approach to the BIG tax liability. He cited the following reasons for not using an earnings-based approach:

Wa-Klo did not generate substantial cash flows from its operations.
The best use of Wa-Klo could be derived from the sale of its assets due to the company’s poor historical performance.
There was substantial value in the appreciated value of Wa-Klo’s underlying assets.
The estate’s 82% interest in Wa-Klo was a controlling interest.

In contrast, the IRS’s expert used a methodology whereby closed-end fund data was analyzed for exposure to BIG tax. Based on the analysis, the IRS’s expert determined that only BIG tax exposure above 41.5% of net asset value should be discounted on a dollar-for-dollar basis. The expert also discussed possible BIG tax avoidance methods, such as converting to S corporation status and waiting the 10-year period.

The Ruling. The Tax Court rejected the IRS analysis based on closed-end fund data, concluding that it wasn’t relevant. It also dismissed the potential methods discussed for avoiding the BIG tax on the property.

The court performed its own calculation of BIG tax liability, using a present value analysis. The eventual calculation approximated the amount derived by the estate’s expert under the dollar-for-dollar approach.

The end result was a tax victory for the estate.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.