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Built-In Gains Taxes and Business Valuation

A string of recent federal court decisions recognizes the impact of built-in gains taxes on the value of a business, and holds implications for valuing pass-through entities

Don Wenk

 
 

Prior to enactment of the Tax Reform Act of 1986, the consideration of built-in capital gains taxes on property was not an issue, because those tax liabilities could be avoided through generally available tax elections. However, the 1986 tax act repealed the General Utilities Doctrine and thereby eliminated those elections, and business appraisers have since become concerned about the effects of built-in gains taxes, especially for holding companies.

Recent Developments

In recent years, the courts have begun to recognize how built-in gains taxes affect business value. Most of the headway has been made in the tax courts, with several notable decisions occurring since 1998. According to noted valuation expert Shannon Pratt, “Family law courts often quote IRS authority and Tax Court cases in support of positions taken. And, this movement on the part of the Tax Court and the IRS could be a catalyst in family law courts for increased recognition of trapped-in capital gains liability.”

For some time, the IRS has successfully argued that no discount for potential capital gains is appropriate if the liquidation of the appreciated corporate assets is speculative. Until 1998, the courts agreed with the IRS, refusing to allow discounts for built-in capital gains. Beginning in 1998, however, the decisions in certain court cases began to signal a significant shift in the thinking of some courts. Some of the more notable Tax Court cases are discussed below.

  • In Estate of Davis v. Commissioner (110 T.C. 530, 110 T.C. No. 35, 1998 U.S. Tax Ct.), the court held that even though no liquidation of the company or sale of the assets was planned or contemplated as of the valuation date, a hypothetical willing buyer and a hypothetical willing seller would not have agreed upon a price that did not take into account the company’s built-in capital gains tax liability.

  • In Eisenberg v. Commissioner (155 F.3d 50, 1998 U.S. App. (2nd Cir. Aug. 18, 1998)) the court held: “The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the market value of the property he considers buying…We find that even though no liquidation was planned or contemplated on the valuation date, a hypothetical willing seller and a hypothetical willing buyer would not have agreed on that date on a price for each of the blocks of stock in question that took no account of the corporation’s built-in capital gains tax.”

  • Estate of Richard R. Simplot (112 T.C., No.13) is noteworthy in that experts for both the taxpayer and the IRS took – and the court allowed – a full discount for built-in capital gains. This continued the trend begun in 1998 with the Davis and Eisenberg decisions; however, in those earlier cases, only a partial discount was allowed, with the court pulling the discount out of the air in both cases. Simplot, therefore, marked one of the first instances where the court allowed a full discount for built-in gains.

  • In Dunn v. Commissioner (CA-5, 2002-2 USTC Para. 60,446, 301 Fsd 339) the Appellate Court held: "The Tax Court made a significant mistake in the way it factored the 'likelihood of liquidation' into its methodology, a quintessential mixing of apples and oranges: considering the likelihood of a liquidation sale of assets when calculating the asset-based value of the Corporation. Under the factual totality of this case, the hypothetical assumption that the assets will be sold is a foregone conclusion – a given – for purposes of the asset-based test. The process of determining the value of the assets for this facet of the asset-based valuation methodology must start with the basic assumption that all the assets will be sold, either by Dunn Equipment to the willing buyer or by the willing buyer of the Decedent’s block of stock after he acquires her stock. By definition, the asset-based value of a corporation is grounded in the fair market value of its assets, which in turn is determined by applying the venerable willing buyer-willing seller test. By its very definition, this contemplates the consummation of the purchase and sale of the property, i.e., the asset being valued." The Fifth Circuit Appellate Court went on to state that, unlike in the asset-based approach, the built-in tax liability would not be considered in the calculation of the corporation’s earnings-based value (since an earnings-based value implicitly assumes a going-concern and no liquidation).

In summary, it is clear that the tax courts have recognized the economic reality that capital gains taxes are considered by both buyer and sellers of business interests in the real world. This is especially true for holding companies, whose values are typically determined by the values of their underlying assets. When a holding company is valued by summing the underlying values of the company’s assets, this inherently implies a liquidation of these assets by the company, and therefore the tax implications upon such a liquidation should be considered.

The court cases discussed above were tax court cases that involved C-corporations and the fair market value standard (i.e., willing buyer and willing seller of the corporate stock). In the next Valuation Perspectives, Part II of this article will discuss the ramifications of these court rulings on valuing pass-through entities such as LLCs and S-corporations, as well as the applicability of the rulings to valuations performed outside the tax arena.

Implications for Valuing Pass-Through Entities

Up to this point, we have discussed recent court decisions that recognized the economic reality of potential built-in gains taxes on a corporation’s underlying assets. Those court cases, however, were Tax Court cases that involved C-corporations and the fair market value standard of value (i.e., willing buyer and willing seller of the corporate stock).

The question then becomes whether the recognition of built-in capital gains taxes would be appropriate for valuations performed for reasons other than tax reporting and/or their relevance for pass-through entities (e.g., S-corporations and limited liability companies).

Unfortunately, the answer to these questions is often an ambiguous “it depends.” The uncertainty stems from:

  • the tax complexities associated with pass-through entities and the wide number of scenarios that could occur subsequent to the asset sale;

  • the amount of control the subject interest has over the entity;

  • the nature of the entity (is it an operating business or simply an investment holding company?);

  • the investor’s ability to use capital losses to offset other capital gains outside of the entity; and

  • the entity’s structure (is it a partnership, LLC, or S-corporation?).

Obviously, this topic is a complex one, and many of these issues are outside the scope of this article. Therefore, we will limit this discussion simply to demonstrating how built-in gains taxes may be avoided by investors in pass-through entities.

Inside Basis vs. Outside. In order to comprehend the tax ramifications of selling company assets with respect to a pass-through entity, one must understand the difference between the inside tax basis and the outside tax basis.

The inside tax basis is the net tax basis of the individual asset on the corporation’s books. For a piece of equipment, the inside tax basis is usually its original cost less accumulated depreciation. For an investment in marketable securities, it is the cost of the investment plus any reinvested dividends. Depending on whether the price received by the entity is more than or less than the inside tax basis, the entity will record a gain or loss which is subsequently passed through to the individual partner, member or shareholder.

The investor also has an outside tax basis on his or her investment in the company. This is based on what the investor paid for his or her investment in the company and is increased by profits passed through to the owner. The outside tax basis is also reduced as losses are passed through to the owner or as distributions to owners are paid by the company.

The sale of an appreciated asset can mean the pass-through of capital gains tax liabilities to the partners, members or S-corporation shareholders. Although this can result in an increased outside tax basis in the entity – the benefits of which may or may not be realized in the near-term – it also likely results in an immediate tax liability for the individual, resulting from the capital gain calculated using the inside tax basis.

The key difference between a C-corporation and a pass-through entity with respect to built-in gains is that, with a pass-through entity, it may be possible for a hypothetical buyer into the corporation to avoid most, if not all, capital gains taxes associated with the sale of the underlying property.

LLCs. For a limited liability company (LLC) or partnership, a new member or new partner purchasing an interest may avoid built-in gains taxes if the entity elects to make a Section 754 election. This election enables the new member or partner to take a stepped-up inside tax basis on the underlying property.

Essentially, the company now keeps two separate sets of accounting records, one for existing members and one for new members. If the stepped-up property is depreciable property, the new member must also recognize incremental depreciation on the stepped-up property. And, if the property is sold, the new member will have a different inside tax basis than the original members. Obviously, in the context of valuation, the willingness of the partnership or LLC to make the Section 754 election must be considered.

S-Corporations. For an S-corporation, a new shareholder can also avoid capital gains taxes if the corporation is dissolved in the same year that the underlying property is sold and the capital gain is realized. This is most often applicable to investment holding companies that are organized as S-corporations, since a new investor in the corporation will take into consideration the market value of the underlying investments when deciding what price to pay for the investment.

So, in the “tax avoidance” scenario, the new S-corporation investor buys into the corporation at the higher market value of the underlying assets. If all of the corporation’s assets are sold for an inside gain, the new shareholder can offset his or her losses on the outside basis of the investment in the corporation upon its dissolution. Again, in a valuation context, the specific facts and circumstances surrounding the company and the amount of control vested in the subject interest must be considered in determining whether capital gains taxes should be incorporated into the analysis.

As was mentioned previously, these tax strategies are available only for new shareholders or members buying into the company at a higher tax basis. This is applicable under the fair market value standard, where a hypothetical buyer and a hypothetical transaction are assumed.

In some cases, however, it is necessary to value an interest as it pertains to its current owners without necessarily assuming a transaction. This is often the case in the divorce setting. In his March 2004 Business Valuation Update, Shannon Pratt wrote:

“… trapped-in capital gains taxes should be deducted when valuing for divorce. I think it is exceedingly unfair in a marital dissolution property distribution to award an appreciated asset to one spouse without any deduction for the trapped-in capital gains tax while awarding the other spouse property that is free and clear of potential capitals gains taxes.”

Mr. Pratt’s article, however, is silent with respect to whether he is discussing C-corporations or pass-through entities.

There are no clear-cut answers pertaining to the issue of potential capital gains taxes in determining the value of a company or an interest in a company. If the subject company is a pass-through entity, the issue becomes increasingly complex. Ultimately, the appraiser must consider all of the relevant facts and use common sense to determine the likelihood of a true economic impact to the owner of the interest.