Recent case brings element of rationality to tax laws

by Ronald A. Morris, Elliot Pisem
Published: September 01, 1998
Source: National Real Estate Investor

In our most recent column, in the July Investor, we wrote about estate and gift tax discounts -- amounts subtracted from some hypothetical valuation of property in order to determine the actual value subject to tax. One of the cases on which we reported, Estate of Welch v. Commissioner (May 6, 1998), involved the proper discount to be applied to be applied in the valuation of corporate stock, in order to reflect the impact of potential corporate taxes. We focused on the additional income tax burden that arises from fact that, in the case of property (including real estate) held through a "C corporation," a full corporate income tax will often be payable if the corporation disposes of the property, even after the individual's death. In light of changes made by the Tax Reform Act of 1986, it is now, difficult, if not impossible, to avoid this corporate income tax. Accordingly, a buyer of stock will generally apply some discount for this inherent tax, compared to the amount that would be paid for the underlying assets.

Prior to the 1986 changes, the law was different; techniques existed through which the corporate tax could often be avoided and, in that context, the Tax Court ruled that, unless an actual taxable sale of the underlying property was likely to occur, a hypothetical corporate income tax could not be taken into account to any extent in valuing stock for estate or gift tax purposes. Even after the 1986 changes, the Tax Court in numerous cases, including Welch, continued to stand by its "no discount" rule. On June 30, 1998, too late for inclusion in the July column, the Tax Court, in Estate of Davis v. Commissioner, finally adopted to a more realistic view. We are writing this column to update you on this important development.

Artemus Davis was one of the founders of WinnDixie Stores, Inc. Davis owned all of the stock of A.D.D. Investment and Cattle Company (ADDICC), a holding company which in turn owned various assets, the lion's share of which constituted WinnDixie stock. On November 2, 1992, Davis made two gifts, each consisting of 25.77% of the stock in ADDICC. On that date, ADDICC's assets had a fair market value, in excess of ADDICC's liabilities, of over $80,000,000, but a tax basis of under $8,000,000. The Tax Court calculated that, if ADDICC were to have sold its assets, it would have been subject to a corporate "built-in capital gains" tax of approximately $25,000,000. The issue before the court was whether all or any portion of that $25,000,000 could be subtracted in determining the gift tax value of the ADDICC stock.

As the court noted is customary in valuation cases, each of the parties submitted expert reports. As is not customary, however, the IRS disagreed with its own expert! That expert had concluded that a discount of 38% of the value of the ADDICC stock should be allowed by reason of "lack of marketability," of which almost half was attributable to the built-in corporate tax. Unsurprisingly, the taxpayer's experts did not agree with the IRS's expert regarding the dollar amount of discount that was appropriate on account of this factor, but all of the experts agreed that some discount was appropriate. (One of the taxpayer's experts actually came up with a smaller discount attributable to this factor, but made up for it with larger discounts on other items.) Notwithstanding the unanimity of the experts (including the IRS's own) that, as a factual matter, the value of the ADDICC stock was depressed as a result of the built-in corporate tax, the IRS argued that the allowance of such a discount would be "contrary to Federal tax law," unless a liquidation of ADDICC or a sale of its assets was actually planned or contemplated on the date of the gifts.

The Tax Court rejected the IRS's position. Following a careful review of the cases, including its recent decision in Welch, the court concluded that the taxpayer in the present case was arguing something different from what had been argued unsuccessfully by the taxpayers in every prior case, including those involving gift or estate taxes arising after the 1986 tax law changes. In all those other cases, according to the Tax Court, the taxpayers had been contending that the full amount of the built-in corporate tax should be applied as a discount in computing the estate or gift tax. The court continued to feel that the position taken by those taxpayers was clearly incorrect. Moreover, since those taxpayers had not presented the court with evidence of the amount by which a hypothetical "willing buyer" would actually reduce the amount to be paid for the corporate stock on account of the built-in tax, no discount at all was allowed. By contrast, the experts in Davis provided the court with exactly that evidence and the court relied on it in allowing a discount of almost 1/3 of the total amount of corporate tax that would have been triggered if ADDICC's assets were sold.

The IRS also argued that, even in light of the 1986 tax law changes, ADDICC's corporate tax could have been eliminated had ADDICC elected to become an S corporation and then deferred any sale of its assets for 10 years. The court rejected this argument, noting that, in order for ADDICC to become an S corporation, its stock could have been held only by certain individuals or trusts. (For example, an S corporation cannot have a corporation or a nonresident alien individual as a shareholder.) This requirement, combined with the need to defer any asset sales for 10 years, would itself have had a depressing effect on the value of the ADDICC stock, possibly one that was greater than the discount attributable to the corporate tax. Thus, it was inappropriate to take this alternative into account in valuing the ADDICC stock.

Kudos, then, to the late Artemus Davis and his advisors for their services both in bringing an element of rationality to the tax law and in saving some money for taxpayers to follow.