BusinessStock Valuation Discount Related to the Built-in Gains (BIG) Tax Liability

Journal Issue

Mar 2003

Column Name

Journal HTML Content

The valuation of a closely held business is a common assignment
within a bankruptcy environment. The business/stock of a closely held
corporation may need to be valued to determine loan collateral value, to assess
spinoff opportunities, to determine corporate solvency or insolvency, to
estimate the value of investments for fresh-start reporting, and for many other
purposes. The closely held business subject to valuation may be a family owned
or other privately owned corporation, or the closely held business may be a
division or subsidiary of a publicly traded corporation. In any event, analysts
use three generally accepted approaches to value the business/stock: the income
approach, market approach and asset-based approach. Analysts typically
synthesize the quantitative value conclusions of two or more of these
analytical approaches in reaching a final business/stock value conclusion.

The income approach
values a corporation as the present value of the future income expected to be
earned by the owners of the business. The most common income approach
business/stock valuation methods are (1) the direct capitalization method and
(2) the yield capitalization (or discounted cash-flow) method.

The
market approach values a corporation by reference to market-derived pricing
multiples extracted from actual sales of comparative companies or securities.
The most common market approach business/stock valuation methods are (1) the guideline
merged and acquired company method and (2) the guideline publicly traded
company method.

The
asset-based approach values a corporation by reference to (1) the current value
of all its assets (both tangible and intangible) less (2) the current value of
all of its liabilities (both contingent and recorded). The most common
asset-based approach business/stock valuation methods are (1) the net asset
value (NAV) method (where total corporate asset appreciation is estimated
collectively) and (2) the asset accumulation method (where the company's
individual tangible and intangible assets are separately identified and
valued).

<h3>The BIG Tax Liability Issue</h3>

In
the asset-based approach, the appraised corporate asset value is typically in
excess of the income tax basis of the subject assets. If the company's
assets are sold in a fair market value transaction (i.e., the conceptual premise of the asset-based approach), the
corporation would have to pay capital gains tax. The amount of the capital
gains is based on the appreciation of the company's assets—i.e., the assumed fair market value sales price of the assets less the
income tax basis of the assets. The capital gains tax liability is based on (1)
the amount of the capital gains (i.e., the asset
appreciation over income tax basis) and (2) the corporate capital gains tax
rate.

Since
this capital gains tax liability is associated with the appraised value of the
corporate assets, it is typically called the built-in gains (or BIG) tax
liability. The asset-based approach analysis is often performed using the
"value in continued use, as part of a going concern" asset
appraisal premise of value. This premise of value assumes that the subject
corporate assets are sold collectively as a going-concern business.

However,
such a hypothetical sale would, in fact, trigger the BIG tax. This conceptual
issue ultimately relates to a basic procedural question: How should the analyst
account for the BIG tax liability in an asset-based business/stock valuation?

This
valuation issue has not been specifically addressed in a published bankruptcy
court decision. However, it has been addressed over the years in several
federal gift and estate tax court cases. Recently, the Fifth Circuit weighed in
on this valuation issue (based on an appeal of a U.S. Tax Court estate tax
case). While this recent Fifth Circuit decision does not relate specifically to
bankruptcy matters, it does provide important professional guidance to
valuation analysts who practice in the bankruptcy arena.

<h3>Case Summary</h3>

In
the <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=C…
of Beatrice Ellen Jones Dunn, 5th Cir., 2002</a> U.S. App. Lexis 15453, 8/1/02, reversing and remanding (with
instructions) <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=T…
Memo 2000-12</a>, 79 T.C.M. (CCH) 1337, 1339 (2000), the
Fifth Circuit accepted the taxpayer argument that stock valuations should be
adjusted for the potential BIG tax on appreciated corporate assets. Prior gift
and estate tax cases held that a holding company valuation may be adjusted (i.e., discounted) for the potential BIG tax liability.
However, the valuation discounts allowed by the courts in these previous
holding company valuation cases typically did not reflect the full 34 percent
corporate capital gain tax rate. In Estate of Dunn, the appeals court upheld the taxpayer position of a BIG tax
valuation discount on appreciated assets based on the full 34 percent corporate
capital gains rate tax.

In
addition to allowing a valuation adjustment for the full BIG tax liability, Estate
of Dunn is significant because of the type of
business enterprise involved. The subject corporation was an operating company,
not a property-holding company. The previous judicial precedent related to the
BIG tax valuation discount all involved property-holding companies.

<h3>The Facts of the Case</h3>

On
the date of her death in 1991, Beatrice Ellen Jones Dunn owned a block of stock
in Dunn Equipment Inc. Dunn Equipment Inc. was incorporated in Texas in 1949.
It was a family-owned business throughout its existence and operated from four
locations throughout Texas. In 1991, the company had 134 employees, including
three executives and eight salesmen.

Dunn
Equipment Inc. owned and rented out heavy equipment and provided related
services, primarily in the petroleum refinery and petrochemical industries. The
personal property rented from the company by its customers consisted
principally of large cranes, air compressors, backhoes, manlifts, and sanders
and grinders. The company frequently furnished operators for the equipment that
it rented to its customers, charging for both equipment and operators on an
hourly basis. For example, the company's revenues resulted in significant
part from the renting of large cranes, both with and without operators.

Ms.
Dunn died on June 8, 1991, at the age of 81. After Ms. Dunn's death, the
estate timely filed the Form 706 federal estate tax return. The
decedent's block of shares represented approximately 63 percent of the
outstanding stock of the subject C corporation. Accordingly, the decedents
block of stock represented a controlling ownership interest in the subject
closely held corporation.

However,
at the trial level, the tax court found that, even though the decedent's
63 percent of stock ownership gave Ms. Dunn operational control of the company,
under Texas law she lacked the power to compel a liquidation, a sale of all or
substantially all of its assets, or a merger or consolidation. In order to
initiate any of these control events under Texas law, a
"super-majority" equal to or greater than 66.67 percent of the
outstanding shares is required.

<h3>The IRS Position</h3>

In
the tax court proceeding, the Internal Revenue Service (IRS) valued the
decedent's stock ownership using an asset-based valuation approach and,
specifically, the NAV method. The IRS, however, did not apply a valuation
discount related to the potential BIG tax liability on the company's
appreciated assets.

At
the tax court trial, the IRS argued that a BIG tax valuation discount was not
an appropriate methodological procedure in an asset-based business/stock
valuation analysis. In addition, the IRS argued that there was no plan to
liquidate the profitable company or to actually sell the appreciated corporate
assets. Therefore, the company would not actually have to pay the BIG tax
liability in the foreseeable future.

<h3>The Taxpayer Position</h3>

At
the tax court trial, the taxpayer's valuation expert estimated the value
of the decedent's stock ownership using two business valuation
approaches. First, the taxpayer's expert used the income approach and,
specifically, the direct capitalization of income method. In this
expert's application of the direct capitalization method, the income was
measured as net income, and not as net cash flow.

Second,
like the methodology proposed by the IRS, the taxpayer's expert used the
asset-based approach, specifically the NAV method. The taxpayer's expert
made an adjustment (i.e., a reduction) to the
NAV method value indication for the associated BIG tax liability. This
adjustment was based on the $7.1 million BIG tax liability that would arise if
the corporation actually sold its assets at their individual appraised fair
market values.

The
taxpayer's expert reached a final value conclusion for the subject stock
by (1) weighing the income approach value indication by 50 percent and (2)
weighing the asset-based approach value indication (adjusted for a $7.1 million
BIG tax liability discount) by 50 percent.

<h3>The Tax Court Decision</h3>

As
reported in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=T…
v. Commissioner, TC Memo 2000-12</a>, the tax court concluded an overall value of the decedent's
stock by assigning (1) a 65 percent weight to the NAV method value indication
and (2) a 35 percent weight to the direct capitalization of income method value
indication. However, the tax court reduced the NAV method value indication by
only 5 percent of the estimated $7.1 million BIG tax liability.

The
tax court reasoned that a hypothetical willing buyer would not necessarily
liquidate the company. Rather, a hypothetical willing buyer may buy the subject
stock with the intention of entering into a different but ongoing line of
business. Accordingly, the tax court concluded that the likelihood of a
near-term corporate liquidation—an event that would actually trigger the
payment of the corporation BIG tax liability—was low.

Finally,
in its valuation of the decedent's stock, the tax court allowed (1) a 15
percent discount for lack of marketability and (2) a 7.5 percent discount for
lack of super-majority control. The estate did not appeal the amount of these
two valuation discounts at the appeals court proceeding. Accordingly, the
appeals court did not have to opine on either of these two valuation
adjustments.

<h3>The Appellate Court Decision</h3>

The
appellate court ultimately assigned (1) an 85 percent weight to the income
approach value indication and (2) a 15 percent weight to asset-based approach
value indication. Within the asset-based approach value indication, the court
rejected the tax court's 5 percent BIG tax valuation discount. Rather,
the court applied a BIG tax valuation discount based on the full 34 percent
corporate capital gains tax rate.

Commenting on this valuation
issue, the decision states:

<blockquote>
No one can dispute
that if Dunn Equipment had sold all of its heavy equipment, industrial real
estate and townhouse on the valuation date, the corporation would have incurred
a 34 percent federal tax on the gain realized, regardless of whether that gain
were labeled as capital gain or ordinary income. The question, then, is not the
rate of the built-in tax liability of the assets or the dollar amount of the
inherent gain, but the method to employ in accounting for that inherent tax
liability when valuing the corporation's assets (not to be confused with
the ultimate task of valuing its stock).
</blockquote>

The
court reasoned that the asset-based business/stock valuation approach should
not consider the likelihood of a corporate liquidation in determining the
corporation's NAV. Rather, the court concluded that the estimation of the
BIG tax liability is an integral component of a corporation's value as
derived by an asset-based approach valuation.

Regarding this fundamental
valuation issue, the court decision states the following:

<blockquote>
Bottom line: The likelihood of liquidation has no place in either of
the two disparate approaches to valuing this particular operating company.
</blockquote>

<h3>Summary and Conclusion</h3>

Valuation
analysts often use income and market approach methods more commonly than asset-based
approach methods in business/stock valuations for bankruptcy purposes. However,
the asset-based approach is a generally accepted approach for bankruptcy
valuations. In addition, the asset-based approach is applied often enough so
that the BIG tax discount conceptual issue should be resolved.

The
asset-based approach assumes that the subject company sells the business in an
asset, rather than a stock, transaction. The corporate assets sell at the total
of their appraised fair market values. After the assumed sale, the corporation
would generally have to pay capital gains tax on the excess of the
assets' sales price over the assets' tax basis. Since the repeal of
the General Utilities doctrine in 1986, corporations have few options available
to mitigate this capital gains tax.

All
business/stock valuations are based on hypothetical sales transactions. In the
market approach, there is a hypothetical sale of the corporate stock (in either
a public market or in a private transaction). The fact that the company does
not actually sell its stock does not invalidate the use of the market approach.
Likewise, the fact that the company does not actually sell its assets does not
invalidate the use of the asset-based approach. In a hypothetical sale of the
corporate assets, a hypothetical BIG tax liability would be paid.

Dunn concludes that a company's NAV should be adjusted
(discounted) for the amount of this hypothetical BIG tax liability. The Fifth
Circuit reaches this conclusion regardless of whether or not the company plans
to actually sell its corporate assets. Additionally, the court reaches this
conclusion regardless of whether or not the company is an operating company or
a property-holding company.

In fact, the court's
conclusion regarding this issue in Estate of Dunn is unambiguous:

<blockquote>
We must reject as
legal error, then, the tax court's treatment of built-in gains tax
liability and hold that—under the court's asset-based
approach—determination of the value of Dunn Equipment must include a
reduction equal to 34 percent of the taxable gain inherent in those assets as
of the valuation date.
</blockquote>

Dunn provides important professional guidance to valuation analysts on
two issues. First, when the asset-based approach—specifically the NAV
method—is used to estimate business/stock value, Dunn supports the calculation of the BIG tax valuation discount at the
full capital gains corporate tax rate. According to the decision, the estimated
BIG tax liability should not be reduced by an estimate of the probability of a
near-term corporate liquidation.

Second,
Dunn indicates that the BIG tax adjustment
should be considered in the asset-based valuation of any going-concern
business—and not just in the valuation of property-holding companies. The
estimation of the potential BIG tax liability on appreciated assets is an
integral methodological step in any asset-based approach business valuation.

Although
Dunn does not have legal precedent value in a
bankruptcy controversy, it does provide practical professional guidance to
valuation practitioners. This is because the BIG tax valuation adjustment is as
relevant an issue to bankruptcy business/stock valuations as it is to gift and
estate tax business/stock valuations.

Journal Authors

Robert F. Reilly

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003