Valuation and C Corp. Taxes on Embedded Gains

The First Department Appellate Division's Oct. 21, 2008 decision in Wechsler v. Wechsler, 866 NYS2d 120 (1st Dept. 2008), demonstrated how, when financial experts present differing points of view when valuing a marital asset, a seemingly simple concept can nonetheless raise many questions.

The Puzzle

The principal issue addressed in the Wechsler decision is the extent to which the value of a holding company structured as a subchapter C corporation should be reduced to reflect the federal and state corporate level income taxes associated with the unrealized appreciation of marketable securities (or real estate or other assets in a different situation) owned by the corporation. The allowance, or provision, for deferred taxes is contingent, and is not realized until the underlying securities are sold.

Everyone agrees that under current tax law, a C corporation is subject to taxation on realized capital gains at the statutory rates in effect for the year in which such gains are realized. There are, however, significant differences of opinion regarding when and how a reduction (or discount) for the contingent taxes associated with these embedded (or built-in) gains should be quantified when valuing a business or an interest therein. This is currently a hot issue, not only for New York's matrimonial courts but also for federal estate and gift tax matters, and in shareholder oppression cases and buy-out proceedings under New York's Business Corporation Law (BCL).

Many factors affect the method of quantification that may be selected by a valuation expert or the court, including but not limited to: 1) the size of the ownership interest being appraised; 2) the method or methods of valuation used to appraise the business; 3) the weight given to each method utilized in arriving at a conclusion of value; 4) the premise of value (i.e., going concern value or liquidation value); 5) the expected holding period for the marketable securities portfolio (or real estate or other assets having embedded gains); 6) the amount, if any, of the provision for deferred taxes already reflected in the corporation's financial statements; and 7) perhaps most importantly, the specific facts and circumstances of each case.

Repeal of the General Utilities Doctrine

Before turning to a discussion of the decision in Wechsler, let's look at some of the statutory, regulatory and case law history surrounding the issue. Long ago, based on the 1935 Supreme Court decision in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), a corporation's distribution of property, whether in complete liquidation or partial liquidation, produced neither gain nor loss to the distributing corporation. This non-recognition concept became known as the “General Utilities” doctrine and was subsequently codified in 1954 with the enactment of Section 311(a) for distributions not in complete liquidation, and Sections 336 and 337 for distributions in complete liquidation. There were some exceptions to the rule and, as time passed, statutory changes and judicial interpretations resulted in an increasing number of circumstances in which gains or losses were recognized.

The Tax Reform Act of 1986 (TRA86) fully repealed the General Utilities doctrine and dramatically changed the tax code, including new rules enacted under Section 311(b), which require the recognition of corporate-level gains on distributions of appreciated property. Before TRA86 became effective, the General Utilities doctrine permitted a C corporation to distribute certain appreciated assets to its shareholders without incurring corporate level income taxes on the gain. Under current tax law, tax avoidance opportunities for distributions of appreciated property are very limited. Corporations recognize a capital gain on nearly all distributions of appreciated property to shareholders. As a result of the repeal, such distributions are taxed twice, since the C corporation is deemed to have sold the property at fair market value and then to have distributed a taxable cash dividend to the shareholders. Accordingly, gains on post 1986 distributions of appreciated property by C corporations are generally subject to corporate-level income taxation.

Although pre-1986 tax cases were superceded by statute, the IRS maintained its position that case law did not allow a discount for built-in capital gains tax liability when a sale or liquidation was neither planned nor imminent, and it continued to be treated by courts as too uncertain, remote or speculative for well over a decade. During this period the IRS uniformly denied a discount for built-in capital gains tax liability (frequently referred to as BIG Tax), unless the taxpayer could prove payment was imminent. It wasn't until the Tax Court's 1998 decision in Estate of Davis v. Commissioner of Internal Revenue, 110 T.C. 530 (2nd Cir. 1998), and the Second Circuit Court of Appeals' 1998 decision in Estate of Eisenberg v. Commissioner of Internal Revenue, 155 F.3d 50 (2nd Cir. 1998), that the concept of a reduction for BIG Tax was embraced by the courts. These cases set a new precedent that, although no liquidation of the corporation or sale of corporate assets was imminent or contemplated at the valuation date, the requirement of an imminent sale was unnecessary; it was the opinion of the courts that a willing buyer would demand a discount to take account of the fact that, sooner or later, BIG Tax would have to be paid. The IRS ultimately acquiesced in the face of these and other decisions, accepted the concept, and now generally argues only about how the discount for BIG Tax should be quantified given the particular set of facts and circumstances presented in each case ' but not the legal right of taxpayers to claim the discount.

Conclusion

In next month's issue, we'll look at non-matrimonial cases that have dealt with this issue, and discuss the Wechsler trial court's decision-making process.

Thomas A. Hutson, CPA/ABV, CFP', is a partner at BST Valuation & Litigation Advisors LLC. He is a Certified Public Accountant, Accredited in Business Valuation by the American Institute of Certified Public Accountants, and a Certified Financial Planner.

The First Department Appellate Division's Oct. 21, 2008 decision in Wechsler v. Wechsler , 866 NYS2d 120 (1st Dept. 2008), demonstrated how, when financial experts present differing points of view when valuing a marital asset, a seemingly simple concept can nonetheless raise many questions.

The Puzzle

The principal issue addressed in the Wechsler decision is the extent to which the value of a holding company structured as a subchapter C corporation should be reduced to reflect the federal and state corporate level income taxes associated with the unrealized appreciation of marketable securities (or real estate or other assets in a different situation) owned by the corporation. The allowance, or provision, for deferred taxes is contingent, and is not realized until the underlying securities are sold.

Everyone agrees that under current tax law, a C corporation is subject to taxation on realized capital gains at the statutory rates in effect for the year in which such gains are realized. There are, however, significant differences of opinion regarding when and how a reduction (or discount) for the contingent taxes associated with these embedded (or built-in) gains should be quantified when valuing a business or an interest therein. This is currently a hot issue, not only for New York's matrimonial courts but also for federal estate and gift tax matters, and in shareholder oppression cases and buy-out proceedings under New York's Business Corporation Law (BCL).

Many factors affect the method of quantification that may be selected by a valuation expert or the court, including but not limited to: 1) the size of the ownership interest being appraised; 2) the method or methods of valuation used to appraise the business; 3) the weight given to each method utilized in arriving at a conclusion of value; 4) the premise of value (i.e., going concern value or liquidation value); 5) the expected holding period for the marketable securities portfolio (or real estate or other assets having embedded gains); 6) the amount, if any, of the provision for deferred taxes already reflected in the corporation's financial statements; and 7) perhaps most importantly, the specific facts and circumstances of each case.

Repeal of the General Utilities Doctrine

Before turning to a discussion of the decision in Wechsler, let's look at some of the statutory, regulatory and case law history surrounding the issue. Long ago, based on the 1935 Supreme Court decision in General Utilities & Operating Co. v. Helvering , 296 U.S. 200 (1935), a corporation's distribution of property, whether in complete liquidation or partial liquidation, produced neither gain nor loss to the distributing corporation. This non-recognition concept became known as the “General Utilities” doctrine and was subsequently codified in 1954 with the enactment of Section 311(a) for distributions not in complete liquidation, and Sections 336 and 337 for distributions in complete liquidation. There were some exceptions to the rule and, as time passed, statutory changes and judicial interpretations resulted in an increasing number of circumstances in which gains or losses were recognized.

The Tax Reform Act of 1986 (TRA86) fully repealed the General Utilities doctrine and dramatically changed the tax code, including new rules enacted under Section 311(b), which require the recognition of corporate-level gains on distributions of appreciated property. Before TRA86 became effective, the General Utilities doctrine permitted a C corporation to distribute certain appreciated assets to its shareholders without incurring corporate level income taxes on the gain. Under current tax law, tax avoidance opportunities for distributions of appreciated property are very limited. Corporations recognize a capital gain on nearly all distributions of appreciated property to shareholders. As a result of the repeal, such distributions are taxed twice, since the C corporation is deemed to have sold the property at fair market value and then to have distributed a taxable cash dividend to the shareholders. Accordingly, gains on post 1986 distributions of appreciated property by C corporations are generally subject to corporate-level income taxation.

Although pre-1986 tax cases were superceded by statute, the IRS maintained its position that case law did not allow a discount for built-in capital gains tax liability when a sale or liquidation was neither planned nor imminent, and it continued to be treated by courts as too uncertain, remote or speculative for well over a decade. During this period the IRS uniformly denied a discount for built-in capital gains tax liability (frequently referred to as BIG Tax), unless the taxpayer could prove payment was imminent. It wasn't until the Tax Court's 1998 decision in Estate of Davis v. Commissioner of Internal Revenue , 110 T.C. 530 (2nd Cir. 1998), and the Second Circuit Court of Appeals' 1998 decision in Estate of Eisenberg v. Commissioner of Internal Revenue , 155 F.3d 50 (2nd Cir. 1998), that the concept of a reduction for BIG Tax was embraced by the courts. These cases set a new precedent that, although no liquidation of the corporation or sale of corporate assets was imminent or contemplated at the valuation date, the requirement of an imminent sale was unnecessary; it was the opinion of the courts that a willing buyer would demand a discount to take account of the fact that, sooner or later, BIG Tax would have to be paid. The IRS ultimately acquiesced in the face of these and other decisions, accepted the concept, and now generally argues only about how the discount for BIG Tax should be quantified given the particular set of facts and circumstances presented in each case ' but not the legal right of taxpayers to claim the discount.

Conclusion

In next month's issue, we'll look at non-matrimonial cases that have dealt with this issue, and discuss the Wechsler trial court's decision-making process.

Thomas A. Hutson, CPA/ABV, CFP', is a partner at BST Valuation & Litigation Advisors LLC. He is a Certified Public Accountant, Accredited in Business Valuation by the American Institute of Certified Public Accountants, and a Certified Financial Planner.