Valuation and C Corp. Taxes on Embedded Gains

In the first part of this article, we noted that the problem of how to value a holding company structured as a subchapter C corporation was recently tackled by the Appellate Division, First Department, in the context of a dissolution of marriage. But the question of whether and how such value should be reduced to reflect the federal and state corporate-level income taxes associated with the unrealized appreciation of marketable securities owned by a corporation is controversial. Before taking an in-depth look, in next month's issue, at the First Department's reasoning in the appeal of Wechsler v. Wechsler, 866 NYS2d 120 (1st Dept. 2008), we need to understand the Wechsler trial court's decision and discuss how other courts have handled the issue.

Recent Non-Matrimonial Cases

Outside of the matrimonial arena, a Dec. 9, 2008 decision and May 22, 2008 decision in the Business Corporations Law (BCL) Section 1118 valuation case, Murphy v. U.S. Dredging Corp., 2008 NY Slip Op 31535 (Sup. Ct., NY Cty. 5/19/08), also addressed the built-in capital gains tax (BIG Tax) issue for C corporation assets, and the many factors that may influence how it is applied and quantified. In addition, since Murphy v. U.S. Dredging is a Section 1118 case, the applicable standard of value ' i.e., fair value versus fair market value ' was an important consideration in the decision rendered by the Nassau County Supreme Court. Factors addressed in the Court's May 22, 2008 decision included: 1) the nature of the assets owned by U.S. Dredging, which was a real estate holding company with substantial cash equivalent investments; 2) the premise of value (going concern or liquidation value); 3) the nature of valuation approaches used by the experts (an asset-based approach and an income-based approach); 4) the nature of valuation methods used by the experts (net asset value method and discounted future net cash flow method); 5) the shareholders' intent and the corporation's history, as these items bear on whether or not an election to become an S corporation (pass-through entity) may possibly be made, and on a decision to enter into an Internal Revenue Code Section 1031 tax-free exchange that deferred the recognition of the capital gain and BIG Tax associated with a sale of real estate, since the proceeds were reinvested in like-kind property; 6) the weighting that should be afforded the result returned by each method of valuation for purposes of arriving at an overall conclusion of value; 7) whether the entire date of valuation BIG Tax should be reflected in the calculations or a discounted present value of the BIG Tax, assuming a hypothetical sale some years in the future since the BIG Tax is not payable until the property is sold; and 8) the holding period assumed for the underlying corporately owned assets.

In Murphy v. U.S. Dredging, the court decided that a discounted value for the BIG Tax should be used and, in its Dec. 9, 2008 decision, applied a weighting of 45% to the net-asset-value method and 55% to the discounted-future-net-cash-flow method.

In the appeal of the Tax Court case, Estate of Dunn v. Commissioner of Internal Revenue, 301 F3d 339 (5th Cir. 2002), the U.S. Court of Appeals for the Fifth Circuit concluded, in a case where many similar issues presented themselves, that a weighting of 85% to the earnings-based approach and 15% to the asset-based approach was appropriate, and that under the asset-based approach the market value of appreciated assets should be reduced by the full amount of the BIG Tax (rather than a discounted value), assuming a hypothetical sale took place on the date of valuation.

In a more recent Tax Court case, Estate of Jelke v. Commissioner of Internal Revenue, 507 F3d 1317 (11th Cir. 2007), the fact pattern was somewhat different, but the U.S. Court of Appeals for the Eleventh Circuit likewise decided that the full amount of the BIG Tax should be reflected in the calculations (rather than a discounted value), assuming a hypothetical sale took place on the date of valuation. It was not necessary to apply a weighting to different methodologies in the Jelke decision, since both experts used an asset-based approach to valuation.

The Supreme Court Decision In Wechsler

In Wechsler, the Supreme Court, New York County, equitably distributed the divorcing parties' marital properly. At the date of commencement, Wechsler & Co., Inc. (WCI) was a C corporation and was in essence a holding company that bought and sold marketable securities for its own account, which securities constituted virtually all of its assets. The valuation date selected in Wechsler was the date of commencement. Three experts testified in the case before the Supreme Court: a neutral expert, an expert chosen by the husband, and an expert chosen by the wife. All three agreed that Mr. Wechsler's 100% ownership interest in WCI should be valued using a net asset-based approach to valuation. Accordingly it was unnecessary for the Supreme Court to assign a weighting to an income-based approach to valuation, since none of the three experts used it. Supreme Court Justice Judith J. Gische adopted a baseline value of $70,848,107, meaning the value determined by the neutral expert before any reduction for embedded taxes, and that amount was not disputed on appeal. The primary issue decided by the First Department related to the differing approaches to quantifying a reduction for the contingent corporate level capital gains taxes taken by each expert.

With respect to quantifying a reduction for embedded taxes, the Supreme Court rejected the approach taken by the Fifth Circuit in Estate of Dunn, which includes the assumption that under asset-based methodologies a hypothetical sale of the corporation's assets has taken place on the date of valuation and that the value of the corporation's net assets (assets minus liabilities) should be further reduced by the full amount of capital gains taxes that would be generated by the sale of the securities. At an effective combined federal and state tax rate of 41.74%, the contingent liability for embedded taxes would have been calculated to be $29,572,000 using this method.

After rejecting the Estate of Dunn method, the Supreme Court accepted the approach of the wife's expert, which reduced the baseline value by only 11%, or $7,793,292. The 11% represented the wife's expert's quantification of the historical rate of annual taxes paid by WCI relative to its annual gross revenue. The neutral expert and the husband's expert both disagreed strongly, and testified that the procedure was, in essence, fundamentally flawed, since taxes should be calculated as a percentage of pre-tax net income rather than as a percentage of gross revenues, among other things.

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.

In the first part of this article, we noted that the problem of how to value a holding company structured as a subchapter C corporation was recently tackled by the Appellate Division, First Department, in the context of a dissolution of marriage. But the question of whether and how such value should be reduced to reflect the federal and state corporate-level income taxes associated with the unrealized appreciation of marketable securities owned by a corporation is controversial. Before taking an in-depth look, in next month's issue, at the First Department's reasoning in the appeal of Wechsler v. Wechsler , 866 NYS2d 120 (1st Dept. 2008), we need to understand the Wechsler trial court's decision and discuss how other courts have handled the issue.

Recent Non-Matrimonial Cases

Outside of the matrimonial arena, a Dec. 9, 2008 decision and May 22, 2008 decision in the Business Corporations Law (BCL) Section 1118 valuation case, Murphy v. U.S. Dredging Corp. , 2008 NY Slip Op 31535 (Sup. Ct., NY Cty. 5/19/08), also addressed the built-in capital gains tax (BIG Tax) issue for C corporation assets, and the many factors that may influence how it is applied and quantified. In addition, since Murphy v. U.S. Dredging is a Section 1118 case, the applicable standard of value ' i.e., fair value versus fair market value ' was an important consideration in the decision rendered by the Nassau County Supreme Court. Factors addressed in the Court's May 22, 2008 decision included: 1) the nature of the assets owned by U.S. Dredging, which was a real estate holding company with substantial cash equivalent investments; 2) the premise of value (going concern or liquidation value); 3) the nature of valuation approaches used by the experts (an asset-based approach and an income-based approach); 4) the nature of valuation methods used by the experts (net asset value method and discounted future net cash flow method); 5) the shareholders' intent and the corporation's history, as these items bear on whether or not an election to become an S corporation (pass-through entity) may possibly be made, and on a decision to enter into an Internal Revenue Code Section 1031 tax-free exchange that deferred the recognition of the capital gain and BIG Tax associated with a sale of real estate, since the proceeds were reinvested in like-kind property; 6) the weighting that should be afforded the result returned by each method of valuation for purposes of arriving at an overall conclusion of value; 7) whether the entire date of valuation BIG Tax should be reflected in the calculations or a discounted present value of the BIG Tax, assuming a hypothetical sale some years in the future since the BIG Tax is not payable until the property is sold; and 8) the holding period assumed for the underlying corporately owned assets.

In Murphy v. U.S. Dredging, the court decided that a discounted value for the BIG Tax should be used and, in its Dec. 9, 2008 decision, applied a weighting of 45% to the net-asset-value method and 55% to the discounted-future-net-cash-flow method.

In the appeal of the Tax Court case, E state of Dunn v. Commissioner of Internal Revenue , 301 F3d 339 (5th Cir. 2002), the U.S. Court of Appeals for the Fifth Circuit concluded, in a case where many similar issues presented themselves, that a weighting of 85% to the earnings-based approach and 15% to the asset-based approach was appropriate, and that under the asset-based approach the market value of appreciated assets should be reduced by the full amount of the BIG Tax (rather than a discounted value), assuming a hypothetical sale took place on the date of valuation.

In a more recent Tax Court case, Estate of Jelke v. Commissioner of Internal Revenue , 507 F3d 1317 (11th Cir. 2007), the fact pattern was somewhat different, but the U.S. Court of Appeals for the Eleventh Circuit likewise decided that the full amount of the BIG Tax should be reflected in the calculations (rather than a discounted value), assuming a hypothetical sale took place on the date of valuation. It was not necessary to apply a weighting to different methodologies in the Jelke decision, since both experts used an asset-based approach to valuation.

The Supreme Court Decision In Wechsler

In Wechsler, the Supreme Court, New York County, equitably distributed the divorcing parties' marital properly. At the date of commencement, Wechsler & Co., Inc. (WCI) was a C corporation and was in essence a holding company that bought and sold marketable securities for its own account, which securities constituted virtually all of its assets. The valuation date selected in Wechsler was the date of commencement. Three experts testified in the case before the Supreme Court: a neutral expert, an expert chosen by the husband, and an expert chosen by the wife. All three agreed that Mr. Wechsler's 100% ownership interest in WCI should be valued using a net asset-based approach to valuation. Accordingly it was unnecessary for the Supreme Court to assign a weighting to an income-based approach to valuation, since none of the three experts used it. Supreme Court Justice Judith J. Gische adopted a baseline value of $70,848,107, meaning the value determined by the neutral expert before any reduction for embedded taxes, and that amount was not disputed on appeal. The primary issue decided by the First Department related to the differing approaches to quantifying a reduction for the contingent corporate level capital gains taxes taken by each expert.

With respect to quantifying a reduction for embedded taxes, the Supreme Court rejected the approach taken by the Fifth Circuit in Estate of Dunn, which includes the assumption that under asset-based methodologies a hypothetical sale of the corporation's assets has taken place on the date of valuation and that the value of the corporation's net assets (assets minus liabilities) should be further reduced by the full amount of capital gains taxes that would be generated by the sale of the securities. At an effective combined federal and state tax rate of 41.74%, the contingent liability for embedded taxes would have been calculated to be $29,572,000 using this method.

After rejecting the Estate of Dunn method, the Supreme Court accepted the approach of the wife's expert, which reduced the baseline value by only 11%, or $7,793,292. The 11% represented the wife's expert's quantification of the historical rate of annual taxes paid by WCI relative to its annual gross revenue. The neutral expert and the husband's expert both disagreed strongly, and testified that the procedure was, in essence, fundamentally flawed, since taxes should be calculated as a percentage of pre-tax net income rather than as a percentage of gross revenues, among other things.

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.