Estate of Richmond, T.C. Memo 2014-26

This case deals with the estate of a woman who owned a 23.44% interest in a family-owned holding company, a Subchapter “C” corporation. Most of the company’s $52.16 million in assets consisted of publicly traded securities. Because the company had held the assets for a long period of time, the Company’s value included $45 million in stock value appreciation. The actual value of the assets needed to be adjusted to include some portion of the amount of built-in capital gains tax (BICG tax) of over $18M that the shareholders would owe if the corporation sold its assets and/or it was subsequently liquidated.

How BICG Works

“The term ’Built-in Capital Gains’ means in this instance that we have a “C” corporation that has ownership of securities that have appreciated in value far in excess of their original purchase price. Therefore, a large taxable capital gain will be reported whenever those securities are sold and a significant amount of corporate income tax will be payable at the time of sale. Also, if you had to liquidate the corporation for some reason, there would be a lot of corporate income tax to pay on the appreciation in value related to the securities held,” Denny Taylor pointed out. “You wouldn’t want to buy that corporation’s stock without considering the income tax liability related to the BICG, also known as the BIG tax.

Because of the BIG tax, the present value of the corporate stock of a “C” Corporation is correspondingly less. The amount of this reduction in value of the corporate stock corresponds to the estimated present value of that future payment of the BIG tax in some future year. The estimated present value of the tax liability is determined by applying a discount rate to an estimated amount of tax paid at an estimated future date.

What Happened in the Case?

The executors of the estate used a qualified appraiser from an accounting firm to value the stock and the corresponding tax liability, taking into account a discount for the BICG tax owed that would effectively reduce the marketable value of the stock. The estate calculated the amount of the decedent’s interest to be worth $3.15 million for the percentage of the company she had owned and listed that amount on the estate’s tax return. However, an IRS auditor, upon performing an exam of the estate tax return, asserted that the decedent’s interest was worth $9.2 million and added a $1.14 million penalty for grossly understating the value of the corporate stock on the federal estate tax return as filed. The estate took the case to Tax Court to get a ruling on the fair market value of the decedent’s assets and whether the estate really owed an under valuation penalty.

Three valuation experts provided estimates of the holding company’s value for the trial:

  • The initial appraiser was retained by the executor of the decedent’s estate. He estimated the value of the estate’s interest at $3.15 million. A CPA and certified financial planner, this expert was not a certified appraiser. He had submitted an unsigned valuation, based on the information provided by the estate. The estate never asked him to finalize his valuation.
  • The IRS secured the services of an experienced business valuator for trial to support their position that the corporate stock value was understated on the estate tax return. He opined that the value of the decedent’s ownership interest of the corporate stock was worth $12.2 million out of the corporation’s total value of $52.1 million. After figuring in a 6% discount for lack of control, a 36% discount for lack of marketability and the BICG tax liability, he determined the estate’s ownership interest was worth $7.3 million. Ultimately, the IRS expert set the present value of the BICG tax liability at $7.8 million.
  • The estate’s expert at trial, a certified business appraiser, used a different methodology, basing his opinion, in part, on the market rate of return for a similar company. He estimated the present value of the decedent’s share at $5 million. The estate asked the court to use this revised number in place of the $3.15 million in the original calculation.

Both appraisers for the estate initially used an “Income Approach” valuation method called capitalization-of-dividends approach wherein estimated future dividend income was discounted to present value to determine the value of the shares of the corporation in the decedent’s estate. The Tax Court found this “Income Approach” method at odds with the facts in this case as the fair market value of the publicly traded securities held by the “C” Corporation were readily obtainable. If the securities had consisted, say, of dividend paying corporate stock of a closely held family owned business, the income approach would have been supportable. Here the Court determined that the only logical method to determine the value of the underlying assets of the corporation was the Net Asset Value (NAV) method.

In response to the IRS’s expert having chosen the NAV method, the estate’s expert at trial also then used the NAV method to produce an estimate of $4.7 million in value for the decedent’s corporate shares. The Tax Court considered the merits of the various methodologies used and settled on the NAV approach.

The court found problems with each appraiser’s BICG approach, but accepted a range of $5.5 million to $9.6 million for the value of the BICG tax liability discount. Because the $7.8 million calculated by the IRS appraiser fell within this range, the court went with that number for the BICG discount.

After subtracting the $7.8 M from the net asset value of $52M and applying a 7.75% lack of control and 32.1% lack of marketability discounts, the Court settled on the fair market value of the decedent’s stock (a 23.44% stock ownership interest) to be worth $6.5 million.

What About the Penalty?

The Tax Court found that, by using the unsigned draft by an accountant who wasn’t a certified appraiser, the estate had not properly valued the decedent’s interest in the company and had understated the value. For that reason, the court said the estate still owed the penalty. The estate argued that the very fact that four different valuators (including the original IRS auditor) came up with four different calculations revealed the complexity of the situation and, thus, reasonable cause for waiver of the penalty, but the court did not accept that logic and upheld the undervaluation penalty.

The case underscores the value of getting qualified assistance. “You need to get a qualified appraiser when filing tax returns with valuation issues,” Denny Taylor added. TD&T CPAs and Advisors’ team of business appraisers can help you with quality valuation services in compliance with IRS requirements.