Opinion ID: 28167
Heading Depth: 3
Heading Rank: 1

Heading: Adjustment for Built-In Tax Liability of Assets

Text: 38 None 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% federal tax on the gain realized, regardless of whether that gain were labeled as capital gain or ordinary income. 22 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). 39 The Estate's expert took the position that, when determining the asset-based value to be used in calculating the fair market value of the Corporation, its assets must be treated as though they had in fact been sold, in which event the Corporation would have incurred federal income tax equal to 34% of the gain realized on the sale. This in turn would have instantly reduced the Corporation's fair market value, dollar for dollar, for taxes payable. But, if the willing buyer were to purchase the Decedent's block of stock with the assets still owned by the Corporation, then regardless of whether thereafter that buyer could and would cause all or essentially all of the Corporation's assets to be sold, either in the ordinary course of business or globally in liquidation, the value to the Corporation of its assets qua assets would still be the amount that the Corporation could realize on disposition of those assets, net of all costs (including gains tax). The Estate contends that, like advertising and transportation costs, commissions, and other unavoidable expenses of disposition of these assets accepted by the Tax Court, the assets' gross value must be reduced by their built-in gains tax liability to reach their net fair market value for purposes of calculating the asset-based value of the Corporation. 40 In diametric opposition, the Commissioner argued to the Tax Court that no reduction for built-in tax liability should be allowed. He grounded this contention solely on the assertion that liquidation was not imminent or even likely. 41 Although the Tax Court accepted the 34% rate and acknowledged that the value of the Corporation had to be reduced by some factor to account for inherent tax liability of its assets, the court followed the Commissioner's no imminent liquidation red herring and concluded that only if the hypothetical willing buyer of the Decedent's block of stock intended to liquidate the Corporation in the short term — which the holder of that block of stock, acting alone, could not force — would that buyer seek a substantial reduction for built-in capital gain. The Tax Court then proceeded to discuss such a postulational buyer's alternatives to liquidation and to calculate the present value (actually, negative value) of future tax liability. The court concluded that the asset-based value of Dunn Equipment should be reduced by only 5% for potential tax costs, not by the full 34% gains tax that the Corporation would have to pay when and if its assets were sold, whether in globo or seriatim. 42 The Tax Court's fundamental error in this regard is reflected in its statement that — for purposes of an asset-based analysis of corporate value — a fully-informed willing buyer of corporate shares (as distinguished from the Corporation's assemblage of assets) constituting an operational-control majority would not seek a substantial price reduction for built-in tax liability, absent that buyer's intention to liquidate. This is simply wrong: It is inconceivable that, since the abolition of the General Utilities doctrine and the attendant repeal of relevant I.R.C. sections, such as §§ 333 and 337, any reasonably informed, fully taxable buyer (1) of an operational-control majority block of stock in a corporation (2) for the purpose of acquiring its assets, has not insisted that all (or essentially all) of the latent tax liability of assets held in corporate solution be reflected in the purchase price of such stock. 43 We are satisfied that the hypothetical willing buyer of the Decedent's block of Dunn Equipment stock would demand a reduction in price for the built-in gains tax liability of the Corporation's assets at essentially 100 cents on the dollar, regardless of his subjective desires or intentions regarding use or disposition of the assets. Here, that reduction would be 34%. This is true in spades when, for purposes of computing the asset -based value of the Corporation, we assume (as we must) that the willing buyer is purchasing the stock to get the assets, 23 whether in or out of corporate solution. We hold as a matter of law that the built-in gains tax liability of this particular business's assets must be considered as a dollar-for-dollar reduction when calculating the asset -based value of the Corporation, just as, conversely, built-in gains tax liability would have no place in the calculation of the Corporation's earnings -based value. 24 44 The Tax Court made a more significant mistake in the way it factored the likelihood of liquidation into its methodology, a quintessential mixing of apples and oranges: considering the likelihood of a liquidation sale of assets when calculating the asset -based value of the Corporation. Under the factual totality of this case, the hypothetical assumption that the assets will be sold is a foregone conclusion — a given — for purposes of the asset-based test. 25 The process of determining the value of the assets for this facet of the asset-based valuation methodology must start with the basic assumption that all assets will be sold, either by Dunn Equipment to the willing buyer or by the willing buyer of the Decedent's block of stock after he acquires her stock. By definition, the asset-based value of a corporation is grounded in the fair market value of its assets (a figure found by the Tax Court and not contested by the estate), which in turn is determined by applying the venerable willing buyer-willing seller test. By its very definition, this contemplates the consummation of the purchase and sale of the property, i.e., the asset being valued. Otherwise the hypothetical willing parties would be called something other than buyer and seller. 45 In other words, when one facet of the valuation process requires a sub-determination based on the value of the company's assets, that value must be tested in the same willing buyer/willing seller crucible as is the stock itself, which presupposes that the property being valued is in fact bought and sold. It is axiomatic that an asset-based valuation starts with the gross market (sales) value of the underlying assets themselves, and, as observed, the Tax Court's finding in that regard is unchallenged on appeal: When the starting point is the assumption of sale, the likelihood is 100%! 46 This truism is confirmed by its obverse in today's dual, polar-opposite approaches (cash flow; assets). The fundamental assumption in the income or cash-flow approach is that the assets are retained by the Corporation, i.e., not globally disposed of in liquidation or otherwise. So, just as the starting point for the asset-based approach in this case is the assumption that the assets are sold, the starting point for the earnings-based approach is that the Corporation's assets are retained — are not sold, (other than as trade-ins for new replacement assets in the ordinary course of business) — and will be used as an integral part of its ongoing business operations. This duly accounts for the value of assets — unsold — in the active operations of the Corporation as one inextricably intertwined element of the production of income. 47 Bottom Line: The likelihood of liquidation has no place in either of the two disparate approaches to valuing this particular operating company. We hasten to add, however, that the likelihood of liquidation does play a key role in appraising the Decedent's block of stock, and that role is in the determination of the relative weights to be given to those two approaches: The lesser the likelihood of liquidation (or sale of essentially all assets), the greater the weight (percentage) that must be assigned to the earnings(cash flow)-based approach and, perforce, the lesser the weight to be assigned to the asset-based approach. 48 Belabored as our point might be, it illustrates the reason why, in conducting its asset-based approach to valuing Dunn Equipment, the Tax Court erred when it grounded its time-use-of-money reduction of the 34% gains tax factor to 5% on the assumption that the corporation's assets would not likely be sold in liquidation. As explained, the likelihood of liquidation is inapposite to the asset-based approach to valuation. 49 In our recent response to a similarly misguided application of the built-in gains tax factor by the Tax Court, we rejected its treatment as based on internally inconsistent assumptions. 26 In that case we reversed and remanded with instructions for the Tax Court to reconsider its valuation of the subject corporation's timber property values by using a more straightforward capital gains tax reduction. Similarly, because valuing Dunn Equipment's underlying corporate assets is not the equivalent of valuing the Company's capital stock on the basis of its assets, but is merely one preliminary exercise in that process, the threshold assumption in conducting the asset-based valuation approach as to this company must be that the underlying assets would indeed be sold. And to whom? To a fully informed, non-compelled, willing buyer. That is always the starting point for a fair market value determination of assets qua assets. That determination becomes the basis for the company's asset-based value, which must include consideration of the tax implications of those assets as owned by that company. 50 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% of the taxable gain inherent in those assets as of the valuation date. 27 Moreover, the factually determined, real world likelihood of liquidation is not a factor affecting built-in tax liability when conducting the asset-based approach to valuing Dunn Equipment stock. 28 Rather, the probability of a liquidation's occurring affects only (but significantly) the relative weights to be assigned to each of the two values once they have been determined under the asset-based and income-based approaches, respectively — which brings us to the second methodology issue presented in this appeal.