New Guidance on Valuation Discounts for Built-In LTCG Tax

November 19, 2010

A recent Tax Court decision, Estate of Jensen v. Commissioner, sheds light on different methods of calculating estate tax discounts for built-in long-term capital gains tax, giving appraisers and fiduciaries helpful advice as they seek to accurately estimate discounts.

Estate of Jensen v. Commissioner, T.C. Memo. 2010-182

Built-In LTCG Tax Discounts

Following the 1986 Tax Act, corporations were required to recognize capital gains upon the distribution of appreciated property. This new liability suggested that corresponding valuation discounts in the computation of estate tax for built-in long-term capital gains (LTCG) tax liability would be appropriate for C corporations. However, the IRS and the Tax Court were slow to accept such discounts. After a dozen years of rejection, in the late 1990s, the Tax Court – and a number of circuit courts reviewing the Tax Court – began to accept taxpayers’ claimed discounts. Litigation continued over the proper calculation of the discount, with some circuits, notably the 5th and 11th, approving discounts of 100% of the capital gains liability, dollar for dollar. However, not all circuits have adopted this approach, so litigation over the amount of the discount continues to occur, particularly in other circuits.

Estate of Jensen

In Estate of Jensen v. Commissioner, T.C. Memo 2010-182, the decedent, a resident of New York at her death in 2005, owned 164 shares of stock (82% of the total shares) of Wa-Klo, Inc., a closely held C corporation that owned a summer camp property in New Hampshire. The estate’s appraisers valued the shares at $4.24 million before any discounts, and then applied the 5th and 11th Circuit dollar-for-dollar approach to estimate the appropriate discount for built-in LTCG tax liability as $965,000. (On appeal to the Tax Court, the estate increased its estimate for the discount to $1.13 million.) The IRS disagreed, conceding the propriety of a discount but limiting it to $250,042.

Letting the Circuits Speak for Themselves

Proceedings in the Tax Court were governed by the decisions of the 2nd Circuit, which had accepted the concept of built-in LTCG tax discounts in Eisenberg v. Commissioner, 155 F.3d 50, 57 (2d Cir. 1998), but had not addressed the method of calculation in subsequent years. The estate urged the Tax Court to predict that the 2nd Circuit would adopt decisions by the 5th and 11th Circuits and employ the dollar-for-dollar method in calculating the discount. The Tax Court, however, “decline[d] to speculate as to how the Court of Appeals for the Second Circuit may hold in the future,” but proceeded to review the parties’ calculation arguments in light of existing authority.

Discounts for Dissimilar Assets Not Helpful

The appraiser hired by the IRS had arrived at the much smaller discount by comparing the Wa-Klo shares to closed-end funds – a type of investment company for which built-in LTCG tax discounts are also common. The Tax Court rejected this approach, finding the closed-end funds so dissimilar from the real estate owned outright by Wa-Klo that any comparison between them was not useful.

Holding Period: A New Factor

The Tax Court also rejected the estate’s proposed dollar-for-dollar discount, finding instead that the present value of LTCG liability was only the starting point. From there, the court (following several of its decisions in other valuation contexts) calculated a holding period of 17 years, equivalent to the remaining useful life of the real estate and improvements owned by Wa-Klo. Using estimates of the future value of the property and the projected long-term capital gains at the end of the holding period, the Tax Court estimated the correct discount for the estate’s interest in Wa-Klo to be $939, 292.60. This was almost the same discount initially proposed by the estate.

Built-In LTCG Tax Discounts after Jensen

The Tax Court’s methodology in arriving at the built-in LTCG tax discount in Jensen v. Commissioner suggests how such discounts might be calculated by appraisers and defended by executors, at least for estates located in circuits other than the 5th and 11th. While those circuits have adhered to the more straightforward though perhaps arbitrary dollar-for-dollar method, the Jensen approach seems more closely tailored to the circumstances of each particular estate, and might spur some interest in revisiting built-in LTCG tax discounts in the future. However, one must question how a court using a discounted future value methodology can reach a figure close to that of a dollar-for-dollar discount. For that reason, circuit courts may prefer the dollar-for-dollar reduction for LTCG tax in computing the discount for estate tax valuation purposes.

McGuireWoods Fiduciary Advisory Services

Fiduciary Advisory Services advises financial institutions and other clients about planning, tax, and fiduciary matters. This includes advising executors and trustees in managing risks, avoiding litigation, and handling litigation when it does arise.

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