Effect of Built-in Gain on Value of Closely Held Stock

TAX CASE

The valuation of stock in a closely held corporation is a difficult issue frequently argued before the courts. Since no independent valuations, such as market quotations, are available, a stock’s fair value may be difficult to determine. Treasury regulations section 20.2031-2(f) and revenue ruling 59-60, 1959-1 CB 237, provide factors CPAs can consider in valuing closely held stock for estate tax purposes. Generally, the value is what a willing buyer would pay a willing seller to receive the economic benefits attached to a stock. However, in any given case, it’s not always easy to determine what factors the buyer and seller would consider.

Helen Jameson owned stock in a family-owned company at the time of her death. The corporation, Johnco, owned and operated timber property. It earned the majority of its income by receiving fees from companies that harvested timber on the property. The income the property generated was considered low in relation to its underlying value. The estate’s appraisers argued the valuation should be based on an immediate sale of the company’s assets and liquidation of the corporation. This would permit the estate to reduce the value by the amount of the capital gains taxes it would pay on the sale of the assets.

The Tax Court rejected the expert valuations and formulated its own method to value the stock: It took the underlying value of the timber property the corporation owned and reduced it by the net present value of the capital gains tax liability the company would incur as the timber was cut. This valuation method was based on the assumption that a willing buyer would operate the timber property as a going concern. The estate disputed this valuation and appealed.

Result. For the taxpayer. The Fifth Circuit Court of Appeals vacated the decision and remanded the case to the Tax Court for further consideration. The Fifth Circuit had concluded it would be proper to value the Johnco stock under revenue ruling 59-60 based on the fair market value of the company’s assets. The IRS has typically applied this asset approach when a closely held corporation functions as a holding company and earnings are relatively low in comparison to the fair market value of the underlying assets. The Tax Court had assumed a willing buyer would operate the timber property as a going concern, accepting the low earnings and paying the capital gains tax over a period of years.

The Fifth Circuit determined the Tax Court had used an inconsistent assumption—namely, that a hypothetical purchaser would engage in long-range timber production even though the timber property’s annual rate of return was substantially lower than the return most investors would require. This assumption fatally flawed the Tax Court decision. The Fifth Circuit remanded the case because it could not determine whether Tax Court records would support other valuation estimates.

Taxpayers should be sure to provide evidence of stock valuation in closely held corporations based on the worth of the underlying property. They should include valuation methods other than capitalization of corporate earnings, particularly in situations where those earnings are relatively low in relation to the fair market value of the underlying property. These methods could include a valuation based on sales of comparable properties.

Estate of Helen B. Jameson v. Commissioner, 88 AFTR 2d 2001-5323.

Prepared by Sharon Burnett, CPA, PhD, assistant professor of accounting, and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.