Dunn Does It Again

The Eleventh Circuit Court of Appeals vacated a Tax Court judgment and allowed a valuation discount of 100% of an estate’s built-in capital gains tax. The court based the contingent tax liability and resulting discount on an assumed immediate liquidation of the decedent’s interest in a closely held investment holding company, rather than the 16-year indexed discount allowed by the Tax Court. On an issue of first impression for this court, the Eleventh Circuit followed the Fifth Circuit’s approach in Estate of Dunn , 90 AFTR2d 2002-5527.

When Frazier Jelke III died in 1999 in Miami, he held through a revocable trust a 6.44% interest in Commercial Chemical Company (CCC), a closely held C corporation that held and managed investments for its shareholders. The other CCC shareholders were irrevocable trusts for other Jelke family members. The terms of the trusts did not prohibit the sale or transfer of CCC stock. CCC’s primary investments were marketable securities, and the portfolio was well managed by a stockholder-elected board. The investment strategy was long-term capital growth, which resulted in low asset turnover and large unrealized capital gains. There were no plans to liquidate any significant portion of CCC’s portfolio.

The federal estate tax return reported the value of Jelke’s interest in CCC as $4,588,155, which was computed by reducing CCC’s net asset value by the entire built-in capital gains tax liability, as if the securities had been sold at the date of death, then applying a 20% discount for lack of control and a 35% discount for lack of marketability. The IRS issued a notice of deficiency based on the same net asset value but discounting for the built-in capital gains tax liability by $21 million, or 41%, to reflect when it was expected to be incurred, and using lesser discounts for lack of control (5%) and lack of marketability (10%).

The Tax Court agreed with the IRS and disallowed the full reduction for built-in capital gains tax liability, on the presumption that the tax would be incurred in the future. However, the Tax Court applied a 10% lack-of-control discount and a 15% lack-of-marketability discount.

In siding with the estate, the Eleventh Circuit used Dunn’s “snap shot of valuation” approach, which takes into account only the facts known at the date of death “without present values or prophesies,” the court said.

In a scathing dissent, Judge Ed Carnes derided Dunn’s and the instant majority’s “rule of least effort,” saying “sometimes prophesying is necessary.” The Tax Court’s calculation produced a result closer to reality than assuming an immediate liquidation, Carnes wrote.

Although this is the first time this valuation issue has come before the Eleventh Circuit, it has been addressed by several other circuits besides the Fifth. The Second Circuit in Eisenberg v. Commissioner (82 AFTR2d 98-5757) and the Sixth Circuit in Estate of Welch (85 AFTR2d 2000-1200) allowed discounts (less than 100%) for built-in capital gains taxes. The Fifth Circuit vacated the Tax Court’s judgment in Estate of Jameson (88 AFTR2d 2001-5922) and remanded the case with instructions to allow a discount for built-in capital gains. A year later, the Fifth Circuit reversed the Tax Court again, in Dunn . Increasingly since 1998, when the Tax Court in Estate of Davis (110 TC 530) began recognizing such discounts, the question has been not whether they can be taken, but by how much. We will likely see more aggressive positions taken in this area. For estate tax valuation, tax advisers may want to consider the cases in their jurisdiction.

Estate of Frazier Jelke III v. Commissioner , 100 AFTR2d 2007-6694

Prepared by Karyn Bybee Friske , CPA, Ph.D., Pickens Professor of Business and associate professor of accounting, and Darlene Pulliam , CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.