Matrimonial Actions and the Valuation of C Corp. Taxes on Embedded Gains

After eloquently summarizing the Eleventh Circuit's divided decision in Jelke, including the dissenting opinion of Justice Edward Carnes, the First Department noted that the Wechsler appeal did not require them to decide, based on the merits and demerits of the majority and dissenting opinions in Jelke, which of the two approaches is preferable with respect to the issue of embedded taxes. This is because, at trial, the Supreme Court was not asked to decide between the Fifth Circuit and Eleventh Circuit decisions in Dunn and Jelke versus the approach argued by the Commissioner of Internal Revenue or in Justice Carnes' dissent. Rather, the Supreme Court was asked to choose between the approach of the Fifth Circuit in Dunn and an approach different from the one advanced by the Commissioner of Internal Revenue in Jelke ' namely, the approach advanced by the wife's expert.

The Majority Decision

The First Department's decision, after thoroughly discussing the many reasons why they rejected the historical approach adopted by the wife's expert, concluded, given the factual circumstances of the case, only that as and between the competing methodologies advanced at trial the Supreme Court should have adopted the methodology adopted by the Fifth Circuit in Dunn. Accordingly they determined WCI was overvalued by $21,778,708 ($29,572,000 – $7,793,292). In arriving at its decision, the First Department also explained how others of the Supreme Court's rulings, including the size of the distributive award and the equitable distribution of other marital assets, require the husband to bear the lion's share of the risk of a decline in the value of the securities owned by WCI. This was of particular concern to them since the husband was left without any substantial cushion to protect himself in the event of a significant decline in the market value of these securities. A need for liquidity required to pay, among other things, the distributive award, could also trigger realization of BIG Tax if and when corporately owned securities are sold.

The First Department also reviewed the various arguments presented in Justice John W. Sweeney's dissent (summarized below), and explained that they were at a loss to understand why the dissenter expressly rejected not only the approach of the majority in Jelke, but also implicitly rejected the dissent of Justice Carnes in that case, and of the IRS, without explaining why.

The First Department further noted that it is simply wrong to attempt to distinguish the Wechsler case from Dunn and Jelke on the grounds that there is no indication that Mr. Wechsler's ownership of WCI will cease or that WCI will cease operations with the entry of the decree. In Dunn, the corporation was an operating company, not an investment holding company like WCI, and the Tax Court found that the likelihood of liquidation was slight. The First Department noted that the Fifth Circuit could not have been clearer in holding that a dollar-for-dollar reduction for the built-in tax was required because the likelihood of liquidation is inapposite to the asset-based approach to valuation and that the probability of a liquidation's occurring affects only the relative weights to be assigned to the different approaches and methodologies that are advanced by the experts (there are three generally recognized approaches to valuation, namely the income-based approach, the asset-based approach and the market-based approach). The First Department also points out that in Jelke, there is no indication at all that the investment holding company was about to cease operations or sell the securities it owned. The Eleventh Circuit held that when valuing an investment holding company using the net-asset value method, whether or not the company will actually liquidate its assets is irrelevant, and an assumption that a liquidation has occurred should be made for purposes of quantifying the amount of the BIG Tax liability so that it is unnecessary to prophesize the future and discount such prophecies to present value.

The Jelke and Dunn courts favored this approach in no small part because they viewed it as a simple and logical analysis that provides practical certainty to tax practitioners, appraisers, and financial planners ' noting that it eliminates the need for complex and uncertain prognostications about the present value of future events, which require a crystal ball. Basing the BIG Tax calculation on a snapshot of a date of valuation balance sheet, marked to market, provides certainty and finality, which these courts preferred to what they perceived as an unnecessary expenditure of judicial resources to wade through myriad divergent expert witness testimony, based upon subjective conjecture. In Dunn, the Fifth Circuit noted that its methodology may be viewed by some valuation professionals as unsophisticated, dogmatic, overly simplistic, or just plain wrong, but the court made this observation: that on the end of the methodology spectrum opposite of oversimplification lies over-engineering.

Justice Sweeney's Dissent

All of the First Department's Appellate Judges concurred in the Wechsler decision, with the exception of Justice Sweeney, who agreed with the majority on all but one point. Justice Sweeney did not believe that a discount for BIG Taxes should be applied in arriving at a value for WCI. He noted that the valuation methodology discussed in the Jelke and Dunn decisions arose out of valuations performed for estate tax purposes, and he believed that such methodology might not always be appropriate for matrimonial valuation purposes. As similarly noted by Justice Ira B. Warshawsky in Murphy v. U.S. Dredging, Justice Sweeney believes that the nature of the case and the area of law are important considerations in determining the appropriate methodology to employ.

In addition to finding the absence of an expressed intent to sell the appreciated property or dissolve the corporate entity a fact worthy of consideration, Justice Sweeney disagreed with the majority's finding that the trial court erred in accepting the wife's expert's method of valuation, since he used historical taxes as a percentage of gross revenues and, in Justice Sweeney's opinion, no one demonstrated to the trial court that the wife's expert's approach was inherently improper or should not be applied in this case where the amount of capital gains that will actually be paid in the future is uncertain.

After complimenting the majority for their lengthy and eloquent argument for their position, Justice Sweeney stated that there was no reason to substitute the First Department's judgment for that of the trial court on issues of valuation. He further noted that the trial court viewed the witnesses, carefully examined the evidence and wrote a detailed and thoughtful decision. Justice Sweeney emphasized that Mrs. Wechsler was denied any maintenance because of the valuation the trial court placed on her equitable share of WCI and that, although it is still a very sizable award, the appellate decision reduces her award considerably from the amount she was entitled to under trial court's careful analysis of Domestic Relations Law Section 236 (b).

Justice Carnes' Dissent in Jelke

Justice Carnes dissent from the Eleventh Circuit Court of Appeals decision in Jelke focused on the virtues of hard work, as espoused by Teddy Roosevelt, in contrast to the doctrine of ignoble ease that the majority used to justify what he viewed as arbitrary assumptions made for the sake of certainty and finality. The bypassing of what the majority perceived as an unnecessary expenditure of judicial resources did not seem a valuable goal to Justice Carnes, who argued that the expenditure of judicial resources is required to make more realistic calculations. He warned that the idea of taking the easier route, if allowed to reign, would result in no end to the shortcuts that can be taken by the judiciary.

Justice Carnes pointed out that the history of the judicial system reveals that prophesying is sometimes necessary, and he quoted Justice Oliver Wendell Holmes' decision in Ithaca Trust Co. v. United States, 279 U.S. 151, as follows: “The value of property at a given time depends upon the relative intensity of the social desire for it at that time, expressed in the money that it would bring in the market. Like all values, as the word is used by the law, it depends largely on more or less certain prophecies of the future, and the value is no less real at that time if later the prophecy turns out false than when it comes out true.”

In summary, Justice Carnes expressed his belief in Jelke that the effort required to analyze each case's specific attributes, along with any necessary prophesying about the future and expenditure of judicial resources, is time and money well spent.

Conclusion

Interestingly, Paragraph 5(b) of Internal Revenue Service Revenue Ruling 59-60, which applies to valuations performed for estate and gift tax purposes, reads as follows:

The value of the stock of a closely held investment or a real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock. For companies of this type, the appraiser should determine the fair market values of the assets of the company. Operating expenses of such a company and the cost of liquidating it, if any, merit consideration when appraising the relative values of the stock and the underlying assets. The market values of the underlying assets give due weight to potential earnings and dividends of the particular items of property underlying the stock, capitalized at rates deemed proper by the investing public at the date of appraisal. A current appraisal by the investing public should be superior to the retrospective opinion of an individual. For these reasons, adjusted net worth should be accorded greater weight in valuing the stock of a closely held investment or real estate holding company, whether or not family owned, than any of the other customary yardsticks of appraisal, such as earnings and dividend paying capacity.

No one argues with the simple concept that, after the repeal of the General Utilities doctrine in 1986, a C corporation almost universally pays corporate level taxes on the disposition of appreciated assets. However, many complex subtleties make the quantification of an appropriate discount for BIG Taxes, given each particular set of facts and circumstances, a many faceted task that has already required a great deal of effort by numerous courts.

The Commissioner of Internal Revenue filed a petition for a writ of certiorari with the Supreme Court of the United States on July 21, 2008 with respect to the Eleventh Circuit's decision in Jelke. The Estate filed its brief in opposition on Aug. 20, 2008 and the IRS filed its reply on Sept. 3, 2008. Although the Supreme Court denied the IRS's petition on Oct. 6, 2008, for those who may be interested, the papers filed provide some interesting additional insight regarding the issues and the positions taken by the IRS versus those taken by taxpayers and courts' relative to a dollar-for-dollar discount for contingent embedded capital gains taxes existing at the date of valuation.

The cases discussed in this article are not the only cases addressing the quantification of a contingent liability for BIG Taxes, but they do squarely address the fundamental concepts raised in the Wechsler case. One thing is for certain: Whether it comes from the New York State Court of Appeals, the Tax Court, the United States Court of Appeals, or some other judicial body, additional guidance on the application of a C corporation discount for embedded capital gains taxes will almost certainly be forthcoming in the relatively near future.

Thomas A. Hutson, CPA/ABV, CFP', is a partner at BST Valuation & Litigation Advisors LLC. He is a Certified Public Accountant, Accredited in Business Valuation by the American Institute of Certified Public Accountants, and a Certified Financial Planner.

The first part of this article noted that the problem of how to value a holding company structured as a subchapter C corporation was recently tackled by the Appellate Division, First Department in the context of a dissolution of marriage. But the question of whether and how such value should be reduced to reflect the federal and state corporate-level income taxes associated with the unrealized appreciation of marketable securities owned by a corporation is controversial. Last month's continuation discussed the First Department's reasoning in the appeal of Wechsler v. Wechsler , 866 NYS2d 120 (1st Dept. 2008). Herein, we take an in-depth look at the decision itself.

First Department Appellate Decision

It is important to bear in mind that at the time of the Supreme Court's decision in Wechsler , which was issued Aug. 11, 2005, the Nov. 15, 2007 decision of the Eleventh Circuit Court of Appeals in Estate of Jelke v. Commissioner of Internal Revenue, 07 F3d 1317 (11th Cir. 2007) , had not yet been rendered. In fact, the First Department noted that the Supreme Court's comprehensive, thoughtful and painstakingly written opinion relied in significant part on the decision of the Tax Court in Estate of Jelke, which was reversed by the Eleventh Circuit after the Wechsler appeal was argued, but before its opinion was issued. In Jelke, the Eleventh Circuit adopted the approach of the Fifth Circuit in Dunn, and concluded, based on the assumption of a sale of the corporations assets on the date of valuation (under an asset-based approach), that the value of the corporation's net assets should be reduced by the full amount of the embedded taxes that would be payable as a result of the sale.

After eloquently summarizing the Eleventh Circuit's divided decision in Jelke, including the dissenting opinion of Justice Edward Carnes, the First Department noted that the Wechsler appeal did not require them to decide, based on the merits and demerits of the majority and dissenting opinions in Jelke, which of the two approaches is preferable with respect to the issue of embedded taxes. This is because, at trial, the Supreme Court was not asked to decide between the Fifth Circuit and Eleventh Circuit decisions in Dunn and Jelke versus the approach argued by the Commissioner of Internal Revenue or in Justice Carnes' dissent. Rather, the Supreme Court was asked to choose between the approach of the Fifth Circuit in Dunn and an approach different from the one advanced by the Commissioner of Internal Revenue in Jelke ' namely, the approach advanced by the wife's expert.

The Majority Decision

The First Department's decision, after thoroughly discussing the many reasons why they rejected the historical approach adopted by the wife's expert, concluded, given the factual circumstances of the case, only that as and between the competing methodologies advanced at trial the Supreme Court should have adopted the methodology adopted by the Fifth Circuit in Dunn. Accordingly they determined WCI was overvalued by $21,778,708 ($29,572,000 – $7,793,292). In arriving at its decision, the First Department also explained how others of the Supreme Court's rulings, including the size of the distributive award and the equitable distribution of other marital assets, require the husband to bear the lion's share of the risk of a decline in the value of the securities owned by WCI. This was of particular concern to them since the husband was left without any substantial cushion to protect himself in the event of a significant decline in the market value of these securities. A need for liquidity required to pay, among other things, the distributive award, could also trigger realization of BIG Tax if and when corporately owned securities are sold.

The First Department also reviewed the various arguments presented in Justice John W. Sweeney's dissent (summarized below), and explained that they were at a loss to understand why the dissenter expressly rejected not only the approach of the majority in Jelke, but also implicitly rejected the dissent of Justice Carnes in that case, and of the IRS, without explaining why.

The First Department further noted that it is simply wrong to attempt to distinguish the Wechsler case from Dunn and Jelke on the grounds that there is no indication that Mr. Wechsler's ownership of WCI will cease or that WCI will cease operations with the entry of the decree. In Dunn, the corporation was an operating company, not an investment holding company like WCI, and the Tax Court found that the likelihood of liquidation was slight. The First Department noted that the Fifth Circuit could not have been clearer in holding that a dollar-for-dollar reduction for the built-in tax was required because the likelihood of liquidation is inapposite to the asset-based approach to valuation and that the probability of a liquidation's occurring affects only the relative weights to be assigned to the different approaches and methodologies that are advanced by the experts (there are three generally recognized approaches to valuation, namely the income-based approach, the asset-based approach and the market-based approach). The First Department also points out that in Jelke, there is no indication at all that the investment holding company was about to cease operations or sell the securities it owned. The Eleventh Circuit held that when valuing an investment holding company using the net-asset value method, whether or not the company will actually liquidate its assets is irrelevant, and an assumption that a liquidation has occurred should be made for purposes of quantifying the amount of the BIG Tax liability so that it is unnecessary to prophesize the future and discount such prophecies to present value.

The Jelke and Dunn courts favored this approach in no small part because they viewed it as a simple and logical analysis that provides practical certainty to tax practitioners, appraisers, and financial planners ' noting that it eliminates the need for complex and uncertain prognostications about the present value of future events, which require a crystal ball. Basing the BIG Tax calculation on a snapshot of a date of valuation balance sheet, marked to market, provides certainty and finality, which these courts preferred to what they perceived as an unnecessary expenditure of judicial resources to wade through myriad divergent expert witness testimony, based upon subjective conjecture. In Dunn, the Fifth Circuit noted that its methodology may be viewed by some valuation professionals as unsophisticated, dogmatic, overly simplistic, or just plain wrong, but the court made this observation: that on the end of the methodology spectrum opposite of oversimplification lies over-engineering.

Justice Sweeney's Dissent

All of the First Department's Appellate Judges concurred in the Wechsler decision, with the exception of Justice Sweeney, who agreed with the majority on all but one point. Justice Sweeney did not believe that a discount for BIG Taxes should be applied in arriving at a value for WCI. He noted that the valuation methodology discussed in the Jelke and Dunn decisions arose out of valuations performed for estate tax purposes, and he believed that such methodology might not always be appropriate for matrimonial valuation purposes. As similarly noted by Justice Ira B. Warshawsky in Murphy v. U.S. Dredging, Justice Sweeney believes that the nature of the case and the area of law are important considerations in determining the appropriate methodology to employ.

In addition to finding the absence of an expressed intent to sell the appreciated property or dissolve the corporate entity a fact worthy of consideration, Justice Sweeney disagreed with the majority's finding that the trial court erred in accepting the wife's expert's method of valuation, since he used historical taxes as a percentage of gross revenues and, in Justice Sweeney's opinion, no one demonstrated to the trial court that the wife's expert's approach was inherently improper or should not be applied in this case where the amount of capital gains that will actually be paid in the future is uncertain.

After complimenting the majority for their lengthy and eloquent argument for their position, Justice Sweeney stated that there was no reason to substitute the First Department's judgment for that of the trial court on issues of valuation. He further noted that the trial court viewed the witnesses, carefully examined the evidence and wrote a detailed and thoughtful decision. Justice Sweeney emphasized that Mrs. Wechsler was denied any maintenance because of the valuation the trial court placed on her equitable share of WCI and that, although it is still a very sizable award, the appellate decision reduces her award considerably from the amount she was entitled to under trial court's careful analysis of Domestic Relations Law Section 236 (b).

Justice Carnes' Dissent in Jelke

Justice Carnes dissent from the Eleventh Circuit Court of Appeals decision in Jelke focused on the virtues of hard work, as espoused by Teddy Roosevelt, in contrast to the doctrine of ignoble ease that the majority used to justify what he viewed as arbitrary assumptions made for the sake of certainty and finality. The bypassing of what the majority perceived as an unnecessary expenditure of judicial resources did not seem a valuable goal to Justice Carnes, who argued that the expenditure of judicial resources is required to make more realistic calculations. He warned that the idea of taking the easier route, if allowed to reign, would result in no end to the shortcuts that can be taken by the judiciary.

Justice Carnes pointed out that the history of the judicial system reveals that prophesying is sometimes necessary, and he quoted Justice Oliver Wendell Holmes' decision in Ithaca Trust Co. v. United States , 279 U.S. 151, as follows: “The value of property at a given time depends upon the relative intensity of the social desire for it at that time, expressed in the money that it would bring in the market. Like all values, as the word is used by the law, it depends largely on more or less certain prophecies of the future, and the value is no less real at that time if later the prophecy turns out false than when it comes out true.”

In summary, Justice Carnes expressed his belief in Jelke that the effort required to analyze each case's specific attributes, along with any necessary prophesying about the future and expenditure of judicial resources, is time and money well spent.

Conclusion

Interestingly, Paragraph 5(b) of Internal Revenue Service Revenue Ruling 59-60, which applies to valuations performed for estate and gift tax purposes, reads as follows:

The value of the stock of a closely held investment or a real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock. For companies of this type, the appraiser should determine the fair market values of the assets of the company. Operating expenses of such a company and the cost of liquidating it, if any, merit consideration when appraising the relative values of the stock and the underlying assets. The market values of the underlying assets give due weight to potential earnings and dividends of the particular items of property underlying the stock, capitalized at rates deemed proper by the investing public at the date of appraisal. A current appraisal by the investing public should be superior to the retrospective opinion of an individual. For these reasons, adjusted net worth should be accorded greater weight in valuing the stock of a closely held investment or real estate holding company, whether or not family owned, than any of the other customary yardsticks of appraisal, such as earnings and dividend paying capacity.

No one argues with the simple concept that, after the repeal of the General Utilities doctrine in 1986, a C corporation almost universally pays corporate level taxes on the disposition of appreciated assets. However, many complex subtleties make the quantification of an appropriate discount for BIG Taxes, given each particular set of facts and circumstances, a many faceted task that has already required a great deal of effort by numerous courts.

The Commissioner of Internal Revenue filed a petition for a writ of certiorari with the Supreme Court of the United States on July 21, 2008 with respect to the Eleventh Circuit's decision in Jelke. The Estate filed its brief in opposition on Aug. 20, 2008 and the IRS filed its reply on Sept. 3, 2008. Although the Supreme Court denied the IRS's petition on Oct. 6, 2008, for those who may be interested, the papers filed provide some interesting additional insight regarding the issues and the positions taken by the IRS versus those taken by taxpayers and courts' relative to a dollar-for-dollar discount for contingent embedded capital gains taxes existing at the date of valuation.

The cases discussed in this article are not the only cases addressing the quantification of a contingent liability for BIG Taxes, but they do squarely address the fundamental concepts raised in the Wechsler case. One thing is for certain: Whether it comes from the New York State Court of Appeals, the Tax Court, the United States Court of Appeals, or some other judicial body, additional guidance on the application of a C corporation discount for embedded capital gains taxes will almost certainly be forthcoming in the relatively near future.

Thomas A. Hutson, CPA/ABV, CFP', is a partner at BST Valuation & Litigation Advisors LLC. He is a Certified Public Accountant, Accredited in Business Valuation by the American Institute of Certified Public Accountants, and a Certified Financial Planner.