In Davis v. Commissioner (Estate of Artemus D. Davis v. Commissioner, 110 T.C. 35 (1998)), the Tax Court ruled favorably for an economic consideration of the embedded capital gains tax inside an asset holding company for the first time since the repeal of The General Utilities doctrine in 1986.

Brief Summary of Case

In November 1992, Taxpayer made two minority gifts of approximately 26% each of an asset holding company, the primary asset of which was a 1.3% interest in Winn-Dixie, a large, publicly traded grocery chain. The market value of the interest was some $70 million, which approximated the embedded capital gain. The blocks of shares represented founders’ shares, and were subject to restrictions under Rule 144 of the SEC Act of 1934.

The Tax Court heard from two experts for the taxpayer and one for the IRS. All three were experienced business appraisers who held senior member designations (ASA or FASA) from the American Society of Appraisers. All three experts submitted appraisal reports to the Court.

Upon review of the appraisal reports and the testimony of the experts, and of a stipulation of the net asset value of the holding entity (before consideration of embedded capital gains), the Court dealt with four issues.

  1. Whether the gifted blocks of stock warranted discounts for blockage or their restricted nature. The taxpayer’s experts recommended discounts of 4.9% (based on using the Black-Scholes option pricing model) and 10% (based on an unquantified, judgmental analysis). The expert representing the IRS offered a similar, unquantified, judgmental analysis and recommended no blockage or restricted stock discount. The Court held for no blockage or restricted stock discount, which seemed unusual, given the nature and size of the blocks.
  2. What is the appropriate minority interest discount? The experts recommended minority interest discounts ranging from 12% to 20%. Without discussion, the Court concluded that the appropriate minority interest discount was 15%.
  3. Whether the embedded capital gains of some $70 million, with its implied embedded capital gains tax liability of $26.7 million, should be considered as a valuation discount at all, and if so, to what degree. One of the taxpayer’s experts advanced the argument that the entire embedded capital gain liability should be deducted as an adjustment to net asset value. The other of the taxpayer’s experts and the expert for the IRS suggested that the embedded liability should cause an addition to the marketability discount, and each added an extra 15% to their marketability discounts (with slightly different dollar implications because of earlier differences) to account for the impairment to liquidity. The Court concluded that the appropriate treatment was as an increment to the marketability discount (about 13% after splitting the dollar-calculated discounts of the two experts concurring on this issue). The effect of this decision was to allow consideration of 34% at the embedded liability – not the whole apple, but a good bite.
  4. What is the appropriate marketability discount? The two experts for the taxpayer agreed that the appropriate marketability discount should be 35% (excluding consideration of the embedded tax issue), and the expert for the IRS recommended a 23% marketability discount. The Court’s concluded marketability discount was 28% (or 32%, giving effect for a theoretically consistent sequencing of the allowed discounts).

Based on a review of the case, it appears that the Court was presented with an array of valuation evidence that it considered, in the main, to be credible. There is nothing unusual about the Court’s treatment of the minority interest discount, or the marketability discount (excluding the embedded gains issue). The restricted stock/blockage issue was unusual in that no discount was allowed.

The Good News

Davis v. Commissioner will be remembered as an embedded capital gains tax liability case because it is the first post-1986 Tax Court case that has allowed explicit consideration of this liability.

The Not-So-Good News

Neither of the experts advancing the “incremental marketability discount” treatment of the embedded gains liability offered any evidence or rationale for their selected increment. The Court provided no further insight.¬† Appraisers relying on the “Davis methodology” are likely to find themselves using unreliable evidence, absent a compelling rationale or explanation of their own.

The Real News

The Court should have allowed a deduction from net asset value for the entire amount of the embedded capital gains tax liability. The rationale for this conclusion is developed in a forthcoming article that will appear in the November/December 1998 issue of Valuation Strategies. The article’s working title is “Embedded Capital Gains in Post-1986 C Corporation Asset Holding Companies.” The arguments and analyses presented in this article can help solve the problem of the “Not So Good News” noted above.

The article also comments on the Second Circuit Court of Appeals decision {Eisenberg v. Commissioner [1998 WL 480814] (2nd Cir.)} regarding Eisenberg v. Commissioner [T.C.M. 1997-483, October 27, 1997], which effectively eliminates (at least from our valuation-oriented reading) the ability of the IRS to cite pre-1986 cases to support an argument for not considering embedded capital gains liabilities in a post-General Utilities world.


Embedded capital gains tax liabilities are now recognized as real liabilities by the Tax Court. Appraisers must begin to provide economic arguments to support their positions regarding economic consideration.

Reprinted from Mercer Capital’s E-Law Newsletter 98-02, October 29, 1998.

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