Court Demands NAV Reduced by 100% of BIG Tax Liability
"There has been substantial controversy regarding the appropriate treatment of embedded capital gains in determining the fair market value of interests in C corporations since the repeal of the General Utilities doctrine by the Tax Reform Act of 1986 (TRA '86)." The preceding is the first sentence in an article titled "Embedded Capital Gains in C Corporation Holding Companies," written by Z. Christopher Mercer, ASA, CFA and published in Valuation Strategies November/December 1998; and, it is as true today as it was some ten years ago. Hopefully, the United States Court of Appeals for the Eleventh Circuit decision on Jelke v. Commissioner will put an end to this controversy.
As Chris mentions in his article, prior to TRA '86 investors were not much concerned with built-in capital gains in C corporations as it was possible for the corporation to distribute appreciated property to its shareholders without incurring any taxable income at the corporate level. TRA '86 required recognition of corporate level gains and losses on liquidating sales and on distributions of corporate property. At that point it became important to consider the built-in capital gain tax liability at the corporate level as it affects the value of the corporation.
In the years since TRA '86, the Tax Court has been inconsistent in the treatment of built-in gains tax liabilities, from no acknowledgement of this liability to consideration of 100% of the liability. Mercer Capital's position has always been that rational buyers will not negotiate pricing that does not recognize the full built-in gain tax liability and rational sellers cannot expect to receive more favorable pricing than that available through liquidating the asset holding entity (because buyers are assumed to have alternative investments available not inside a C corporation wrapper).
The position is supported in Exhibit 2 of the 1998 article mentioned above. In this exhibit five alternative purchase options available to a buyer of appreciating assets are analyzed. The analysis shows that there are two ways to produce the best (and same) return to the buyer, no matter what the assumed holding period. They are the purchase of the asset in the market at market prices or the purchase of the stock of the asset holding C corporation for the market value of the assets held by that corporation less the entire built-in gain tax liability.