Thank You, Court: A Business-Valuation Victory for the Good Guys

A simple question: How much would you pay for property worth $100,000 if you must spend $25,000 to fix it or for commissions or special taxes prior to collecting your $100,000? Certainly not more than $75,000 if you wanted to make a profit.

Yet, over the years the IRS and the courts just didn’t understand basic economics in the real world, and how to answer the above question. Now they do. Here’s the story.

Let’s set up a scenario repeated almost every time business owners want to sell their businesses. If you are a potential buyer, generally you are willing to pay more for the individual assets owned by the corporation than the corporation’s stock. Why? Two reasons: 1) to obtain a higher tax basis for the low-basis assets owned by the corporation and 2) to avoid hidden and contingent corporate liabilities.

Now, let’s look at the seller’s side of the coin. After the acquired company sells its assets, it will owe corporate income tax (remember, corporations do not enjoy the luxury of low capital-gains rates) on any gain. On the other hand, if the shareholders sell their stock, they will pay less tax (bless those low—15 percent—capital-gains rates). But the low-tax basis of the assets stays with the corporation. Sorry, when the buyer (really your acquired corporation) sells these assets, the corporation will be socked with those high corporate tax rates on the gain.

Despite this reality, up until now the IRS and the courts have never allowed a reduction in the value of corporate stock for potential taxes due on a future asset sale or corporate liquidation. Now we can sound the victory bell.

Two 1998 cases allowed such a discount for the first time. Best of all, the well-reasoned decisions are still the law today.

Case No. 1, Estate of Artemus Davis —Davis, one of the founders of the Winn-Dixie grocery chain, created a holding company to own some of his publicly traded Winn-Dixie shares. Davis gave 26 percent interest in the holding company to each of his two sons. At the time of the gift, the holding company owned $70 million of Winn-Dixie stock and $10 million of other assets.

You’ll love this part. Davis claimed three discounts on his gift-tax returns to report the transfers: 1) lack of marketability, 2) minority interest and 3) corporate taxes due if the Winn-Dixie stock were to be sold.

The total of these discounts reduced the value of the gifted stock by more than 60 percent when compared to the real dollar value of the holding company’s assets.

The IRS rejected the valuation and assessed additional gift taxes of $5.2 million. Davis fought the IRS and when he died, his estate continued the fight. Thumbs up. The tax court held that a discount for taxes must be allowed. The court saw no the holding company could avoid the taxes and allowed discounts totaling 50 percent of the value of the assets.