On November 15, 2007, the U.S. Court of Appeals for the Eleventh Circuit decided Estate of Frazier Jelke III v. Comm'r of IRS (Case No. 05-15549, Docket No. 3512-03; PDF, 53 pages) regarding the value, for federal estate tax purposes, of a business interest burdened by "built-in" capital gains tax at the holder's death.
This case, although not binding authority in the U.S. Circuit Court for the Third Circuit (in which Pennsylvania is located), still is illustrative of a key point in reporting values on a federal estate tax return, and claiming discounts for lack of marketability or for other factors depressing value.
This is the overall holding of the Opinion:
Based upon the following historical overview, discussion, and precedential authority, we are in accord with the simple yet logical analysis of the tax discount valuation issue set forth by the Fifth Circuit in Estate of Dunn [301 F.3d 339, Doc 2002-17949, 2002 TNT 151-6 (5th Cir. 2002)], 301 F.3d at 350-55, providing practical certainty to tax practitioners, appraisers and financial planners alike.The case followed the rationale applied in Dunn, decided in the Fifth Circuit.
Under a de novo review, as a matter of law, we vacate the judgment of the Tax Court and remand with instructions that it recalculate the net asset value of [the company] on the date of Jelke’s death, and his 6.44% interest therein, using a dollar-for-dollar reduction of the entire $51 million built-in capital gains tax liability of [the company], under the arbitrary assumption that [the company] is liquidated on the date of death and all assets sold.
The New York State Society of CPAs posted an excellent article entitled "Estate Tax Case Ruling Opens Door -- IRS Proposes Method to Determine Capital Gains Tax Liability", by Brian K. Pearson, dated November 15, 2007, analysing the holdings in Jelke:
In the estate tax case Estate of Jelke v. Commissioner, the main issue of the case centered on the differing methods used by Jelke’s estate and by the IRS for treating built-in capital gains tax liabilities of stock holdings. Also at issue in the case were other valuation discount considerations, such as lack of control and lack of marketability. This particular case is significant because it demonstrates an IRS-proposed method to determine the value of a built-in capital gains tax liability of certain estates. * * *
The court agreed with the IRS’ treatment of the capital gains liabilities, resulting in an 11.2 percent reduction in the company’s value for the built-in gains liability—which was considerably less than the 27.3 percent reduction assumed by Jelke’s estate.
The significance of this is that the IRS did not object to the estate’s reducing the value of the company based on built-in gains tax liabilities, and proposed a logical method of accounting for these liabilities. The IRS’ treatment of this liability provides a reasonable, logical means for determining the value of a built-in capital gains tax liability that is not unlike other techniques commonly used in business valuations. * * *
Such valuations of privately-held business interests involve complex facts & projections, with court determinations heavily reliant upon expert appraisal testimony presented. For a detailed analysis of past rulings in other cases and of the lower court rulings in Jelke that led to the recent decision involving reversal, see: "Reflecting Tax on Built-In Gain When Valuing Stock" (2005), by J.W. Burgess & William L. Raby, published by Tax Analysts.
A personal note about the case decision occurred, after its release, on the listserv maintained by the American College of Trust & Estate Counsel (ACTEC), by Susan K. Smith:
Congratulations to John Porter! He persuaded the Eleventh Circuit to reverse the Tax Court and to follow the Dunn decision (also John’s) where the Court held that the estate tax is calculated upon a “snap shot at-death valuation” and thus allowed a full deduction for the built in capital gains. * * *In rendering its recent decision in Jelke, the court declined to follow either the taxpayer's or the IRS' calculations precisely, but performed its own analysis of the facts presented in testimony about the subject company.
We think the approach set forth by the Fifth Circuit in the Estate of Dunn is the better of the two. The estate tax owed is calculated based upon a "snap shot of valuation" frozen on the date of Jelke’s death, taking into account only those facts known on that date. It is more logical and appropriate to value the shares of [the company's] stock on the date of death based upon an assumption that a liquidation has occurred, without resort to present values or prophesies.Essentially, the Court's approach harked back to the analysis of market factors set forth in Mandelbaum v. Commissioner, T.C. Memo. 1995-254 (06/12/95). These factors were noted in an article entitled "Marketability Discounts -- The Mandelbaum Case Raises Key Issues", by George B. Hawkins & Michael A. Paschall, published in the "Fair Value" Newsletter (Spring, 1996).
The rationale of the Fifth Circuit in the Estate of Dunn eliminates the crystal ball and the coin flip and provides certainty and finality to valuation as best it can, already a vague and shadowy undertaking. It is a welcome road map for those in the judiciary, not formally trained in the art of valuation.
The Estate of Dunn dollar-for-dollar approach also bypasses the unnecessary expenditure of judicial resources being used to wade through a myriad of divergent expert witness testimony, based upon subjective conjecture, and divergent opinions. The Estate of Dunn has the virtue of simplicity and its methodology provides a practical and theoretically sound foundation as to how to address the discount issue. * * *
Following the rationale declared in Dunn and considering the testimony de novo, the court ordered a discount of fifteen percent for the lack of marketability of the shares.
For a contrary viewpoint, read the blistering 16-page dissent by Circuit Judge Carnes:
[N]o longer is all that bother necessary. The parties need not quarrel over, and courts need not concern themselves with, all the variables that go into calculating a fair award for lost future earnings.
After all, the quest for a best estimate of economic reality in such a case is, in the majority’s view: “fluidly etheral,” it involves “hunt-and-peck forecasting,” it is like “flip[ping] a coin,” and it is no better than “gaz[ing] into a crystal ball.”
So, the Advanced Telecommunications decision, like so many others of ours that require estimating present value based on predictions about future events, will have to go. All of
those prior precedents will have to yield to the easy arbitrary assumption method of valuation, to the judicial equivalent of the doctrine of ignoble ease.