First, a simple question: How much would you pay for property that is worth $100,000, if you had to spend $25,000 (to fix it, commissions, special taxes or whatever) before collecting your $100,000?
Certainly not more than $75,000… or less if you wanted to make a profit. Yet, over the years the IRS and the courts just didn’t understand these basic economics in the real world, or how to answer the above question.
Second, let’s set up a scenario that’s repeated almost every time business owners want to sell their businesses. If you’re a potential buyer, generally you’re willing to pay more for the individual assets owned by the corporation than for the corporation’s stock. You do this for 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% capital gains rates). But the low-tax basis of the assets stays with the corporation. 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. 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 #1: Estate of Artemus Davis, (110 TC 530-1998). 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 about a 26% 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) for the 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% when compared with the real dollar value of the holding company’s assets.
The IRS rejected the valuation and assessed additional gift taxes of $5.2 million. Ouch! 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 way that the holding company could avoid the taxes and allowed discounts totaling 50% of the value of the assets.
Post this article on the wall. When you want to transfer your business for tax purposes, reread it. Hey, that’s about $500,000 off of every $1 million your business is worth. (A little side note to blow our CPA’s firm horn… the valuation department of our office has been successfully taking advantage of the same three-discount strategy for 20 years.)
Case #2: Irene Eisenberg, (155 F3d 50–1998). In this case, the corporation owned real estate that it rented to third parties. The Second Circuit concluded that a similar discount (like the Davis case) for taxes was appropriate in valuing stock of a holding company.
And here are two more reasons to keep this article handy: 1) We often use a family limited partnership (FLIP)—to beat up the IRS legally, when a client owns real estate and/or marketable securities and wants to transfer them (taking a discount in the 35% to 40% range) during his life as a gift or for estate tax purposes. So if you have a significant amount of investment property, look into a FLIP.
2) When a client owns a family business and wants to transfer it to younger family members, a powerful tax strategy we use is to combine a valuation discount with an intentionally defective trust (IDT). The little-known tax result of an IDT is that the owner of the family business (usually Dad) can pass the business tax-free (no income, gift or estate tax). Yes, it’s true... No tax to Dad... no tax to the kids who wind up owning the business. Bonus: Dad maintains absolute control of the business for as long as he lives.