Jensen Est. v. Comr. New Tax Court Decision on BIG Discount


In this federal estate tax case, the Tax Court determined the discount for built-in capital gains for an 82% interest in a New Hampshire C corporation, which owned, as its principal asset, a 94 acre waterfront parcel.  The result was a complete victory for the estate.  The case is appealable to the U.S. 2nd Circuit Court of Appeals.

Facts:  At the time of her death, the decedent, through her revocable trust, owned 82%% of the stock of Wa-Klo, a closely-held New Hampshire C corporation that owned one principal asset: a 94 acre tract of waterfront property.

Valuation Positions

The valuation positions of the parties and how the Tax Court came out are as follows:

Position                                            Estate            IRS                             Tax Court

 

Value of Wa-Klo shares                 $2,554,317    $3,268,465                $2,554,317

Built-in capital gains discount       $1,133,283    $490,383                   $1,133,283

Average holding period                  5 years           53.76 years               5 years

Built-In Capital Gains Discount

The Appraisers’ Methodology

The estate’s appraiser simply computed the amount of the built-in capital gain (fair market value less adjusted basis) and deducted that sum dollar for dollar from the fair market value of the property.

The IRS’s appraiser took a more complex route in its determination.  That appraiser used closed-end funds to assist in the determination of the proper level of discount for built-in capital gain.

Interestingly, that appraiser concluded that there was no “direct correlation between exposure to built-in capital gains and discounts from net asset value at levels of exposure of 41.5 percent or less…” [which was the highest percentage of built-in gains among the six closed-funds that he examined].  As a result, it only recognized the built-in gain above 41.5%, which was 24.5% since the amount of built-in gain in Wa-Klo was 66%.  However, as to this excess, he permitted a dollar-for-dollar discount for built-in capital gains.

Enter the Tax Court

Judge Vasquez turned back the estate’s argument that the federal Second Circuit Court of Appeals, to which any appeal of his decision would lie, would have agreed with the Fifth and Eleventh Circuits in Dunn Est. v. Comr. and Jelke Est. v. Comr, declining “to speculate how the Court of Appeals for the Second Circuit may hold in the future.”

However, as to the IRS appraiser’s use of closed-end funds to assist in the determination of the proper level of discount for built-in capital gain, Judge Vasquez ruled against the IRS, noting that he didn’t feel that the funds were comparable in any way to the subject parcel.  Moreover, he noted that closed-end funds invest indirectly in real estate through REIT’s and further that “discounts from a closed-end fund’s net asset value are attributable to several factors including supply and demand, manager or fund performance, investor confidence, or liquidity.”  Judge Vasquez also expressly noted that the “studies on the effect of unrealized capital gains on the discounts from a closed-end fund’s net asset value are inconclusive.”

Judge Vasquez went on to assume a 17 year holding period as no party had offered evidence of holding period.  After making his calculations, Judge Vasquez determined that the estate was entitled to at least that discount it claimed.

 Comments: All I could do was shake my head when I read the opinion’s description of the IRS appraiser’s analysis.  It struck me as voo doo economics, and Judge Vasquez wasn’t buying it either. 

With respect to the built-in capital gains tax issue, this is essentially another 100% of the appreciation case, as we’ve seen recently for C corporations as in Estate of Dunn and Estate of Jelke. 

This decision highlights how important it is for appraisers to interview management and to be consistent with prior appraisals, or at least have the appraiser explain any differences very well in the valuation report.

 Cites: Jensen Estate v. Comr., T.C. Memo 2010-182.

About lpaulhoodjr

I am an inactive lawyer who practiced almost 20 years as a tax and estate planning lawyer. Today, I am the Director of Planned Giving for The University of Toledo Foundation. I am the co-author of four books, the sole author of another book and a frequent speaker and writer on estate planning, planned giving and business valuation.
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