When a decedent dies owning stock in a closely held corporation or partnership, the valuation of those shares is a perennial problem precisely because they are closely-held (i.e., there’s no ready market for the ownership interests). Since estate tax is ad valorem (based on the assets’ values), valuation usually impacts the ultimate estate tax liability significantly.

The IRS position on the estate taxable value of closely held business interests is generally that they should reflect the underlying assets’ values, i.e., the market value of the investments inside the entity. For example, a family limited partnership owning publicly traded stock should generally be valued at the market value of the publicly traded stock, as opposed some valuation reached by another valutaion approach (e.g., present value of future discounted cash flows, data from actual sales of comparable limited partnerships, etc.).

To date, the IRS has been generally unwilling to allow for the “built-in” capital gains tax on those underlying assets when computing the value of the interests in the closely held entity (sometimes referred to as “tax-effecting” the valuation). This is problematic when the entity holds highly appreciated assets which, if sold, would generate a significant capital gains tax.

A recent decision by the Eleventh Circuit (Alabama, Florida, Georgia) in Estate of Jelke v. Commissioner reversed the Tax Court and held that, when valuing a decedent’s stock in a closely held company, the estate is entitled to a discount for the company’s entire “built in” capital gains tax liability on its underlying investments. By following this rationale, the Eleventh Circuit observed that courts are not burdened with trying to predict when a decedent’s assets will be sold and the tax paid to arrive at the taxable value of the closely held business interests.

That decision by itself – that the built in capital gains tax potential is fully allowable in computing the value of the assets in the entity – is significant. Other courts (namely, the Tax Court) dealing with this issue have proposed speculative ways to discount the potential tax liability based on the present value of some expected future liquidation. In so doing, the discount for the tax is clearly less than the dollar-for-dollar approach in the Eleventh Circuit’s decision in Jelke.

NOTE: Query whether other circuits will follow the Eleventh Circuit on this issue. The Fifth Circuit (Texas, Louisiana, Mississippi) has an earlier court decision (Estate of Dunn) which was actually the first to emerge with a precise methodology re: the allowable reduction for built in capital gains taxes and how to calculate them for estate tax valuation purposes.

NOTE: Query how this result will bolster tax-effecting closely held business interests where the underlying assets themselves are not publicly traded and thus have no ready ascertainable fair market value (e.g., an operating business). That debate has been ongoing…

For professional investment advice on this topic contact:
Allgen Financial Services, Inc.
888.6ALLGEN (888) 625-5436