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The Impact of Built In Gains Tax On Business Valuation

By: David Goldner

Prior to the Tax Reform Act of 1986, a C corporation could sell its appreciated assets, or liquidate, and avoid any tax inside of the company. The shareholder would only pay a single capital gains tax.

However, after the law changed and it’s still the case today things became less advantageous for the shareholder. Now, if a C corporation liquidates, they pay a tax inside of the corporation on any appreciation of its assets, and then a second tax is paid on the liquidation. 

This leads to a question: if an appreciated asset (or business) is owned inside of a C corporation, is that corporation’s stock worth less than the same corporation that owns the appreciated asset, but has always been an S corporation? 

Let’s look at a simple example to illustrate this question.

In our example, a building is owned inside of a C Corporation as opposed to a being owned directly by an individual. If the C corporation sells a fully depreciated building for $2 million, the company pays a tax at, say, 40% or $800,000. So, if you liquidated that company, you would get $1,200,000.

On the other hand, if you buy the building directly for $2 million and then resell it, you get your $2 million.

Which is a better buy buying the building directly, or buying the stock of a C corporation that owns the building inside? The building is worth $2,000,000, but inside of the C corporation, how much is the stock of that corporation really worth? Is it worth $1,200,000, or $2,000,000?

That’s the big question.

Different Rules for Business Valuations

In the real world of business deals, buyers and sellers negotiate the built in gains tax as part of any agreement of sale. But in the world of valuations, different rules have applied.

For many years, the IRS took the position that no adjustment was appropriate for hypothetical built in gains. For a long time, the courts followed the IRS’s position. However, in the landmark Estate of Davis case in 1998, the tax court held that even though no planned sale of the appreciated assets was contemplated, it was reasonable that a hypothetical willing buyer and willing seller would take into account the built in gains tax when valuing the stock for estate tax purposes. Subsequent court decisions have followed the decision in favor of the taxpayer, allowing for a reduction in value for built in gains tax.

Other court cases have accepted the idea of discounts, and have applied a variety of computations of what the discount should be. Some approach the discount as a simple adjustment from the value of an asset. Others say the adjustment should be included in the discount for marketability. Overall, the key factors that enter into the computation include (1) the expected holding period, (2) the appreciation of the asset and (3) discounting that value back.

The Missing Piece In Determining a Discount

Most analysis stops right there. In my opinion, this analysis is missing one of the key factors in determining the amount of a discount.

One side of the discount, as the courts have discussed and ruled on, is related to the future tax cost of the asset. The other impact to the buyer who will continue to own the building or business is the lost tax savings opportunities of depreciation or amortization deductions. The depreciation and amortization deductions would be available to save taxes each and every year until that asset is sold.

Valuing a Business In a Divorce

In divorce cases, courts often follow the decisions of tax court cases regarding applicability of discounts. Shannon Pratt, the leading authority on valuations, stated that he considered it an unfair result if taxes are not included as an adjustment to the value of the assets, as compared to giving assets that have no built in gain. The interesting extension of Pratt’s opinion as it relates to divorce is: does the idea of the discounts only apply to C corporations or should it be applied to partnerships and S corporations as well?

There are no clear-cut answers pertaining to the issue of potential capital gains taxes in determining the value of a business in a divorce. State tax law is the preeminent authority in the area of divorce. Divorce case law across the different states is not consistent in the analysis of discounts for built in gains taxes, although the general expectation is that the courts will be slow to apply a tax discount, unless there is an immanent transaction. If the company being valued is a C corporation as opposed to a pass-through entity, like an S corporation, the issue becomes even more cloudy.

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Published October 30, 2017

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