THE IMPACT OF UNREALIZED CAPITAL GAINS

As a result of TRA ’86 and the repeal of the General Utilities doctrine, an acquirer purchasing all the stock of a corporation for a price which exceeds the acquired corporation’s cost basis for its assets does not receive a stepped-up basis for those assets. They carry built-in gains which will be taxable at the time the assets are sold.

Built-in capital gains can be of particular significance in valuing the stock of real estate or securities investment companies because the value of their stock is heavily influenced by the value of their underlying assets. When those assets carry substantial unrealized capital gains, an informed buyer of the investment company stock will adjust his price downward to allow for the corporate capital gains tax attributable to the unrealized gains. Such an adjustment is necessary to keep the effective cost of the assets equivalent to the cost they would have had if purchased directly. (Assets purchased directly would have a cost basis equal to their purchase price and therefore would incur a lesser capital gains tax when subsequently sold.)

These economic facts should be clearly recognized and allowed for when determining the fair market value of the stock of a closely held investment company whose assets have unrealized capital gains. The result will be a substantially lower valuation in many cases.

Example:In a recent IRS examination, a valuation of a controlling interest in a real estate holding company prepared by Management Planning, Inc. gave significant weight to a discount for taxes on unrealized capital gains. The IRS Appeals Officer accepted our approach.

Revenue Reconciliation Act of 1990

Valuation Issues:
The Revenue Reconciliation Act of 1990 addresses two important issues at the heart of business valuation: estate freezes and buy-sell agreements.

Chapter 14 repeals and replaces Section 2036(c) in regard to estate freezes. The new sections, 2701-2704, return to the concept that taxable transfers pursuant to estate freezing transactions are present gifts which should be valued at the time of transfer. These transactions are now regulated by a series of valuation rules for the interests normally transferred in estate freezes. These rules allow considerably more flexibility and opportunity for the creation of preferred interests in family controlled corporations and partnerships than the October 1987 rules. Liquidation, put, call or conversion rights may be used to enhance the value of a preferred interest if the right must be exercised at a specific time and amount.

RPA ’90 also limits the circumstances under which buy-sell agreements and other restrictions on transfer can be recognized for valuation purposes. The potential impact on clients is great since they frequently use these provisions in planning. Under Section 2703, buy-sell and other transfer restrictions will be ignored for valuation purposes unless the following requirements are met:

It is a bona fide business arrangement,
It is not a device to transfer property at less than full value to a member of the family,
Its terms are comparable to an arm’s length business transaction between unrelated parties.

The key to satisfying these requirements will be the fair market value of the assets as determined by a qualified independent appraiser. Section 2073 is in effect for transfers and agreements entered into or substantially modified after October 8, 1990.

Valuation Strategies: Some strategies for taking advantage of recapitalization estate freeze rules under RRA ’90:

Transfers made during a slow economy (recession) or industry low when actual market values are depressed can minimize transfer taxes on the freeze.

Bona fide restrictions with third parties will be excepted from the law.

Partnerships are probably more attractive than incorporated businesses for freezes because they do not pay out preferred dividends with after-tax dollars.

Buy/Sell Agreement Considerations:

Professional, expert appraisals will be the only sure way to establish that a family buy-sell agreement conforms to the arm’s length relationship test (that is, similar to an arrangement between unrelated parties typical of the industry).

The sale of a minority interest to an unrelated senior executive may show the arm’s length fairness of an agreement.

Tax Planning Tip :
Estate tax planners should not overlook the opportunity that exists for clients with grandfathered, non-cumulative preferred stocks. In many cases, the fair market value of most of these issues for gift and estate tax purposes will be well below their stated par value. This is because the unpaid dividend history of the issue would be considered by a willing buyer of such an issue and discounted accordingly.

To properly value preferred stock, it is necessary to examine and evaluate prevailing market yields, asset coverage, earnings coverage and other qualitative characteristics. The analysis of a properly selected group of publicly held preferred stock issues can provide such a basis for valuation.

Recent Valuation Decisions

Estate of Samuel I. Newhouse, 94 T.C 193 (1990)

Estate of Frederick R. Smith 94 T.C. 872 (1990)

Question: Can lifetime gifts be revalued for the purpose of determining federal estate tax?

Tax Court Held: Yes. Lifetime gifts may be revalued for the purpose of determining donor’s federal estate tax even though further gift tax assessments on the undervalued gifts are barred (IRC Section 6501). The court declined to follow Boatman’s First National Bank of Kansas City v. United States, 705 F. Supp. 1407 (W.d. Mo. 1988).

Note: IRS recently acquiesced in the Smith decision. This indicates they will follow the Tax Court’s holding in similar situations.