Jelke and BIG Tax Liability

Chris Mercer’s Value Matters newsletter offered a succinct summary of the Eleventh Circuit’s recent decision in Jelke v. Com., an important decision dealing with built-in capital gains (BIG) tax liability of Subchapter C corporations. The subject company in the case was a C corporation established 80 years ago, whose principal asset was an investment portfolio managed for long-term capital growth. The company was valued for estate tax purposes, and the decedent’s expert discounted the net asset value by $51.6 million tax liability, assuming liquidation of the investment portfolio. The IRS took the position that liquidation was not imminent, and spread out the tax liability over 16.8 years (which was consistent with the slow rate of asset turnover). Discounting the future tax liability back to its net present value, the IRS estimated the tax liability at $21.0 million. The Tax Court adopted the IRS position, and the taxpayer appealed.

The Eleventh Circuit Court of Appeals employed the principal of substitution in its analysis, wondering why a hypothetical buyer would choose to purchase an interest in a corporation with BIG tax liabilities when the buyer could simply buy the underlying stocks in the market. The Eleventh Circuit court held that liquidation was the proper assumption when determining net asset value, and sided with the taxpayer by discounting the corporation’s value for the entire tax liability.

This decision might be persuasive in the divorce courts of Pennsylvania, where hypothetical tax consequences may be considered in determining the value of marital assets. Were the divorce court faced with the valuation of a C corporation having BIG tax liability, it might be appropriate to subtract the tax liability from the company’s net asset value. The market alternative for an interest in a corporation having BIG tax would be the underlying assets themselves without tax liability, according to Jelke.