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Taxpayers Beat IRS In Lengthy Battle Over Built-In Gains

After more than a decade of courtroom wrangling with the Internal Revenue Service, taxpayers have established a principle that sounds like common sense: Something that carries a built-in tax liability is worth less than something else that does not.

Suppose a corporation paid $10,000 many years ago for a piece of land that today is worth $1 million. Let’s also suppose that Mr. Smith dies and leave his 50-percent share of the corporation’s stock to his children. What is the value of that stock?

The starting point would be $500,000, representing 50 percent of the corporation’s net asset value. This value would be adjusted up or down depending upon many factors, such as whether the 50 percent represents a controlling interest. But the corporation could not really sell the land and distribute $500,000 to the holders of Mr. Smith’s stock, because capital gains tax would be due. Nor can the corporation be liquidated to avoid the tax, because since the 1986 repeal of the General Utilities rule, the liquidation would trigger corporate-level gain. Even if the corporation is an S corporation, tax would be due at either the corporate or shareholder level on either sale or liquidation.

So Mr. Smith’s stock must be worth less than $500,000, to account for the inevitable tax, right? Not in the IRS view. For years the Service has contended, and the courts have generally agreed, that the built-in tax burden must be ignored unless an actual sale or liquidation is planned at the valuation date.

But a pair of 1998 cases rejected that view. The Tax Court found in the case of Estate of Artemus D. Davis v. Commissioner, 110 T.C. No. 35, that the IRS position is unsupported by law. Even the Service’s own expert appraiser argued for a discount in that case. The Second U.S. Circuit Court of Appeals, whose decisions are controlling in New York, Connecticut and Vermont, came to a similar decision in Irene Eisenberg v. Commissioner, 82 AFTR2d ¶98-5173.

Exactly how much of a discount to allow is still a sticky question. The discount generally will not be equal to the entire potential tax, and in some cases the discount may be negligible. But taxpayers have established that economic reality should have something to do with the outcome.