Estate of Jelke v. C.I.R.

• Decision Date: 15 November 2007
• Docket Number: No. 05-15549.,05-15549.
• Parties: ESTATE OF Frazier JELKE, III, Deceased, Wachovia Bank, N.A., f.k.a. First Union National Bank, Personal Representative, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Eleventh Circuit

507 F.3d 1317

ESTATE OF Frazier JELKE, III, Deceased, Wachovia Bank, N.A., f.k.a. First Union National Bank, Personal Representative, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 05-15549.

United States Court of Appeals, Eleventh Circuit.

November 15, 2007.

John W. Porter, Stephanie Loomis-Price, Baker Botts, L.L.P., Houston, TX, J. Graham Kenney, Vinson & Elkins, LLP, Austin, TX, for Petitioners-Appellants.

Michelle B. Smalling, Jonathan S. Cohen, U.S. Dept. of Justice, Tax Div., Washington, DC, for CIR.

Appeal from a Decision of the United States Tax Court.

Before TJOFLAT, CARNES and HILL, Circuit Judges.

HILL, Circuit Judge:

This estate tax case presents on appeal an issue of first impression in this circuit.¹ It involves the proper valuation for estate tax purposes of a 6.44% stock interest, or 3,000 shares, owned by the decedent, Frazier Jelke III (Jelke or decedent or estate),² in a closely-held, investment holding company, Commercial Chemical Company (CCC), owning appreciated, marketable securities.³

The issue is whether or not the Tax Court used the appropriate valuation methodology in computing the net asset value of CCC to determine the value of Jelke's interest in CCC for estate tax purposes on the date of death. The Tax Court, adopting the Commissioner's expert witness appraiser's approach, allowed the estate only a partial $21 million discount for CCC's built-in capital gains tax liability, indexed to reflect present value on the date of Jelke's death, using projections based upon the court's findings as to when the assets would likely be sold and when the tax liability would likely be incurred, i.e., in this case, over a sixteen-year period. Using what could be termed an economic market reality theory, the estate argued, under the rationale set forth by the Fifth Circuit Court of Appeals in Estate of Dunn v. Comm'r, 301 F.3d 339 (5th Cir. 2002), that a 100% dollar-for-dollar discount was mandated for CCC's entire contingent $51 million capital gains tax liability. Under this theory, it is assumed that CCC is liquidated on the date of Jelke's death, the valuation date, and all assets of CCC are sold, regardless of the parties' intent to liquidate or not, or restrictions on CCC's liquidation in general.

Based upon the following historical overview, discussion, and precedential authority, we are in accord with the simple yet logical analysis of the tax discount valuation issue set forth by the Fifth Circuit in Estate of Dunn, 301 F.3d at 350-55, providing practical certainty to tax practitioners, appraisers and financial planners alike. Under a de novo review, as a matter of law, we vacate the judgment of the Tax Court and remand with instructions that it recalculate the net asset value of CCC on the date of Jelke's death, and his 6.44% interest therein, using a dollar-for-dollar reduction of the entire $51 million built-in capital gains tax liability of CCC, under the arbitrary assumption that CCC is liquidated on the date of death and all assets sold.⁴

I. FACTUAL BACKGROUND⁵

Jelke died testate on March 4, 1999, in Miami, Florida. On the date of his death, CCC's marketable securities had a fair market value of $178 million, plus a built-in contingent capital gains tax liability of $51 million on those securities. Combined with $10 million in other CCC assets, without regard to the tax liability, CCC's net asset value totaled $188 million.⁶

On the estate's federal estate tax return filed December 6, 1999, Jelke's 6.44% interest in CCC, held through his revocable trust, was included in his gross estate under Section 2031 at a value of $4,588,155. I.R.C. § 2031. The estate calculated this figure by reducing CCC's $188 million net asset value by $51 million, or 100% of the built-in capital gains tax liability. It then applied a 20% discount for lack of control and a 35% discount for lack of marketability.

In his December 2, 2002, notice of deficiency issued to the estate, the Commissioner determined that Jelke's estate owed a deficiency in estate tax of $2,564,772, resulting from an undervaluation of Jelke's 6.44% interest in CCC.⁷ The Commissioner determined that the value of Jelke's 6.44% interest in CCC was $9,111,000, not the $4,588,155, claimed by the estate. Unlike the estate's 100% discount, he calculated the $9,111,000 using a zero discount for built-in capital gains taxes, and what he described as "reasonable" discounts for lack of control and lack of marketability.

II. PROCEDURAL BACKGROUND

The estate filed a petition in Tax Court in March 2003, contesting the Commissioner's $9,111,000 fair market value of Jelke's 6.44% interest in CCC stock on the date of death. It claimed that the Commissioner had based his value on an incorrect net asset value of CCC, by declining to discount CCC's net asset value of $188 million, by the $51 million in contingent built-in capital gains tax liability, accrued as of the date of death. The estate also claimed that the Commissioner undervalued the two additional discounts available to the estate, one for lack of marketability and one for lack of control.⁸

After a two-day bench trial, the Tax Court rejected the estate's position that CCC's net asset value must be reduced dollar-for-dollar by the entire amount of the built-in capital gains tax liability under Estate of Dunn, 301 F.3d at 351-53, as the Estate of Dunn was a Fifth Circuit, not an Eleventh Circuit, case. It determined that a discount was available, but not one for 100%.

The Tax Court noted that a hypothetical buyer of 6.44% of CCC stock single-handedly would be unable to cause or force a liquidation of CCC. It stated that CCC's long-term history of dividends and appreciation, with no immediate plans to liquidate (one trust continues until 2019), together with its low annual turnover of securities in the portfolio, belied the Estate of Dunn's threshold, arbitrary assumption of complete liquidation on the valuation date. Further, the Tax Court distinguished Estate of Dunn on the fact that the Fifth Circuit in Estate of Dunn was valuing a majority, not a minority, shareholder interest as was present here. Also the company valued in the Estate of Dunn was primarily (85%) an operating company, unlike CCC, a 100% investment holding company.

Under the net asset valuation approach, the Tax Court adopted the Commissioner's argument that the capital gains tax discount should be reduced to present value, as computed on an annualized, indexed basis, over the sixteen-year period it was expected to be incurred as the assets turned over.⁹ Instead of a $51 million reduction, the Tax Court's present value application to net asset value resulted in a $21 million tax discount reduction, and a net deficiency in estate tax of $1 million.¹⁰

This appeal follows.

III. STANDARD OF REVIEW

The question of whether the Tax Court used the correct standard to determine fair market value is a legal issue. See Powers v. Comm'r, 312 U.S. 259, 260, 61 S.Ct. 509, 85 L.Ed. 817 (1941). We review de novo the Tax Court's rulings on the interpretation and application of the tax code. See Estate of Blount v. Comm'r, 428 F.3d 1338, 1342 (11th Cir.2005) (citation omitted). The Tax Court's findings of fact are reviewed for clear error. Id. Where a question of fact, such as valuation, requires legal conclusions, we review those underlying legal conclusions de novo. See Adams v. United States, 218 F.3d 383, 386 (5th Cir.2000). A determination of fair market value is a mixed question of fact and law: the factual premises are subject to a clearly erroneous standard while the legal conclusions are subject to de novo review. See Estate of Dunn, 301 F.3d at 348 (citations omitted). "The mathematical computation of fair market value is an issue of fact, but determination of the appropriate valuation method is an issue of law that we review de novo." Id.

IV. DISCUSSION

A. Introduction

The issue in this case is, for estate tax purposes, the proper calculation of the magnitude of the discount for built-in capital gains taxes in valuing stock in a closely-held corporation on the date of death. A general overview of the applicable tax statutes, regulations and revenue rulings is appropriate.

1. The Tax Code and Treasury Regulations

Section 2031(a) provides that the value of a decedent's gross estate shall be determined by including the value at the time of death of all property, real or personal, tangible or intangible, wherever situated. I.R.C. § 2031(a). Section 20.2031-1(b) provides that the value of every item of property includable in a decedent's gross estate . . . is its fair market value at the time of the decedent's death. Treas. Reg. § 20.2031-1(b). The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.¹¹ Id. All relevant facts and elements of value as of the applicable valuation date shall be considered. Id.

2. Internal Revenue Service Guidelines

Revenue Ruling 59-60 provides the foundation for undertaking an analysis of a closely-held stock's value. Rev. Rul. 59-60, 1959-1 C.B. 237.¹² Although it has been modified and amplified over the years, Revenue Ruling 59-60 still remains the focal point for the proper method of valuing closely-held securities.¹³

Closely-held corporations, are, by definition, corporations of which the shares are owned by a relatively limited number of shareholders. Id. at § 2.03. Their shares are traded little, if any, in the marketplace so there are usually no asked prices or third-party sales that would represent an ascertainable basis for determining the fair market value of the stock under the rules generally applicable to publicly traded stock. Id.

The fair market value of closely-held securities also clearly depends upon the potential buying public's estimate of the worth...