The valuation of a closely held business is a common assignment within a bankruptcy environment. The business/stock of a closely held corporation may need to be valued to determine loan collateral value, to assess spinoff opportunities, to determine corporate solvency or insolvency, to estimate the value of investments for fresh-start reporting, and for many other purposes. The closely held business subject to valuation may be a family owned or other privately owned corporation, or the closely held business may be a division or subsidiary of a publicly traded corporation. In any event, analysts use three generally accepted approaches to value the business/stock: the income approach, market approach and asset-based approach. Analysts typically synthesize the quantitative value conclusions of two or more of these analytical approaches in reaching a final business/stock value conclusion.

The income approach values a corporation as the present value of the future income expected to be earned by the owners of the business. The most common income approach business/stock valuation methods are (1) the direct capitalization method and (2) the yield capitalization (or discounted cash-flow) method.

The market approach values a corporation by reference to market-derived pricing multiples extracted from actual sales of comparative companies or securities. The most common market approach business/stock valuation methods are (1) the guideline merged and acquired company method and (2) the guideline publicly traded company method.

The asset-based approach values a corporation by reference to (1) the current value of all its assets (both tangible and intangible) less (2) the current value of all of its liabilities (both contingent and recorded). The most common asset-based approach business/stock valuation methods are (1) the net asset value (NAV) method (where total corporate asset appreciation is estimated collectively) and (2) the asset accumulation method (where the company's individual tangible and intangible assets are separately identified and valued).

The BIG Tax Liability Issue

In the asset-based approach, the appraised corporate asset value is typically in excess of the income tax basis of the subject assets. If the company's assets are sold in a fair market value transaction (i.e., the conceptual premise of the asset-based approach), the corporation would have to pay capital gains tax. The amount of the capital gains is based on the appreciation of the company's assets—i.e., the assumed fair market value sales price of the assets less the income tax basis of the assets. The capital gains tax liability is based on (1) the amount of the capital gains (i.e., the asset appreciation over income tax basis) and (2) the corporate capital gains tax rate.

Since this capital gains tax liability is associated with the appraised value of the corporate assets, it is typically called the built-in gains (or BIG) tax liability. The asset-based approach analysis is often performed using the "value in continued use, as part of a going concern" asset appraisal premise of value. This premise of value assumes that the subject corporate assets are sold collectively as a going-concern business.

However, such a hypothetical sale would, in fact, trigger the BIG tax. This conceptual issue ultimately relates to a basic procedural question: How should the analyst account for the BIG tax liability in an asset-based business/stock valuation?

This valuation issue has not been specifically addressed in a published bankruptcy court decision. However, it has been addressed over the years in several federal gift and estate tax court cases. Recently, the Fifth Circuit weighed in on this valuation issue (based on an appeal of a U.S. Tax Court estate tax case). While this recent Fifth Circuit decision does not relate specifically to bankruptcy matters, it does provide important professional guidance to valuation analysts who practice in the bankruptcy arena.

Case Summary

In the Estate of Beatrice Ellen Jones Dunn, 5th Cir., 2002 U.S. App. Lexis 15453, 8/1/02, reversing and remanding (with instructions) TC Memo 2000-12, 79 T.C.M. (CCH) 1337, 1339 (2000), the Fifth Circuit accepted the taxpayer argument that stock valuations should be adjusted for the potential BIG tax on appreciated corporate assets. Prior gift and estate tax cases held that a holding company valuation may be adjusted (i.e., discounted) for the potential BIG tax liability. However, the valuation discounts allowed by the courts in these previous holding company valuation cases typically did not reflect the full 34 percent corporate capital gain tax rate. In Estate of Dunn, the appeals court upheld the taxpayer position of a BIG tax valuation discount on appreciated assets based on the full 34 percent corporate capital gains rate tax.

In addition to allowing a valuation adjustment for the full BIG tax liability, Estate of Dunn is significant because of the type of business enterprise involved. The subject corporation was an operating company, not a property-holding company. The previous judicial precedent related to the BIG tax valuation discount all involved property-holding companies.

The Facts of the Case

On the date of her death in 1991, Beatrice Ellen Jones Dunn owned a block of stock in Dunn Equipment Inc. Dunn Equipment Inc. was incorporated in Texas in 1949. It was a family-owned business throughout its existence and operated from four locations throughout Texas. In 1991, the company had 134 employees, including three executives and eight salesmen.

Dunn Equipment Inc. owned and rented out heavy equipment and provided related services, primarily in the petroleum refinery and petrochemical industries. The personal property rented from the company by its customers consisted principally of large cranes, air compressors, backhoes, manlifts, and sanders and grinders. The company frequently furnished operators for the equipment that it rented to its customers, charging for both equipment and operators on an hourly basis. For example, the company's revenues resulted in significant part from the renting of large cranes, both with and without operators.

Ms. Dunn died on June 8, 1991, at the age of 81. After Ms. Dunn's death, the estate timely filed the Form 706 federal estate tax return. The decedent's block of shares represented approximately 63 percent of the outstanding stock of the subject C corporation. Accordingly, the decedents block of stock represented a controlling ownership interest in the subject closely held corporation.

However, at the trial level, the tax court found that, even though the decedent's 63 percent of stock ownership gave Ms. Dunn operational control of the company, under Texas law she lacked the power to compel a liquidation, a sale of all or substantially all of its assets, or a merger or consolidation. In order to initiate any of these control events under Texas law, a "super-majority" equal to or greater than 66.67 percent of the outstanding shares is required.

The IRS Position

In the tax court proceeding, the Internal Revenue Service (IRS) valued the decedent's stock ownership using an asset-based valuation approach and, specifically, the NAV method. The IRS, however, did not apply a valuation discount related to the potential BIG tax liability on the company's appreciated assets.

At the tax court trial, the IRS argued that a BIG tax valuation discount was not an appropriate methodological procedure in an asset-based business/stock valuation analysis. In addition, the IRS argued that there was no plan to liquidate the profitable company or to actually sell the appreciated corporate assets. Therefore, the company would not actually have to pay the BIG tax liability in the foreseeable future.

The Taxpayer Position

At the tax court trial, the taxpayer's valuation expert estimated the value of the decedent's stock ownership using two business valuation approaches. First, the taxpayer's expert used the income approach and, specifically, the direct capitalization of income method. In this expert's application of the direct capitalization method, the income was measured as net income, and not as net cash flow.

Second, like the methodology proposed by the IRS, the taxpayer's expert used the asset-based approach, specifically the NAV method. The taxpayer's expert made an adjustment (i.e., a reduction) to the NAV method value indication for the associated BIG tax liability. This adjustment was based on the $7.1 million BIG tax liability that would arise if the corporation actually sold its assets at their individual appraised fair market values.

The taxpayer's expert reached a final value conclusion for the subject stock by (1) weighing the income approach value indication by 50 percent and (2) weighing the asset-based approach value indication (adjusted for a $7.1 million BIG tax liability discount) by 50 percent.

The Tax Court Decision

As reported in Dunn v. Commissioner, TC Memo 2000-12, the tax court concluded an overall value of the decedent's stock by assigning (1) a 65 percent weight to the NAV method value indication and (2) a 35 percent weight to the direct capitalization of income method value indication. However, the tax court reduced the NAV method value indication by only 5 percent of the estimated $7.1 million BIG tax liability.

The tax court reasoned that a hypothetical willing buyer would not necessarily liquidate the company. Rather, a hypothetical willing buyer may buy the subject stock with the intention of entering into a different but ongoing line of business. Accordingly, the tax court concluded that the likelihood of a near-term corporate liquidation—an event that would actually trigger the payment of the corporation BIG tax liability—was low.

Finally, in its valuation of the decedent's stock, the tax court allowed (1) a 15 percent discount for lack of marketability and (2) a 7.5 percent discount for lack of super-majority control. The estate did not appeal the amount of these two valuation discounts at the appeals court proceeding. Accordingly, the appeals court did not have to opine on either of these two valuation adjustments.

The Appellate Court Decision

The appellate court ultimately assigned (1) an 85 percent weight to the income approach value indication and (2) a 15 percent weight to asset-based approach value indication. Within the asset-based approach value indication, the court rejected the tax court's 5 percent BIG tax valuation discount. Rather, the court applied a BIG tax valuation discount based on the full 34 percent corporate capital gains tax rate.

Commenting on this valuation issue, the decision states:

No one can dispute that if Dunn Equipment had sold all of its heavy equipment, industrial real estate and townhouse on the valuation date, the corporation would have incurred a 34 percent federal tax on the gain realized, regardless of whether that gain were labeled as capital gain or ordinary income. The question, then, is not the rate of the built-in tax liability of the assets or the dollar amount of the inherent gain, but the method to employ in accounting for that inherent tax liability when valuing the corporation's assets (not to be confused with the ultimate task of valuing its stock).

The court reasoned that the asset-based business/stock valuation approach should not consider the likelihood of a corporate liquidation in determining the corporation's NAV. Rather, the court concluded that the estimation of the BIG tax liability is an integral component of a corporation's value as derived by an asset-based approach valuation.

Regarding this fundamental valuation issue, the court decision states the following:

Bottom line: The likelihood of liquidation has no place in either of the two disparate approaches to valuing this particular operating company.

Summary and Conclusion

Valuation analysts often use income and market approach methods more commonly than asset-based approach methods in business/stock valuations for bankruptcy purposes. However, the asset-based approach is a generally accepted approach for bankruptcy valuations. In addition, the asset-based approach is applied often enough so that the BIG tax discount conceptual issue should be resolved.

The asset-based approach assumes that the subject company sells the business in an asset, rather than a stock, transaction. The corporate assets sell at the total of their appraised fair market values. After the assumed sale, the corporation would generally have to pay capital gains tax on the excess of the assets' sales price over the assets' tax basis. Since the repeal of the General Utilities doctrine in 1986, corporations have few options available to mitigate this capital gains tax.

All business/stock valuations are based on hypothetical sales transactions. In the market approach, there is a hypothetical sale of the corporate stock (in either a public market or in a private transaction). The fact that the company does not actually sell its stock does not invalidate the use of the market approach. Likewise, the fact that the company does not actually sell its assets does not invalidate the use of the asset-based approach. In a hypothetical sale of the corporate assets, a hypothetical BIG tax liability would be paid.

Dunn concludes that a company's NAV should be adjusted (discounted) for the amount of this hypothetical BIG tax liability. The Fifth Circuit reaches this conclusion regardless of whether or not the company plans to actually sell its corporate assets. Additionally, the court reaches this conclusion regardless of whether or not the company is an operating company or a property-holding company.

In fact, the court's conclusion regarding this issue in Estate of Dunn is unambiguous:

We must reject as legal error, then, the tax court's treatment of built-in gains tax liability and hold that—under the court's asset-based approach—determination of the value of Dunn Equipment must include a reduction equal to 34 percent of the taxable gain inherent in those assets as of the valuation date.

Dunn provides important professional guidance to valuation analysts on two issues. First, when the asset-based approach—specifically the NAV method—is used to estimate business/stock value, Dunn supports the calculation of the BIG tax valuation discount at the full capital gains corporate tax rate. According to the decision, the estimated BIG tax liability should not be reduced by an estimate of the probability of a near-term corporate liquidation.

Second, Dunn indicates that the BIG tax adjustment should be considered in the asset-based valuation of any going-concern business—and not just in the valuation of property-holding companies. The estimation of the potential BIG tax liability on appreciated assets is an integral methodological step in any asset-based approach business valuation.

Although Dunn does not have legal precedent value in a bankruptcy controversy, it does provide practical professional guidance to valuation practitioners. This is because the BIG tax valuation adjustment is as relevant an issue to bankruptcy business/stock valuations as it is to gift and estate tax business/stock valuations.