In a posting last December I wrote about an important estate tax case, Jelke v Commissioner, in which a federal appeals court adopted a bright-line rule requiring 100% discount for built-in capital gains tax (“BIG”) in the valuation of C corporation assets. At the time I made the following prediction about Jelke‘s impact on stock valuation in corporate dissolution cases:
Jelke likely will not have wide impact on valuation contests in dissolution cases, for two main reasons. First, the great majority of dissolution cases involve S corporations and other entities that opt for pass-through partnership tax treatment. Second, the standard of value in estate tax cases such as Jelke is fair market value as opposed to the fair value standard specified by New York’s buyout statute. In a BCL §1118 valuation case involving a real estate holding C corporation called Matter of La Sala, a New York trial court refused to apply a discount for BIG tax liability on the ground that it was required to value the corporation as a going concern and, therefore, it would not consider capital gains taxes triggered upon liquidation. Undoubtedly, this will not be the last word on the subject of BIG discounts in stock valuation proceedings.
I was right about one thing: it was not the last word on BIG and §1118 stock valuation proceedings. As it turns out, when I wrote those words there already was percolating in Nassau County Supreme Court a buy-out proceeding in a shareholder oppression case, Murphy v. U.S. Dredging Corp., requiring the court to decide the same issue presented in the La Sala case, namely, the appropriateness under the fair value standard of applying a BIG discount to the appreciated assets of a real estate holding C corporation. The Murphy court’s answer — applying a partial discount based on the present value of future gains taxes — lands between Jelke‘s 100% discount and La Sala‘s zero discount.
Murphy involved a dredging company formed in the 1930’s owned by several families. The company ceased dredging operations in the 1970’s but continued to own valuable waterfront properties in Brooklyn and Jersey City which more recently were sold for over $30 million. Most of the proceeds were reinvested, through tax exempt §1031 like-kind exchanges, in commercial properties under long term triple net leases. A minority shareholder faction sued for judicial dissolution claiming oppression by the controlling shareholders who then elected underBusiness Corporation Law §1118 to purchase the minority’s shares for “fair value.”
The valuation hearing featured dueling business appraisal experts, each of whom used net asset value and discounted cash flow methods in valuing the company’s shares. In computing net asset value the purchasing shareholders’ expert subtracted 100% of deferred capital gains tax on the property sales (about $11.6 million). The selling shareholders’ expert deducted the present value of the gains tax assuming a 19-year holding period for the replacement properties (about $3.4 million). This was the primary reason for the experts’ widely disparate company net asset valuations, almost $25 million (sellers) versus about $15 million (purchasers). A secondary factor was the purchasers’ expert’s use of a 15% discount for lack of marketability (DLOM) whereas the sellers’ expert objected to any DLOM.
In his 29-page decision dated May 19, 2008, Commercial Division Justice Ira B. Warshawsky sides with the sellers’ expert on BIG and with the purchasers’ expert on DLOM. In discussing the applicable law, Justice Warshawsky significantly observes that the determination of fair value under BCL §1118 “is not identical to the procedure of Tax Court” in estate and gift tax cases where company liquidation as of the valuation date may be assumed. Rather, the judge writes, “it is clear from the evidence that no liquidation was or is contemplated by [the controlling shareholders] in our case and thus a ‘liquidation’ or semi-liquidation scenario is not appropriate when dealing with the BIG tax.” The evidence in the case included a report by the company’s president, shortly before the dissolution case was filed, indicating a plan to hold the replacement properties until the financing is retired in 19 years. For that reason, among others, Justice Warshawsky agrees with the sellers’ expert that a hypothetical buyer would demand, and the hypothetical seller would give, a discount equal to the present value of the BIG tax assuming liquidation in 19 years.
In the La Sala case noted above, Justice Kenneth W. Rudolph of the Westchester County Supreme Court’s Commercial Division denied a deduction for BIG taxes in a §1118 valuation case also involving a real estate holding C corporation (read decision here). Justice Warshawsky in Murphy writes that he “agrees with the logic expressed by Justice Rudolph” but that “under these circumstances with the BIG representing such a large portion of corporate assets it appears that a willing purchaser would expect to deduct the present value of the BIG tax along with a percentage for lack of marketability.”
The Murphy decision does not render a final award. The decision recomputes the net asset value based on the present value of the BIG tax and 15% DLOM, and directs the parties to submit new computations of their income approach valuations using a court-determined working capital figure. As of this writing the court has not issued its final ruling.
In sum, Murphy may be the first and only case to date in which a BIG discount, albeit a partial one, is granted in a valuation under the fair value standard. If another such case comes along, undoubtedly there will be an interesting debate as one side draws comparison to the facts and circumstances in La Sala while the other side does the same with Murphy.
P.S. I have written a more detailed analysis of Murphy which will be published in the upcoming August issue of Business Valuation Update. BVU is a highly informative monthly newsletter published by Business Valuation Resources in Portland, Oregon. I have subscribed to BVU for many years, and highly recommend it to lawyers who want to stay current on valuation theory and case law.
Update October 26, 2008: This past week the Appellate Division, First Department, in Wechsler v. Wechsler, 2008 NY Slip Op 07983 (Oct. 21, 2008), issued a lengthy opinion in a matrimonial case vacating the trial judge’s equitable distribution award insofar as it computed BIG discount based on the historical tax rate of annual taxes paid by the husband’s securities trading firm. The court ordered application of a dollar-for-dollar discount as contended by the husband’s expert and the court-appointed neutral. The decision, with one judge dissenting, seems to endorse the Eleventh Circuit’s Jelke approach but does not close the door under the right circumstances on a partial discount based on the present value of future gains taxes. Indeed, the majority decision explicitly notes that the latter approach was not advanced by the wife’s expert in the trial court proceedings. Wechsler therefore cannot be read as mandating a dollar-for-dollar discount in all matrimonial cases applying a fair market value standard, much less in dissenting or oppressed shareholder buyout proceedings applying a fair value standard.
Update December 16, 2008: The final verdict is in. In a written decision dated December 9, 2008 (2008 NY Slip Op 33318(U)), Justice Warshawsky determined a fair value award of $5,956,735 for the petitioners’ 36.77% interest in United States Dredging Corp. The number, based on a 45% and 55% weighting of the net asset cost and income approaches, respectively, is eerily close to the midway point between the two experts’ competing valuations at the time of trial. The decision contains detailed discussions of the discrepancies in the post-trial submissions of the parties’ experts on a variety of issues. The only point of law in the decision is at the end, where Justice Warshawsky states that the First Department’s Wechsler decision “is not applicable to our facts, and not binding on this court.”
Update June 6, 2010: On June 1, 2010, the Appellate Division, Second Department, decided appeals brought by both sides from Justice Warshawsky’s rulings. The decision affirms the key rulings on marketability and BIG discounts. You can view the decision here, and my article on the decision here.