Memorandum Decision by Judge Wells Rejects Presence of Payment of Control Premium in Determining the Value of a Partnership Interest for Purposes of the Built-in Gains Tax Under Section 1374; Ringgold Telephone Company v. Commissioner, TC Memo 2010-103
With the repeal of the General Utilities doctrine to the taxation of corporate liquidations as part of the 1986 Tax Reform Act, Congress, in preventing avoidance of corporate level taxation for liquidations, with the exception of liquidations of controlled (and solvent) subsidiaries, block safe passage from corporate level tax for C or regular corporations converting to Subchapter S. While there are several provisions which embody this thought, the main provision is section 1374. Section 1374 imposes a tax on built-in gains, i.e., unrealized appreciation, while an asset is held by a C corporation which later makes a Subchapter S election. The tax applies generally for a period of 10 years although a recent revision to section 1374 permits it to expire at the end of 7 years.
An S corporation's gain upon disposition of an asset generally is treated as recognized built-in gain under section 1374 to the extent that the fair market value of that asset on the first day of the first taxable year for which the corporation's subchapter S election is in effect exceeds that asset's adjusted basis on such date. §1374(d)(1). If an asset with built-in gain is sold during the 10-year period beginning on such date, the S corporation will be taxed on the built-in gain. §§1374(a), 1374(d)(7). The tax is then treated as a "loss" or reduction in gain for pass through purposes. §1366(f)(2).
In Ringgold Telepone, supra, the corporation, which provided telecommunications services to customers, converted to Subchapter S status effective January 1, 2000. On such date it owned a 25% partnership interest in Cellular Radio of Chattanooga (CRC). The other 25% partners were Bell South, Trenton Telephone Co. and Beldsoe Telephone Co. CRS’s primary asset was in turn a 29.54% limited partnership interest in Chattanooga MSA limited partnership (CHAT), a wireless service provider. At all times between January 1 and November 27, 2000, petitioner indirectly owned a 7.385% interest in CHAT as a result of petitioner's 25% interest in CRC and CRC's 29.54% limited partnership interest in CHAT. The partnership interests in CHAT were not publicly traded.
The petitioner’s accounting firm valued the CRC (25%) interest based on 1998 financial data at approximately $4.6M. This report was issued on September, 1999. This valuation was updated on February 20, 2000 based on 1999 financial data to $2.6M. In March, 2000, petitioner hired an investment banking firm to sell its 25% interest at $7M which included a sales incentive to the investment banker and thus it could be inferred the asking price exceeded an objective assessment of value. Finally, on July 6, 2000, BellSouth offered to purchase the CRC interest for an amount slightly in excess of $5M subject to working capital adjustments to the date of closing. The transaction closed on November 27, 2000 for a $5.2M sales price.
On its 2000 Form 1120S, petitioner reported the amount of recognized built-in gain attributable to the CRC interest using a fair market value as of January 1, 2000 (the valuation date), of $2,600,000, the amount determined by the February 2000 report. Petitioner used the valuation of the CRC interest contained in the February 2000 report on the advice of Stephen Henley, a certified public accountant petitioner consulted to review its 2000 Federal income tax return. The IRS disagreed and contended that the corporation had a deficiency in income tax of $925,260 under section 1374 and an accuracy related penalty of 20% or $185,052. The issue was whether the FMV of the partnership interest owned by the petitioner as of the effective date of the conversion, January 1, 2000, was $2.98M as the taxpayer argued, or $5.220M as the IRS asserted was the amount paid by BellSouth. At trial the parties each submitted the report and expert testimony of valuation experts with each report supporting its respective position. In addition, the Service argued that an arms length sale reasonably close in time to the valuation event should be treated as the best evidence of value. Here the sale contract was signed 6 months after the effective date of the conversion. The taxpayer argued that the sale price should not be controlling as BellSouth paid a premium to acquire its 25% interest and should therefore not be treated as the "average hypothetical buyer" since it already owned a controlling interest in CHAT, the primary asset of CRC.
Finding the sale to be highly probative of value and negotiated at arms length, Judge Wells stated that the Court, based on special circumstances surrounding the buyer, the seller and the transaction, may have skewed the purchase price from the hypothetical fair market value of the interest. The opinion cited Epic Associates 84-III v. Commissioner, T.C. Memo. 2001-64; Hansen v. Commissioner, TCM 1952, and Treas. Reg. §20.2031-2(e). The seller-taxpayer argued that BellSouth paid a control premium for its 25% interest. The IRS argued that BellSouth already controlled CHAT prior to the acquisition of the 25% interest in CRC and did not gain any additional measure of control over CHAT by virtue of its purchase of the CRC interest. In other words, the purchase price paid by Bell South according to the IRS reflected a discount for lack of control.
After considering the sales price and terms that were close in time to the valuation date, and the expert testimony and reports submitted, the Court concluded that the fair market value of the CRC interest as of the valuation date was $3.727M. The Court used a weighted average of: (i) business enterprise analysis ($2.718M); distribution yield analysis ($3.243M) and the BellSouth sales price ($5.22M), weighted equally, in arriving at its value.
The Court rejected the government’s claim for the imposition of a 20% substantial understatement penalty finding that record reflected that the taxpayer acted in a reasonable manner and with good faith. §6664(c)(1).
