One BIG Article: What are Built-In Gains (“BIG”) and Why Are They Important?

When a company holds a significant asset or a collection of assets that has appreciated over time, it’s a good thing. When the Internal Revenue Service sees a good thing, it wants to tax it. Enter: capital gains. If assets, such as real estate, investments, or artwork, have increased in value, capital gains taxes could potentially be due upon the sale of the asset. If a corporation owns the asset, then the company is responsible for the tax. If the asset is owned by a pass-through entity, then the partner/shareholder/member is responsible for the tax. Regardless of corporate structure, this contingent tax liability can seriously impact the value of an interest in the company. Unfortunately, a good investment can lead to a large tax liability, and this liability may cause the value of the interest to be transferred to decrease.

Capital gains are taxed at the following rates¹:

In September 2021, the House Ways and Means Committee proposed increasing the top individual capital gains tax rate from 20% to 25%. This increase would impact any gain realized after September 13, 2021, unless the seller entered a binding contract prior to that date.

Is there any relief? There is for partnerships. A partnership can file for an IRC Section 754 election⁴ (“754 election”), which allows the partnership to adjust the basis of an asset in the event of a property distribution⁵ or a transfer of interest upon a sale or death of a partner⁶. If the partnership makes this election, a step up in basis can be taken, potentially eliminating the BIG tax liability on the property distributed or the interest transferred. But this decision may not be available for a minority interest holder because it is typically made by the tax matters partner or management.

That leaves corporations and the remaining types of pass-through entities open to the BIG tax liability, which could affect their value. So what can be done to limit this tax exposure? Keep track of all improvements and casualty losses because these will affect the taxable basis of the asset. For other ways to mitigate this tax, consult your tax accountant.

How do built-in gains affect the valuation of a holding company? Assume two identical companies are holding assets with the same fair market value and the same level of debt. If one of the company’s assets has a much lower tax basis, that company would have different adjusted net asset values when considering a potential BIG tax. A minority interest holder in that company would not have much, if any, control over how the tax is mitigated or when it would be incurred. That’s because, in most cases, they do not have control over the tax matters or the management of the company. There are a few methodologies for addressing the BIG tax’s effect on value.

Dollar-for-dollar BIG discount: Some appraisers calculate an estimated capital gains tax liability as of the date of valuation. This assumes a sale is occurring and the tax will be incurred. It may result in a large discount to the value of the company which would be applied to the net asset value of the company. However, it is easy to question the validity of this discount. A sale has not taken place and may never occur. There is not an impending actual BIG tax liability. Individual taxpayers may not even have to pay this tax if they can offset this passed-through gain against losses on assets held outside the company. In addition, applying a dollar-for-dollar discount depends on what has been allowed by the tax courts in the company’s district. Here is an example calculation of a dollar-for-dollar BIG discount:

Future BIG discount: Another possible adjustment is based on the estimated amount of a future BIG tax liability. This would require the appraiser to estimate (or have management estimate) when the company expects to sell the property. To estimate the future sale price, the current fair market value would be increased by the annual rate of return on that property until the date it is sold. Then the BIG tax can be determined on that estimated future value. The future BIG tax amount would be discounted back to the valuation date at the company’s cost of capital. This amount would impact the net asset value of the company.

Many unknown variables have to be estimated, which makes it easy to call this BIG discount into question. Applying this methodology also depends on what has been allowed in the tax courts in the company’s local district. Below is an example calculation of the future BIG discount:

Increase the discount for lack of marketability: Because the actual effect of the BIG tax is difficult to determine, some appraisers increase the discount for lack of marketability of the interest being valued. The extent of the increase would vary based on the extent of the potential tax liability. This is a relatively easy adjustment to support qualitatively and allows for flexibility quantitatively.

Such a large potential liability can have a big impact on the value of an interest in a company that owns investment assets. There are many variables to consider and ways to address the BIG that have accumulated on the asset. Reviewing the tax court’s decisions in the company’s district is highly recommended. The issue of a potential BIG tax needs to be carefully considered when valuing the interest in a company that holds assets with significant appreciation.

Sources

1. Additional state taxes may be incurred if the company operates in a state with a state income tax.
2. Capital gains are taxes along with the ordinary income of the corporation.
3. The long term capital gains tax rates vary by income bracket. For $0 up to $40,000, the rate is 0%, for $40,001 up to $441,450, the rate is 15%, and for income over $441,451, the rate is 20%
4. 26 U.S. Code §754
5. 26 U.S. Code §734(b)
6. 26 U.S. Code §743(b)