Estate of Artemus D. Davis, Robert D. Davis, Personal Representative v. Commissioner , 110 T.C. 530 ( 1998 )

110 T.C. No. 35UNITED STATES TAX COURT
ESTATE OF ARTEMUS D. DAVIS, DECEASED, ROBERT D. DAVIS,
PERSONAL REPRESENTATIVE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9337-96. Filed June 30, 1998.
Held: In determining the fair market value on a
valuation date after the repeal of the doctrine
established in General Utils. & Operating Co. v.
Helvering, 296 U.S. 200 (1935), of each of two minority
blocks of common stock of company A, the Court is not
precluded on the record presented from giving
consideration to A’s built-in capital gains tax as of
that date of about $26.7 million. Held, further, the
fair market value on the valuation date of each block
of stock at issue is $10,338,725, determined by first
ascertaining A’s net asset value on that date without
regard to any discount or adjustment attributable to
blockage and/or 17 C.F.R. sec. 230.144 (1992) or A’s
built-in capital gains tax, reducing that value by a
15-percent minority discount to which the parties
agree, and reducing the resulting value by a lack-of-
marketability discount of $28 million which the Court
arrived at by giving consideration to, inter alia, A’s
built-in capital gains tax and including as part of
that discount $9 million attributable to such tax.
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Gregory V. Nelson, John W. Porter, and Richard A. Husseini,
for petitioner.
Victoria J. Sherlock, Norman N. Pickett, and Harve M.
Lewis, for respondent.
CHIECHI, Judge: Respondent determined a deficiency of
$5,283,894 in the Federal gift tax of Artemus D. Davis (decedent)
who died on June 11, 1995, after he made the two gifts to which
that deficiency pertains. The sole issue for decision is the
fair market value on November 2, 1992, of each of two blocks of
25 shares of common stock of A.D.D. Investment and Cattle Company
(ADDI&C), one of which decedent gave to his son Robert D. Davis
(Robert Davis) and the other of which decedent gave to his son
Lee W. Davis (Lee Davis).
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
Decedent, who was one of the founders of Winn-Dixie Stores,
Inc. (Winn-Dixie), died testate on June 11, 1995, while he was a
legal resident of Florida. Robert Davis, the personal
representative of decedent's estate, resided in Jacksonville,
Florida, at the time the petition was filed.
On or about November 2, 1992 (the valuation date), ADDI&C, a
closely held Florida corporation that was incorporated on
December 22, 1947, had a total of 97 shares of common stock
issued and outstanding, all of which were owned by a trust (Davis
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trust) for the benefit of decedent and none of which was subject
to any restrictive sale provisions or buy-sell agreements. On
the valuation date, decedent transferred 25 shares of such stock
to his son Robert Davis and 25 shares of such stock to his son
Lee Davis. On that date, each of those two blocks of ADDI&C
common stock constituted 25.77 percent of the issued and
outstanding common stock of ADDI&C.
As of the valuation date, ADDI&C was primarily a holding
company for various assets of decedent, although ADDI&C also had
certain cattle operations (both feeder and breeding cattle) as of
that date. Specifically, on the valuation date, ADDI&C owned
1,020,666 shares, or 1.328 percent, of the issued and outstanding
common stock of Winn-Dixie, which was at all relevant times
traded on the New York Stock Exchange (NYSE); 3,456 shares, or
.0737 percent, of the issued and outstanding common stock of
D.D.I., Inc. (DDI), which was a holding company for various
assets of decedent and his family and the stock of which was at
all relevant times not publicly traded; various feeder and
breeding cattle; certain equipment; and certain other
unidentified assets.
As of the valuation date, ADDI&C's management group
consisted of the following individuals who were serving in the
positions indicated: Artemus D. Davis, chairman of the board of
directors, president, and director; James E. Davis, executive
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vice president and director; Robert Davis, vice president,
assistant secretary, and director; H. J. Skelton, vice president,
treasurer, and director; Harry D. Francis, vice president and
assistant secretary; and G. P. Bishop, Jr., secretary and
assistant treasurer.
On or before the valuation date, decedent, James E. Davis,
and Robert Davis were directors of Winn-Dixie. For the 12-month
period prior to the valuation date, the average daily trading
volume of Winn-Dixie stock was 47,400 shares. For the 4-week
period prior to the valuation date, the average weekly trading
volume of Winn-Dixie stock was 310,675 shares.
As of the valuation date, decedent, ADDI&C, and the Davis
trust were affiliates within the meaning and for purposes of 17
C.F.R. sec. 230.144 (1992)1 with respect to the sale of Winn-
Dixie stock. Pursuant to SEC rule 144, shares of Winn-Dixie
stock held by affiliates were subject to certain restrictions,
including restrictions on the sale of such shares prescribed by
SEC rule 144(e)(1).
ADDI&C received the following dividends during its fiscal
years ended October 31, 1988, 1989, 1990, 1991, and 1992:
1
We shall refer to 17 C.F.R. sec. 230.144 (1992), which was
promulgated by the Securities and Exchange Commission (SEC), as
SEC rule 144. All references to SEC rule 144 are to the Code of
Federal Regulations in effect on the valuation date.
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Fiscal Year Dividends
Ended October 31 Received
1988 $888,330
1989 996,584
1990 1,044,926
1991 1,145,370
1992 1,272,699
Over $1.2 million of the dividends that ADDI&C received during
its fiscal year ended October 31, 1992, were dividends received
on the Winn-Dixie stock that it owned.
DDI declared and paid dividends with respect to all of its
issued and outstanding stock, including the shares of such stock
owned by ADDI&C, in the following aggregate amounts during its
fiscal years ended November 30, 1989, 1990, 1991, 1992:
Fiscal Year Aggregate
Ended Dividends
November 30 Paid
1989 $21,093,694
1990 21,796,815
1991 23,437,435
1992 23,906,184
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Subject to the caveats stated below, the following table
shows as of the valuation date ADDI&C's assets and liabilities,
the historical cost basis and the fair market value of each such
asset, and ADDI&C's net asset value:
Historical
Asset Cost Basis Fair Market Value
Feeder cattle, cost $6,474,368 $8,074,368
Breeding herd, net 1,072,843 1,894,400
Winn-Dixie stock 338,283 70,043,204
DDI stock 120,263 535,162
Total equipment, net 172,999 130,294
Other assets 1,295,539 1,295,539
Total assets 9,474,295 81,972,967
Total liabilities 1,832,698 1,832,698
Net asset value 7,641,597 80,140,269
The fair market value of ADDI&C's Winn-Dixie stock and its net
asset value that are shown in the foregoing table do not reflect
any type of discount or adjustment with respect to that stock
which is attributable to blockage and/or SEC rule 144 (blockage
and/or SEC rule 144 discount). Nor do the fair market value of
each of ADDI&C's assets and its net asset value that are shown in
the foregoing table reflect any type of discount or adjustment
which is attributable to, inter alia, lack of a controlling
interest, lack of marketability, or the Federal and State income
tax (ADDI&C's built-in capital gains tax) that ADDI&C would have
incurred at a combined tax rate of 37.63 percent on the gains as
of the valuation date on ADDI&C's assets (i.e., the difference
between the historical cost basis and the fair market value of
each of its assets, hereinafter referred to as ADDI&C's built-in-
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capital gains) if on that date each such asset had been sold or
otherwise disposed of or ADDI&C had liquidated.
During 1990, ADDI&C paid $252,602 to an affiliated company as
reimbursement for the use of an airplane by one of its
shareholders. For Federal income tax purposes, ADDI&C reported
that payment as a shareholder dividend. With the exception of
that dividend, ADDI&C has not declared or paid any dividends to
its shareholders.
On the valuation date, ADDI&C had not adopted a formal plan
of liquidation, nor was there any intention by that corporation or
decedent to liquidate ADDI&C or to dispose of its Winn-Dixie
stock.
On October 31, 1992, ADDI&C's net operating loss carry-
forwards totaled $1,580,217.
On or about April 15, 1993, decedent timely filed for 1992
Form 709, United States Gift (and Generation-Skipping Transfer)
Tax Return (gift tax return). In that return, decedent reported
that the value on the valuation date of each of the two 25-share
blocks of ADDI&C stock that he transferred to his sons was
$7,444,250, or $297,770 a share. The value reported by decedent
in the gift tax return was based on an appraisal by Alex W. Howard
(Mr. Howard) of Howard Frazier Barker Elliott, Inc. (Mr. Howard's
appraisal).
Respondent determined in the notice of deficiency (notice)
that on the valuation date the fair market value of each of the
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two 25-share blocks of ADDI&C stock that decedent transferred to
his sons was $12,046,975, or $481,879 a share.
OPINION
Petitioner modified the position reflected in decedent's gift
tax return as to the value on the valuation date of each of the
two blocks of stock in question and now claims that the fair
market value of each of those blocks on that date was $6,904,886,
or $276,195 per share. Respondent modified the determination in
the notice as to that value and now contends that the fair market
value on the valuation date of each of the two blocks of ADDI&C
stock in question was $13,518,500, or $540,740 per share.2
If a gift is made in property, its value at the date of the
gift is considered the amount of the gift. Sec. 2512(a);3 sec.
25.2512-1, Gift Tax Regs. The value of the property for Federal
gift tax purposes is
the price at which such 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. * * * All
relevant facts and elements of value as of the time of
the gift shall be considered. * * * [Sec. 25.2512-1,
Gift Tax Regs.]
The willing buyer and the willing seller are hypothetical persons,
rather than specific individuals or entities, and the individual
2
Respondent is not, however, claiming an increased gift tax
deficiency.
3
All section references are to the Internal Revenue Code in
effect on the valuation date. Unless otherwise indicated, all
Rule references are to the Tax Court Rules of Practice and
Procedure.
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characteristics of these hypothetical persons are not necessarily
the same as the individual characteristics of the actual seller or
the actual buyer. Estate of Curry v. United States, 706 F.2d
1424, 1428, 1431 (7th Cir. 1983); Estate of Bright v. United
States, 658 F.2d 999, 1005-1006 (5th Cir. 1981). The hypothetical
willing buyer and the hypothetical willing seller are presumed to
be dedicated to achieving the maximum economic advantage. Estate
of Curry v. United States, supra at 1428; Estate of Newhouse v.
Commissioner, 94 T.C. 193, 218 (1990).
In the case of unlisted stock, like the ADDI&C stock in
question, the price at which sales of stock are made in arm's-
length transactions in an open market is the best evidence of its
value. Champion v. Commissioner, 303 F.2d 887, 893 (5th Cir.
1962), revg. and remanding T.C. Memo. 1960-51. In the instant
case, the record does not disclose any such sales of ADDI&C stock.
Where the value of unlisted stock cannot be determined from
actual sale prices, its value generally is to be determined by
taking into consideration the company's net worth, prospective
earning power, and dividend-paying capacity, as well as other
relevant factors, including the company's good will, its position
in the industry, its management, the degree of control of the
business represented by the block of stock to be valued, and the
values of securities of corporations engaged in the same or
similar lines of business that are listed on a stock exchange.
Sec. 25.2512-2(f)(2), Gift Tax Regs. Section 4 of Rev. Rul. 59-
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60, 1959-1 C.B. 237, 238-242, sets forth criteria that are
virtually identical to those listed in section 25.2512-2(f)(2),
Gift Tax Regs., and "has been widely accepted as setting forth the
appropriate criteria to consider in determining fair market
value". Estate of Newhouse v. Commissioner, supra at 217.
Section 5 of Rev. Rul. 59-60, 1959-1 C.B. at 242-243, which
addresses the determination of the fair market value of the stock
of a closely held investment company, provides in pertinent part:
(b) The value of the stock of a closely held
investment or real estate holding company, whether or
not family owned, is closely related to the value of the
assets underlying the stock. For companies of this type
the appraiser should determine the fair market values of
the assets of the company. Operating expenses of such a
company and the cost of liquidating it, if any, merit
consideration when appraising the relative values of the
stock and the underlying assets. The market values of
the underlying assets give due weight to potential
earnings and dividends of the particular items of
property underlying the stock, capitalized at rates
deemed proper by the investing public at the date of
appraisal. A current appraisal by the investing public
should be superior to the retrospective opinion of an
individual. For these reasons, adjusted net worth
should be accorded greater weight in valuing the stock
of a closely held investment or real estate holding
company, whether or not family owned, than any of the
other customary yardsticks of appraisal, such as
earnings and dividend paying capacity.
There is no fixed formula for applying the factors that are
to be considered in determining the fair market value of unlisted
stock. See Estate of Goodall v. Commissioner, 391 F.2d 775, 786
(8th Cir. 1968), vacating and remanding T.C. Memo. 1965-154. The
weight to be given to the various factors in arriving at fair
market value depends upon the facts of each case. Sec. 25.2512-
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2(f), Gift Tax Regs. As the trier of fact, we have broad
discretion in assigning the weight to accord to the various
factors and in selecting the method of valuation. Estate of
O'Connell v. Commissioner, 640 F.2d 249, 251-252 (9th Cir. 1981),
affg. on this issue and revg. in part T.C. Memo. 1978-191; sec.
25.2512-2(f), Gift Tax Regs.
The determination of the value of closely held stock, like
each of the two 25-share blocks of ADDI&C stock at issue, is a
matter of judgment, rather than of mathematics. Hamm v.
Commissioner, 325 F.2d 934, 940 (8th Cir. 1963), affg. T.C. Memo.
1961-347. Moreover, since valuation is necessarily an
approximation, it is not required that the value that we determine
be one as to which there is specific testimony, provided that it
is within the range of figures that properly may be deduced from
the evidence. Silverman v. Commissioner, 538 F.2d 927, 933 (2d
Cir. 1976), affg. T.C. Memo. 1974-285; Anderson v. Commissioner,
250 F.2d 242, 249 (5th Cir. 1957), affg. in part and remanding in
part T.C. Memo. 1956-178.
As is customary in valuation cases, the parties rely
extensively on the opinions of their respective experts to support
their differing views about the fair market value on the valuation
date of each of the two 25-share blocks of ADDI&C stock in
question. The estate relies on (1) Mr. Howard, who is an
accredited senior appraiser of the American Society of Appraisers
and a principal in the business valuation firm of Howard Frazier
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Barker Elliott, Inc., and (2) Shannon Pratt (Mr. Pratt), who is an
accredited senior appraiser and fellow of the American Society of
Appraisers and a founder and managing director of the business
valuation firm of Willamette Management Associates. Respondent
relies on John A. Thomson (Mr. Thomson), who is an accredited
senior appraiser of the American Society of Appraisers and a vice
president and the managing director of the Long Beach, California,
office of the business valuation firm of Klaris, Thomson &
Schroeder, Inc. Each of the experts prepared an initial expert
report (expert report)4 and a rebuttal expert report (rebuttal
report).5
We evaluate the opinions of experts in light of the
demonstrated qualifications of each expert and all other evidence
in the record. Anderson v. Commissioner, supra at 249; Parker v.
Commissioner, 86 T.C. 547, 561 (1986). We have broad discretion
to evaluate "'the overall cogency of each expert's analysis.'"
Sammons v. Commissioner, 838 F.2d 330, 334 (9th Cir. 1988)(quoting
Ebben v. Commissioner, 783 F.2d 906, 909 (9th Cir. 1986), affg. in
part and revg. in part T.C. Memo. 1983-200), affg. in part and
4
The expert report of petitioner's expert Mr. Howard is
identical to Mr. Howard's appraisal on which the value reported
in the gift tax return for each of the two gifts in question was
based. Hereinafter, we shall refer to Mr. Howard's appraisal as
his expert report.
5
Each of petitioner's experts prepared a rebuttal report with
respect to the expert report of respondent's expert, and
respondent's expert prepared separate rebuttal reports with
respect to the expert reports of petitioner's two experts.
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revg. in part T.C. Memo. 1986-318. We are not bound by the
formulae and opinions proffered by expert witnesses, especially
when they are contrary to our judgment. Silverman v.
Commissioner, supra; IT&S of Iowa, Inc. v. Commissioner, 97 T.C.
496, 508 (1991). Instead, we may reach a determination of value
based on our own examination of the evidence in the record.
Lukens v. Commissioner, 945 F.2d 92, 96 (5th Cir. 1991)(citing
Silverman v. Commissioner, supra at 933), affg. Ames v.
Commissioner, T.C. Memo. 1990-87. The persuasiveness of an
expert's opinion depends largely upon the disclosed facts on which
it is based. See Tripp v. Commissioner, 337 F.2d 432, 434 (7th
Cir. 1964), affg. T.C. Memo. 1963-244. Where experts offer
divergent estimates of fair market value, we shall decide what
weight to give those estimates by examining the factors used by
those experts to arrive at their conclusions. Casey v.
Commissioner, 38 T.C. 357, 381 (1962). While we may accept the
opinion of an expert in its entirety, Buffalo Tool & Die
Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980), we may
be selective in the use of any part of such an opinion, Parker v.
Commissioner, supra at 562. We also may reject the opinion of an
expert witness in its entirety. Palmer v. Commissioner, 523 F.2d
1308, 1310 (8th Cir. 1975), affg. 62 T.C. 684 (1974); Parker v.
Commissioner, supra at 562.
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For convenience, the following chart (chart) shows the
respective positions of the experts6 and the parties on brief with
respect to the net asset value of ADDI&C on the valuation date and
the discounts or adjustments that each believes should be applied
to such value in order to arrive at the fair market value on that
date of each of the two 25-share blocks of ADDI&C stock in
question:7
6
The respective positions of the experts that are shown in the
chart reflect the agreement of the parties as to the fair market
value of each of ADDI&C's assets and the aggregate amount of its
liabilities as of the valuation date without taking into account
any type of discount or adjustment attributable to blockage
and/or SEC rule 144, lack of a controlling interest, lack of
marketability, or ADDI&C's built-in capital gains tax. However,
those positions do not reflect the agreement of the parties at
trial that the applicable minority discount should be 15 percent.
Despite that agreement, the respective dollar amounts of a 15-
percent minority discount urged on brief by petitioner and by
respondent differ. That is because of the differences between
them as to whether a blockage and/or SEC rule 144 discount and a
discount or adjustment attributable to ADDI&C's built-in capital
gains tax should be taken into account in arriving at ADDI&C's
net asset value on the valuation date.
7
All dollar amounts in the chart are rounded to the nearest
dollar.
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Petitioner's Petitioner's Respondent's
Expert Expert Expert
Mr. Howard Mr. Pratt Mr. Thomson Petitioner1 Respondent
Blockage and/or SEC rule 4.9 percent or 10 percent or -$0- 10 percent or -$0-
144 discount $3,432,117 $7,004,320 $7,004,320
Discount or adjustment 25,395,109 Factored in as Factored in as 24,645,525 -0-
attributable to ADDI&C's part of lack-of- part of lack-of-
built-in capital gains marketability marketability
tax discount discount
Net asset value of ADDI&C 51,313,043 73,135,976 80,140,269 49,490,424 80,140,269
Minority discount 15 percent or 20 percent or 12 percent or 15 percent or 15 percent or
7,696,956 14,627,195 9,616,832 7,273,564 12,021,040
Lack-of-marketability 35 percent or 50 percent or 38 percent or 35 percent or 23 percent or
discount 15,265,630 29,254,391 26,798,906 14,425,901 15,667,423
Portion of lack-of- -0- 15 percent or 15 percent or -0- -0-
marketability discount 8,776,317 10,578,516
attributable to
ADDI&C's built-in
capital gains tax
Total dollar amount of 51,789,812 50,885,906 36,415,738 53,349,310 27,688,463
discounts or adjustments
Fair market value of each 7,306,825 7,539,800 11,250,000 6,904,886 13,518,500
25-share block of ADDI&C
common stock
Fair market value of each 292,273 301,592 450,000 276,195 540,740
share of each 25-share
block of ADDI&C common
stock
1
This column reflects petitioner's position on brief
regarding all of the items reflected in the chart except for
ADDI&C's net asset value. The Court had to calculate petitioner's
position with respect to the amount of ADDI&C's net asset value
because nowhere on brief does petitioner state what that figure
should be. The Court calculated petitioner's position as to that
amount, which is shown in the chart, based on petitioner's
contentions that a 10-percent blockage and/or SEC rule 144
discount on the NYSE price of ADDI&C's Winn-Dixie stock (viz.,
$7,004,320) and a discount or adjustment equal to the full amount
of ADDI&C's built-in capital gains tax, which petitioner
calculates to be $24,645,525, should be applied in determining
ADDI&C's net asset value on the valuation date. Even assuming
arguendo that petitioner's contentions regarding a blockage and/or
SEC rule 144 discount and a discount or adjustment for the full
amount of ADDI&C's built-in capital gains tax were correct, we
believe that petitioner erroneously calculated the amount of that
tax to be $24,645,525. It appears that in calculating that amount
petitioner improperly failed to take into account the $1,580,217
of net operating loss carryforwards that ADDI&C had as of Oct. 31,
1992. That error had a domino effect; as a result, the dollar
amounts of the minority and the lack-of-marketability discounts
that petitioner advocates are slightly less than they would have
been if petitioner had not made that error.
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The parties and all of the experts agree that the initial
step in ascertaining the fair market value on the valuation date
of each of the two 25-share blocks in question is to determine as
of that date the fair market value of each of ADDI&C's assets and
the aggregate amount of its liabilities in order to calculate its
net asset value on that date. All of them also are in agreement
that, without taking into account any discounts or adjustments
(including but not limited to a blockage and/or SEC rule 144
discount, a minority discount for lack of a controlling interest,
a lack-of-marketability discount, and a discount or adjustment
attributable to ADDI&C's built-in capital gains tax), on the
valuation date the aggregate fair market value of ADDI&C's assets
was $81,972,967, its liabilities totaled $1,832,698, and its net
asset value was $80,140,269.
Petitioner and petitioner's experts agree that, in
determining the fair market value of ADDI&C's Winn-Dixie stock and
its net asset value on the valuation date, it is necessary to
reduce the fair market value of that stock and ADDI&C's net asset
value to which the parties in this case have stipulated by
applying a blockage and/or SEC rule 144 discount to that stock.
Petitioner and petitioner's expert Mr. Pratt believe that a
blockage and/or SEC rule 144 discount of 10 percent is proper, and
petitioner's expert Mr. Howard concludes that such a discount of
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4.9 percent is appropriate.8 Respondent and respondent's expert
maintain that no blockage and/or SEC rule 144 discount is
warranted.
The parties and their experts agree that the Winn-Dixie stock
held by ADDI&C on the valuation date was subject to the volume
limitation on the sale of that stock prescribed by SEC rule
144(e)(1) (SEC rule 144(e)(1) volume limitation). That rule
limited the amount of restricted or other securities that could
have been sold by an affiliate during a given 3-month period
generally to the greater of (a) one percent of the shares of the
outstanding class of stock or (b) the average weekly reported
trading volume during the 4-week period preceding the filing of a
notice of proposed sale which was required under SEC rule 144(h).
The parties and their respective experts also are in agreement
that as of the valuation date there were two ways in which ADDI&C
could have disposed of its Winn-Dixie stock. One such method was
for ADDI&C to have sold its entire block of that stock in a
private placement to a nonaffiliated investor. Unless that block
of stock were registered, that investor would have been subject to
a 2-year holding period for that stock under SEC rule 144(d)(1)
and thereafter would have been subject for 1 year to the volume
8
In his rebuttal report, Mr. Howard modified the amount of the
blockage and/or SEC rule 144 discount that he believed should be
applied in determining as of the valuation date the fair market
value of ADDI&C's Winn-Dixie stock and its net asset value. Mr.
Howard made that change because of matters brought to his
attention after he had prepared his expert report. See infra
note 10.
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limitation on the sale of that stock prescribed by SEC rule
144(e)(2).9 See SEC rule 144(k). The other method by which ADDI&C
could have sold its Winn-Dixie stock was through the sale of that
stock over a period of time consistent with the SEC rule 144(e)(1)
volume limitation (dribble-out method).
The parties and their respective experts further agree that
(1) because of the size of the block of Winn-Dixie stock owned by
ADDI&C on the valuation date, ADDI&C could not have disposed of
all of its Winn-Dixie stock at the same time without depressing
the market value of such stock; and (2)(a) in order to dispose of
its Winn-Dixie stock without depressing its market value and at
the same time selling that stock in compliance with the
restrictions in SEC rule 144, it would have taken ADDI&C 5 to 6
months after the valuation date to dispose of its Winn-Dixie stock
under the dribble-out method, and (b) a purchaser of that stock
would not have been subject to the 2-year holding period under SEC
rule 144(d)(1) or the volume limitation in SEC rule 144(e)(2), see
SEC rule 144.
Petitioner's expert Mr. Howard and respondent's expert Mr.
Thomson agree that ADDI&C probably would have sold its Winn-Dixie
stock pursuant to the dribble-out method.10 Mr. Pratt opined that
9
The volume limitation in SEC rule 144(e)(2) is identical to
the SEC rule 144(e)(1) volume limitation.
10
Mr. Howard opined in his expert report that a sale by private
placement would have been a "more efficient" way for ADDI&C to
have disposed of its Winn-Dixie stock than the dribble-out
(continued...)
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it was likely that ADDI&C would have disposed of its Winn-Dixie
stock through a private placement. On the record before us, we
find that ADDI&C probably would have used the dribble-out method
to sell its Winn-Dixie stock, since it was likely that such a sale
would have resulted in a higher value for ADDI&C’s Winn-Dixie
stock than would have been yielded if that stock had been sold in
a private placement. That is because a nonaffiliated investor who
purchased that stock in a private placement would have been
subject to a 2-year holding period under SEC rule 144(d)(1) and
thereafter would have been subject for one year to the volume
limitation in SEC rule 144(e)(2). See SEC rule 144(k).
Although respondent's expert Mr. Thomson acknowledges that
ADDI&C's Winn-Dixie stock was subject to the SEC rule 144(e)(1)
volume limitation and that, as we have found, ADDI&C probably
10
(...continued)
method. However, after Mr. Howard prepared that report, he
learned that a purchaser of ADDI&C's Winn-Dixie stock in a
private placement would have been required to hold that stock for
2 years under SEC rule 144(d)(1) and thereafter would have been
subject for 1 year to the volume limitation in SEC rule
144(e)(2). Consequently, Mr. Howard changed the view reflected
in his expert report regarding ADDI&C's sale of its Winn-Dixie
stock by private placement and took the position in his rebuttal
report and at trial that it was more likely that ADDI&C would
have disposed of its Winn-Dixie stock through the dribble-out
method because that method would have yielded a greater value for
that stock than would have been obtained through its sale by
private placement. We reject any contention by respondent that
Mr. Howard should not be permitted to change in his rebuttal
report and at trial the position that he had taken in his expert
report with respect to ADDI&C's Winn-Dixie stock. See Rule
143(f). The Court is interested in reaching the proper result,
aided by witnesses who will recognize and correct an error. We
are not interested in attempts to force a party to maintain an
erroneous or unreasonable position for strategic advantage.
- 20 -
would have used the dribble-out method to sell its Winn-Dixie
stock over a 5-to-6 month period, he did not discount or adjust
the NYSE price of that stock on the valuation date in order to
arrive at its fair market value and ADDI&C's net asset value on
that date. That is because, inter alia, Winn-Dixie's NYSE price
"was on a rising trend line" from January 3, 1992, through
November 2, 1992, the valuation date, and, in fact, "increased 72
percent during that period."11
To counter Mr. Thomson’s view that no blockage and/or SEC rule
144 discount is warranted because, inter alia, the NYSE price of
Winn-Dixie stock “was on a rising trend line” during the 10-month
period preceding the valuation date, petitioner points out that a
Value Line Investment Survey report (Value Line report) dated
August 21, 1992, which was approximately 3 months before the
valuation date, reported that "[the NYSE price of Winn-Dixie]
stock has risen about 15% in the past few months. As a result,
long-term total return prospects have been diminished". We do not
believe that the opinion expressed in the Value Line report
11
Nor did Mr. Thomson apply a premium to the NYSE price of
ADDI&C Winn-Dixie stock. That is because, even though ADDI&C
owned 1,020,666 shares of the outstanding Winn-Dixie stock, Mr.
Thomson considered that block of stock, which represented only
about 1.33 percent of the total outstanding shares of Winn-Dixie,
to be "too small" to represent a "swing block of shares." It is
noteworthy that petitioner's expert Mr. Pratt acknowledges that
ADDI&C's stock interest in Winn-Dixie on the valuation date "is
generally considered to be a significant investment. An investor
would likely find it difficult to quickly accumulate such a large
investment without some (typically upward) affect [sic] on the
quoted market price on the subject security."
- 21 -
regarding "long-term total return prospects" for Winn-Dixie stock
addressed the short-term prospects as of the valuation date
regarding the NYSE price of that stock over the relatively short
5-to-6 month period after that date over which the parties and all
the experts agree it would have taken ADDI&C to sell its Winn-
Dixie stock under the dribble-out method.
Mr. Pratt determined that a 10-percent blockage and/or SEC
rule 144 discount should be applied to the NYSE price of Winn-
Dixie on the valuation date. However, as stated above, we
disagree with Mr. Pratt's view that it was likely that ADDI&C
would have sold its Winn-Dixie stock in a private placement,
rather than under the dribble-out method. In addition, Mr. Pratt
did not explain in his expert report, as required by Rule 143(f),
how he arrived at a 10-percent blockage and/or SEC rule 144
discount, and we did not find his limited explanation in his
rebuttal report and at trial of how he determined the amount of
that discount to be particularly helpful. See Rule 143(f)(1). On
the record before us, we shall not rely on Mr. Pratt's opinion as
to whether a blockage and/or SEC rule 144 discount should be
applied to the NYSE price of ADDI&C's Winn-Dixie stock on that
date, nor shall we rely on his view regarding the amount of any
such discount that should be applied in the event that we were to
find that use of such a discount is warranted in the instant case.
Mr. Howard determined in his rebuttal report that a 4.9-
percent blockage and/or SEC rule 144 discount should be applied to
- 22 -
Winn-Dixie's NYSE price on the valuation date in determining the
fair market value of ADDI&C's Winn-Dixie stock and its net asset
value on that date. He arrived at that percentage discount based
on the Black-Scholes options pricing model (Black-Scholes model),
which is used to calculate the cost of a call or put option. Mr.
Howard used the Black-Scholes model to value a put option, which
gives the holder the right to sell a specified asset at a
specified price on (or before) a specified date. Mr. Howard
explained in his rebuttal report that the cost of a put option can
be used to determine the cost of "locking-in" the price of a stock
when the future price of that stock cannot be known with
certainty. Mr. Howard determined that the Black-Scholes model was
a good measure of the discount associated with ADDI&C's exposure
to the market risk that the NYSE price of its Winn-Dixie stock
would have fallen during the 5-to-6 month period that would have
been required to sell that stock under the dribble-out method.
Mr. Howard explained in his rebuttal report that the Black-
Scholes model takes into account the following variables in
arriving at the value of an option: (1) Current stock price per
share, (2) exercise price per share, (3) time to maturity, (4)
risk-free interest rate, (5) volatility, and (6) continuous
dividend yield. Using the Black-Scholes model, Mr. Howard
calculated that the cost of a 3-month put option on Winn-Dixie
stock as of the valuation date would be $3.37, or 4.9 percent of
Winn-Dixie's NYSE price on that date.
- 23 -
Respondent argues that use of the Black-Scholes model will
always result in a blockage and/or SEC rule 144 discount. Mr.
Howard agrees, and so do we. The Black-Scholes model takes into
account, inter alia, a “risk-free interest rate” variable. Mr.
Howard acknowledges in his rebuttal report that "there is always a
cost to locking-in the value of a stock price to protect against
market risk no matter what the specific inputs of the model", and
he testified at trial that it would have taken 5 to 6 months for
ADDI&C to sell its Winn-Dixie stock under the dribble-out method
"without moving the market, [thereby] exposing that stock to
market risks which always results in a decreased value, if for no
other reason than present value purposes." On the instant record,
we are not persuaded by Mr. Howard’s use of the Black-Scholes
model that a blockage and/or SEC rule 144 discount is warranted or
that, even if such a discount were warranted, the amount of any
such discount should be 4.9 percent.
Petitioner has the burden of establishing that a blockage
and/or SEC rule 144 discount should be applied to the NYSE price
on the valuation date of ADDI&C’s Winn-Dixie stock and the amount
of any such discount. Based on our examination of the entire
record before us, we find that petitioner has failed to satisfy
that burden. We further find that on the valuation date the fair
market value of ADDI&C's Winn-Dixie stock was $70,043,204 and the
net asset value of ADDI&C without taking into account any other
discounts or adjustments was $80,140,269.
- 24 -
Petitioner and all of the experts, including respondent's
expert, agree that, in determining the fair market value on the
valuation date of each of the two blocks of ADDI&C stock at issue,
it is necessary to reduce ADDI&C's net asset value on that date by
applying a discount or adjustment attributable to ADDI&C's built-
in capital gains tax. However, there are disagreements as to the
amount of such a discount or adjustment. In addition, petitioner
and petitioner's expert Mr. Howard disagree with petitioner's
expert Mr. Pratt and respondent's expert Mr. Thomson as to the
point at which such a discount or adjustment should be taken into
account in the valuation process. Petitioner and petitioner's
expert Mr. Howard believe that, in calculating ADDI&C's net asset
value on the valuation date, the full amount of ADDI&C's built-in-
capital gains tax should be subtracted before any minority and
lack-of-marketability discounts are applied. Petitioner's expert
Mr. Pratt and respondent's expert Mr. Thomson believe that a 15-
percent discount or adjustment attributable to ADDI&C's built-in
capital gains tax should be taken into account as part of the
lack-of-marketability discount that each agrees should be applied
to ADDI&C's net asset value on the valuation date after that net
asset value has been reduced by a minority discount. Of the 50
percent lack-of-marketability discount equal to $29,254,391 that
Mr. Pratt determined should be applied, $8,776,317 is attributable
to ADDI&C's built-in capital gains tax. Of the 38-percent lack-
of-marketability discount equal to $26,798,906 that Mr. Thomson
- 25 -
determined should be applied, $10,578,516 is attributable to that
tax.12
It is respondent's position that no discount or adjustment
attributable to ADDI&C's built-in capital gains tax should be
applied in determining the fair market value on the valuation date
of each of the two blocks of stock in question. Respondent thus
not only rejects the views of petitioner and petitioner's two
experts, but also the opinion of respondent's expert Mr. Thomson,
that such a discount or adjustment is warranted. In support of
respondent's rejection of Mr. Thomson's opinion, respondent
asserts on brief:
Respondent recognizes that her own expert included the
potential capital gains in his determination of an
appropriate marketability discount; nevertheless, this
inclusion is contrary to Federal tax law.
In support of respondent's position that a discount or
adjustment attributable to ADDI&C's built-in capital gains tax is
"contrary to Federal tax law", respondent advances the following
argument in respondent's opening brief:
12
There are differences between the respective dollar amounts
of the 15-percent discount or adjustment attributable to ADDI&C's
built-in capital gains tax, which both petitioner's expert Mr.
Pratt and respondent's expert Mr. Thomson included as part of the
respective lack-of-marketability discounts that they concluded
should be applied to ADDI&C's net asset value on the valuation
date after that net asset value has been reduced by a minority
discount. That is because of the differences between those two
experts (1) as to whether a blockage and/or SEC rule 144 discount
is warranted and (2) as to the amount of the minority discount
that each believed should be applied. See chart above showing,
inter alia, those differences.
- 26 -
In an established line of cases, this Court has held
that projected capital gains taxes do not reduce the
value of closely held stock when liquidation is
speculative. Ward v. Commissioner, 87 T.C. 78, 104
(1986); Estate of Andrews v. Commissioner, 79 T.C. 938,
942 (1982); Estate of Piper v. Commissioner, 72 T.C.
1062, 1086-1087 (1979); Estate of Cruikshank v.
Commissioner, 9 T.C. 162, 165 (1947); Estate of Luton v.
Commissioner, T.C. Memo. 1994-539, 68 T.C.M. (CCH) 1044,
1052 (1994); Estate of Bennett v. Commissioner, T.C.
Memo. 1993-34, 65 T.C.M. (CCH) 1816, 1825 (1993). These
cases reach that conclusion for two reasons.
First, prior to 1986, former I.R.C. §§ 336 and 337
allowed the tax-free liquidation of a corporation; the
corporation could thereby completely avoid capital gains
taxes upon a subsequent sale of all its assets. Courts
reasoned that the corporation's ability to avoid taxes
upon liquidation rendered the projected liability so
speculative as to be irrelevant. Estate of Piper, 72
T.C. at 1087.
The repeal of those provisions, in the Tax Reform
Act of 1986, P.L. 99-514, §§ 631-633, 100 Stat. 2269-
2282, as reprinted in 1986-3 C.B. (Vol. 1) 186-199, did
not foreclose the possibility of avoiding capital gains
taxes at the corporate level upon sale of all assets. A
subchapter C corporation can convert to a corporation
described in subchapter S (I.R.C. § 1361, et. seq.) and
avoid recognition of any gain, if the corporation retains
the assets for a period of ten years from the date of
conversion to an S corporation. See I.R.C. § 1374(d)(7).
One of petitioner's experts recognized this possible
alternative. Since Artemus D. Davis was a long term
investor in Winn-Dixie stock, electing subchapter S
appears to be a reasonable method to avoid the corporate
level capital gains tax.
Although the willing buyer might incorporate a
reduction in his price for costs of a subsequent
liquidation, the willing seller has no incentive to
accommodate that reduction. Why would the willing
seller, knowing that the capital gains taxes can be
deferred or avoided, agree to that reduction? Why would
the willing seller, knowing further that the buyer
controls the incidence of tax, agree to any reduction
based on the buyer's purely speculative tax burden? See
Mandelbaum v. Commissioner, T.C. Memo. 1995-254, 69
T.C.M. (CCH) 2852, 2866 (1995), aff'd, 91 F.3d 124 (3d
Cir. 1996).
- 27 -
Second, and more importantly, when the actual facts
do not suggest that the shareholders intended to
liquidate the corporation, this Court has refused to
assume that the hypothetical buyer would do so. Estate
of Ford v. Commissioner, T.C. Memo. 1993-580, 66 T.C.M.
(CCH) 1507, 1517 (1993), aff'd, 53 F.3d 924 (8th Cir.
1995); Estate of Bennett v. Commissioner, T.C. Memo.
1993-34, 65 T.C.M. (CCH) 1816, 1825 (1993). Here,
petitioner stipulated that no liquidation was
contemplated at the time of the subject gifts.
* * * * * * *
Petitioner will no doubt argue that the Tax Court
has not unequivocally stated that the potential capital
gains taxes cannot be considered as a legal matter.
Respondent recognizes that valuation is inherently a
factual consideration. Nevertheless, this Court has
consistently held that when liquidation is speculative,
projected capital gains taxes do not reduce value, Ward
v. Commissioner, 87 T.C. 78, 104 (1986); Estate of Luton
v. Commissioner, T.C. Memo. 1994-539; Estate of Ford v.
Commissioner, T.C. Memo. 1993-580; and that unforeseen
future events cannot affect value, Messing v.
Commissioner, 48 T.C. 502, 509 (1967); Mandelbaum v.
Commissioner, T.C. Memo. 1995-255. The only proper
construction of this conclusory language is that
consideration of these speculative future events,
including capital gains taxes, is improper as a legal
matter. [Fn. ref. omitted.]
We reject respondent's position that, as a matter of law, no
discount or adjustment attributable to ADDI&C's built-in capital
gains tax is allowable in the instant case. Indeed, it appears
that even respondent abandons, or at least contradicts, that
position when respondent acknowledges in respondent's answering
brief that
if a sale or liquidation of ADDI&C's assets was in fact
contemplated on the valuation date or if, in fact,
avoidance of a corporate level capital gains tax was not
available, some reduction in value would be appropriate.
* * * [Emphasis added.]
- 28 -
Respondent thus concedes that, irrespective of whether a
liquidation of ADDI&C or sale of its assets was planned or
contemplated on the valuation date, "some reduction in value would
be appropriate if, in fact, avoidance of a corporate level capital
gains tax was not available". However, respondent argues that
although ADDI&C would have been required under the Federal income
tax law in effect on the valuation date to recognize gains on its
assets if it had liquidated and distributed those assets, sec.
336(a), made a nonliquidating distribution of one or more of
those assets, sec. 311, or sold or otherwise disposed of those
assets, sec. 1001(c), it could have avoided the tax on such
gains.13 That is because, according to respondent, ADDI&C could
have converted to S corporation status and retained its assets for
10 years from the date of such conversion, see sec. 1374(a),
(d)(7), and petitioner's expert Mr. Pratt acknowledged that
possibility in his expert report.
13
The Tax Reform Act of 1986 (1986 Act), Pub. L. 99-514, sec.
631-633, 100 Stat. 2269-2282, inter alia, modified sec. 336(a) in
effect prior to passage of the 1986 Act, thereby repealing the
doctrine (General Utilities doctrine) that had been established
in General Utils. & Operating Co. v. Helvering, 296 U.S. 200(1935). Under the General Utilities doctrine, corporations
generally did not recognize gain on certain distributions of
appreciated property to their shareholders and on certain
liquidating sales of property. See H. Rept. 99-426 at 274-275
(1985), 1986-3 C.B. (Vol. 2) 274-275. The change to sec. 336(a)
that was effected by the 1986 Act was intended “to require the
corporate level recognition of gain on a corporation’s sale or
distribution of appreciated property, irrespective of whether it
occurs in a liquidating or nonliquidating context.” H. Conf.
Rept. 99-841, 1986-3 C.B. (Vol. 4) 204.
- 29 -
Although Mr. Pratt recognized in his expert report that as of
the valuation date it would have been possible for ADDI&C to
convert to an S corporation, he did not consider conversion to S
corporation status to be likely as of that date for several
reasons. First, according to Mr. Pratt, it is improper to assume,
as respondent does, that ADDI&C would have been able to make an S
corporation election. That is because such an assumption would
have impermissibly limited the hypothetical willing buyer of each
of the two blocks of stock at issue to certain individuals and
entities who were permitted as of the valuation date to be
shareholders of an S corporation, see sec. 1361(b)(1)(B) and (C),
thereby improperly excluding as a hypothetical willing buyer of
each such block, for example, a C corporation, see sec.
1361(b)(1)(B). In addition, Mr. Pratt believes that the
assumption by respondent that none of ADDI&C’s assets would be
sold for 10 years would have reduced the marketability of each
block of ADDI&C stock at issue, and such a requirement would have
made it unlikely that ADDI&C’s stockholders would have consented
to an S corporation election. Mr. Pratt also notes that section
1362(d)(3) could be a problem for an investment company, like
ADDI&C, unless ADDI&C were to retain its cattle operations or
engage in some other operating business that generated
substantially more gross income than the passive income generated
by ADDI&C's other assets. That is because pursuant to section
1362(d)(3) an otherwise valid S corporation election will be
- 30 -
terminated if ADDI&C (1) had earnings and profits at the close of
each of 3 consecutive taxable years that had been accumulated
prior to the S corporation election, see sec. 1362(d)(3)(A) and
(B), and (2) had more than 25 percent of its gross receipts for
each of those taxable years from passive investment income, which
includes dividend income, see sec. 1362(d)(3)(A), (D)(i).
Although we agree with Mr. Pratt that section 1362(d)(3)
could have caused an otherwise valid S corporation election by
ADDI&C to be terminated if ADDI&C were not to maintain its cattle
operations or engage in some other operating business, there are
no facts established by the record to indicate that as of the
valuation date ADDI&C intended to curtail or eliminate its cattle
operations. Nonetheless, we agree with the other two reasons
advanced by Mr. Pratt in support of his view that as of the
valuation date it was unlikely that ADDI&C would have converted to
an S corporation. Based on the record before us, we reject
respondent's unwarranted assumptions that ADDI&C could have
avoided all of ADDI&C's built-in capital gains tax by having it
elect S corporation status and by not permitting it to sell any of
its assets for 10 years thereafter, and the record does not
establish that there was any other way as of the valuation date by
which ADDI&C could have avoided all of such tax.
We turn now to respondent's position in respondent’s opening
brief, which, as discussed above, we believe was contradicted by
the position in respondent’s answering brief. The former position
- 31 -
was that, irrespective of whether as of the valuation date ADDI&C
could have avoided all of ADDI&C's built-in capital gains tax, no
discount or adjustment attributable to that tax is permissible, as
a matter of law, because as of that date no liquidation of ADDI&C
or sale of its assets was planned or contemplated. The record
shows that as of the valuation date ADDI&C's built-in capital
gains tax relating to ADDI&C's built-in capital gains on all its
assets was $26,686,614.14 The record also establishes that as of
the valuation date ADDI&C's Winn-Dixie stock constituted more than
85 percent of the aggregate fair market value of all of its
assets; the portion of ADDI&C’s built-in capital gains
attributable to that stock (viz, $69,704,921) constituted more
than 96 percent of such gains; and the portion of ADDI&C’s built-
in capital gains tax attributable to that stock (viz,
approximately $25,660,000) constituted more than 96 percent of
such tax. Petitioner and all of the experts believe that a
hypothetical willing seller and a hypothetical willing buyer of
each of the two 25-share blocks of ADDI&C stock at issue would
have taken ADDI&C’s built-in capital gains tax into account in
14
We calculated ADDI&C's built-in capital gains tax by
multiplying (1) the stipulated combined Federal and State capital
gains tax rate of 37.63 percent by (2) ADDI&C's built-in capital
gains reduced by $1,580,217 of net operating loss carryforwards
that ADDI&C had as of the valuation date. In computing the
amount of such gains, we utilized the stipulated historical cost
basis and the fair market value of each of ADDI&C's assets,
including its Winn-Dixie stock, as of the valuation date, since
we have found on the instant record that petitioner has not
established that any blockage and/or SEC rule 144 discount to the
NYSE price on the valuation date of that stock is permissible.
- 32 -
arriving at the price on the valuation date at which each such
block of stock would have changed hands and that therefore a
discount or adjustment attributable to that tax should be applied
in determining the fair market value of each such block.15 On the
record before us, we agree.
We are convinced on the record in this case, and we find,
that, even though no liquidation of ADDI&C or sale of its assets
was planned or contemplated on the valuation date, a hypothetical
willing seller and a hypothetical willing buyer would not have
agreed on that date on a price for each of the blocks of stock in
question that took no account of ADDI&C's built-in capital gains
tax. We are also persuaded on that record, and we find, that such
a willing seller and such a willing buyer of each of the two
blocks of ADDI&C stock at issue would have agreed on a price on
the valuation date at which each such block would have changed
hands that was less than the price that they would have agreed
upon if there had been no ADDI&C's built-in capital gains tax as
of that date. Respondent’s position to the contrary is
inconsistent with the record in this case.16 We have found
15
As discussed herein, there are disagreements as to the amount
of any such discount or adjustment and the point at which such a
discount or adjustment should be taken into account in the
valuation process.
16
Moreover, it is contrary to the record in this case to
assume, as respondent apparently does, (1) that a hypothetical
willing seller and a hypothetical willing buyer would not have
been aware on the valuation date that Winn-Dixie stock, which
constituted over 96 percent of ADDI&C's assets on that date,
(continued...)
- 33 -
nothing in the following cases on which respondent relies that
requires us, as a matter of law, to alter our view: Ward v.
Commissioner, 87 T.C. 78 (1986); Estate of Andrews v.
Commissioner, 79 T.C. 938 (1982); Estate of Piper v. Commissioner,
72 T.C. 1062 (1979); Estate of Cruikshank v. Commissioner, 9 T.C.
162 (1947); Estate of Luton v. Commissioner, T.C. Memo. 1994-539,
supplemented by T.C. Memo. 1996-181; Estate of Ford v.
Commissioner, T.C. Memo. 1993-580, affd. 53 F.3d 924 (8th Cir.
1995); Estate of Bennett v. Commissioner, T.C. Memo. 1993-34.
We note initially that one of the cases on which respondent
relies, Estate of Bennett v. Commissioner, supra, involved a
valuation date that preceded the repeal of the General Utilities
doctrine and did not involve a request by the taxpayer for a
reduction in valuing the stock interest in question for the
capital gains tax that would have been due upon liquidation of the
corporation whose stock was at issue, absent tax planning to avoid
that tax which was permissible as of the valuation date in that
case. Instead, the taxpayer in the Estate of Bennett case asked
the Court to reduce the value of the stock interest in question
there by the "estimated costs of liquidation" which consisted of a
"discount for commissions", a "discount for losses on
16
(...continued)
could be sold and bought on the open market with none of ADDI&C’s
built-in capital gains tax being applicable to that stock and (2)
that that knowledge would not have affected the price to which
they would have agreed on the valuation date for each of the
blocks of stock at issue.
- 34 -
liquidation", and a "discount for the costs of overhead and sales
costs". Estate of Bennett v. Commissioner, supra.
Turning to the remaining cases on which respondent relies, it
is significant to us that, except for Estate of Luton v.
Commissioner, supra, none of the cases on which respondent relies
indicates that any of the expert witnesses who testified in those
cases considered corporate built-in capital gains tax as a factor
in appraising the respective stock interests at issue in those
cases. In the Estate of Luton case, one of the taxpayer's
experts, but not respondent’s expert, reduced the asset value of
each of the corporations at issue by liquidation costs that
included, inter alia, Federal and State capital gains taxes that
would have been incurred on liquidation of those corporations.
Estate of Luton v. Commissioner, supra. In contrast, in the
present case, all of the experts for both parties are of the view
that ADDI&C’s built-in capital gains tax must be taken into
account as a factor in ascertaining the fair market value of each
of the two blocks of ADDI&C stock in question.
Except for Estate of Luton v. Commissioner, supra, and Estate
of Ford v. Commissioner, supra, the other cases on which
respondent relies (like Estate of Bennett v. Commissioner, supra)
involved valuation dates that preceded the repeal of the General
Utilities doctrine. As we read all of those cases, including
Estate of Luton and Estate of Ford, the taxpayers requested the
Court for a reduction in valuing the respective stock interests in
- 35 -
question equal to the full amount of capital gains taxes that
would have been due upon liquidation of the respective
corporations whose stock was at issue in those cases, absent tax
planning to avoid those taxes which was permissible as of the
respective valuation dates in those cases. The Court denied each
of those requests for a reduction for the full amount of such
capital gains taxes where there was no evidence as of those
respective valuation dates that a liquidation of the corporation
in question or sale of corporate assets was planned or
contemplated or that the full amount of such taxes could not have
been avoided.17
In the present case, petitioner and all of the experts,
including respondent's expert, believe, and we have found, that,
in determining the fair market value on the valuation date of each
of the blocks of stock at issue, it is necessary to apply a
discount or adjustment attributable to ADDI&C's built-in capital
17
See Estate of Welch v. Commissioner, T.C. Memo. 1998-167, and
Eisenberg v. Commissioner, T.C. Memo. 1997-483, which were
decided after the parties filed their briefs in this case and
which involved valuation dates that occurred after the repeal of
the General Utilities doctrine. In neither of those cases was a
liquidation of the corporation in question or a sale of its
assets planned or contemplated as of the respective valuation
dates. In valuing the respective stock interests at issue in
those cases, the taxpayers asked the Court for a reduction equal
to the full amount of capital gains taxes that would have been
due upon liquidation of the respective corporations involved
there, absent tax planning to avoid those taxes which was
permissible as of the respective valuation dates. In neither of
those cases does the Court indicate that any expert believed that
such a reduction was warranted. The Court denied the taxpayers'
requests.
- 36 -
gains tax because that is what a hypothetical willing seller and a
hypothetical willing buyer would have done under the facts and
circumstances existing on that date. Petitioner adopts the view
of petitioner's expert Mr. Howard and argues that the full amount
of such tax should reduce ADDI&C's net asset value in making that
determination. On the record before us, we reject petitioner's
position and Mr. Howard’s opinion. On that record, we find that,
where no liquidation of ADDI&C or sale of its assets was planned
or contemplated on the valuation date, the full amount of ADDI&C's
built-in capital gains tax may not be taken as a discount or
adjustment in determining the fair market value on that date of
each of the two blocks of stock in question, even though we have
found that as of that date it was unlikely that ADDI&C could have
avoided all of ADDI&C’s built-in capital gains tax, and the record
does not show that there was any other way as of that date by
which ADDI&C could have avoided all of such tax. See Ward v.
Commissioner, 87 T.C. 78 (1986); Estate of Andrews v.
Commissioner, 79 T.C. 938 (1982); Estate of Piper v. Commissioner,
72 T.C. 1062 (1979).
We thus are in agreement with petitioner's expert Mr. Pratt
and respondent's expert Mr. Thomson that in the present case it is
not appropriate in valuing each of the two blocks of ADDI&C stock
in question to apply a discount or adjustment equal to the full
amount of ADDI&C's built-in capital gains tax. Nonetheless, on
the instant record, we find that on the valuation date there was
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even less of a ready market for each of those two blocks because
of ADDI&C's built-in capital gains tax than there would have been
for each such block without such a tax. We thus also agree with
and accept the views of petitioner's expert Mr. Pratt and
respondent's expert Mr. Thomson that a discount or adjustment for
some amount of ADDI&C's built-in capital gains tax should be taken
into account in valuing each block of stock at issue and that such
a discount or adjustment should be part of the lack-of-
marketability discount that the parties and all of the experts
concluded should be applied in that valuation process.18
Petitioner's expert Mr. Pratt included $8,776,317 of the total
ADDI&C's built-in capital gains tax as part of the lack-of-
marketability discount that he applied in valuing each of the
18
See Estate of Luton v. Commissioner, T.C. Memo. 1994-539,
which involved, inter alia, valuation of a stock interest in a
corporation for which an election to be taxed as an S corporation
had been made and which was subject to the transitional rules in
the Subchapter S Revision Act of 1982, Pub. L. 97-354, sec. 2, 96
Stat. 1669, 1683. Consequently, that corporation was required to
recognize certain of its net capital gain for the 3 taxable years
immediately following the date of that S corporation election.
Although we refused to allow a reduction equal to the full amount
of the Federal and State capital gains taxes that would have been
incurred if that corporation had liquidated on the valuation date
involved in the Estate of Luton case, we found:
Accordingly, with the exception of the 14-month period
from the valuation date until December 31, 1988, RSJ,
Inc.,'s built-in capital gains could be recognized
without a corporate level tax. Notwithstanding the
potential elimination of any corporate level tax, we do
recognize that some discount is in order. We believe
such discount is appropriately considered in the
discount for lack of marketability, discussed below.
* * * [Emphasis added.]
Estate of Luton v. Commissioner, supra.
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blocks of stock at issue, and respondent's expert Mr. Thomson
included $10,578,516 of that total tax as part of the lack-of-
marketability discount that he applied in that valuation process.
Although those dollar amounts vary because of other differences
that those experts have in the valuation process, see chart above,
each of those experts independently concluded that a 15-percent
discount or adjustment attributable to ADDI&C's built-in capital
gains tax should be included as part of the respective lack-of-
marketability discounts that they determined. We have examined
the manner in which petitioner's expert Mr. Pratt and respondent's
expert Mr. Thomson determined the respective amounts attributable
to ADDI&C's built-in capital gains tax that they believe should be
included as part of the total lack-of-marketability discount which
should be applied in valuing each of the blocks of stock at issue.
We are satisfied on the record before us that those amounts (i.e.,
$8,776,317 to $10,578,516) set the appropriate range from which we
may determine the amount attributable to ADDI&C’s built-in capital
gains tax that should be included as part of the lack-of-
marketability discount to be applied in determining the value of
each such block. Bearing in mind that valuation is necessarily an
approximation and a matter of judgment, rather than of
mathematics, Hamm v. Commissioner, 325 F.2d at 940, on which
petitioner has the burden of proof, Rule 142(a), we find on the
instant record that $9 million which is attributable to ADDI&C's
built-in capital gains tax should be included as part of the lack-
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of-marketability discount that is to be applied in valuing each of
the two blocks of ADDI&C's stock at issue.
We now turn to the balance of the lack-of-marketability
discount attributable to factors other than ADDI&C's built-in
capital gains tax that the parties and all of the experts agree
should be applied in ascertaining the fair market value on the
valuation date of each of the blocks of stock in question.
Petitioner and petitioner's experts believe that the percentage
amount thereof should be 35 percent, while respondent's expert Mr.
Thomson believes that it should be 23 percent. Because of other
differences among them, see chart above, the dollar amount of the
lack-of-marketability discount that each determined without regard
to any amount included therein that is attributable to ADDI&C's
built-in capital gains tax ranges from $15,265,630 (Mr. Howard's
determination) to $20,478,074 (Mr. Pratt's determination). Mr.
Thomson's determination thereof was $16,220,390.
Mr. Howard determined to apply a 35-percent lack-of-
marketability discount19 by relying on a number of so-called
restricted stock studies that are cited in his expert report.
Those studies show the amounts of discounts at which private
transactions in restricted stock (i.e., stock of public companies
19
Hereinafter, unless otherwise stated, all references to a
lack-of-marketability discount are to such a discount determined
without regard to ADDI&C's built-in capital gains tax that we
have found should be taken into account in arriving at the total
amount of the lack-of-marketability discount that should be
applied in this case.
- 40 -
that is restricted from trading on the open market for a certain
period) took place compared to the prices on the open market of
identical but unrestricted stock (i.e., stock of public companies
that is freely tradable on the open market). Mr. Howard also
relied on one so-called initial public offering (IPO) study cited
in his expert report that shows the amounts of discounts at which
private transactions in stock occurring shortly before an IPO took
place compared to the prices of such stock after an IPO. In other
words, that IPO study analyzed the prices of stock in private
transactions compared to the prices of subsequent public offerings
of stock of the same companies.
Mr. Pratt determined to apply a 35-percent lack-of-
marketability discount by relying on the same restricted stock
studies and the same IPO study on which Mr. Howard relied as well
as on an additional restricted stock study and an additional IPO
study.20 In addition, Mr. Pratt considered ADDI&C's history as of
the valuation date of not paying dividends in determining that
discount. In order to ascertain whether the aggregate amount of
the minority discount and the lack-of-marketability discount that
he separately determined was reasonable, Mr. Pratt also examined
certain transactions involving the trading of units of various
publicly registered limited partnerships (limited partnership
units) that were not trading on a formal exchange such as the
20
In his rebuttal report, Mr. Howard also considered the
additional restricted stock and IPO studies on which Mr. Pratt
relied in his expert report.
- 41 -
NYSE. Most of those partnerships were making distributions to
their partners (distributing limited partnerships) as of the
valuation date. In examining the trading transactions of the
limited partnership units, Mr. Pratt focused on those transactions
involving publicly registered limited partnerships that, like
ADDI&C, were not making distributions to partners (nondistributing
limited partnerships) as of the valuation date. After studying
the data relating to the trading transactions of the limited
partnership units, Mr. Pratt made a number of different
calculations regarding the amounts of discounts from net asset
value at which those units were trading, including separate
calculations of the median amounts of the discounts from net asset
value at which limited partnership units of distributing limited
partnerships and nondistributing limited partners were trading.
Although Mr. Pratt reproduced in an exhibit to his expert report
the data from the document (source document)21 that he had used in
making those calculations, he did not use the average discount
that was printed in the source document and that was based on the
average of the range of trading prices for each of those units
that were reflected in that document. Instead, Mr. Pratt admitted
21
Mr. Thomson included in his rebuttal report a copy of the
source document from which Mr. Pratt obtained data with respect
to the publicly registered limited partnership units that he
examined. That document provided the name of the limited
partnership, the value per limited partnership unit, the range of
prices at which that unit traded, and the average discount
reflected in the trading price from the value of that unit, which
was computed by using the average of that range of prices.
- 42 -
at trial that he calculated the amounts of discounts from net
asset value at which the limited partnership units were trading
based on the lowest trading prices listed in the source document,
which resulted in his generating slightly higher discounts (about
3 percent higher) than would have been produced if he had used the
average of the range of trading prices for each limited
partnership unit that were reflected in the source document.
Mr. Thomson determined to apply a 23-percent lack-of-
marketability discount. He stated in his expert report and at
trial that the starting point for that discount was 33 to 36
percent (base range), which he identified as the discount for lack
of marketability applicable to relatively small minority interests
in companies that were for the most part operating companies. In
arriving at the base range for his lack-of-marketability discount,
Mr. Thomson reviewed certain, but not all, of the restricted stock
studies considered by Mr. Howard and/or Mr. Pratt. Mr. Thomson
found that the restricted stock studies that he examined showed
that the discounts for restricted stock ranged from 26.5 percent
to 36 percent, and he used the upper end of that range, i.e., 33
to 36 percent, as the base range for determining the lack-of-
marketability discount for each of the blocks of ADDI&C stock at
issue. Mr. Thomson also relied on the following factors to
determine the specific lack-of-marketability discount applicable
to each of those blocks: (1) The size of each block of ADDI&C
stock at issue and its ability to influence management decisions;
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(2) the swing block potential of each such block; (3) the public
awareness or exposure of the business or assets of ADDI&C; (4) the
type of business in which ADDI&C was engaged and the composition
and relative attractiveness of its assets; (5) the financial
strength of ADDI&C and its potential for paying dividends; (6) the
basis of value and the method of value used to determine the asset
value of ADDI&C; and (7) any other relevant factors that could
influence the marketability of each of the blocks of stock at
issue. Mr. Thomson concluded that the first six of the foregoing
factors tended to lower the lack-of-marketability discount that
should be applied to each of those blocks.22 Consequently, he
lowered the base range of 33 to 36 percent that he had used as a
starting point to 20 to 24 percent. He then selected 23 percent
as an appropriate lack-of-marketability discount.23
Respondent points out that neither Mr. Howard nor Mr. Pratt
specifies in their respective expert reports and rebuttal reports
how each used the restricted stock and IPO studies as well as
factors specific to ADDI&C and each of the blocks of stock in
question in order to arrive at a 35-percent lack-of-marketability
22
Mr. Thomson determined that the seventh and last factor,
which gives consideration to ADDI&C's built-in capital gains tax,
should increase the lack-of-marketability discount that he
otherwise determined by $10,578,516.
23
Taking account of all the factors, including ADDI&C's built-
in capital gains tax, that Mr. Thomson concluded were proper in
arriving at the lack-of-marketability discount to be applied in
valuing each of the two blocks of stock at issue, he determined a
38-percent lack-of-marketability discount.
- 44 -
discount. We agree. Nonetheless, we found those reports and the
additional testimony at trial of Mr. Pratt to be quite helpful in
ascertaining the lack-of-marketability discount that we shall
apply in this case.
Petitioner contends that the 23-percent lack-of-marketability
discount determined by Mr. Thomson is too low because, inter alia,
Mr. Thomson failed to consider the IPO studies relied on by Mr.
Howard and/or Mr. Pratt. In Mr. Thomson's rebuttal report and at
trial, he explained that, to the extent that the IPO studies
examined data with respect to stock prices subsequent to the
valuation date, he believed that those data could not be
considered in valuing each of the two blocks of stock at issue
because the Uniform Standards of Professional Appraisal Practice
provide that the cutoff date for data used in a retrospective
appraisal is the valuation date. We agree. However, Mr. Thomson
admitted at trial that, to the extent that the IPO studies
considered data with respect to stock prices prior to the
valuation date, those data were readily available on the valuation
date and could have been considered in valuing each such block.24
We agree and find that Mr. Thomson should have considered the pre-
24
At trial, Mr. Thomson indicated that he believes that at
least one of the IPO studies may be biased because it was based
on “insider transactions”. However, Mr. Thomson’s rebuttal
report, which was submitted to the Court well before trial, did
not reflect any such criticism of that IPO study (or of the other
IPO study), which means to us that Mr. Thomson does not consider
his criticism at trial about the possible bias of one of the IPO
studies to be significant.
- 45 -
valuation date price data reflected in those IPO studies because
they, together with the restricted stock studies, would have
provided a more accurate base range and starting point for
determining the appropriate lack-of-marketability discount than
the base range that he determined. Mr. Howard and Mr. Pratt both
explained in their rebuttal reports that the restricted stock
studies examine stock that, although restricted for a period of
time, is freely tradable after that period expires. They point
out that the IPO studies, rather than the restricted stock
studies, may be more indicative of the lack-of-marketability
discount to be applied in the present case because the IPO studies
examine the price differences between stock, like ADDI&C stock,
that is not freely tradable and stock of the same corporations
after it becomes freely tradable in an IPO. The average median
price discount (adjusted for industry price/earnings multiples)
for years prior to the valuation date (viz, 1975 through 1991)
only, based upon an IPO study undertaken by Willamette Management
Associates for those years as well as 1992 and 1993, was
approximately 52 percent. The average median price discount for
years prior to the valuation date (viz, 1980 through 1991) only,
based upon an IPO study undertaken by Robert W. Baird & Company
for those years as well as 1992 through 1995, was approximately 47
percent. On the record before us, we find that, in determining
the lack-of-marketability discount that is applicable here without
regard to ADDI&C's built-in capital gains tax, the prevaluation
- 46 -
date data in the IPO studies are relevant and provide some insight
into the price differences between stock that is freely tradable
and stock, like ADDI&C stock, that is not freely tradable.
Mr. Thomson stated in his expert report that, because each
block of ADDI&C stock at issue represented 25.77 percent of
the outstanding stock of ADDI&C, no shareholder had control of
that corporation on the valuation date. However, Mr. Thomson
concluded that each of those blocks could influence management
and represented a swing block. Petitioner contends, Mr. Pratt
believes, and Mr. Thomson acknowledged at trial that, in deter-
mining the value of each of the two blocks of stock in question,
the actual owner of the other such block and the actual owner of
the remaining ADDI&C stock on the valuation date should be
considered. We agree. On that date, one of decedent's sons, who
received the other block of stock from his father, and decedent,
respectively, were the actual owners of that other block and that
remaining stock. Petitioner contends that as of the valuation
date it was unlikely that a member of decedent's family would join
with an outsider to compel ADDI&C to act or not to act in a
specified matter. We agree. On the record before us, we find
that Mr. Thomson made invalid assumptions about, and gave undue
weight to, the ability of each 25-share block of ADDI&C stock in
question to influence management and to be a swing block.
Both Mr. Howard and Mr. Pratt criticize Mr. Thomson for, inter
alia, his emphasis in determining a lack-of-marketability discount
- 47 -
on ADDI&C's capacity to pay dividends and his disregard of its 45-
year history as of the valuation date of not paying dividends.25
As of that date, each of those blocks of stock constituted a
minority interest, and neither represented a swing block. On the
instant record, we find that a hypothetical willing seller and a
hypothetical willing buyer would have no reason to believe on the
valuation date that ADDI&C's 45-year history of not paying
dividends was likely to change. See also Rev. Rul. 59-60, sec. 5,
1959-1 C.B. at 242-243 (“adjusted net worth should be accorded
greater weight in valuing the stock of a closely held investment *
* * company, whether or not family owned, than any of the other
customary yardsticks of appraisal, such as earnings and dividend
paying capacity.”).
On the record before us, we are satisfied that the respective
amounts of the lack-of-marketability discounts determined by the
experts without regard to ADDI&C's built-in capital gains tax
(i.e., $15,265,630 determined by Mr. Howard, $16,220,390
determined by Mr. Thomson, and $20,478,074 determined by Mr.
Pratt) set the appropriate range from which we may determine the
lack-of-marketability discount without regard to such tax. In
making that determination, we bear in mind that valuation is
necessarily an approximation and a matter of judgment, rather than
25
Both of petitioner's experts point out that, except for a
shareholder's use of an airplane during 1990 that was treated for
that year as a dividend for Federal income tax purposes, ADDI&C
had neither declared nor paid any dividends to its shareholders
throughout its 45-year history as of the valuation date.
- 48 -
of mathematics, Hamm v. Commissioner, 325 F.2d at 940, on which
petitioner has the burden of proof, Rule 142(a). Based on our
examination of the entire record in this case, and using the
figures in the restricted stock and IPO studies cited in the
expert reports of Mr. Howard and Mr. Pratt as benchmarks of the
lack-of-marketability discount without regard to ADDI&C's built-in
capital gains tax and evaluating various factors specific to
ADDI&C and each of the blocks of stock in question, including the
factors listed in the expert report of Mr. Thomson, we find that
the lack-of-marketability discount without regard to that tax
should be $19 million. We further find that the total lack-of-
marketability discount that should be applied in this case and
that we have found should include $9 million which is attributable
to ADDI&C'S built-in capital gains tax is $28 million.
Based on our examination of the entire record in this case, we
find that on the valuation date the fair market value of each of
the two 25-share blocks of ADDI&C stock in question was
$10,338,725, or $413,549 per share.
To reflect the foregoing,
Decision will be entered
under Rule 155.