The opinion
T.C. Memo. 2002-98
UNITED STATES TAX COURT
ESTATE OF PAUL MITCHELL, DECEASED, PATRICK T. FUJIEKI, EXECUTOR,
Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent*
Docket No. 21805-93. Filed April 9, 2002.
David Wing Keong Wong, Miriam Louise Fisher, Karen L. Hirsh,
and Melvin E. Lefkowitz, for petitioner.
Henry E. O’Neill, Alan Summers, and Paul G. Robeck, for
respondent.
*
This Memorandum Opinion supplements our Memorandum
Opinion in Estate of Mitchell v. Commissioner, T.C. Memo. 1997-
461, vacated and remanded 250 F.3d 696 (9th Cir. 2001).
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SUPPLEMENTAL MEMORANDUM OPINION
JACOBS, Judge: This case is before us on remand from the
Court of Appeals for the Ninth Circuit. Estate of Mitchell v.
Commissioner, 250 F.3d 696 (9th Cir. 2001), affg. 103 T.C. 520
(1994) and vacating and remanding T.C. Memo. 1997-461. The Court
of Appeals has directed us to shift the burden of proof to
respondent regarding the determination of additional taxes and to
explain our valuation of stock included in decedent’s estate for
purposes of Federal estate tax consistent with the standards
established in Leonard Pipeline Contractors v. Commissioner, 142
F.3d 1133 (9th Cir. 1998), revg. and remanding T.C. Memo. 1996-
316.1
We incorporate herein the findings of fact set forth in Estate
of Mitchell v. Commissioner, T.C. Memo. 1997-461, by this
reference. For ease of understanding, we herein summarize the
relevant facts from that opinion as well as set forth additional
findings of fact for the purpose of deciding the issue on remand.
The stipulations and exhibits are also incorporated herein by this
reference.
Background
1
On remand, in Leonard Pipeline Contractors v.
Commissioner, T.C. Memo. 1998-315, affd. without published
opinion 210 F.3d 384 (9th Cir. 2000), we reentered our decision.
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Paul Mitchell (Mr. Mitchell or decedent) died on April 21,
1989. Among the assets included in Mr. Mitchell’s taxable estate
were 1,226 shares of John Paul Mitchell Systems common stock held
by the Paul Mitchell Trust (the trust), a revocable trust
established by Mr. Mitchell. It is our determination of the value
of those shares (at the moment of Mr. Mitchell’s death) that is the
subject of the remand.
In 1979, Mr. Mitchell and John Paul “Jones” DeJoria joined
together to market Mr. Mitchell’s hair care products (particularly
the sculpting lotion) through professional-only hair salons. On
March 31, 1980, Messrs. Mitchell and DeJoria formed Paul Mitchell
Systems, Inc. The name of the corporation was subsequently changed
to John Paul Mitchell Systems (JPMS). Messrs. Mitchell and DeJoria
granted JPMS all proprietary and distribution rights to the hair
and skin products that Mr. Mitchell had developed, including the
products’ trademark, service mark, or other intellectual property
rights.
JPMS’s bylaws provided for a board of directors (the board)
consisting of four directors and cumulative voting for the election
of directors. However, from 1984 until April 15, 1989, Mr.
Mitchell, Mr. DeJoria, and Peter Langenberg were the only board
members. On April 15, 1989, Mr. Langenberg resigned, and Jeanne
Braa was elected to replace him.
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From 1984 until April 1989, Mr. Mitchell served as president
of JPMS; Mr. DeJoria served as chairman of the board, chief
executive officer, chief financial officer, and secretary.
JPMS adopted a fiscal year ending July 31. Beginning with the
fiscal year ended July 31, 1984, the corporation elected subchapter
S status for Federal income tax purposes.
As of April 21, 1989, the stock in JPMS had not been
registered under any securities law; moreover, neither Mr. DeJoria
nor Mr. Mitchell had ever contemplated such a registration or a
public offering of JPMS’s common stock.
JPMS products were sold only through professional salons. Mr.
Mitchell was the heart of JPMS’s connection to hair stylists, who
were the foundation for JPMS’s marketing strategy of promoting and
selling products that Mr. Mitchell developed. Mr. Mitchell was
JPMS’s creative trendsetter, and his hair sculpting technique
revolutionized hair styling. Mr. Mitchell was the focal point of
JPMS’s advertising. In 1986, JPMS began using photographs of Mr.
Mitchell in its advertising.
Mr. DeJoria ran the daily operations at JPMS, making all
management decisions and having all managers reporting directly to
him. Mr. Mitchell, however, had the last word on all policy
matters.
JPMS was known for its styling products. Over the years, JPMS
developed into a major force in the hair care industry, with brand
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recognition by the consuming public, a sophisticated distribution
network, and hundreds of hair stylists trained in the use of the
company’s products. From 1982 through April 21, 1989, JPMS’s share
of the salon-only market, in comparison with those of its chief
competitors, improved every year. In April 1989, JPMS was among
the top five companies in the salon-only market.
From JPMS’s inception until Mr. Mitchell’s death in April
1989, neither Mr. Mitchell nor Mr. DeJoria had any formal contract
with JPMS regarding compensation. Instead, they set sales and
profitability goals for JPMS at the beginning of each fiscal year.
Thereafter, in September or October of each year, they divided
equally the company’s available income.
For fiscal years ended July 31, 1984 through 1988, Messrs.
Mitchell and DeJoria each received the following payments from
JPMS:
FYE 7/31 Salary Management Fees Total
1
1984 --- --- $1,086,500
1
1985 --- --- 2,305,000
1
1986 --- --- 4,162,525
1987 $185,125 $8,565,000 8,750,125
1988 1,308,000 10,500,000 11,808,000
1
Payments to Messrs. Mitchell and DeJoria for this year
were not broken down into salary or management fees.
JPMS characterized these payments as compensation for services
rendered.
Between August 1, 1988, and April 21, 1989, JPMS paid Mr.
Mitchell $10,758,046 (which JPMS characterized as compensation for
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services rendered). For fiscal year 1989, Messrs. Mitchell and
DeJoria agreed that each of them would receive a $2 million annual
salary and a $15 million management fee. The JPMS board approved
these compensation amounts on October 21, 1988.
From the inception of JPMS until the moment of Mr. Mitchell’s
death, the only dividend declared by JPMS was for its fiscal year
ended July 31, 1988. The dividend was originally set at $1.4
million, but the dividend was subsequently raised to $2.5 million.
Robert Taylor was president and chief executive officer of
Minnetonka Corp. (Minnetonka), a publicly traded company. As
chairman, Mr. Taylor was responsible for Minnetonka’s strategic
acquisitions.
Mr. Taylor initiated discussions with Mr. DeJoria in the fall
of 1987 (JPMS’s 1988 fiscal year) when JPMS’s sales were
approximately $50 million. Mr. Taylor informed Mr. DeJoria that
Minnetonka was willing to pay $100 million to acquire all of the
JPMS stock, assuming officers’ salaries were revised. Mr. Taylor
regarded the level of compensation for Messrs. Mitchell and DeJoria
as too high; he considered a more appropriate level of compensation
to be in the $500,000 to $1 million range, including performance
bonuses. Mr. DeJoria insisted on a $125 million acquisition price.
Mr. Taylor refused to raise Minnetonka’s bid, and the negotiations
were terminated.
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In the fall of 1988, Mr. Taylor again approached Messrs.
DeJoria and Mitchell. (At the time, JPMS’s sales were in the $65
million range.) Mr. Taylor offered $125 million to acquire all of
the JPMS stock. The proposed acquisition price assumed that: (1)
Mr. DeJoria would continue managing JPMS; (2) Mr. Mitchell would
continue promoting the products for at least 18 months to 2 years;
and (3) both Messrs. Mitchell and DeJoria would be compensated in
salary and stock at a level paid to officers of other Minnetonka
subsidiaries, such as Calvin Klein.
Mr. DeJoria did not accept Minnetonka’s $125 million offer; he
believed that Minnetonka was “just a little short every time”.
(Mr. DeJoria represented to Mr. Taylor that he had received from
the Gillette Co. (Gillette) a $150 million offer plus a royalty of
2 percent of sales for life. Mr. Taylor informed Mr. DeJoria that
he could not match Gillette’s offer.) Sales discussions with
Minnetonka thus ended.
KPMG Peat Marwick (or one of its predecessors) certified
JPMS’s audited financial statements. JPMS’s net sales and net
income after taxes for fiscal years ended July 31, 1982 through
1988, inclusive, were as follows:
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FYE 7/31 Net Sales Net Income After Taxes
1982 $1,369,316 $142,375
1983 3,590,641 159,947
1984 5,349,152 4,004
1
1985 11,266,610 207,777
1986 24,131,739 2,265,875
1987 41,371,318 281,777
1988 60,693,857 2,569,297
1
The audited financial statements for the years ended July
31, 1986 and 1985, state this amount as $10,918,252.
Until approximately May 1988, Mr. Mitchell’s health had been
good. In July 1988, he was hospitalized and diagnosed as having
pancreatic cancer; thereafter, his pancreas, spleen, gall bladder,
and a portion of his stomach were surgically removed. He remained
in the hospital until September 30, 1988, undergoing additional
surgeries and medical procedures, including radiation therapy.
Although follow-up tests revealed no evidence of metastasis, a
November 1988 blood test raised a possibility of a recurrence of
cancer, but the test was inconclusive.
Although Mr. Mitchell continued his roles as the JPMS creative
force, spokesman, and executive, his medical condition prevented
him from working or performing at hair shows until approximately
January 1989.
In February 1989, tests revealed a recurrence of cancer.
Physicians encouraged Mr. Mitchell to begin chemotherapy, but he
refused. Mr. DeJoria avoided disclosing the severity of Mr.
Mitchell’s illness to quell any fears about the uncertainty of
JPMS’s future without Mr. Mitchell.
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To a degree, the 1989 advertising campaign (which was shot in
November or December 1988) still focused on Mr. Mitchell. However,
Mr. DeJoria and JPMS began shifting emphasis away from Mr. Mitchell
as an individual and towards the products themselves.
During the latter part of Mr. Mitchell’s illness, Messrs.
DeJoria and Mitchell discussed Mr. DeJoria’s future compensation.
Mr. DeJoria promised Mr. Mitchell that in the event of Mr.
Mitchell’s death, he would reduce his management fee from $15
million to $10 million for JPMS’s fiscal year ending July 31, 1990.
However, Mr. DeJoria’s $2 million salary for that year was to
remain intact.
Mr. Mitchell died on April 21, 1989, at the age of 53.
As of April 21, 1989, the common stock of JPMS was owned as
follows:
Number of Shares Percent
Mr. DeJoria 1,250 50.00
The trust 1,226 49.04
Ms. Braa1 16 0.64
Angus Mitchell1 8 0.32
Total 2,500 100.00
1
Ms. Braa and Angus Mitchell, Mr. Mitchell’s son, acquired
their shares by gift from Mr. Mitchell.
On June 29, 1989, Patrick Fujieki, trustee of the trust, and
Michaeline Re2 were elected to the JPMS board. (The board thus
2
Ms. Re, an attorney, joined JPMS on Jan. 1, 1989, as
vice president and general counsel, to oversee the correction of
certain operational problems. On Mar. 1, 1989, she became JPMS’s
(continued...)
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comprised Mr. DeJoria, Ms. Braa, Mr. Fujieki, and Ms. Re.) At this
time, the trust was the shareholder of record of 49.04 percent of
the outstanding common shares of JPMS, of which 1 percent was to be
transferred to Mr. DeJoria in accordance with the terms of Mr.
Mitchell’s will and trust.
In June 1989, Mr. Fujieki (in his capacities as director of
JPMS, trustee for the trust, and executor of Mr. Mitchell’s estate)
asked to inspect the JPMS corporate records and financial
information. On April 10, 1992, representatives of Mr. Fujieki
were permitted to review JPMS’s financial records but were not
allowed to make copies. Before permitting Mr. Fujieki’s
representatives to review its financial records, JPMS required Mr.
Fujieki and his representatives to execute confidentiality
agreements.
Mr. Fujieki continually questioned the actions of the JPMS
board at its meetings and the accuracy of the corporate minutes.
Beginning July 30, 1992, through at least April 20, 1993, James
Ukropina, Esq., outside legal counsel for JPMS, attended the JPMS
board meetings.
Mr. DeJoria assumed many of Mr. Mitchell’s corporate
responsibilities following Mr. Mitchell’s death. Between April 22
and July 31, 1989, JPMS paid Mr. DeJoria $4,901,537 as compensation
2
(...continued)
chief operating officer.
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for services rendered to JPMS. For JPMS’s fiscal year ended July
31, 1990, Mr. DeJoria agreed to reduce his management fee from $15
million to $10 million, as promised to Mr. Mitchell. Mr. DeJoria
also received $2 million in salary for that year. In summary, JPMS
paid Mr. DeJoria the following amounts for fiscal years ended July
31, 1990 through 1994:
FYE 7/31 Amount
1990 $12,000,000
1991 17,025,000
1992 17,025,568
1993 17,000,000
1994 17,000,000
JPMS characterized these payments as compensation for services
rendered.
From August 1, 1989 through 1992, Mr. Fujieki repeatedly
requested that the board retain an independent compensation
consultant to consider the reasonableness of Mr. DeJoria’s
compensation. The board rejected Mr. Fujieki’s requests. At this
time, tension began to mount among members of the board.
In late 1990, Mr. Fujieki retained Coopers & Lybrand to
determine a reasonable level of compensation for Mr. DeJoria.
Coopers & Lybrand preliminarily determined that a reasonable level
of compensation was within the range of $600,000 to $1 million,
with a possible $2 million ceiling. At the January 10, 1992, board
meeting, the board approved Mr. DeJoria’s compensation at 13
percent of JPMS’s gross sales, not to exceed $17 million per year,
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for JPMS’s fiscal years ended July 31, 1992 through 1996. Mr.
Fujieki objected to this approval by the board.
In June 1993, Mr. Fujieki brought suit against Mr. DeJoria,
Ms. Re, and JPMS on the trust’s behalf, alleging that Mr. DeJoria’s
compensation was excessive. In April 1995, the litigation between
the trust and JPMS was settled. The JPMS board and shareholders,
as well as the court, approved the settlement agreement.
On its estate tax return, the estate valued the trust’s
interest in the 1,226 shares of JPMS common stock at the moment of
decedent’s death at $28.5 million. In the notice of deficiency,
respondent determined that the fair market value of the trust’s
interest in the 1,226 shares of JPMS common stock at the moment of
death was $105 million. Accordingly, respondent determined that
the value of the gross estate should be increased by $76.5 million.
The estate filed a petition in this Court challenging
respondent’s moment-of-death valuation for the trust’s 1,226 shares
of JPMS common stock.
In this Court’s opinion, T.C. Memo. 1997-461, we held that the
value of decedent’s interest was $41,532,600 as of the moment of
his death. We calculated this amount as follows:
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Value of JPMS at the moment immediately
prior to Mr. Mitchell’s death $150,000,000
Less: Discount to reflect the loss of
Mr. Mitchell to JPMS (15,000,000)
Value of JPMS at the moment of Mr.
Mitchell’s death 135,000,000
Percent of trust’s interest in JPMS x 49.04
Value of trust’s interest in JPMS before
discounts 66,204,000
Discount for lack of marketability and
minority interest (35%) (23,171,400)
43,032,600
Discount for possibility of lawsuit (1,500,000)
Value of trust’s interest in JPMS after
discounts 41,532,600
On appeal, the Court of Appeals for the Ninth Circuit vacated
our decision and remanded the case for findings to explain our
valuation. More specifically, the Court of Appeals stated that it
is unclear whether a 35-percent combined discount for lack of
control and lack of marketability falls within a range that is
supported in the record.
Additionally, the Court of Appeals directed us to shift the
burden of proof to respondent. Pursuant to the mandate of the
Court of Appeals, we shift the burden of proof to respondent.
Consequently, respondent has the burden of proving by a
preponderance of the evidence the existence and the amount of the
deficiency. Cohen v. Commissioner, 266 F.2d 5, 11 (9th Cir. 1959),
remanding T.C. Memo. 1957-172.
The deficiency in this case is attributable to the valuation
of 1,226 shares of JPMS common stock at the moment of decedent’s
death. On its estate tax return, the estate valued the shares at
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$28.5 million. Thus, respondent must prove by a preponderance of
the evidence that the value of the shares at the moment of
decedent’s death was greater than $28.5 million.
With the discussion that follows, we attempt to provide the
Court of Appeals with a reasoned account of how we reach our
valuation conclusion in this case, mindful that the burden of
persuasion is on respondent.
Discussion
Fair market value for Federal estate and gift tax purposes is
defined as “the price at which the 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.” United States v. Cartwright, 411
U.S. 546, 551 (1973); Snyder v. Commissioner, 93 T.C. 529, 539
(1989); sec. 20.2031-1(b), Estate Tax Regs.; sec. 25.2512-1, Gift
Tax Regs. The standard is objective; it uses a hypothetical
willing buyer and willing seller. See Propstra v. United States,
680 F.2d 1248, 1251-1252 (9th Cir. 1982); Estate of Newhouse v.
Commissioner, 94 T.C. 193, 218 (1990). However, “the hypothetical
sale should not be constructed in a vacuum isolated from the actual
facts that affect the value of the stock”. Estate of Andrews v.
Commissioner, 79 T.C. 938, 956 (1982).
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When valuing unlisted stock, it may be appropriate to apply a
discount for lack of marketability, a discount for a minority
interest, or a premium for control.
Discounts for lack of marketability and lack of control are
conceptually distinct when valuing stock of closely held
corporations. Estate of Newhouse v. Commissioner, supra at 249.
The distinction between the two discounts is succinctly stated in
Estate of Andrews v. Commissioner, supra at 953:
The minority shareholder discount is designed to reflect
the decreased value of shares that do not convey control
of a closely held corporation. The lack of marketability
discount, on the other hand, is designed to reflect the
fact that there is no ready market for shares in a
closely held corporation. Although there may be some
overlap between these two discounts in that lack of
control may reduce marketability, it should be borne in
mind that even controlling shares in a nonpublic
corporation suffer from lack of marketability because of
the absence of a ready private placement market and the
fact that flotation costs would have to be incurred if
the corporation were to publicly offer its stock. * * *
A control premium may be appropriate when valuing a large
block of stock. A control premium represents the additional value
associated with the shareholder’s ability to control the
corporation by dictating its policies, procedures, or operations.
Estate of Chenoweth v. Commissioner, 88 T.C. 1577, 1581-1582
(1987); Rev. Rul. 59-60, 1959-1 C.B. 237, 242.
Application of a premium for control is based on the principle
that the per-share value of minority interests is less than the
per-share value of a controlling interest. Estate of Salsbury v.
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Commissioner, T.C. Memo. 1975-333. A premium for control is
generally the percentage by which the amount paid for a controlling
block of shares exceeds the amount which would have otherwise been
paid for the shares if sold as minority interests. Id.
Although, generally, the minority discount is the inverse of
the control premium, Rakow v. Commissioner, T.C. Memo. 1999-177,
the control premium which is added to the majority block might be
less than the proper minority discount to be attributed to a
minority of the shares, Estate of Chenoweth v. Commissioner, supra
at 1589-1590.
Whether a premium for control, a discount for a minority
interest, or a discount for lack of marketability should be applied
in valuing nonpublicly traded closely held stock depends on the
valuation method employed in reaching the unadjusted value of the
stock.
The approach or approaches used in the valuation each
lead to a value with certain characteristics
(control/minority, marketable/nonmarketable, and so on).
* * * The characteristics of the value produced by the
approach dictate, to a large degree, the premiums and/or
discount(s) appropriate for the standard and premises of
value being sought.* * *
Pratt et al., Valuing A Business: The Analysis and Appraisal of
Closely Held Companies 303 (3d ed. 1996).
The market approach (comparable companies analysis) is based
on comparisons with publicly traded stocks and derives a value
based on publicly traded minority shares. Thus, the method
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provides a marketable, minority ownership indication of value. Id.
at 304. Under this method, a discount from the listed value is
typically warranted in order to reflect the lack of marketability
of the unlisted stock. Mandelbaum v. Commissioner, T.C. Memo.
1995-255, affd. without published opinion 91 F.3d 124 (3d Cir.
1996). If the stock to be valued by the market approach represents
a minority interest, no discount for the lack of control is applied
because the method reflects a minority interest. If, on the other
hand, the stock represents a control interest, a control premium is
warranted in order to reflect the increased value over the minority
value determined under the market valuation method. Estate of
Desmond v. Commissioner, T.C. Memo. 1999-76.
A discounted economic income approach can produce either a
control value or a minority value, depending on the assumptions
used in determining the economic income projections and the
discount rate. Where the method used values the stock as if it
were a controlling interest, no control premium is necessary
because the control aspect has already been accounted for within
the unadjusted value. Pratt, supra at 303-306. “The most common
example of economic income projections that would lead to a
minority or control value is whether or not owners’ compensation is
adjusted to reflect value of services rendered.” Id. at 304.
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Generally, if the inputs in the valuation model reflect
changes that only a control owner would (or could) make
(e.g., changed capital structure, reduced owner’s
compensation, and so on), then the model would be
expected to produce a control value. * * *
If the economic income projections merely reflect
the continuation of present policies, then the model
would be expected to produce a minority value. * * *
Id. at 194-195.
Under a discounted cashflow analysis, a discount rate based on
a traditional capital asset pricing model relates to marketable,
minority ownership in the investment to be valued. Issues of
control and lack of marketability are usually treated separately
rather than incorporating them in the discount rate. Id. at 162-
163.
If an indication of value is developed on the basis of
acquisition data, applying a minority interest discount is usually
appropriate when valuing a minority ownership interest. Id. at
305. However, “if the benchmark for the estimated sale price is
valuation multiples observed in acquisitions of public companies,
data indicate that valuation multiples for acquisitions of private
companies tend to be less.” Id. at 354.
In this case, the parties relied on expert testimony to
establish the fair market value of the trust’s 1,226 shares of JPMS
as of the moment of decedent’s death. The estate offered the
expert reports and testimony of George B. Weiksner and Kenneth W.
McGraw, and respondent offered the report and testimony of Martin
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D. Hanan, to establish the value of the stock.3 All three experts
created earnings models that generally served as the bases of their
analyses, and all experts used comparable companies, discounted
cashflow, and/or comparable acquisitions analyses. The experts
treated their comparable companies analyses as the estimated
publicly traded value of the minority interest of JPMS stock to
determine an initial value of the company before applying discounts
for lack of marketability.
In deriving their earnings models, all the experts made
adjustments to JPMS’s financial data. Most significant were
adjustments (or lack thereof) to Mr. DeJoria’s compensation. The
estate’s experts, Messrs. Weiksner and McGraw, assumed that Mr.
DeJoria’s compensation would be $12 million in 1990 and $17 million
thereafter. Respondent’s expert, Mr. Hanan, created three models.
The initial model assumed that a 49-percent shareholder could
negotiate a reduction in Mr. DeJoria’s compensation to $5 million
3
Respondent also offered the report and testimony of E.
James Brennan to evaluate the reasonable level of compensation
for services provided by Messrs. Mitchell and DeJoria before Mr.
Mitchell’s death and to make an estimate of the reasonable level
of compensation for Mr. DeJoria for the 5 fiscal years following
Mr. Mitchell’s death. Mr. Brennan opined that the amounts
Messrs. Mitchell and DeJoria paid themselves for the 1984-89
fiscal years were far greater than the maximum amounts paid to
comparable top executives at equivalent enterprises for employee
services. Mr. Brennan concluded that the maximum level of
reasonable compensation for Mr. DeJoria for 1990-94 would range
between $820,300 and $1,159,420, on the basis of projections of
an increase in sales revenue for those years.
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per year. The second assumed compensation of $2.5 million, and the
third assumed compensation of $12 million in 1990 and $17 million
thereafter.
Another significant difference in the experts’ analyses was
the discount rates used by the experts in their discounted cashflow
analyses. Messrs. Hanan and Weiksner determined that JPMS’s
weighted average cost of capital (WACC) was 15 percent. Mr. Hanan
used the 15 percent WACC as his discount rate. Mr. Weiksner used
discount rates between 17 and 21 percent to take into account
JPMS’s smaller size. Mr. McGraw determined JPMS’s WACC at 24.7
percent and used a discount rate of 25 percent. Mr. McGraw
attributed 3 percent to JPMS’s smaller size and 6 percent to
reflect individual risk associated with JPMS. The individual risk
specified by Mr. McGraw was the limited number of prospective
purchasers for the stock due to the size of the investment, the
minority interest status of the block of stock, and the control
exercised by Mr. DeJoria.
The enterprise values (in millions of dollars) determined by
the experts under their comparable companies and discounted
cashflow analyses are shown in the following table:
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Enterprise Value
DeJoria Comparable Discounted
Expert Compensation Companies Cashflow
Hanan $2.5 $302 $227
Hanan 5.0 272 (267-281) 218
Hanan 12.0-17.0 193 155
Weiksner 12.0-17.0 85-105 115-140
McGraw 12.0-17.0 109 101
Under their comparable companies analyses, Messrs. Weiksner
and McGraw applied a 45-percent discount to reflect lack of
marketability. Mr. McGraw also applied the 45-percent lack of
marketability discount in his discounted cashflow analysis; he did
not apply a minority interest discount or assert that the value
reflected a premium for control. Mr. Weiksner opined that his
discounted cashflow analysis produced a control value that
demonstrated a 34-percent control premium over the comparable
companies value and confirmed his valuation under the comparable
companies analysis. Mr. Hanan applied a 30-percent discount for
lack of marketability from the value determined under both his
comparable companies approach and his discounted cashflow analysis.
Mr. Weiksner applied a 10-percent extraordinary risk discount
to JPMS’s comparable companies value. This discount accounted for:
(1) The approximate cost of replacing Mr. Mitchell’s services that
was estimated in the projections of JPMS’s operating expenses; (2)
operational difficulties; (3) dependence on Mr. DeJoria; and (4)
difficulty in maintaining future growth.
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Mr. Weiksner valued the trust’s 49.04-percent interest in JPMS
common stock (1,226 shares) at $20,634,000 to $25,489,000, with a
midpoint value of $23,062,000.
Mr. McGraw’s comparative companies analysis resulted in a
$29.5 million value for the 1,226 shares of JPMS common stock. His
discounted cashflow analysis resulted in a $27.2 million value for
the 1,226 shares of JPMS common stock.
Mr. Hanan determined an $81 million fair market value for the
1,226 shares of JPMS common stock under his comparable companies
analysis. Although Mr. Hanan proposed an $81 million fair market
value for the 1,226 shares of JPMS common stock, he conceded that
because of a likely disagreement between the buyer/seller and Mr.
DeJoria over Mr. DeJoria’s compensation and the possibility of
litigation, the value of the subject stock could be as high as
$165.3 million and as low as $57.7 million.
Expert witness reports may help the Court understand an area
requiring specialized training, knowledge, or judgment. Snyder v.
Commissioner, 93 T.C. at 534. We may be selective in deciding what
part of an expert witness’s report we will accept. Helvering v.
Natl. Grocery Co., 304 U.S. 282, 295 (1938); Parker v.
Commissioner, 86 T.C. 547, 561 (1986). The purpose of expert
testimony is to assist the trier of fact to understand evidence
that will determine the fact in issue. Laureys v. Commissioner, 92
T.C. 101, 127-129 (1989). An expert has a duty to the Court that
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exceeds his duty to his client; the expert is obligated to present
data, analysis, and opinion with detached neutrality and without
bias. Estate of Halas v. Commissioner, 94 T.C. 570, 577-578
(1990). In the context of valuation cases, experts lose their
usefulness (and credibility) when they merely become advocates for
the position argued by a party. Laureys v. Commissioner, supra at
129; Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C.
441, 452 (1980). When an expert displays an unyielding allegiance
to the party who is paying his or her bill, we generally will
disregard that testimony as untrustworthy. Estate of Halas v.
Commissioner, supra; Laureys v. Commissioner, supra.
Where experts offer divergent estimates of fair market value,
we decide what weight to give these estimates by examining the
factors they used in arriving at their conclusions. Casey v.
Commissioner, 38 T.C. 357, 381 (1962). We have broad discretion in
selecting valuation methods, Estate of O’Connell v. Commissioner,
640 F.2d 249, 251 (9th Cir. 1981), affg. on this issue and revg. in
part T.C. Memo. 1978-191, and the weight to be given the facts in
reaching our conclusion, Colonial Fabrics, Inc. v. Commissioner,
202 F.2d 105, 107 (2d Cir. 1953), affg. a Memorandum Opinion of
this Court.
We have considered all of the testimony before us, as well as
the expert witness reports, and have weighed all other relevant
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factors. All of the expert reports in this case are subject to
criticism.
Mr. Weiksner describes his discounted cashflow analysis as an
estimation of the company’s value that “presumes certainty of
outcome and control of the company’s cash flows.” Consequently, he
asserts that the method results in an estimate of value that is
substantially higher than the public enterprise value of the
company determined under his comparable companies analysis.
Similarly, Mr. Weiksner opines that his comparable acquisitions
analysis generates control values that include a significant
premium to public values. In his discounted cashflow and
comparable acquisitions analyses, however, Mr. Weiksner assumed Mr.
DeJoria’s compensation would be $12 million in 1990 and $17 million
thereafter. That assumption clearly presupposes lack of control
and shows a minority interest value. Rather than demonstrating a
34-percent control premium, we find that Mr. Weiksner’s discounted
cashflow analysis demonstrates the inaccuracy of the comparable
companies method of valuing the stock in this case.
Mr. McGraw also set Mr. DeJoria’s compensation at $12 million
in 1990 and $17 million thereafter. Mr. McGraw properly did not
claim that the value he determined under the discounted cashflow
analysis demonstrates a control premium. In setting his discount
rate at 25 percent, however, he attributed 6 percent to the
individual risk, described by Mr. McGraw as the limited number of
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prospective purchasers for the stock due to the size of the
investment, the minority interest status of the block of stock, and
the control exercised by Mr. DeJoria. The individual risk reflects
lack of marketability. We find that increasing the discount rate
to reflect this “individual risk” in addition to applying a large
separate discount for lack of marketability results in an
undervaluation of the stock.
We are of the opinion that here the comparable companies and
discounted cashflow methods (which are theoretical valuation
methods) are not appropriate. We did not use them because (1)
there were real-world acquisition offers by Minnetonka and
Gillette, and (2) the discounted cashflow and comparable companies
analyses, as determined by the estate’s experts, produced
theoretical values for JPMS that were substantially less than these
real-world acquisition offers.
While listed market prices are the benchmark in the case of
publicly traded stock, recent arm’s-length transactions generally
are the best evidence of fair market value in the case of unlisted
stock. See Estate of Andrews v. Commissioner, 79 T.C. at 940;
Duncan Indus., Inc. v. Commissioner, 73 T.C. 266, 276 (1979);
Estate of Branson v. Commissioner, T.C. Memo. 1999-231.
In Estate of Mitchell v. Commissioner, T.C. Memo. 1997-461, we
began our analysis by placing a $150 million value on JPMS at the
moment immediately prior to Mr. Mitchell’s death. In determining
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this value, we considered all the evidence but gave the greatest
consideration to Minnetonka’s real-world $125 million offer in the
fall of 1988 (which Mr. DeJoria found “a little short”) and the
Gillette offer of $150 million. This value represents the
acquisition value of all the nonpublicly traded stock of JPMS.
In Estate of Mitchell v. Commissioner, 250 F.3d at 705, the
Court of Appeals stated:
Acquisition value and publicly traded value are different
because acquisition prices involve a premium for the
purchase of the entire company in one deal. Such a
lumpsum valuation was not taken into account when the
minority interest value of the stock was calculated by
the experts. In general, the acquisition price is
higher, resulting in an inflated tax consequence for the
Estate.
In reaching our valuation determination, we were, and are,
mindful that, in general, a publicly traded value (determined under
the comparable companies analysis) represents a minority,
marketable value. Moreover, we were, and are, mindful that
acquisition value, if determined by reference to acquisitions of
publicly traded companies, reflects a premium over the publicly
traded value. It produces a control, marketable value that is
greater than the minority, marketable publicly traded value. If
the acquisition price of publicly traded companies is used to value
a minority interest in a closely held corporation, discounts for
both lack of marketability and lack of control would apply.
The real-world acquisition value of $150 million we applied in
this case is the acquisition value based on an offer to purchase
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all of the stock of JPMS, which is not publicly traded. The
acquisition value based on that offer reflects the fact that there
is no ready market for shares in JPMS, a closely held corporation.
As we pointed out in Estate of Andrews v. Commissioner, 79 T.C. at
953, “even controlling shares in a nonpublic corporation suffer
from lack of marketability because of the absence of a ready
private placement market and the fact that flotation costs would
have to be incurred if the corporation were to publicly offer its
stock.” The $150 million acquisition value reflects a control,
nonmarketable value. Therefore, a discount for lack of
marketability of JPMS stock from the value determined by reference
to the offer to purchase the JPMS stock is not appropriate.
Because we used the real-world acquisition (control,
nonmarketable) value of $150 million for the entire company, we
were not convinced that the combined discounts opined by the
experts in their theoretical values are appropriate. Those
combined rates would apply an additional separate 30- to 40-percent
discount for lack of marketability to a value that reflects that
lack of marketability, in effect doubling the discount.
We recognize, however, that there may be some overlap between
discounts for a minority interest and for lack of marketability in
that lack of control may reduce marketability. Mr. Weiksner
applies a larger lack of marketability discount for minority
interests than for a controlling interest. In his report, he
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opines that a “larger illiquidity and private company discount”
always applies to a minority shareholding of stock than to a
control shareholding of that same stock because the minority holder
does not have the same access to information and ability to create
liquidity as a control holder has. In this case, because the
acquisition price includes the discount for lack of marketability,
we were, and remain, of the opinion that it is more appropriate to
account for any lack of marketability attributable to the minority
interest in the minority discount we apply, which for lack of a
better term we have referred to as the combined discount.
Mr. McGraw, in setting his discount rate under his discounted
cashflow analysis, attributed 6 percent to the individual risk,
described by him as the limited number of prospective purchasers
for the stock due to the size of the investment, the minority
interest status of the block of stock, and the control exercised by
Mr. DeJoria. Mr. McGraw’s individual risk reflects lack of
marketability specifically related to decedent’s minority interest.
We have increased the minority discount by 6 percentage points to
reflect this additional lack of marketability.
Mr. Hanan’s discounted cashflow analysis setting Mr. DeJoria’s
compensation at $2.5 million, resulting in a value of $227 million,
reflects a control value of the enterprise. His analysis setting
Mr. DeJoria’s compensation at $12 to $17 million, resulting in an
enterprise value of $155 million, reflects lack of control.
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Finally, his analysis setting the compensation at $5 million,
resulting in an enterprise value of $218 million, reflects some
power but less than control. We think that a comparison of those
values demonstrates most accurately the difference between the
value of control of the company, the value of shares having some
power, and the value of shares lacking any control. A comparison
of these values supports a minority discount of 29 percent for some
power but less than control (155/218 = 0.711) and 32 percent for
lack of any control (155/227 = 0.683).
The 49.04-percent interest in JPMS to be valued in this case
had significant power. This interest, through the cumulative
voting provision, could elect at least one of three directors. (If
there were four directors as provided for in the articles of
incorporation, decedent’s stock could elect two directors, giving
decedent’s stock power equal to that of Mr. DeJoria). Mr. Weiksner
acknowledges in his report that in some cases investors would
consider a 49.04-percent shareholding adequate to influence or even
control a company but cautions that an investor would have had no
assurance of his ability to influence the management or disposition
of the company except through cooperative means.
We find that a 29-percent discount for decedent’s 49.04-
percent shareholding is appropriate to reflect some power but less
than control. We also find that here the minority discount should
be increased by 6 percentage points (a total of 35 percent) to
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reflect the additional lack of marketability attributable to a
minority interest.
On the basis of a thorough review of the entire record before
us, we believe that we correctly arrived at a 35-percent discount
rate that combines the lack of control and any additional lack of
marketability attributable to that lack of control that is not
reflected in the $150 million control, nonmarketable acquisition
value.
The experts generally agreed that the most significant factors
included the impact of Mr. Mitchell’s death on the reputation of
the company, the costs of the DeJoria litigation, cashflow
patterns, the marketability of the estate’s minority (i.e.
noncontrolling) interest of stock in the company, and the overall
competition in the hair care industry. The $150 million
acquisition price reflects the cashflow patterns and the overall
competition in the hair care industry. We apply a 10-percent
discount to the $150 million to reflect the impact of Mr.
Mitchell’s death on the value of the corporation.4 We apply a 35-
percent discount for lack of control and additional lack of
marketability attributable to the minority interest. Finally, we
reduce the value of the 49.04-percent ownership interest by
$1,500,000 to account for the possibility of litigation with Mr.
4
This 10-percent discount is consistent with Mr.
Weiksner’s extraordinary risk discount.
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DeJoria. Thus, we find that the value of the shares of stock at
the moment of decedent’s death was $41,532,600.
We calculated this amount as follows:
Value of JPMS at the moment immediately
prior to Mr. Mitchell’s death $150,000,000
Less: Discount to reflect the loss of
Mr. Mitchell to JPMS (15,000,000)
Value of JPMS at the moment of Mr.
Mitchell’s death 135,000,000
Percent of trust’s interest in JPMS x 49.04
Value of trust’s interest in JPMS before
discounts 66,204,000
Discount for lack of marketability and
minority interest (35%) (23,171,400)
43,032,600
Discount for possibility of lawsuit (1,500,000)
Value of trust’s interest in JPMS after
discounts 41,532,600
To reflect the foregoing,
Decision will be entered as
previously entered on January 5,
1999.