tax affecting not appropriate when the taxpayer presumed that an S corporation would lose its S corporation status after a sale
How later courts described this case
- tax affecting not appropriate when the taxpayer presumed that an S corporation would lose its S corporation status after a sale
Written by the judges who cited it.
The opinion
T.C. Memo. 2006-212
UNITED STATES TAX COURT
ROBERT DALLAS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7493-04. Filed September 28, 2006.
John M. Elias, Peter J. Ulrich, Rita M. Danylchuk, and Laura
Lavie, for petitioner.*
Wendy D. Gardner and Brian E. Derdowski, Jr., for
respondent.
*
Kenneth N. Laptook was substituted as counsel for John M.
Elias after trial, and all briefs except respondent’s response to
petitioner’s supplement to reply brief were filed.
- 2 -
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Chief Judge: Respondent determined deficiencies in
petitioner’s gift tax of $1,715,526 for 1999 and $823,160 for
2000.1
Petitioner transferred about 55 percent of the nonvoting
stock of the Dallas Group of America, Inc. (DGA), an S
corporation the stock of which is not publicly traded, to trusts
established for the benefit of his sons (the trusts) in exchange
for cash and promissory notes signed by his sons. The transfers
occurred on November 29, 1999 and 2000. Petitioner and his sons
agreed to be bound by a value for DGA stock as estimated in a
third-party appraisal. Each promissory note used to pay for the
stock at issue in 1999 provides it is deemed paid if petitioner
dies before it is paid. Respondent determined that the
transactions were bargain sales and thus were gifts. The issues
for decision are:
1. Whether the value of the DGA stock at issue on November
29, 1999, was $907 as respondent determined or $620 as petitioner
contends; and whether the value of the DGA stock at issue on
November 29, 2000, was $906 as respondent determined or $650 as
petitioner contends. We hold that the fair market value of the
1
Amounts are rounded to the nearest dollar.
- 3 -
DGA stock was $751 per share on November 29, 1999, and $801 per
share on November 29, 2000.
2. Whether the value of each 1999 note was $2,232,000, as
petitioner contends, or $1,687,704 as respondent determined. We
hold that it was $1,687,704.
Unless otherwise specified, section references are to the
Internal Revenue Code as in effect for 1999 and 2000, and Rule
references are to the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
A. Petitioner
Petitioner resided in Whitehouse, New Jersey, when he filed
the petition in this case. He was 84 years old at the time of
trial.
B. Dallas Group of America
1. Reagent Chemical & Research., Inc.
In 1959, petitioner and Thomas Skeuse (Skeuse) formed
Reagent Chemical & Research, Inc. (Reagent), in Texas. Reagent
initially processed elemental sulfur and later distributed
hydrochloric acid. In the 1970s, Reagent expanded into the
ammonium chloride and magnesium silicate businesses.
2. Formation of Dallas Group of America, Inc.
In February 1989, petitioner and Skeuse decided to split
their interests in Reagent. Reagent spun off its ammonium
- 4 -
chloride and magnesium silicate divisions to form Dallas Group of
America, Inc. (DGA), the stock of which petitioner received in
exchange for his interest in Reagent. DGA manufactures and
distributes ammonium chloride and synthetic magnesium silicate.
Its headquarters is in Whitehouse, New Jersey. It is an S
corporation for Federal income tax purposes.
DGA had nonoperating assets including 79 percent of Trenton
Liberty Insurance Co.,2 Unity Bankcorp, Inc. stock, land in New
Jersey, and split-dollar insurance receivables in 1999 and 2000.
3. Ammonium Chloride and Magnesium Silicate Production
In the mid-1990s, DGA sold ammonium chloride to about 130
different distributors in volumes of at least one truckload.
Ammonium chloride is used as an ingredient in fertilizer, cattle
feed, cough medicine, and intravenous solutions, and in personal
products such as cosmetics and shampoo. It is also used in
galvanizing metal, producing dry cell batteries, growing baker’s
yeast, and servicing oil wells. As of September 1999, DGA
supplied about 90 percent of the ammonium chloride used in the
United States and Canada, or 18,000 tons per year, and exported
about 5,000 tons per year. About 29 percent of DGA’s gross
revenue from 1998 to 2000 was from sales of ammonium chloride.
2
Trenton Liberty Insurance Co. was formed to provide
product liability insurance for DGA.
- 5 -
DGA also manufactures synthetic magnesium silicate. DGA is
the only manufacturer of synthetic magnesium silicate in the
Western Hemisphere. It markets this product under the trade name
Magnesol.
About 50 percent of DGA’s sales of Magnesol are to fast food
chains such as McDonald’s (DGA’s largest customer), which use
Magnesol to filter frying oil from other compounds to extend the
life of the frying oil. About 40 percent of DGA’s sales of
Magnesol are for use in the manufacture of polymers. Ten to
twenty percent of DGA’s sales of Magnasol are to international
food services and industries. About 70 percent of DGA’s gross
revenue in 1999-2000 was from sales of Magnasol.
4. Financial Status and Senior Management
Petitioner chairs DGA’s board. His son, Robert Dallas II
(Robert), is president, his son, David Dallas (David), is chief
executive officer, and John Felowitz (Felowitz) is chief
financial officer and executive vice president. David has worked
for Reagent or DGA since 1974, and Robert has worked for either
Reagent or DGA since 1972. DGA paid petitioner and his two sons
salaries and bonuses in the following amounts in 1998, 1999, and
2000:
- 6 -
1998 1999 2000
Petitioner
Salary $873,224 $983,164 $733,229
Robert
Salary 833,851 785,709 821,253
Bonus 250,000 -- --
David
Salary 831,238 785,275 820,931
Bonus 250,000 -- --
Total 3,038,313 2,554,148 2,375,413
Petitioner originally owned all of DGA’s series A voting
stock and series B nonvoting stock. Paul Rosenberg (Rosenberg)
and Steven Holt (Holt) were petitioner’s estate planning counsel.
They recommended that petitioner use grantor retained annuity
trusts (GRATs) and an estate freeze as part of his estate plan.
In 1992, petitioner and his wife, Fay Dallas (Fay), formed
two GRATs and contributed 4,100 shares of DGA’s series B stock to
each trust. Petitioner transferred another 7,000 shares to Fay
in 1998. Fay died on January 24, 1999. At that time she owned
the 7,000 shares.
Rosenberg recommended that Fay’s estate retain Empire
Valuation Consultants, Inc. (Empire), a business appraiser, to
appraise the stock as of the date Fay died. Empire appraised the
stock in a report dated October 28, 1999.
Empire used a capitalization of income approach to estimate
the value of DGA stock. In doing so, Empire opined that a
- 7 -
reasonable buyer would assume that DGA’s net income would be
reduced by 40 percent due to tax-affecting.3
Empire also assumed that executive compensation for
petitioner and his sons would be set at about $1.4 million per
year, causing DGA’s future annual earnings to increase. Empire
applied a 15-percent discount for lack of control and a 35-
percent discount for lack of marketability. Empire concluded
that the fair market value of a minority interest of DGA stock
was $610 per share as of January 24, 1999.
The GRATs terminated in 1999, and 4,100 shares of DGA stock
were transferred to Robert and David. Also in 1999, petitioner
acquired 78 additional shares of series B stock.
DGA used retained earnings to expand. DGA paid enough
dividends to its shareholders (petitioner, his sons, and the
trusts established for his sons) to pay income tax that resulted
from dividend distributions.
3
Generally speaking, in the context of valuation of stock
of an S corporation, “tax-affecting” is the discounting of
estimated future corporate earnings on the basis of assumed
future tax burdens imposed on those earnings, such as from the
loss of S corporation status and imposition of corporate-level
tax. See Gross v. Commissioner, T.C. Memo. 1999-254, affd. 272
F.3d 333 (6th Cir. 2001); Bogdanski, Federal Tax Valuation, par.
6.03[6][e][i], at S-36-38 (2006 & Supp. 2006).
- 8 -
C. Stock Transfers to Petitioner’s Children
1. 1999 Stock Transfers From Petitioner to His Sons
On a date not stated in the record, Rosenberg advised
petitioner to transfer stock of DGA to trusts established for the
benefit of his sons in exchange for cash and notes signed by his
sons as trustees of the trusts for their benefit promising to pay
for the stock. Petitioner wanted the notes to be deemed paid in
full if he died before all payments were made.4
Rosenberg and Holt chose Empire to appraise DGA’s series B
stock to determine the price for a sale of the stock by
petitioner to the trusts. Petitioner and his sons agreed that
the trusts would buy the stock at the price set by Empire.
Empire prepared a report dated November 15, 1999, and sent
it to Felowitz. Empire concluded that the fair market value of
the series B shares was $620 as of September 30, 1999. Empire
used the same methodology that it had used to appraise the DGA
shares held by Fay’s estate. See par. B-4, above.
On November 29, 1999, petitioner transferred 4,000 shares of
series B stock to the trust established for the benefit of Robert
and 4,000 shares to the trust established for the benefit of
David. In return, each trust transferred to petitioner $248,000
in cash and a promissory note for $2,232,000 (collectively the
4
If the notes were deemed prepaid when petitioner died,
the value of the notes would not be included in his estate.
- 9 -
1999 notes), on the basis of Empire’s estimate of the value of
the DGA stock at issue in 1999 ($620).
Petitioner and his sons signed the sale agreements and
promissory notes. The sale agreements included the following
share adjustment clause:
In the event that the value of the Shares is finally
determined in any IRS proceeding to be greater than
$620 per share, the number of shares purchased and sold
hereunder shall be reduced to the number which is the
quotient of $2,480,000 divided by the value per share
determined in such proceeding. In such event, Buyer
shall transfer to Seller, for no additional
consideration, the number of Shares which is equal to
the difference between 4,000 minus the quotient
determined under this Section 1.2.
The 1999 notes5 include the following self-canceling clause:
In the event that Holder shall die before the Maturity
Date, this note shall be deemed to have been paid,
satisfied and discharged on the day before the date of
the Holder’s death.
In 1999, Fay’s estate distributed 544 shares of series B
stock to Robert and 544 shares to David.
2. 2000 Stock Transfers From Petitioner to His Sons
On November 29, 2000, Fay’s estate and the trusts signed an
agreement under which the estate transferred 2,956 shares of
series B stock to each of the trusts, and each trust transferred
to the estate $192,140 in cash and a promissory note for
$1,729,260 (collectively the 2000 notes), on the basis of
5
The maturity date of the 1999 notes is Nov. 29, 2004.
- 10 -
Felowitz’s estimate that the stock was worth $650 per share.6
Felowitz assumed that Empire had correctly valued DGA stock at
$620 per share as of November 29, 1999, and estimated that the
value had increased to $650 per share as of November 29, 2000.
The 2000 sale agreements between Fay’s estate and the trusts
had the following share adjustment clause:
In the event that the value of the Shares is finally
determined in any IRS proceeding to be greater than
$650 per share, the number of shares purchased and sold
hereunder shall be reduced to the number which is the
quotient of $1,921,400 divided by the value per share
determined in such proceeding. In such event, Buyer
shall transfer to Seller, for no additional
consideration, the number of Shares which is equal to
the difference between 2,956 minus the quotient
determined under this Section 1.3.
The 2000 notes did not have a self-canceling clause.
Respondent audited petitioner’s 1999 gift tax return in
2001. During the audit, respondent’s tax examiner told Rosenberg
that the 1999 notes were self-canceling and thus were worth less
than face value because the notes were canceled if the holder of
the notes died before payment.
On June 21, 2001, after respondent’s tax examiner told
Rosenberg about the self-canceling 1999 notes, petitioner and the
trustees of the trusts executed new promissory notes that were
6
The parties do not dispute that the transfers on Nov. 29,
2000, are treated as made by petitioner because the shares of DGA
transferred in the 2000 transaction would have passed to him if
Fay’s estate had not transferred them to the trusts.
- 11 -
substantially identical to the original notes except that they
did not contain the self-canceling clauses.
After all of the above transactions, the 25,078 shares of
series B stock were owned as follows:
Individual Number of shares
Petitioner 1,878
Robert 4,644
David 4,644
Robert’s trust 6,956
David’s trust 6,956
D. Respondent’s Determinations
Respondent determined: (1) The DGA stock at issue had a
fair market value of $907 per share on November 29, 1999, and
$906 per share on November 29, 2000; (2) each of the 1999 notes,
which had a face value of $2,232,000, had a fair market value of
$1,687,704; and (3) petitioner is liable for gift tax as a result
of these transfers because he received consideration worth less
than the fair market value of the transferred stock.
OPINION
A. Contentions of the Parties
Petitioner contends that the fact that the price paid for
the DGA stock at issue in November 29, 1999, was set by Empire,
an unrelated third-party appraiser, means the price was the fair
market value. Petitioner also contends that testimony of his
expert witnesses supports Empire’s estimate of the value.
Respondent disagrees with petitioner’s contentions.
- 12 -
B. Whether the Price for the DGA Stock at Issue Was an Arm’s-
Length Price
Petitioner points out that the 1999 price paid for the DGA
stock at issue was set by Empire and contends that the parties
properly structured and documented the sales of stock at issue as
arm’s-length transactions, thus establishing the fair market
value of the DGA stock at issue. We disagree.
Intrafamily transfers are presumed to be gifts. Frazee v.
Commissioner, 98 T.C. 554, 561 (1992); Harwood v. Commissioner,
82 T.C. 239, 258 (1984), affd. without published opinion 786 F.2d
1174 (9th Cir. 1986). While the presumption may be overcome with
evidence, see, e.g., Estate of Stone v. Commissioner, T.C. Memo.
2003-309, we conclude that petitioner has not done so.
The transactions were designed by petitioner’s counsel to
serve petitioner’s estate planning goals. The facts that payment
of the 1999 notes need not have been made if petitioner had not
survived until they were due7 and that the 1999 and 2000 notes
contain a share adjustment clause show that the transactions were
for estate planning purposes.
Petitioner’s sons were not represented by their own counsel
in the transactions. Petitioner’s sons did not negotiate the
terms of the agreements, and while that is not dispositive, see
Estate of Thompson v. Commissioner, 382 F.3d 367, 382 (3d Cir.
7
See discussion of the self-canceling clauses below at
par. D.
- 13 -
2004), affg. T.C. Memo. 2002-246, it is a factor suggesting the
lack of arm’s-length transactions in these circumstances. See
Harwood v. Commissioner, supra at 259 (family transaction
structured by the family accountant with no arm’s-length
bargaining did not overcome the family transaction presumption);
cf. Estate of Stone v. Commissioner, supra (arm’s-length
transaction where each member of the Stone family negotiated the
transaction through his or her own independent counsel).
We conclude that the prices petitioner’s sons agreed to pay
for the DGA stock at issue were not arm’s-length prices.
C. Expert Testimony
1. Introduction
We next consider the matters disputed by the expert
witnesses who testified as to the value of the DGA stock at
issue. Empire and Management Planning, Inc. (MPI), each
submitted an expert report for petitioner. Scott A. Nammacher
(Nammacher) testified for Empire, and Robert P. Oliver (Oliver)
and Joseph C. Hassan (Hassan) testified for MPI. Appraisal
Economics, Inc. (AE), submitted an expert report for respondent.
T. Scott Vandervliet (Vandervliet) and Joseph G. Kettell
(Kettell) testified for AE.
The primary points of disagreement among the expert
witnesses were: (1) Whether to decrease the assumed income
stream from DGA because of tax burdens imposed on DGA or its
- 14 -
shareholders after the hypothetical sale (i.e., tax-affecting);
(2) whether to increase DGA’s assumed income stream on the
assumption that DGA’s executive compensation will decrease after
the hypothetical sale; and (3) whether, and if so, to what
extent, to apply discounts for lack of control, lack of voting
power, and lack of marketability.
- 15 -
The following chart summarizes the positions taken in the
expert reports:
Empire MPI AE
(Nammacher) (Oliver, Hassan) (Vandervliet,
Kettell)
Valuation methods Capitalization of Discounted cash Capitalization of
income flow; guideline income; guideline
company company;
guideline
transactions
Capitalization 15.57% for 1999 16.5% for 1999; 16% for 1999; 15%
rates 15.5% for 2000 for 2000
Tax-affecting Reduced net Reduced net None
earnings by 40% earnings by 35%
Executive Reduced expenses None Reduced expenses
compensation by $1.4 million by $1.3 million
adjustment for 1998; for 1999,
compensation compensation
adjusted 8% per adjusted 5% per
year for 1994-98 year for 1994-
2000
Discounts 15% minority 40% lack of 20% minority
interest and lack marketability; 5% interest and lack
of control for lack of voting of control for
nonoperating power operating assets;
assets; 35% lack 15% minority
of marketability interest and lack
of control for
nonoperating
assets; 20% lack
of marketability
1999 per-share $620 $528 $1,004
value
2000 per-share None given $584 $1,026
value
We may accept or reject expert testimony according to our
own judgment, and we may be selective in deciding what parts of
an expert’s opinion, if any, we accept. Helvering v. Natl.
Grocery Co., 304 U.S. 282, 295 (1938). In general, we found AE’s
report and the testimony of Vandervliet and Kettell to be more
- 16 -
convincing than Empire’s and MPI’s reports and the testimony in
support of those reports. AE’s report and the testimony of
Vandervliet and Kettell were cogent and thorough. Vandervliet
and Kettell wrote the AE report and explained it clearly.
Empire’s letter report was, by its terms, limited. Nammacher’s
testimony in support of Empire’s report was unconvincing for
reasons stated at paragraph C-2-b-ii, below. MPI copied portions
of its report verbatim from the Empire report.
2. Tax-Affecting
a. Background
Petitioner’s expert witnesses reduced DGA’s projected income
by 40 percent (Empire) and 35 percent (MPI) based on “tax-
affecting”. Empire reduced DGA’s projected profits by 40 percent
on the assumption that, after a sale, the corporation will lose
its S corporation status.8 See, e.g., Gross v. Commissioner, T.C.
Memo. 1999-254, affd. 272 F.3d 333 (6th Cir. 2001). MPI reduced
DGA’s projected profits by 35 percent because a shareholder is
8
The income of a C corporation is subject to income tax at
the corporate level, and shareholders are taxed on dividends paid
by a C corporation. Secs. 11, 61. In contrast, the income of an
S corporation generally is not taxed at the corporate level, but
is passed through to the shareholder and taxed to the shareholder
when earned, whether or not the corporation pays dividends. Sec.
1366.
Nammacher’s testimony suggests that Empire tax-affected
DGA’s earnings on the assumption that DGA would lose its S
corporation status after or as a result of the hypothetical sale
of its stock. Oliver testified that this is why MPI tax-affected
DGA’s earnings.
- 17 -
liable for income tax on S corporation profits even if those
profits are not distributed to the shareholder.
b. Whether To Assume DGA Would Cease Being an S
Corporation
Petitioner points out that DGA’s S corporation election
could be ended at any time. Petitioner also points out that some
potential buyers (e.g., C corporations) of DGA stock are not
qualified to be S corporation shareholders. See secs.
1361(b)(1), 1362(d)(2).
There is no evidence in the record that DGA expects to cease
to qualify as an S corporation. DGA has a history of
distributing enough earnings for shareholders to pay their
individual income tax liabilities on DGA’s earnings. There is no
evidence that DGA intends to change its practice of distributing
enough to cover individual income tax liability.9 See Davis v.
9
Petitioner contends that DGA’s practice of distributing
only enough to cover individual income tax liability
distinguishes this case from Gross v. Commissioner, T.C. Memo.
1999-254, in which the corporation distributed substantially all
of its income, and thus tax-affecting is appropriate here.
Whether tax-affecting applies turns on valuation principles
including consideration of the hypothetical willing seller and
buyer, the experts, and specific facts of the case, Gross v.
Commissioner, 272 F.3d at 351-352, and not necessarily on
formulas and opinions proffered by an expert witness, see
Anderson v. Commissioner, 250 F.2d 242, 249 (5th Cir. 1957),
affg. in part and remanding in part on another ground T.C. Memo.
1956-178; Estate of Newhouse v. Commissioner, 94 T.C. 193, 217
(1990); Estate of Hall v. Commissioner, 92 T.C. 312, 338 (1989).
In addition, petitioner misunderstands our analysis of the effect
of a shareholder-level tax in Gross v. Commissioner, supra. Our
analysis did not depend on the proportion of corporate income
(continued...)
- 18 -
Commissioner, 110 T.C. 530, 559 (1998). The assumptions of
petitioner’s witnesses that a hypothetical buyer and seller would
assume without any supporting evidence that those events would
occur detracts from the credibility of their opinions. See Gross
v. Commissioner, 272 F.3d at 351-355.
Petitioner contends that the testimony of Oliver and
Nammacher establishes that a hypothetical willing buyer would
tax-affect earnings in valuing DGA stock. We disagree.
i. Oliver’s Testimony
Oliver initially testified that MPI tax-affected DGA’s
earnings to apply C corporation tax rates and later testified
that MPI reduced DGA’s earnings to reflect individual income tax
rates. Oliver was substantially unfamiliar with the MPI report.10
The MPI report contained passages lifted verbatim from the Empire
report. We give Oliver’s testimony little weight.
9
(...continued)
distributed. We said that, in determining the present value of
an expected stream of earnings, any tax-affecting to reflect the
shareholder-level tax burden should be done equally (or not at
all) to both the discount rate and the expected cashflows, with
the result that, in either case, the present value determined
would be the same. That analysis is independent of the
proportion of earnings distributed.
10
Petitioner also called Hassan, another MPI employee, as
a witness. However, Hassan did not testify about tax-affecting,
executive compensation, or discounts.
- 19 -
ii. Nammacher’s Testimony
Nammacher testified that: (1) He has always tax-affected S
corporation income for the past 20 years;11 (2) an informal poll
at a recent conference showed 90 to 95 percent of responding
appraisers tax-affect S corporation income; (3) the American
Society of Appraisers (ASA) Board of Review rejects any
application for certification if the candidate submits test
answers or reports for review that do not tax-affect S
corporation income; (4) his experience is that all bankers,
investment bankers, and business brokers use tax-affecting in
estimating the value of S corporation stock; and (5) Empire uses
tax-affecting in valuing S corporation stock held by employee
stock ownership plans (ESOP) that it submits to the Department of
Labor.
We give little weight to Nammacher’s testimony about an
informal poll at an unidentified conference held on a date not
stated in the record. Nammacher admitted that ASA has never
issued an official directive or recommendation on tax-affecting S
corporations’ earnings.
Nammacher’s claim that ASA’s Board of Review rejects test
answers or reports by a candidate applying for ASA certification
11
Nammacher’s testimony about whether the tax-affecting
adjustment was based on individual or corporate income tax rates
was vague and suggests that Empire applied tax-affecting based on
C corporation income tax rates.
- 20 -
which do not apply tax-affecting is unpersuasive because Kettell
testified that ASA’s Board of Examiners approved Kettell for ASA
certification even though he submitted a report to the board that
did not tax-affect S corporation income. Respondent’s expert
witnesses do not automatically tax-affect all S corporation
earnings.
Nammacher’s testimony about valuing ESOP stock for the
Department of Labor is not convincing because there is no
evidence that the Department of Labor’s definition of value is
similar to the definition of fair market value in this case.
c. Del. Open MRI Radiology Associates, P.A. v.
Kessler
Petitioner contends that the reasoning in Del. Open MRI
Radiology Associates, P.A. v. Kessler, 898 A.2d 290 (Del. Ch.
2006), supports application of tax-affecting in this case. We
disagree. The issue in Del. Open MRI was whether the minority
stockholders of Delaware Open MRI Radiology Associates, P.A.,
received fair value of the going concern in a merger (fair merger
price). Id. at 299, 310. The court of chancery said the fair
merger price had to take into account the loss of the favorable
tax treatment for the S corporation shareholders. Id. at 326.
The fair merger price reflected equitable considerations
including the possibility that in a merger minority shareholders
might be squeezed out. Id. at 311-312.
- 21 -
“Fair value” in minority stock appraisal cases is not
equivalent to “fair market value”. Swope v. Siegel-Robert, Inc.,
243 F.3d 486, 492-493 (8th Cir. 2001); Union Ill. 1995 Inv. L.P.
v. Union Fin. Group, Ltd., 847 A.2d 340, 355 (Del. Ch. 2003); see
Cavalier Oil Corp. v. Harnett, 564 A.2d 1137 (Del. 1989); see
also JPMorgan Chase & Co. v. Commissioner, 458 F.3d 564, 569 (7th
Cir. 2006), affg. in part, vacating in part and remanding Bank
One Corp. v. Commissioner, 120 T.C. 174 (2003). In Del. Open MRI
the court of chancery used a method to estimate the fair merger
price that considered the difference between the value that a
stockholder of Delaware Radiology would receive in Delaware
Radiology as a C corporation and the value that a stockholder
would receive in Delaware Radiology as an S corporation and
applied a type of tax-affecting. Id. at 327. However, the court
of chancery did not decide the price that a hypothetical willing
buyer would pay a hypothetical willing seller, both having
reasonable knowledge of all the relevant facts and neither being
under compulsion to buy or to sell that we use in this case.
d. Conclusion
We conclude that there is insufficient evidence to establish
that a hypothetical buyer and seller would tax-affect DGA’s
earnings and that tax-affecting DGA’s earnings is not
appropriate.
- 22 -
3. Whether To Assume DGA Would Reduce Executive
Compensation
Respondent contends that DGA’s projected net income should
be increased on the assumption that the Dallas family officers
are receiving unreasonable compensation and that those amounts
would be reduced voluntarily or as a result of litigation brought
by a minority shareholder if a minority block of DGA shares were
sold to an unrelated investor. Respondent relies on AE’s report
to support this position. Petitioner contends that AE is
incorrect and that DGA’s compensation to petitioner and his sons
would not decrease after the hypothetical sale, leading to higher
income for DGA.
The record does not contain the quality of factual analysis
customarily used by courts in deciding whether compensation is
reasonable. Further, there is nothing in the record to suggest
that DGA is planning to change how it pays petitioner and his
sons. See Davis v. Commissioner, 110 T.C. 530 (1998). Thus, we
have no more reason to assume changes in DGA’s executive
compensation policies than we have to assume changes in dividend
paying policies or a change in its S corporation status.12 On
this record we, unlike AE and Empire,13 do not assume DGA’s
12
We disagree with petitioner’s expert Empire on all of
these points.
13
Empire’s position on executive compensation is more
(continued...)
- 23 -
projected profits will increase as a result of reduced
compensation to petitioner and his sons after the hypothetical
sale of DGA stock.14
4. Discount for Lack of Control or Minority Interest
a. Discount for Lack of Voting Power
MPI did not apply a discount for lack of control or minority
interest because it estimated the value of a minority interest of
the DGA stock at issue. However, MPI applied a 5-percent
discount for lack of voting power. Petitioner contends that this
discount for lack of voting power is warranted because the stock
at issue is nonvoting stock. Petitioner contends that nonvoting
stock is worth less than a minority interest because minority
shareholders could pool their votes to influence the S
corporation. Any anticipation of minority shareholders’ pooling
13
(...continued)
favorable to respondent than MPI’s position and fairly similar to
AE’s position. One may ask whether respondent viewed Empire’s
analysis as a concession of the matter. The record makes clear
that respondent did not. At the start of the trial, petitioner’s
counsel listed valuation matters in dispute, including the
executive compensation issue. Respondent’s counsel concurred
that it remained in dispute. Thus, it is clear that both parties
understood that the executive compensation issue remained in
dispute and thus were on notice of the need to present evidence
relating to that issue.
14
We do not consider AE’s guideline company and
transaction methods because the application of those methods is
based on an incorrect assumption that adjustments must be made
for executive compensation. Thus, AE’s guideline companies and
transaction methods are not comparable to DGA and its methods.
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their votes is speculative. We conclude that no additional
discount is warranted for lack of voting power.
b. Minority Interest Discount for Nonoperating Assets
AE and Empire estimated minority interest discounts of 15
percent for nonoperating assets.15 Petitioner does not dispute
the appropriateness of a minority interest discount of 15 percent
for nonoperating assets.
c. Minority Interest Discount for Operating Assets
AE applied a 20-percent minority interest discount for
operating assets.16 Petitioner contends that amount is too low
because AE computed it using a formula based on a control
premium, and, in estimating the control premium, AE adjusted for
excessive executive compensation. We disagree. There is no
indication that AE based its selection of the control premium on
excessive executive compensation.
5. Discount for Lack of Marketability
Each expert concludes that some discount for lack of
marketability is appropriate because there was no ready market
for DGA stock on the valuation dates.
15
MPI did not use a separate minority interest discount
for nonoperating assets because MPI used a net asset value
approach to value a minority interest and because MPI’s method
assumed that the DGA stock at issue was for a minority interest.
16
MPI did not use a minority interest discount for
operating assets because MPI’s method assumed that the DGA stock
at issue was for a minority interest.
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Respondent defends AE’s conclusion that a lack of
marketability discount of 20 percent is correct. Petitioner
agrees with MPI that a lack of marketability discount of 40
percent is correct. We disagree with petitioner.
MPI compiled information from Private Equity Week, a weekly
newsletter, on comparable private placements in recent years and
found that the mean discount for lack of marketability for
restricted stock like DGA’s before 1990 was 34.2 percent, from
1990 to 1997 was 20.7 percent, and from 1997 to the present has
been 13 percent. MPI used the 34.2-percent discount and adjusted
it to 40 percent because DGA stock had no prospect of becoming
public in more than 2 years. We believe MPI should have used the
discount studies from the period that includes the transactions
at issue. The valuation dates are in 1999 and 2000 when,
according to MPI, the median lack of marketability discount rate
was 13 percent. We conclude that a 20-percent discount for lack
of marketability is appropriate.
6. Conclusion as to Fair Market Value of DGA Stock
We calculated the fair market value of DGA stock as
follows:17
17
This computation is based on AE’s capitalization of
income approach adjusted for executive compensation. Earnings
before interest and tax (EBIT) are adjusted by $1,300 for 1999
and $1,100 for 2000 to correct the adjustment for executive
compensation. Each amount (other than percentages and number of
shares) in this calculation is multiplied by one thousand.
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Total Equity
1999 2000
Net sales $30,867 $33,225
Adjusted EBIT:
$4,600 less $1,300 for 1999 3,300
and $1,100 for 2000 3,500
Long-term growth rate 3% 3%
EBIT (next 12 months) 3,399 3,605
Less incremental operating working capital (148) (159)
Net operating cashflow for capitalization 3,251 3,446
Capitalization rate (16%-3%; 15%-3%) 13% 12%
Indicated enterprise value (excl.
nonoperating assets) 25,008 28,717
Indicated enterprise value (rounded) 25,000 28,700
Plus excess working capital 1,108 623
Fair market value of business enterprise 26,108 29,323
Nonoperating assets 3,253 3,199
Total equity value 29,361 32,522
Total equity value (rounded) 29,400 32,500
Discounted Equity
Total equity value 29,400 32,500
Discounts for lack of control:
Operating assets (20%) (5,222) (5,865)
Nonoperating assets (15%) (488) (480)
As-if freely traded value 23,690 26,155
Discount for lack of marketability (20%) (4,738) (5,231)
Fair market value of equity 18,952 20,924
Fair Market Value Per Share
Number of shares 25,250 25,328
Fair market value per share 751 801
The fair market value of the DGA stock at issue was $751 per
share on November 29, 1999, and $801 per share on November 29,
2000.
D. Fair Market Value of the 1999 Notes
Respondent determined that the fair market value of each of
the 1999 notes was $1,687,704, which is less than face value
because they were self-canceling. Petitioner contends that the
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value of each 1999 note was its face value of $2,232,00018 and the
self-canceling clauses should be given no effect.
Petitioner contends generally that the promissory notes used
to pay for the stock were not self-canceling because they were
ambiguous on that point. We disagree. The notes unambiguously
provided that they were self-canceling.
Petitioner contends that we should reform the 1999 notes
because inclusion of the self-canceling clauses was a drafting
mistake. We disagree. Rosenberg testified that he drafted the
1999 notes and that he meant for the self-canceling clauses to
require the 1999 notes to be deemed paid if petitioner died
before they were paid. Holt testified that the intent of the
clauses was to treat the unpaid portion of the notes as a gift
from petitioner to his sons in the event of petitioner’s death.
Holt’s testimony is corroborated by a memorandum to his file
dated September 28, 1999.
Petitioner cites cases which involve typographical errors.
See, e.g., Woods v. Commissioner, 92 T.C. 776 (1989); Buchine v.
Commissioner, T.C. Memo. 1992-36, affd. 20 F.3d 173 (5th Cir.
1994); Atkinson v. Commissioner, T.C. Memo. 1990-37. Those cases
have no bearing here because this case involves no typographical
errors. Petitioner may not disavow the self-canceling clauses.
18
Petitioner offered no evidence about the value of the
1999 notes.
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They are not the result of mistake, undue influence, fraud, or
duress.
We conclude on the basis of the foregoing that the self-
canceling clauses must be given effect, and that the value of
each of the 1999 notes is $1,687,704 as determined by
respondent.19 To reflect the foregoing,
Decision will be
entered under Rule 155.
19
In the opening brief, respondent contended that the
share adjustment clauses are void because they are against public
policy. Petitioner did not respond to respondent’s argument.
We deem this issue conceded because petitioner made no argument
about it on brief. See Chevron Corp. v. Commissioner, 104 T.C.
719, 758 (1995); Remuzzi v. Commissioner, T.C. Memo. 1988-8,
affd. without published opinion 867 F.2d 609 (4th Cir. 1989).