UNITED STATES TAX COURT
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T.C. Memo. 2004-174
UNITED STATES TAX COURT
ESTATE OF JOSEPHINE T. THOMPSON, DECEASED,
CARL T. HOLST-KNUDSEN AND THE BANK
OF NEW YORK, EXECUTORS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4939-02.
Filed July 26,
2004.
Kirk H. O'Ferrall, Robert H. Goldie, Jonathan G. Blattmachr,
Andrew E. Tomback, Edward A. Stelzer, and Jonathan W. Wolfe,
for
petitioner.
Robert A. Baxer and Joseph J. Boylan, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
SWIFT, Judge:
Respondent determined a deficiency of
$17,910,408 in the Federal estate tax of the estate of decedent
BERVED JUL 2 6 2004
- 2 Josephine T. Thompson and a $7,164,163 accuracy-related penalty
under section 6662(a).
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect on May 2, 1998, the date of
decedent's death, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
The issues for decision are:
(1) The fair market value of
487,440 shares of the voting common stock of Thomas Publishing
Co., Inc.
(TPC), that were owned by. decedent on her death; and
(2) whether the estate is liable for the accuracy-related
penalty.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
On May 2, 1998, the date of her death, decedent resided in
New York.
On May 14,
1998, Carl T. Holst-Knudsen (Holst-Knudsen),
decedent's son, and The Bank of New York were appointed by the
Surrogate Court of the State of New York, County of Westchester,
as co-executors of decedent's estate.
Holst-Knudsen resides in
New Jersey, and The Bank of New York is headquartered in New York
City.
TPC is a private, closely held corporation that was formed
over 100 years ago, on January 28, 1898, as a New York
- 3 corporation.
At the time of trial, TPC's principal place of
business was located in New York City.
The 487,440 shares of TPC voting common stock that decedent
owned constituted 20.57 percent (hereinafter generally rounded to
20 percent) of TPC's total outstanding common stock.
Decedent's
shares constituted the largest block of TPC common stock owned by
any single stockholder.¹
On May 2, 1998, all but 300,000 shares of the remaining TPC
common stock were owned by approximately 20 other relatives of
Harvey Mark Thomas, the founder of TPC.
Holst-Knudsen was designated as the sole testamentary
beneficiary of decedent's 487,440 shares of TPC common stock.
As
of May 2, 1998, taking into account the 162,000 shares of TPC
common stock that he already owned and the 487,440 shares that he
inherited from decedent, it appears that Holst-Knudsen
individually and beneficially owned 649,440 shares of TPC stock
(nr approximately 27 percent of the total outstanding TPC common
stock.
The last 300,000 shares of TPC common stock, representing
12.66 percent of the total outstanding TPC common stock, were
owned by an outside stockholder -- namely, Capital Cities/ABC,
¹ Decedent also owned 237.6 shares of TPC nonvoting
preferred stock the value of which is not in dispute.
- 4 Inc., a New York Stock Exchange publicly traded company.2
As of
the date of decedent's death, Capital Cities/ABC, Inc., or its
predecessor, apparently had owned these shares of TPC common
stock for at least 10 years.
During 1998 and subsequent years through the time of trial
in 2003, Holst-Knudsen was president and Jose E. Andrade was
chairman of the TPC board of directors.
Both Holst-Knudsen and
Andrade are grandsons of Harvey Mark Thomas, TPC's founder.
None of the shares of TPC common stock has ever been
publicly traded, and, in the 10 years before decedent's death and
in the years after decedent's death through the time of trial, no
sales of TPC common stock occurred.
Also, as of May 2, 1998, no
buy/sell agreement or stockholder agreement affecting the value
of TPC common stock was in existence.
Over the years, TPC's primary business has been the
production and sale of industrial and manufacturing business
guides and directories.
TPC's business directories provide
2 In 1996, the Walt Disney Co. (Disney) acquired Capital
Cities/ABC, Inc., for $19 billion. The TPC stockholder list in
evidence apparently does not take into account this 1996 Disney
acquisition and therefore provides the former name of this
outside TPC stockholder. Herein, we refer to this stockholder as
shown on TPC's stockholder list.
- 5 detailed information on products and services, company profiles,
contact information, and catalog files.3
As of May 2, 1998
TPC published and sold throughout the
United States and abroad approximately 24 business-to-business
industrial business directories, including the Thomas Register of
American Manufacturers (the Thomas Register), TPC's 34-volume
directory which is recognized throughout North America as the
most comprehensive resource for finding manufacturing companies
and products.
TPC also published and sold a variety of news
magazines, software comparison guides, and a magazine relating to
factory automation, and it owned a product information exchange
service and a custom publishing group.
By any measurement, as of May 2, 1998, TPC was regarded as a
very successful and profitable company and by some as holding an
effective monopoly in the United States on business-to-business
industrial and manufacturing print publications.
3 The first buying directory was published by Harvey Mark
Thomas in 1890, prior to incorporation of the business, and was
titled "Thomas' Machinery, Iron, Steel, and Metal Trades
Reference Book".
- 6 In its own publications, TPC describes itself as follows:
Thomas
Publishing
Company
Your product information headquarters
For more than 95 years, Thomas Publishihg Company has
concentrated its full energies on filling one of industry's
greatest needs...the need for up-to-date product information.
other publisher is as totally dedicated to this mission.
No
Decision makers throughout industry need product information
to operate their companies successfully. Regardless of job
function, the hunger for up-to-date product information is
universal. It's given priority attention because industry's
appetite for products and services of every type is enormous.
It
can be filled only when buying influences have comprehensive,
reliable, up-to-date vendor information. It influences
profitability profoundly because dozens of new products enter the
marketplace daily -- providing new functional and economic
benefits. To not keep up with these developments means operating
without the benefit of these improvements. And ultimately that
means relinquishing market position to one's competitors.
Thomas Publishing Company has become the acknowledged leader
in providing industry with the product information it needs.
Today, we publish twenty-four major buying guides, thirty-one
product news magazines, two product information exchange services,
a magazine on factory automation, and a publication to help buyers
select the most cost-efficient transportation modes for their
inbound freight.
In addition, Thomas Business Lists·offers
comprehensive list services for direct marketing. Also, the
Thomas Marketing Information Center helps industrial marketers
research and respond to industry's need for new products. All of
these services are described in the pages that follow.
*
*
*
*
*
*
*
Published annually, Thomas Register of American
Manufacturers is by far the most complete and helpful specifying
and buying guide published today. It provides "instant" sourcing
information on nearly 52,000 industrial products and services,
along with comprehensive specifications and availability
information from thousands of manufacturers. In all, more than
1,500,000 individual product/service sources are included. Thomas
Register also contains a complete 2-volume Company Profiles
section and a comprehensive 8-volume Catalog File section.
Headquarters and branch addresses, phone numbers and asset ratings
are provided on more than 148,000 U.S. firms.
- 7 For everyone involved in specifying and buying industrial
products and services, Thomas Register is invaluable. For
everyone involved in selling industrial products and services,
Thomas Register is invaluable.
[22 Thomas Register of American
Manufacturers 3573 (86th ed. 1996).]
The primary sales force for TPC directories was made up of
independent salespersons located throughout the United States and
Canada.
The salespersons were paid on a commission basis with
the right to receive commission advances from TPC.
In the early 1990s, the development and increased use of
electronic and digital media provided alternatives to the form
and manner in which information could be packaged and
distributed.
For example, the development of CD-ROM format
facilitated the transmission of large amounts of data quickly and
permitted the user to sort and to access data in different ways.
Also, the development and expansion of the Internet and of
Internet search engines allowed traditional buyers of TPC's
directories, to a certain extent, to locate and to purchase
products on their own without reference to TPC's print
directories.
Historically, TPC's buying directories were published only
in print or paper format.
By the early 1990s, however, it was
recognized by TPC's management that the Internet and other
technological advances would have an impact on TPC' s business,
presenting to TPC special challenges, risks, and new competition,
but also providing to TPC new growth opportunities.
- 8 -
In 1993, in response to the significant advancements in
technology and to increased use by business entities of
electronic media, TPC began publishing and offering some of its
business-to-business buying directories on CD-ROM.
In 1994, in an internal TPC management publication, the
Thomas Register was described as "the undisputed leader * * * in
electronic publishing" relating to business-to-business buying
directories.
Also, in that same internal publication, a TPC
management objective (relating to TPC's continuing competitive
position with electronic publishing) was stated as follows:
Finding ourselves now at such a juncture, we seek an
approach to securing for * * * [TPC] a dominant
position in the electronic interchange of information
among industrial buyers and sellers comparable to that
which it has enjoyed in the hard copy realm.
In early 1995, although TPC's management recognized that
TPC's historical existence as a print publisher constituted a
certain liability in the new electronic environment, TPC's
management also recognized that TPC brought "to the competitive
electronic information wars ahead" certain "great assets" which
were described as "the information that it traffics and the
methodologies, relationships and brand name recognition that
support that traffic".
In 1995, TPC began publishing and making its directories
available for free on the Internet.
The record does not indicate
- 9 exactly on which dates TPC's various directories became available
on the Internet.
At TPC's 1996 -annual stockholder meeting, Holst-Knudsen gave
a speech in which he acknowledged that the rapid advancements in
technology created uncertainty for the future of TPC, but in
which speech Holst-Knudsen also stated that the technological
advancements that were occurring constituted a "great"
opportunity for TPC.
A colorful excerpt from a January 1998 TPC publication
comments on the positive manner by which TPC's management, as of
early 1998, was addressing and dealing with the technological
challenges TPC faced:
As the company's flagship, Thomas Register absorbs the brunt
of competitive initiative from the various evil empires
aiming to unseat us in the new digital world. Asked to
respond with a major Internet launch in 1996 and to add to
that a major CD-ROM program in 1997 * * * [Thomas
Register's] production, editorial, circulation, sales and
administrative people have handled a hailstorm of change and
complexity with energy and skill that few would have been
bold enough to anticipate only three years ago.
By early 1998, ThomasRegister.com was recognized as one of
the 200 leading business-to-business Web sites in the United
States.
Among the 200 Web sites so recognized, TPC's Web site
was ranked sixth.
- 10 For its fiscal years 1993-98, the number of purchasers or
subscribers to TPC' s print and CD-ROM directories, and the number
of subscribers to TPC's Internet directories are set forth below:
Fiscal
Year
1993
1994
1995
1996
1997
1998
*
Subscribers
CD-ROM
Subscribers
Internet
Subscribers
73,500
78,000
81,000
80,000
67,500
45,500
1,000
2,500
5,000
13,000
25,000
45,500
N/A
N/A
40,000
225,000
550,000
*
Not in evidence
Historically, TPC's revenue was generated from the sale of
subscriptions to and advertising in its print directories.
For
the last 30-plus years, the largest percentage of TPC's revenue
was generated from the sale of advertising.
For example, for its
fiscal year 1972, advertising revenue associated with TPC's
directories accounted for 86 percent of TPC's total revenue.
By
its 1993 fiscal year, advertising revenue associated with TPC's
directories accounted for more than 90 percent of TPC's total
revenue.
Set forth below for each of TPC's fiscal years 1993-2002 are
the numbers for TPC' s subscription and advertising revenue and
the percentage of TPC's total sales revenue reflected by
subscription revenue and by advertising revenue:
- 11 -
Fiscal
Year
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
subscription
Percentage
of Total
Revenue
Sales Revenue
$14,901,781
15,310,520
16,978,851
17,173,690
17,240,197
14,068,891
8,834,385
6,580,888
*
957,646
*
8.3
7.9
7.9
7.4
6.7
5.2
3.0
2.2
*
0.4
Advertising
Percentage
of Total
Revenue
Sales Revenue
$165,386,826
177,924,154
197,451,678
215,653,261
239,828,771
257,901,815
284,004,912
291,617,859
*
249,187,069
91.7
92.1
92.1
92.6
93.3
94.8
97.0
97.8
*
99.6
Not in evidence.
For 1993-2002,. decreases in TPC's subscription revenue
generally coincided with TPC making its directories available on
CD-ROM and on the Internet.
For 1993-2000, however, increases in
TPC' s advertising revenue relating to CD-ROM and Internet
versions of its directories, more than offset decreases in TPC's
subscription revenue.
For its fiscal years 1998-2002, TPC' s combined subscription
and advertising revenue relating to its respective print, CD-ROM,
and Internet directories is set forth below:
Combined Subscription and Advertising Sales Revenue
CD-ROM
Internet
Fiscal
Year
Directories
Directories
Directories
Multimedia*
1998
1999
2000
2001
2002
$60,974,928
55,183,301
49,567,582
40,320,705
29,054,729
$21,545,793
30,148,498
32,233,952
29,578,071
24,285,826
$ 3,801,224
11,701,065
20,295,520
27,962,016
29,485,156
$190,135,238
196,831,426
196,595,142
187,279,835
167,486,238
*
Multimedia sales revenue reflects the sale of
bundled advertising in TPC's print, CD-ROM, and
Internet directories. Revenue numbers in this
table do not match up entirely with the revenue
numbers in the table above.
t
- 12 In addition to developing and implementing technology to
make its directories available on CD-ROM and on the Internet, TPC
engaged in other technology projects.
A list and a brief
description of other technology-related projects undertaken by
TPC during its 1995-2002 fiscal years are set forth below:
(1)
Development of the nationally recognized TPC Web site;
(2)
Development of TPN Register, a joint venture
between TPC and General Electric Co., through
which product information similar to information
contained in TPC's directories was to be provided
to companies via each company's respective
internal intranet. In 2001, TPC apparently
terminated this TPN Register project;
(3)
Development of Thomas.Net, a software product that
enabled users to use keywords to make online
digital searches of TPC's electronic directories
for industrial product information;
(4)
Development of Product News Network (PNN), an
electronic magazine containing information
regarding new industrial products;
(5)
Development in 1995 of Thomas Global Register
(TGR), an Internet directory for TPC's customers
located outside the United States; and
(6)
Purchase in 1997 of Plant Spec, a Web-based softwareL
system that permitted the electronic transfer of
computer assisted design (CAD) drawings.
During its 1995-97 fiscal years, TPC spent approximately $36
million on the above technology-related projects.
As of May of
1998, TPC's management anticipated that during 1998-2002 TPC
would undertake additional projects, incur additional
- 13 -
expenditures, and realize additional income relating to
technology-related projects.
During its 1998-2002 fiscal years, TPC's actual expenditures
associated with development and marketing of technology-related
projects totaled approximately $234 million.4
Set forth below are TPC's technology-related expenditures
for its 1995-2002 fiscal years:
Fiscal
TPC
Year
Web Site
1995
$
1996
--
TPN
Register
$ 2,901,153
3,450
7,283,842
Thomas.Net
$
-462,942
PNN
$
-N/A
Plant Spec
$
---
TGR
$
Misc
Total
--
$ 1,310,520
1,131,845
2,336,691
$
11,218,770
4,211,673
1997
3,692,116
8,133,557
1,670,582
1,639,314
20,818
3,740,603
2,146,855
21,043,845
1998
6,220,263
6,583,382
3,681,100
3,567,351
7,867,906
4,092,326
2,420,544
34,432,872
1999
3,348,521
5,800,000
5,908,513
3,619,148
7,445,476
5,832,464
6,120,977
38,075,099
2000
6,534,901
16,359,397
6,376,417
2,278,640
10,459,145
9,383,771
16,772,912
68,165,183
2001
8,519,175
3,700,000
5,797,868
2,278,640
9,955,829
9,383,771
16,352,359
55,987,642
2002
7,869,933
TOTAL
$36,188,359
--
$50,761,331
4,173,741
$28,071,163
930,655
$14,313,748
4,547,589
$40,296,763
9,423,411
$42,988,191
8,101,439
$55,562,297
35,046,768
$268,181,852
For its 1993-2000 fiscal years, TPC's reported financial
statements reflect steady, consistent, and increasing revenue and
show that TPC was profitable through the end of its 1999 fiscal
year.
As reported, for each of 1993-2000, TPC realized record
4 Apparently, for Federal income tax purposes and in the
valuations made by the estate's experts herein, TPC treated all
of its technology-related expenditures as current ordinary and
necessary business expenses, rather than as capital expenditures.
Respondent herein complains mildly about such current expense
treatment but stops short of asserting that the technologyrelated expenditures should have been capitalized and stops short
of asking that TPC's financial statements and financial
projections be redone to treat such expenditures as capital in
nature.
- 14 total revenue and, as of the end of TPC's 1997 fiscal year, TPC's
financial data reflected shareholder equity of $148,605.,729.
As of May of 1998, TPC had reported positive net income for
every year for the prior 24 years, and the then-current in-house
management financial forecast for TPC estimated net profits for
1998.
In late 1997, TPC's senior management, while acknowledging'
significant challenges, predicted that 1998 would be better than
1997 and "our best [year] ever. "
For each of its 1993-98 fiscal years, TPC's net sales
revenue, expenditures (including TPC's technology-related
developmental expenditures), operating income, and total net
income, as reported on TPC's financial statements, are reflected
in the table below:
Fiscal
Year
Net Sales
Revenue
Expenditures
Operating
Income
Total
Net Income
1993
1994
1995
1996
1997
1998
$168,059,000
179,287,018
200,487,153
216,924,156
240,116,975
256,806,493
$142,602,855
148,510,315
170,208,645
199,871,672
217,559,833
231,436,437
$25,456,145
30,776,703
30,278,508
17,052,484
22,557,142
25,370,056
$14,333,288
12,804,431
11,107,716
13,171,595
15,927,549
18,024,858
Also at the end of each of its 1993-98 fiscal years, TPC
owned substantial liquid short-term investments and marketable
securities as set forth below:
- 15 -
Fiscal
Year
Short-Term
Investments
Marketable
Securities
Total Liquid
Investments
1993
1994
1995
1996
1997
1998
$38,052,200
45,640,865
52,919,162
50,915,037
68,993,367
68,687,060
$10,264,800
12,050,249
18,292,503
21,986,280
28,261,773
29,988,533
$48,317,000
57,691,114
71,211,665
72,901,317
97,255,140
98,675,593
For each of its 4 fiscal years (1999-2002) , subsequent to
the year in which decedent died, TPC's net sales revenue,
expenditures (including TPC's technology-related developmental
expenditures), operating income or loss, and total net income or
loss, as reported on TPC's financial statements, are reflected in
the table below:
Total
Fiscal
Year
Net Sales
Revenue
1999
2000
2001
2002
$273,386,403
278,741,064
267,003,996
234,832,485
Expenditures
Operating
Income (Loss)
Net Income
(Loss)
$253,677,683
282,500,513
278, 332, 392
234, 323, 041
$19,708,720
(3,759,449)
(11,328,396)
509,444
$14,988,447
(5,477,876)
(13,807,358)
1,738,420
At the end of each of its 1999-2002 fiscal years, TPC
continued to owri substantial liquid short-term investments and
marketable securities as set forth below:
Fiscal
Year
Short-Term
Investments
Marketable
Securities
Total Liquid
Investments
1999
2000
2001
2002
$77,529,513
32,501,250
20,279,591
27,752,994
$36,787,208
45,582,058
37,594,522
34,207,692
$114,316,721
78,083,308
57,874,113
61,960,686
TPC had a long history of paying annual cash dividends to
its stockholders.
In each of its 1993-2002 fiscal years,
including in its 2 loss years of 2000 and 2001, TPC paid cash
- 16 -
dividends on its outstanding common stock ranging from a low of
$.85 per share in its 1993 fiscal year to a high of $3.21 per
share in its 1998 fiscal year.
The total and the per-share cash
dividends paid by TPC in its 1993-2002 fiscal years to its common
and to its nonvoting preferred stockholders is set forth below:
Fiscal
Year
Total
Cash Dividends
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
$2,022,900
2,259,900
2,259,900
2,259,900
2, 615, 400
7,616,100
2,615,400
2,615,400
2,828,700
2,899,800
*
Cash Dividends
Per Share
Common
Preferred*
$0.85
$6
0.95
6
0.95
6
0.95
6
1.10
6
3.21
6
1.10
6
1.10
6
1.10
6
1.22
6
TPC only had 1,400 shares of nonvoting preferred
stock and approximately 99 percent of TPC' s cash
dividends paid each year were paid to TPC' s common
stockholders.
As of May of 1998, TPC's management planned to continue paying
annual cash dividends to its stockholders.
As of the date of decedent's death in May of 1998, the
management of TPC had no intent to liquidate or to sell TPC.
In the early fall of 1998, in anticipation of the filing of
a Federal estate tax return on behalf of the estate, even though
he lived in Alaska, the executors of the estate hired George E.
Goerig (Goerig), an Alaskan lawyer to appraise and to prepare a
valuation report for the estate's 20-percent stock interest in
TPC.
- 17 -
Also, on November 16, 1998, the executors of .the estate
filed a petition with the Surrogate Court of the State of New
York, County of Westchester, requesting that limited estate
administrative powers be granted to Goerig for the purposes of
representing decedent's estate in connection with the anticipated
audit by respondent of the estate's Federal estate tax return and
of handling the anticipated negotiations with respondent over the
fair market value of decedent's 487,440 shares of TPC stock.
On
December 18, 1998, the court granted to Goerig such limited
estate administrative powers.
The acknowledged reason the estate hired Goerig (to value
the TPC stock owned by decedent and to represent the estate as
administrator) was to have respondent's audit of decedent's
Federal estate tax return conducted not by respondent's New York
City office but by respondent's Alaska office, where Goerig
believed and apparently represented to the estate's
representative that he would be able to obtain for the estate a
more favorable valuation of the estate's TPC stock.
Executors for the estate had learned about Goerig from an
attorney for decedent's family who had met Goerig on a fishing
trip.
TPC's financial books and records were maintained on the
basis of a fiscal year ending September 30.
- 18 -
On approximately February 2, 1999, the' executors of the
estate timely filed on behalf of the estate a Federal estate tax
return, whereon the estate, based on a valuation report of Goerig
and Paul M. Wichorek (Wichorek), an Alaskan accountant whom
Goerig had hired to assist him in the valuation, reported a total
value of $1,750,000 for the estate's 20-percent stock interest in
TPC, or $3.59 per share
($1,750,000 ÷ 487,440 shares = $3.59 per
share).
On audit, based on a valuation report dated November 9,
2000, prepared by Brian C. Becker, a valuation expert hired by
respondent, respondent determined a total value of $35,273,000
for the estate's 20-percent stock interest in TPC, or $72.36 per
share ($35,273,000 ÷ 487,440 = $72.36), and respondent determined
an estate tax deficiency of $17,910,408.
Respondent also
determined that the entire $17,910,408 estate tax deficiency
determined was attributable to a substantial.understatement and
therefore that under section 6662 the estate was subject to a
$7,164,163 gross valuation understatement penalty.
Shortly before trial, respondent's expert prepared a revised
valuation report in which respondent's expert adjusted downward
his valuation of the estate's 20-percent TPC stock interest from
- 19 $35,273,000 to $32,387,730, or from $72.36 per share to $66.45
per share ($32,387,730 ÷ 487,440 = $66.45).5
Respondent's expert's revised valuation of the estate's TPC
stock interest was necessitated by errors in his original report.
In his original valuation, respondent's expert had added back to
his calculation of TPC's 1997 cashflow (which was the basis for
his TPC cashflow estimates for 1998-2002) deferred income taxes
of $13,294,000, although the correct amount of deferred taxes
that should have been added back to TPC's 1997 cashflow was only
$1,609,793.
Also shortly before trial, the estate's experts prepared an
"updated" or revised valuation report to make the estate's
original report "more readable", in which revised report the
estate's experts again opined that the May 2,
1998, date-of-death
value of the estate's TPC common stock was $1,750,000, or $3.59
per share.
OPINION
Generally, under section 2031(a) the value of a decedent's
gross estate is based on the fair market value of property owned
by the decedent on the date of death.
For Federal estate tax
purposes, the term "fair market value" is defined as the price at
which property would change hands between a willing buyer and a
5 Based on this adjustment, respondent reduced the estate's
tax deficiency to $16,326,408 and the accuracy-related penalty to
$6,530,563.
- 20 -
willing seller, neither being under any compulsion to buy or sell
and both having reasonable knowledge of relevant facts.
States v. Cartwright, 411 U.S. 546, 551
United
(1973); sec. 20.2031-
1(b), Estate Tax Regs.
With regard particularly to unlisted, closely held stock in
corporations such as TPC (with regard to which no bid and asked
prices or other arm's-length sales information is available), the
statutory language of section 2031rprovides that the value of
stock in comparable public corporations shall be taken into
account.
Section 2031(b) provides --
In the case of stock and securities of a
corporation the value of which * * * cannot be
determined with reference to bid and asked prices or
with reference to sales prices, the value thereof shall
be determined by taking into consideration, in addition
to all other factors, the value of stock or securities
of corporations engaged in the same or a similar line
of business which are listed on an exchange.
In utilizing, however, public companies to estimate the
value of private, closely held companies, care must be taken to
ensure that the public companies used are sufficiently comparable
to the private companies being valued.
59-60,
In this regard, Rev. Rul.
1959-1 C.B. 237, 242, cautions as follows:
Although the only restrictive requirement as to
comparable corporations specified in the statute [sec.
2031(b)] is that their lines of business be the same or
similar, yet it is obvious that consideration must be
given to other relevant factors in order that the most
valid comparison possible will be obtained.
* * *
- 21 -
Courts recognize that a comparable company valuation may be
rejected where the companies relied on are not sufficiently
similar to the company being valued.
Commissioner,
101 T.C. 412, 433
In Estate of Jung v.
(1993), significant differences
between the companies used as comparables and the company being
valued caused the Court to reject the comparable public company
method.
In Estate of Klauss v. Commissioner, T.C. Memo. 2000-
191, an expert's comparability analysis was found to be
inadequate because the expert failed to take into account
differences in size, product mix, customer concentration, and
other factors between the companies used as comparables and the
company being valued.
With regard to "the other factors" referred to in section
2031(b) to be taken into account in the valuation of private,
closely held companies, section 20.2031-2(f), Estate Tax Regs.,
explains, in part, as follows:
(f) Where selling prices or bid and asked prices
are unavailable.
If the provisions of paragraphs (b),
(c), and (d) of this section are inapplicable because
actual sale prices and bona fide bid and asked prices
are lacking, then the fair market value is to be
determined by taking the following factors into
consideration:
- 22 (2)
In the case of shares of stock, the
company's net worth, prospective earning power and
dividend-paying capacity, and other relevant factors.
Some of the "other relevant factors" * * * are:
the
good will of the business; the economic outlook in the
particular industry; the company's position in the
industry and 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 which
are listed on a stock exchange. However, the weight to
be accorded such comparisons or any other evidentiary
factors considered in the determination of a value
depends upon the facts of each case. * * *
Rev. Rul.
59-60,
1959-1 C.B. 237, 238-239, lists eight
factors that are particularly relevant to the fair market value
of stock of closely held companies as follows:
(1)
The nature of the business and the history of the
enterprise;
(2)
The general economic outlook and the particular
outlook for the specific industry;
(3)
The financial condition of the business and its
book value;
(4)
The earning capacity of the company;
(5)
The dividend-paying capacity of the company;
(6)
The value of any intangible assets and goodwill;
(7)
Previous sales of the stock and the size of the
interest to be valued; and
(8)
The market price of stocks of corporations engaged in
the same or a similar line of business having their
- 23 -
stocks actively traded in a free and open market,
either on an exchange or over-the-counter.
Rev. Rul. 59-60, supra, acknowledges that a valuation of
closely held stock is not an exact science, but rather involves a
question of fact.
In this regard, Rev. Rul. 59-60, states --
A sound valuation will be based upon all the relevant
facts, but the elements of common sense, informed
judgment and reasonableness must enter into the process
of weighing those facts and determining their aggregate
significance.
[1959-1 C.B. 237, 238.]
As noted, although in valuing the fair market value of
corporate stock the future prospects of a company are relevant,
generally an appraisal of fair market value is made without
regard to actual subsequent-year events (i.e., to actual events
occurring after the relevant valuation date).
States,
977 F.2d 1454,
1458
Krapf v. United
(Fed. Cir. 1992).
The authorities allow, however, that in a number of
situations subsequent-year events may be considered.
For
example, actual subsequent-year events may be considered where
such "evidence would make more or less probable the proposition
that the property had a certain fair market value on a given
date".
891,
894
First Natl. Bank of Kenosha v. United States, 763 F.2d
(7th Cir. 1985).
Subsequent-year events may be
considered where they are "reasonably foreseeable", Saltzman v.
Commissioner,
131 F.3d 87, 93
(2d Cir. 1997), revg. T.C. Memo.
- 24 1994-641, or "corroborate an appraisal that is based on facts
known as of the valuation date", Jacobson v. Commissioner, T.C.
Memo. 1989-606.
Further, subsequent-year events may be
admissible where relevant as to whether asserted expectations or
prospects (as of the valuation date) were "reasonable and
intelligent."
Estate of Gilford v. Commissioner, 88 T.C. 38, 54
(1987); Estate of Jephson v. Commissioner, 81 T.C. 999, 1002
(1983); Regents Park Partners v. Commissioner, T.C. Memo. 1992336.
As explained, in the case herein, for Federal estate tax
purposes, both parties relied on valuation reports to estimate
the date-of-death value of the estate's 20-percent interest in
TPC.
The estate's experts valued decedent's interest in TPC at
approximately $1.750 million.
Respondent's expert valued
decedent's interest at approximately $32.4 million.
The large
disparity between the parties' valuations is startling.
Where conflicting valuations are submitted, a court may give
different weight to the valuations and factors relied on by the
parties.
Casey v. Commissioner,
38 T.C. 357, 381
(1962).
The
Court is not bound to adopt either party's valuation carte
blanche and is to reach a decision based on its analysis and its
consideration of the evidence.
304 U.S. 282,
295
Helvering v. Natl. Grocery Co.
(1938); McCord v. Commissioner,
120 T.C.
358,
- 25 374
(2003); Estate of Newhouse v. Commissioner,
94 T.C. 193, 217
(1990).6
In this case, the estate's experts impress us as too
inexperienced, accommodating, and biased in favor of the estate.
Respondent's expert appears to have selected his comparable
companies in a casual manner, based only on broad industry
classification factors.
He made significant errors in his
calculations and analysis, and he made questionable and
inadequately explained adjustments in his discounted cashflow
valuation method.
The Estate's Valuation
As stated,
in their original and revised valuation reports
the estate's experts from Alaska calculated a total date-of-death
value of $1,749,709 ($3.59 per share) for the estate's 20-percent
common stock interest in TPC.
In arriving at this number, the
estate's experts concluded that no companies existed that were
6 Under sec. 7491, where a taxpayer produces credible
evidence and otherwise satisfies the requirements of.sec.
7491(a)(2), the burden of proof with respect to a factual issue
relevant to ascertaining the taxpayer's tax liability (such as
the fair market value of property) may shift from the taxpayer to
respondent.
Herein, in preparation for trial, the parties
stipulated that the estate satisfied the requirements set forth
in sec. 7491(a)(2). At trial, we determined that for purposes of
sec. 7491(a)(1), the evidence produced by the estate as to the
valuation of the TPC stock was to be treated as credible
evidence. Therefore, respondent has the burden of proof with
regard to the valuation of the estate's 20-percent stock interest
in TPC.
c
- 26 -
comparable to TPC, and they valued TPC as an entity using the
capitalization of income method.
In capitalizing the income of TPC, however, the estate's
experts significantly downplayed TPC's long history of
substantial income.
They misstated certain financial data,7 and
they opined that TPC's business would be heavily and adversely
impacted by the Internet and by other advances in technology,
even though the estate's experts demonstrated no experience with
the Internet- and technology-related companies.
Under the capitalization of income valuation method, a
business is valued based on a projected stream of "normalized" or
sustainable income, capitalized by a risk-adjusted rate of
return.
The basic steps involved in the capitalization of income
method are as follows:
(1)
A capitalization rate for the business is selected;
(2)
The business's sustainable income is projected;
(3)
The capitalization rate is applied to the projected
sustainable income for the business to calculate an
operating value for the business; and
(4)
The amount or value of nonoperating assets owned by the
business is added to the operating value of the
business.
7 For example, in their original report, the estate's
experts stated that TPC's growth in revenue for years subsequent
to 1994 was flat, contrary to the fact that TPC's revenue reached
record levels in each of the years 1994-99.
- 27 Obviously, the particular capitalization rate that is
selected has a significant impact on the ultimate valuation and
is intended to reflect risks or volatility associated with a
company's income stream and seeks to reflect what a stockholder
would require for a rate of return on an investment in the
company being valued.
The more risky and volatile the income
stream is perceived to be, the higher the capitalization rate.
Conversely, the more stable the income stream is perceived to be,
the lower the capitalization rate.
In this case, the estate's experts calculated a
capitalization rate of 30.5 percent for TPC.
This capitalization
rate was calculated by the estate's experts by adding together
the following risk factors and percentages:
(1)
6 percent to reflect a risk-free rate of return (equal
to the May. 1, 1998, yield on 20-year U.S. Treasury
securities);
(2)
7.8 percent to reflect an equity-risk premium (to
compensate an investor for the risk of investing in
stocks as compared to long-term U.S. government
securities, reflecting the percentage by which the
average annual return on large corporate stocks exceeds
the average annual return on U.S. government
securities, as provided in the Ibbotson Associates'
Stocks, Bonds, Bills & Inflation Yearbook for the years
1926-97);
(3)
4.7 percent to reflect a small stock risk (to
compensate an investor for the risk of investing in
stock of a small corporation as compared to a large
corporation, reflecting the percentage by which the
average annual return earned on small corporate stock
exceeds the average annual return on large corporate
stock, as provided in the Ibbotson Associates' Stocks,
- 28 Bonds, Bills & Inflation Yearbook for the years 192697) ; and
(4)
12 percent primarily to reflect risks to TPC relating
to the Internet and to technology and to the loss of
advertising revenue that might be related thereto,
including perceived risks in TPC's management
structure.
The 30.5-percent capitalization rate used by the estate's experts
in the valuation of TPC stock is summarized below:
Risk Factors
Risk-Free Rate of Return
Corporate Equity Risk
Small Stock Risk
Internet & Management Risk
Capitalization Rate
Percentage
6.0
.
7.8
4.7
12.0
30.5
In estimating TPC's sustainable annual net income against
which to apply the above capitalization rate, the experts for 'the
estate adjusted TPC's historical income statement.s for 1993-97 as
follows:
(1)
Based on projections of TPC management, $10 million'per
year was subtracted from TPC's pretax income to reflect
projected additional expenditures to maintain and to
further TPC's presence on the Internet, and to develop
additional technology-related projects; and
(2)
Because TPC purportedly depreciated its fixed assets at
a slower rate than the assets' actual rate of economic
depreciation, the experts for the estate subtracted an
amount to reflect the cost of additional economic
depreciation to fixed assets not booked each year by
TPC.
- 29 -
The adjustments made by the estate's experts to TPC's historic
pretax income for 1993-97 are summarized below:8
Reported Pretax Income
Less Technology Expenditures
Less Additional Depreciation
Adjusted Pretax Income
1993
1994
1995
1996
1997
$24,902,000
10,000,000
1,340,000
$22,152,000
10,000,000
756,000
$18,737,000
10,000,000
920,000
$23,057,000
10,000,000
1,183,000
$26,921,000
10,000,000
1,078,000
$13,562,000
$11,396,000
$ 7,817,000
$11,874,000
$15,843,000
In order to then calculate an after-tax average sustainable
annual net income for TPC, using the above adjusted pretax income
figures for 1993-97, the estate's experts made the following
calculations:
Year
Adjusted
Pretax Income
1993
1994
1995
1996
1997
$13,562,000
11,396,000
7,817,000
11,874,000
15,843,000
.
Total Adj. Pretax Income for 5 Years
Divided by Number of Years
$60,492,000
5
TPC Average Annual Sustainable Net
Income
Less 35% Taxes
12,098,000
4,234,000
TPC After-Tax Average
Sustainable Annual Net Income
$ 7,864,000
The experts for the estate then applied their 30-percent
capitalization rate for TPC to their $7,864,000 after-tax average
sustainable annual net income.for TPC and thereby calculated a
value for TPC of $25,784,000
($7,864,000 ÷ .305 = $25,784,000).
8 In this and the following tables, generally, the numbers
are rounded to the nearest thousand.
T
- 30 -
After calculating the above $25,784,000 entity value for
TPC, the estate's experts calculated a prediscounted value for
the estate's 20-percent interest in TPC as follows:
Value of TPC
Multiplied by Estate's 20.57% Interest
$25,784,000
.2057
Prediscounted Value of Estate's Interest
$ 5,304,000
The estate's experts then discounted the above $5,304,000 by
applying a 40-percent minority interest discount and an
additional 45-percent lack of marketability discount to arrive at
a date-of-death value of $1,750,000 for the 487,440 shares of TPC
common stock includable in decedent's estate, as summarized
below:
Prediscounted Value of Estate's 20.57% Interest
$5,304,000
Less 40% Minority Interest Discount
2,122,000
Subtotal
Less 45% Lack of Marketability Discount
$3,182,000
1,432,000
Value of Estate's 20.57% TPC Stock Interest
$1,750,000
The estate's experts' 40-percent minority interest discount
was based primarily on their reading of general valuation texts."
The estate's experts' 45-percent lack of marketability
discount was based largely on the following factors:
(1) The
stated intent of TPC's management that it had no interest in
9 Coolidge, "Survey Shows Trend Toward Larger Minority
Discounts", Estate Planning 282 (Sept. 1983) ; Coolidge, "Fixing
Value of Minority Interest in a Business; Actual Sales Suggest
Discount as High as 70%", Estate Planning 141 (Spring 1975) .
- 31 -
going public;
(2) the absence of sales of TPC stock for the
10 years prior to May 2, 1998;
(3) the inability of any
stockholder of TPC to obtain control of TPC by purchasing merely
the estate's 20-percent interest; and (4) the inability of the
holder of the estate's block of TPC stock to force a liquidation
of TPC.
The estate's experts, however, provided no credible
explanation for why they used 40-percent and 45-percent minority
interest and lack of marketability discounts, as distinguished
from some other numbers -- e.g., 20 percent or 30 percent.
Respondent's Valuation
Respondent's expert estimated a date-of-death fair market
value for TPC of $225 million and a date-of-death fair market
value for the estate's 20-percent TPC stock interest of $32.4
million.
Respondent's expert utilized two valuation methods to
value TPC -- the comparable public company method and the
discounted cashflow method.
In his revised report, in the
process of making certain corrections to errors made in his
original report, respondent's expert made significant
questionable adjustments in his discounted cashflow method that
are inconsistent with the methodology utilized in his original
report.
In his original and revised reports respondent's expert
did not utilize the capitalization of income method.
- 32 -
Using the comparable public company method, respondent's
expert identified 11 publicly traded companies and treated them
as comparable to TPC on the basis of only two broad criteria as
follows:
(1)
Classification under the same general U.S. Department
of Labor Standard Industrial Codes as TPC (namely, Code
#2731 -- Books: Publishing, or Publishing and
Printing, and Code '#2741 -- Miscellaneous Publishing);
and
(2)
Reported positive cashflows for 1995-97.
Set forth below in schedule format is a listing of TPC and
the 11 companies selected by respondent's expert as comparable to
TPC, a brief description of the primary type of content material
which each company, as of July 31, 2000, published, and the
amount of each company's 1997 reported revenue:
TPC
Company
Publication Material
Industrial buying directories
American Educational
Products
Educational textbooks, journals, and
games
8,392,000
Harcourt General, Inc.
Scholarly books and journals,
educational material, popular books.
Owns the Neiman Marcus Group, Inc.
3,691,639,000
Houghton Mifflin Co.
Textbooks and educational reference
materials
797,320,000
Intervisual Books, Inc. Popup and dimensional novelty books
18,733,,000
McGraw-Hill Co.
Educational books and magazines.
$
1997 Revenue
240,110,000
3,534,095,000
owns Standard & Poor' s and four
television stations
Millbrook Press, Inc.
Children's nonfiction books
12,573,000
Nelson (Thomas), Inc.
Religious and family value books
243,436,000
- 33 Company
Readers Digest
Association
Publication Material
Magazines, and educational,
condensed, and popular books,
recorded music collections, and home
1997 Revenue
$2,839,000,000
videos
Scholastic Corp.
Children's books and classroom and
professional magazines
966,300,000
Touchstone Applied
Science Associates
Reading and English testing materials
Wiley (John) & Sons
Professional and reference works,
consumer books, and textbooks
4,588,000
431,947,000
From publicly reported financial information relating to the
above public companies, respondent's expert calculated four
financial measurement ratios applicable to each company -namely, stock price to net income, stock price to cashflow, stock
market value to book value of tangible and intangible assets, and
stock price to revenue.
Applying the ratios so calculated to the 11 companies,
respondent's expert calculated the median ratio for each
measurement, and he applied that respective median ratio as a
multiple to TPC' s 5-year (1993-97) average annual net income,
cashflow, book value, and revenue as follows:
TPC 5-Year
Average
Multiple Based on
Median Ratio
for 11 Public
Companies
Total for TPC
Net Income
Cashflow
Book Value
Revenue
$ 13,259,000
$ 15,187,000
$148,606,000
$235,995,000
25.9
14.3
2.5
1.04
$343,659,000
$216,780,000
$364,787,000
$245,681,000
Using the $216,780,000 (rounded to $217 million) calculated
above for the cashflow ratio (apparently because the cashflow
- 34 -
ratio was the most consistent measurement ratio as between the 11
companies), respondent's expert adjusted upward this $217 million
to take into account the higher valuation amounts reflected by
the other measurement ratios, and he calculated a total value for
TPC under his comparable public company method of $260 million.
As stated,
in both his original report- and in his revised
report, respondent's expert also valued TPC using the discounted
cashflow method.
Thereunder, using TPC's 1997 reported income,
respondent's expert calculated a 2.7-percent annual income growth
rate (in his original report) and a 2.4-percent annual income
growth rate (in his revised report), which growth rates he
applied to TPC's actual net cashflow for 1997 to estimate TPC's
net cashflow for the subsequent 5 years (1998-2002).
As explained supra, however, in his original report, for
TPC's 1997 net cashflow number, respondent's expert used
$13,069,000.
This number was incorrect and was significantly
overstated because respondent's expert added back to TPC's 1997
cashflow deferred taxes of $13,294,000, instead of the correct
deferred tax add-back of only $1,609,793.¹°
To his estimated TPC net cashflow numbers for 1998-2002
(based on his calculation of TPC's $13,069,000 net 1997
¹° In his revised report, in calculating TPC's 1997 net
cashflow, respondent's expert used the corrected deferred tax
add-back of $1,609,793.
This correction resulted in a revised or
new number for TPC's 1997 net cashflow of only $1,384,000.
- 35 cashflow), respondent's expert applied a discount rate to
calculate a present value, as of May 2, 1998, of the estimated
1998-2002 net cashflow.
Respondent's expert's discount rate for each year was based
on his estimate of TPC's cost of equity, calculated under the
capital asset pricing model, and involved the following elements:
(1)
A risk-free rate of return of 5.933 percent, equal to
the U.S. government long-term bond rate as of May 2,
1998;
(2)
A market-risk premium that varied to reflect the risk
of investing in a private company and the perceived
risks of investing in stocks rather than in long-term
government bonds; and
(3)
An estimate of unlevered beta for TPC of 0.60 to
reflect the volatility or level of risk associated with
TPC's stock as compared to the volatility of the stock
market as a whole (where the market has an overall beta
of 1).¹¹
In his original report, respondent's expert also calculated
and added to his present value calculations of TPC's estimated
net cashflow for 1998-2002 a $153,174,000 estimate of TPC's
residual value, based on a discounted "terminal value" for TPC.
In the words of respondent's,expert, this terminal value
¹¹ The discount rate which respondent's expert applied to
TPC's estimated net cashflow for each year is set forth below:
Year
Percentage
1998
1999
2000
2001
2002
10.482
9.855
9.497
9.246
9.145
- 36 -
"incorporates all [estimated cash]
flows [for TPC] after Fiscal
2002" discounted back to the end of 2002.
With his discounted
terminal value for TPC added to his present value calculation of
TPC's estimated net cashflow for 1998-2002, respondent's expert
concluded in his original report that TPC had a May 2, 1998, fair
market value of $212.6 million as follows:
Present Value
Fiscal
Year
1998
1999
2000
2001
2002
Subtotal
Plus Discounted Terminal Value
Valuation of TPC
of Estimated
Cashflows
$ 13,141,000
12, 637 , 000
11,884,000
11,217,000
10,579,000
$ 59,458,000
153,174,000
$212,632,000
In his revised report, however, after adjusting his add-back
to TPC's 1997 net cashflow for the corrected $1,609,793 deferred
taxes (discussed supra)
(which as indicated resulted in a greatly
reduced calculation of TPC' s estimated net cashflow number for
1998-2002), respondent's expert switched his residual value
calculation for TPC after 2002 by estimating what he refers to as
a $152, 567, 000 "liquidation" value for TPC.
Respondent ' s
expert's revised discounted cashflow calculation using the much
reduced cashflow numbers but a liquidation (rather than a
terminal) value for TPC is summarized below:
- 37 Present Value
of Estimated
Cashflows
Fiscal
Year
1998
1999
2000
2001
2002
$
Subtotal
Plus Liquidation Value
Valuation of TPC
1,390,000
1,333,000
1,251,000
1,178,000
1,108,000
$ 6,260,000
152,567,000
$158,827,000
In calculating the residual value for TPC to be added to his
net cashflow projections for 1998-2002, respondent's expert's
switch in his revised report from a terminal value to a
liquidation value calculation appears to us to be an effort on
the part of respondent's expert to keep the valuation for TPC
relatively high.¹²
¹² Generally, terminal value is used to compute an entity' s
residual value beyond the period for which an entity's net
cashflows are projected, whereas liquidation value generally is
use.d only when the entity being valued has plans to liquidate at
the end of the projection period.
Copeland, et al., Valuation
284 (3d ed. 2000) (providing that liquidation value should not be
used "unless liquidation is likely at the end of the forecast
period"). Here, TPC's management, as of May of 1998, had no
plans to liquidate TPC.
Using the correct $1.609 million in
deferred tax add-back, the calculation under respondent's
expert's discounted cashflow method using a terminal value
calculation for TPC's 2002 residual value would have reflected a
May 2, 1998, fair market value for TPC of only $21.7 million as
follows:
Present Value
of Estimated
Cashflows
Fiscal
Year
1998
1999
2000
2001
2002
Subtotal
Plus 2002 Terminal Value
Valuation of TPC
$ 1,390,000
1,333,000
1,251,000
1,178,00.0
1,108,000
$ 6,260,000
15 r 415 , 372
$21,675,372
- 38 -
In his revised report, respondent's expert, apparently still
not satisfied with his revised $158.8 million valuation for TPC
(using the corrected deferred tax add-back and a liquidation
value for TPC), goes on to recalculate much higher projected net
cashflow numbers for TPC for 1998-2002, and he calculates
three higher valuations for TPC.
The major aspect or component of respondent's expert's
recalculation of TPC's projected net cashflows for 1998-2002 is
his use of TPC's 1997 yearend total working capital, instead of
TPC's 1997 change in net working capital.
The effect of using
yearend total working capital (against which his growth rate for
TPC was applied) was to significantly increase TPC's estimated
cashflow for 1998-2002 by approximately $12 million a year.
Based on the various calculations under his various methods,
respondent's expert ultimately concluded that the total fair
market value for TPC as an entity, as of May 2, 1998, was
$225 million.
To the estate's $46,282,500 20-percent share of this
$225 million ($225,000,000 x .2057 = $46,282,500), respondent's
expert applied a 30-percent lack of marketability discount and
arrives at a date-of-death value of $32,393,000 for the estate's
20-percent stock interest in TPC.
Respondent's expert bases his 30-percent (as opposed to a
higher)
lack of marketability discount on the following: . (1) TPC
- 39 -
was not publicly traded;
(2) historically, TPC was profitable;
(3) investment risks associated with TPC were moderate;
had consistently paid cash dividends;
(4) TPC
(5) as of May 2, 1998, TPC
held more than $137 million in net liquid assets; and (6) the
estate owned the single largest block of TPC stock.
Respondent's
expert's calculation of the $32,393,000 valuation for the
estate's 20.57-percent stock interest in TPC may be summarized as
follows:
Value of TPC
Multiplied by Estate's Interest in TPC
$225,000,000
20.57%
Prediscounted Value of Estate's Interest
Less 30% Marketability Discount
$ 46,282,500
13,884,750
Value of Estate's 20.57% Interest in TPC
$ 32,393,000*
* $32,393,000 represents the calculation as reflected
in respondent ' s expert ' s revised report . The
corrected math calculates to $32,397,750.
As indicated, respondent's expert does not apply a minority
interest discount to the estate's 20-percent TPC stock interest.
Rather, respondent's expert states that his discounted cashflow
method of valuation inherently reflects a minority interest in
TPC and therefore that no separate or additional minority
interest discount is appropriate.
- 40 -
Our Analysis
As mentioned, we find both the estate's and respondent's
valuations to be deficient and unpersuasive in calculating the
fair market value of TPC as an entity and in calculating the fair
market value of the estate's 20-percent interest therein.
In this case, the estate, the executors of the estate, and
the underlying company, the stock of which is being valued, were
all headquartered and based in the New York City metropolitan
area, but the estate hired a lawyer and an accountant from
Alaska, both with relatively little valuation experience, to
value the estate's 20-percent interest in TPC.
The estate's
experts valued TPC and the estate's interest in TPC in an
aggressive manner largely by over calculating as of the May 2,
1998, valuation date, the risks associated with the Internet and
technology and by applying excessive minority and lack of
marketability discounts.
Goerig is a lawyer with an audit and tax dispute resolution
practice, and a tax return preparer, and he undertakes occasional
valuations for small businesses and private individuals.
From
his resume, he appears to have attended limited appraisal
courses, other than a few courses while working for respondent
many years ago.
Goerig also was appointed to act as
administrator for the estate to handle the anticipated audit. by
respondent of the estate's Federal estate tax return, a role
- 41 which we regard as somewhat in tension with his role as a
purported independent valuation expert for the estate.
Wichorek provides accounting and tax preparation services,
does business consulting, and undertakes occasional valuations
for small businesses, generally in the context of divorce and
property settlement disputes.
He belongs to no professional
organizations or associations relating to his appraisal or
valuation work.
Although we admitted into evidence the estate's valuation
reports and treated them as credible, we regard those reports and
the testimony of the estate's experts to be only marginally
credible.
Goerig and Wichorek were barely qualified to value a
highly successful and well-established New York City-based
company with annual income in the millions of dollars."
In our opinion, in computing the sustainable net income of
TPC, the estate's experts incorrectly applied a 12-percent risk
factor relating to the Internet and technology.
We acknowledge
that while the Internet posed certain risks to TPC, the Internet
also provided significant new business and financial
opportunities to TPC to increase revenue and profitability.
As
" At trial, the estate called additional expert witnesses
in an attempt to provide corroboration for aspects of the
valuation of TPC and of the estate's interest in TPC by Goerig
and Wichorek.
Such witnesses, however, have not.cured the
concerns we have with Goerig's and Wichorek's valuation of TPC
and of the estate's interest therein.
- 42 of May 2, 1998, TPC appeared to be well situated on the Internet,
and TPC's future as to its Internet operations appeared good, if
not, in the words of TPC's president,
"great".
As stated in the
estate's experts' report, as of May of 1998, TPC "appears to be
in a strong overall financial position when compared to the
industry.
[TPC] has more liquidity, no leverage, and operates
more profitably than the median industry.
Based on the financial
analyses of [TPC], the business has less financial risk than does
the median company in the same industry."
The use by the estate's experts of a 12-percent technologyrelated risk factor, particularly in light of their failure to
project any additional income to be produced from technology-
related expenditures., seems to us inappropriate and unjustified.
Supporting our conclusion that TPC's risks relating to the
Internet and technology do not support a 12-percent risk factor,
we note that, during its 1998 fiscal year, TPC paid out cash
dividends to its stockholders in excess of $7 million, a
significant increase over total cash dividends paid out to
stockholders in prior years and inconsistent with any management
perception that, as of May of 1998, or in the near future, TPC
faced extraordinarily risky additional Internet- and technologyrelated expenditures.
TPC's 1998 cash dividends, particularly in light of the I
lower level of stockholder dividends that had been paid in prior
- 43 -
years, are indicative of an optimistic management outlook for TPC
as of May of 1998.
As explained by TPC's president, although its profitability
margins and net income were declining due to increased spending
on technology-related projects, in 1997 and 1998 TPC experienced
record revenue.
Not until 2001 was TPC's total revenue adversely
affected in a significant way by the Internet and by new
technology.
Mr. Holst-Knudsen explained at trial as follows:
Q.
[By petitioner's counsel]
When, if at all, did [TPC]
take what you've termed a "hit"?
A. We were taking a hit in the sense of, as I said before,
the investments we were making. That hit became more
serious as we went on. I would say that the years 2001,
2002, and the fiscal year that will close this year is when
we really began to take the hit on our top line, on
revenues. We have shed approximately 30 percent of our
revenue, and about 35 to 40 percent of our account basis
disappeared over that period of time.
The additional $10 million a year in technology-related
expenditures that the estate's experts factored into their
projections of subsequent-year income, and that we also allow, we
believe to be an adequate indication or quantification of the
level of Internet- and technology-related risks TPC faced, as of
May 2,
1998.
Also, we regard TPC as an extremely well managed company,
with top quality managers throughout the company.
We allow no
- 44 -
separate risk factor for what the estate's experts refer to as
management risk.
Respondent asserts that the estate's $25 million valuation
for TPC as an entity (and $1.7 million for the estate's 20-
percent interest therein) is absurd in light of TPC's 1997 fiscal
yearend book value in the range of $148 million.
Respondent also
asserts that if we utilize the capitalization of income method to
value TPC (as did the estate's experts and as we do), we should
take the cash and short-term liquid assets from TPC's balance
sheet, treat them as nonoperating assets, and add them to any
calculation of the capitalized income aof TPC that we make.
From the end of its 1993 fiscal year through the end of its
1997 fiscal year, TPC's cash and outside short-term (more than 3-
month) investments reported on its yearend balance sheets
increased from $42.3 million to $73.6 million.
Throughout the
1990s, TPC increased its short-term liquid investments and still
paid significant cash dividends to its stockholders.
Not until
its 2000 fiscal year does TPC's yearend balance sheet reflect any
significant reduction in outside short-term investments.
On each of TPC's 1997 and 1998 fiscal yearend balance
sheets, approximately $68 million is shown as outside short-term
investments with an investment term of more than 3 months.
We
treat these $68 million in short-term liquid investments as
nonoperating assets to be added to the valuation of TPC under a
- 45 -
capitalization of income valuation method.
We are not persuaded
that these liquid investments should be treated as operating
assets due to TPC's commitment to advance sales commissions."
TPC's yearend cash on hand, however, is not to be treated as
anything other than an operating asset and is not to be treated
as an add-on in the calculation of TPC's value under the
capitalization of income method.
As to the valuation of the particular 20-percent block of
TPC stock includable in the estate, we disagree with the large
minority (45-percent) and lack of marketability (40-percent)
discounts utilized by the estate's experts in calculating the
fair market value of the estate's 20-percent TPC stock interest.
As noted, the estate's experts based their minority and lack
of marketability discounts on general studies and not on the
facts of this case.
The experts for the estate selected discount
rates that were extreme and highly favorable for the estate,
without any credible substantive discussion of how the facts of
this case support such particular discounts.
Also, as we have noted, as of May of 1998, at least one
outside, public investor owned and had owned for at least 10
years a substantial TPC stock interest.
The evidence before us
does not suggest any problem, discontent, dissatisfaction, or
" In our calculation of prior year TPC income, we also
add-back additional depreciation that the estate's experts addback and that respondent apparently does not dispute.
- 46 -
other concern with the presence of this outside stockholder.
The
longstanding stock interest of this actual outside investor in
TPC suggests that a hypothetical outside investor would be
interested in an investment in TPC in the nature of the minority
20-percent stock interest held by the estate.
We reject the minority and lack of marketability discounts
used by the estate's experts.
Turning to respondent's expert's valuation, respondent's
expert appeared to be concerned with numbers only and did not
appear to make an effort to base his valuation of TPC on a real
company.
His sterile approach is reflected both in his
comparable public company analysis and in his discounted cashflow
analysis.
In his comparable public company analysis, respondent's
expert used information on 11 companies which, only in a broad
sense, relate to TPC.
Valuation of a company under a comparable
public company method may be simple and quick, but such an
approach also may be easily misapplied.
With regard to this
concern, valuation textbooks caution:
The allure of multiples is that they are simple
and easy to relate to.
* * *
By the same token, they are also easy to misuse and
manipulate, especially when comparable firms are used.
Given that no two firms are exactly similar in terms of risk
and growth, the definition of comparable firm is a
I
subjective one.
Consequently a biased analyst can choose a
group of comparable firms to confirm his or her biases about
- 47 -
a firm's value * * *.
[Damodaran, Damodaran on Valuation 16
(1994).]
and further:
Since the selection of comparable firms has such a
paramount role in valuation with multiples, special
attention must be paid to selecting a true comparable
sample of firms -- firms that are in the same industry,
employ the same technology, apply to similar
clienteles, are of similar size, and so on.
* * *
[Benninga & Sarig, Corporate Finance A Valuation
Approach 330 (1997).]
We reject respondent's expert's 11 companies as comparable
to TPC.
See Estate of Clarke v. Commissioner, T.C. Memo. 1976-
328, where we rejected public companies as comparable,
explaining as followsi
the fact that two companies are both part of the same
general industry does not, as respondent's expert
implies, make them comparable per se.
Such a standard
clearly ignores the interplay of the myriad of complex
factors and features that must be accounted for in any
meaningful comparison. Rather we think it imperative
that the characteristics of the subject company and the
purportedly comparable company relevant to the question
of value be isolated and examined so that a significant
comparison can be made. Those factors include the
respective products, market, management, earnings,
dividend paying capacity, book.value, and position in
the industry of each company.
See Cent. Trust Co. v.
United States, 305 F.2d 393 (Ct. Cl. 1962).
[Emphasis
added.]
Also, we reject respondent's expert's discounted cashflow
analysis.
As explained, significant errors were made therein,
- 48 -
and respondent's expert's numerous recalculations were suspect,
not sufficiently explained, and not persuasive.
Also, we disagree with respondent's expert that no discount
should be applied to the estate's 20-percent interest to reflect
its minority status.
In cases cited just in the parties' briefs,
the following minority discounts are observed:
Trust Co. v. Commissioner,
87 T.C. 349, 389
25 percent--N
(1986); 10 percent--
Estate of Heck v. Commissioner, T.C. Memo. 2002-34; 15 percent
and 20 percent--Gow v. Commissioner, T.C. Memo. 2000-93, affd. 19
Fed. Appx. 90
(4th Cir. 2001).
In cases cited in the parties' briefs, the following lack of
marketability discounts are observed:
20 percent--N. Trust Co.
v. Commissioner, supra at 389; 30 percent--Estate of Desmond v.
Commissioner, T.C. Memo. 1999-76; 40 percent and 45 percent-Barnes v. Commissioner, T.C. Memo. 1998-413; 30 percent-Mandelbaum v. Commissioner, T.C. Memo. 1995-255, affd. without
published opinion 91 F.3d 124
(3d Cir. 1996); 30 percent--Estate
of Gallo v. Commissioner, T.C. Memo. 1985-363.
On the evidence before us in this case, we conclude that the
appropriate valuation of the estate's 20-percent stock interest
in TPC, as of May 2, 1998, should be based on a capitalization of
TPC's estimated sustainable net income for 1998-2002 calculated
as an average of TPC's 1993-97 income with an additional $10
million per year in expenditures relating to projected Internet-
I
- 49 and technology-related expenditures.
The 30.5-percent
capitalization rate used by the estate's experts should be
reduced by 12 percent, from 30.5 percent to 18.5 percent, to
better reflect our belief that the Internet, as of May 2, 1998,
constituted a factor for TPC almost as positive as it was
negative.
Also, $68 million of nonoperating assets should be
added.
Our calculation of the appropriate 18.5-percent
capitalization rate is as follows:
Risk Factors
Risk-Free Rate of Return
Corporate Equity Risk
Small Stock Risk
Internet & Management Risk
Capitalization Rate
*
Percentage
6.0
7.8
4.7*
0.0
18.5
We note that, in spite of the size of TPC,
respondent did not discretely challenge
this small stock discount.
In discounting to reflect the estate's minority 20-percent
interest in TPC, we allow a 15-percent minority interest discount
and a 30-percent lack of marketabilitý discount.
We scale back
the minority and lack of marketability discounts from those used
by the estate's experts because, as noted above, we find the
estate's experts' numbers to be arbitrary and without support.
We believe a minority interest discount of 15 percent is a
better reflection of the estate's 20-percent common stock
interest in TPC.
Although a minority interest, the holder of
such interest would own the single largest block of stock in TPC,
- 50 -
a major, well-established, well-run company with relatively few
stockholders, in which a longstanding outside investor is already
present and apparently content.
With regard to the lack of marketability discount, we
believe a 30-percent lack of marketability discount adequately
reflects difficulties the estate and a hypothetical investor
might have in marketing the estate's 20-percent TPC stock
interest.
Indeed, but for the fact that respondent's expert
allowed a 30-percent discount for lack of marketability, we might
have been inclined to reduce this discount.
A discount any
higher would not~appear to be justified, particularly in light of
the presence among TPC's stockholders of a significant outsider
stockholder who already owns a relatively large, minority block
of TPC stock.
We also note the dividend-paying history of TPC,
and TPC's plans, as of May of 1998, to continue its practice of
paying substantial cash dividends, which subsequent-year
dividends would allow a holder of a 20-percent interest in TPC to
recover annually, based on prior-year dividends paid, in excess
of one quarter of a million dollars.
We conclude that the date-of-death value of TPC as an
entity, as of May 2,
1998,
is $110,508,000 and that the date-of-
death value of the estate's 20.57-percent interest in TPC is
$13,525,240, or $27.75 per share.
I
- 51 -
Our calculation of the fair market value of TPC as an entity
and of the estate's 20.57-percent interest in TPC is set forth
below:
.
Capitalization Rate
Minority Discount
Marketability Discount
18.5%
15%
30%
TPC's Sustainable Net Income
1993
1994
1995
1996
1997
Pretax
Income
$ 13,562,000
11,396,000
7,817,000
11,874,000
15,843,000
Total Pretax Income
Divided by Number of Years
$ 60,492,000
5
Year
Average Pretax Income
Less Estimated 35% Taxes
(
$ 12, 098, 000
4,234,000)
Sustainable Net Income
Divided by Capitalization Rate
$
7,864,000
18.5%
Subtotal
Plus Nonoperating Assets
$ 42,508,000
68,000,000
Value of TPC
$110,508,000
Value of Estate's 20-Percent Stock Interest
Value of TPC
Multiplied by Estate's Percent Interest
$110.,508,000
20.57%
Subtotal
Less 15% Minority Discount
$ 22,731,496
3,409,724
Subtotal
Less 30% Marketability Discount
$ 19,321,771
5,796,531
Value of Estate's 20% TPC Interest
$ 13,525,240
Per-Share Value
$27.75
Taking into account all of the evidence 3before us and.the
arguments of the parties, we believe that our above valuation
- 52 -
constitutes a fair and appropriate valuation of TPC and of the
estate's interest in TPC.
Accuracy-Related Penalty
Generally, a 20-percent penalty is imposed on "any portion
of an underpayment of tax required to be shown on a return" where
the underpayment constitutes a substantial estate tax valuation
understatement.
Sec. 6662(a) and (b)(5).
For purposes of section 6662, an estate tax valuation
understatement is treated as substantial where property required
to be reported on an estate tax return is reported at a value
50 percent or less than the value eventually determined by the
court.
Sec. 6662(g)(1).
Where property is reported at a value
less than 25 percent of the value eventually determined by the
court, the penalty imposed under section 6662 is increased from
20 percent to 40 percent.
Sec. 6662(h).
We have determined the value of the estate's 20-percent
interest in TPC to be $13,525,240.
Because the value reported by
the estate for its 20-percent interest in TPC ($1.8 million)
is
less than 25 percent of the.value determined herein ($13,525,240
x .25 = $3,381,310), unless an exception to the application of
the section 6662 penalty applies, the estate would be liable for
a 40-percent penalty on its understated valuation.
Under section 6664, an exception is provided to the
imposition of a section 6662 accuracy-related penalty where a
- 53 taxpayer establishes that there was reasonable cause for the
understatement and that the taxpayer acted in good faith.
Sec.
6664(c).
The regulations provide that whether an understatement of
tax is made in good faith and due to reasonable cause will depend
upon the facts and circumstances of each case.
Income Tax Regs.
Sec. 1.6664-4(b),
In determining whether a taxpayer acted
reasonably and in good faith with regard to the valuation of
property, factors to be considered include:
(1) Whether the
value reported on the tax return was based on an appraisal;
(2) the methodology and assumptions underlying the appraisal;
(3) the appraised value;
(4) the circumstances under which the
appraisal was obtained; and (5) the appraiser's relationship to
the taxpayer.
Sec. 1.6664-4(b)(1), Income Tax Regs.
The estate contends that it acted reasonably and -:Un good
faith in the valuation of the estate's 20-percent TPC stock
interest,
in filing its Federal estate tax return, and in
reporting thereon the value of the TPC stock.
The valuation herein of the estate's 20-percent stock
interest in TPC was particularly difficult and unique.
comparable to TPC were not found.
Companies
Valuation of the estate's 20-
percent TPC stock interest under the capitalization of income and
under the discounted cashflow methods involved a number of
difficult judgment calls.
We believe it noteworthy and relevant
- 54 -
to the appropriateness of the section 6662 penalty that even
respondent's expert made significant errors in his various
calculations.
Complicating the valuation presented to the parties and to
the Court herein was the difficult question as to how the
Internet and the risks and opportunities associated therewith
should be regarded as affecting TPC.
The evaluation in this case
of such intangible risks and opportunities was difficult and
imprecise.
Certainly, the experts for the estate were aggressive in
their relatively low valuation of TPC.
Respondent's expert was
aggressive in his relatively high valuation of TPC.
We note that
our valuation of TPC and of the estate's 20-percent interest i
TPC is closer to the estate's valuation than to respondent's
valuation.
On the record before us, we believe it inappropriate to
impose the accuracy-related penalty.
The estate is not liable
for the accuracy-related penalty.
Accordingly,
Decision will be entered
under Rule 155.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.