UNITED STATES TAX COURT

T.C. Memo. 1997-461

UNITED STATES TAX COURT

ESTATE OF PAUL MITCHELL, DECEASED, PATRICK T. FUJIEKI, EXECUTOR,

Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21805-93.

Filed October 9, 1997.

David W.K. Wong, B. John Williams, Jr., Miriam Louise Fisher,

Karen L. Hirsh, and Melvin E. Lefkowitz, for petitioner.

Henry E. O'Neill, Alan Summers, and Paul G. Robeck, for

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS, Judge: Respondent determined a $45,117,089 Federal

estate tax deficiency, an $8,396,020 penalty under section 6662(g),

and a $147,623 penalty under section 6662(h).

After concessions,

- 2 the issues remaining for decision are: (1) The moment-of-death

value of 1,226 shares of John Paul Mitchell Systems common stock;

and (2) whether petitioner is liable for the section 6662(g)

penalty.1

All section references are to the Internal Revenue Code as

amended and in effect at decedent's date of death, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some

of

accordingly.

the

facts

have

been

stipulated

and

are

found

The stipulations of facts, stipulations of settled

issues, and attached exhibits are incorporated herein by this

reference.

A.

Background

Paul Mitchell (Mr. Mitchell or decedent) was a resident of

Hawaii when he died on April 21, 1989.

Patrick T. Fujieki is the

executor of the Estate of Paul Mitchell.

Mr. Fujieki resided in

Honolulu, Hawaii, at the time the petition in this case was filed.

Among the assets included in Mr. Mitchell's taxable estate

were 1,226 shares of John Paul Mitchell Systems common stock held

by

the

1

Paul

Mitchell

Trust

(the

Trust),

a

revocable

trust

On June 11, 1996, petitioner filed a Motion to Shift

the Burden of Persuasion. By Order dated July 8, 1996, we denied

petitioner's motion. On brief, petitioner again raised this

issue. We reaffirm our conclusions as stated in our July 8,

1996, Order. But even assuming arguendo we would have granted

petitioner's motion, our valuation of the stock at issue would

not be altered.

- 3 established by Mr. Mitchell.

It is the value of these shares at

the moment of Mr. Mitchell's death that we must determine.2

B.

Paul Mitchell

Paul Mitchell was born Cyril Thomson Mitchell in Scotland on

January 27, 1936.

His mother was a hairdresser.

At the age of 16,

he enrolled in beauty school, and after a 5-year apprenticeship, he

became a "qualified hairdresser".

Thereafter, Mr. Mitchell worked

in

competitive

four

salons

and

won

several

hair

contests

in

England.

In the early 1960's, Mr. Mitchell pursued fashion hair styling

working with Vidal Sassoon and became one of London's best known

hair stylists.

When Mr. Sassoon opened his first U.S. salon, he

chose Mr. Mitchell to train the staff.

While employed with Vidal

Sassoon, Mr. Mitchell brought to the United States the "blow dry"

look.

In 1966, Mr. Mitchell left Mr. Sassoon and became director of

Bendel's Beauty Floor at Henri Bendel's in New York City.

While he

was at Bendel's, his work was featured on the covers and pages of

major fashion magazines. He became known as the "haircutter's

haircutter".

In 1967, Mr. Mitchell and other investors opened Crimpers

Salon, a successful high-fashion cutting salon, in New York City.

2

We believe the moment-of-death valuation is appropriate

in this case due to the importance of Mr. Mitchell to, and the

impact of his death on, John Paul Mitchell Systems.

- 4 Other Crimpers Salons subsequently opened in Boston, Chicago,

Dallas, and Philadelphia.

In 1971, Mr. Mitchell sold his share in

Crimpers and spent a year away from the hair styling industry.

In 1972, Mr. Mitchell returned to the hair styling industry,

opening the Superhair Salon in New York City, a high-fashion salon

and cutting school.

Several years later, he moved to Hawaii.

His

reputation as a master stylist continued, and he was invited to

perform as a guest platform artist at professional beauty shows

throughout the United States.

While demonstrating his techniques at professional beauty

shows, Mr. Mitchell developed the "sculpted look" of hair styling.

This new look started with an excellent cut.

A product was

introduced by Mr. Mitchell that gave the cut greater versatility,

permitting the setting of hair without rollers or a curling iron.

Mr. Mitchell's product, called "liquid styling tool", was a gellike liquid that set hair in the shape into which it was combed.

Mr. Mitchell's product line was marketed in orange and white

bottles

and

sold

only

at

the

hair

shows

demonstrated his hair styling techniques.

where

Mr.

Mitchell

Mr. Mitchell's initial

efforts to market his product line proved unsuccessful.

C.

The Hair Care Industry

The hair care products industry is segmented by distribution

channels.

"Mass market" products are sold directly to consumers

through major retail outlets, such as supermarkets, drugstores, and

- 5 discount stores.

Products sold through this distribution channel

are heavily dependent upon extensive and expensive mass-media

advertising to generate an awareness of the product and consumer

demands.

"Over-the-counter" products are sold through beauty

supply stores, which sell products that are not "salon-only"

products (and are generally not available in the mass market).

"Salon-only" (or "professional-only") products (such as the Paul

Mitchell line described hereinafter) are available to the public

only through professional hair salons.

Throughout the 1980's, the

greatest growth in sales of hair care products was in the salononly market.

Salon-only products do not require a high level of advertising

expenditures,

but

they

are

heavily

dependent

upon

the

recommendation of a brand, product, or system, by the hair stylist

to the consumer

in the salon.

Because of the hair stylist's

ability to influence the consumer, companies that sell their

products through salons emphasize marketing to hair stylists and

salon owners.

Furthermore, these companies place importance on

educating hair stylists and salon owners about their products in

order to ensure correct recommendations to consumers, which in turn

increase the possibility of repeat sales.

The professional hair care industry is trendy and fashion

oriented and sells the public on changes in looks.

Hair stylists

learn the latest trends and fashions through trade magazines (such

as Modern Salon, Salon Today, American Salon, and Salon News).

- 6 Growth in sales for a professional hair care company depends upon

maintaining a forward edge in fashion and trends.3

There are three categories of liquid hair products: "Hair

care" (shampoos, conditioners, and rinses); "styling products"

(hair sprays, fixatives, mousses, sculpture lotions, etc.); and

"chemical reactive products" (hair color, perms, and bleaches).

Professional-only

hair

care

products

are

marketed

on

an

implied promise to the hair stylists that such products will not be

mass marketed or sold through drugstores, supermarkets, or discount

stores.

Professional hair stylists will not sell or use mass-

marketed products in their salons. Mass marketing a product closes

the salon or professional market to that product.4

Education is an important aspect of marketing hair care

products to hair stylists.

This education includes hair shows,

product knowledge classes, and styling classes (featuring new ways

to cut hair and new products to achieve the latest looks).

During

hair shows, platform artists demonstrate new styles and techniques,

3

For instance, Redken was a professional hair care

company that dominated the salon-only market through the 1970's.

In the early 1980's, Mr. Mitchell began to convince hair stylists

that the new trend in styling was the "sculpted look". Redken's

sales growth flattened when it did not keep abreast of this

trend.

4

During the 1960's and 1970's, companies such as Wella

Balsam, Aqua Net, Vidal Sassoon, and Jhirmack broke the implied

promise and changed their distribution from salon-only to the

mass market. The products of each of these companies were closed

out of the professional market shortly after being mass marketed.

- 7 using

the

promoted

products.

Hair

shows

occur

at

the

international, national, regional, and local levels.

Hair care industry market revenues grew to $4.2 billion in

1988.

During

that

year,

shampoo

sales

rose

by

4

percent,

conditioner sales rose by 9 percent, and styling products sales

rose by 30.7 percent.

Hair sprays and hair styling products were

growing at double-digit rates.

D.

The Creation of John Paul Mitchell Systems

John Paul "Jones" DeJoria grew up in Los Angeles.

Following

his graduation from high school, he enlisted in the Navy.

Upon his

discharge therefrom, he had a variety of sales jobs, selling

products

such

as

encyclopedias,

photocopiers,

insurance,

and

magazines. In the early 1970's, Mr. DeJoria began working in the

beauty products industry for Redken. He held several positions

including field sales representative, district manager (Texas), and

national chain and salon manager.

DeJoria

gained

promotion,

and

extensive

While employed at Redken, Mr.

experience

distribution

of

in

beauty

the

sale,

products.

He

marketing,

possessed

exceptional organizational, managerial, and marketing skills.

Messrs. Mitchell and DeJoria first met in the early 1970's.

They eventually developed a close friendship. In 1979, they joined

forces to market Mr. Mitchell's hair care products (particularly

the sculpting lotion) through professional-only hair salons.

Mr.

DeJoria believed he could successfully market the line. Initially,

- 8 Messrs. Mitchell and DeJoria were unable to find anyone willing to

provide financial assistance; thus, they pooled their resources of

$700 to purchase an answering machine, bottles, and caps and hire

an artist to design a logo for their labels.

Mr. DeJoria persuaded

a cosmetics laboratory to manufacture the first batch of products

on credit.

Instead of the orange and white bottles Mr. Mitchell

had previously used, these products were packaged in white bottles

with Paul Mitchell's name displayed in black lettering down the

side.

At all relevant times, Paul Mitchell products were sold to the

public only through professional hair salons.

1.

Structure and Ownership

On March 31, 1980, Messrs. Mitchell and DeJoria formed Paul

Mitchell Systems, Inc. On May 9, 1985, the corporation changed its

name to John Paul Mitchell Systems (JPMS).

Messrs. Mitchell and

DeJoria granted JPMS all proprietary and distribution rights to the

hair

and

skin

products

that

Mr.

Mitchell

developed

(or

had

developed under his direction), including the products' trademark,

service mark, or other intellectual property rights.

JPMS' articles of incorporation authorized the issuance of

10,000 shares of common stock.

Between March 31, 1980, and April

21, 1989 (the date of Mr. Mitchell's death), JPMS had 2,500 shares

issued and outstanding.

Article VII of JPMS' bylaws provided that

any transfer of JPMS stock was subject to a right of first refusal,

- 9 exercisable first by the corporation, then by each nontransferring

shareholder.

Initially, Mr. DeJoria owned 1,250 shares of JPMS common stock

and Paul Mitchell Associates, Ltd. (PMA), owned 1,250 shares.

Mitchell owned all of PMA.

Mr.

On February 20, 1982, PMA assigned its

JPMS shares to Mr. Mitchell.

On November 20, 1984, Mr. Mitchell

assigned his JPMS shares to the Trust.

On August 1, 1987,

Mr.

Mitchell, acting as trustee of the Trust, assigned 16 shares of

JPMS common stock to Jeanne Braa, his long-time stage partner in

hair shows, and 8 shares of JPMS common stock to Angus Mitchell,

his son.

Mr. DeJoria and JPMS executed written waivers of the

right of first refusal with respect to all of these transfers.

As of April 21, 1989, the common stock of JPMS was owned as

follows:

Number of Shares

Percent

1,250

1,226

16

8

2,500

50.00

49.04

0.64

0.32

100.00

Mr. DeJoria

The Trust

Ms. Braa

Angus Mitchell

Total

JPMS' bylaws provided for a board of directors (the Board)

consisting of four directors.

However, from 1984 until April 15,

1989, Mr. Mitchell, Mr. DeJoria, and Peter Langenberg were the only

Board members.

On April 15, 1989, Mr. Langenberg resigned and Ms.

Braa was elected to replace him.

- 10 From 1984 until April 1989 Mr. Mitchell served as president of

JPMS; Mr. DeJoria served as chairman of the Board, chief executive

officer, chief financial officer, and secretary.

As

of

April

21,

1989,

the

stock

in

JPMS

had

not

been

registered under any securities law; moreover, neither Mr. DeJoria

nor Mr. Mitchell had ever contemplated such a registration or a

public offering of JPMS' common stock.

2.

Products

JPMS debuted its products at the West Coast Beauty Supply

Spring Style show in 1980, with Mr. Mitchell demonstrating the

product line.

JPMS sold the entire first batch of its products at

the show, generating revenue of approximately $10,000.

That same year, JPMS began selling Paul Mitchell products

through distributors.

"Shampoo

One",

At the time, the product line consisted of

"Shampoo

Two",

"The

Conditioner",

and

"Hair

Sculpting Lotion". The new hair sculpting lotion and sculpted look

were well received in the market.

Messrs. Mitchell and DeJoria

began promoting JPMS products as a "system" of products to be used

in conjunction with each other to achieve "the look".

At the time of Mr. Mitchell's death, JPMS sold the following

products, which were formulated by independent chemists:

Shampoo products

Hair conditioning

products

Shampoo One; Shampoo Two; Awapuhi Shampoo;

Tea Tree Special Shampoo

The Conditioner; Super-Charged Conditioner;

Hair Repair Treatment

- 11 Hair setting and

styling products

Permanent wave

products

3.

Hair Sculpting Lotion; The Spray; Fast Drying

Sculpting Spray; Freeze and Shine Super

Spray; Super Clean Gel; Sculpting Foam;

Super Clean Spray

The Solution; Special Perm Neutralizer; Awapuhi

Conditioning (Box) Perm

Marketing and Distribution

JPMS'

marketing

effort

primarily

targeted,

and

the

distribution network was primarily oriented toward, hair stylists

and salon owners who sold hair care products to their customers,

rather than direct marketing to the consumers themselves.

Mr.

Mitchell's popularity and reputation with hair stylists were used

to introduce JPMS' products, and the hair shows were used to

increase the visibility of JPMS and its products.

JPMS' marketing strategy included the use of distributors to

promote

its

products.

As

of

April

21,

1989,

JPMS

had

38

distributors in the United States and 13 distributors in 12 other

countries.

Nearly

all

of

the

distributors

geographic

territory.

The

distribution

had

an

exclusive

network

was

generally

composed of friends of Messrs. Mitchell and DeJoria who believed

that Mr. Mitchell's reputation as an avant-garde hair stylist, and

Mr. DeJoria's business background, would sell the JPMS products.

As of April 21, 1989, JPMS had no written agreements with its U.S.

distributors.

Mr. DeJoria's organizational and marketing skills, combined

with Mr. Mitchell's artistic creativity and expertise, allowed JPMS

- 12 to create a successful and effective product line.

The JPMS

products were marketed only to salons and emphasized education as

a selling technique.

E.

Mr. Mitchell's Role in JPMS

In

1980,

Mr.

Mitchell

promised

hair

stylists

that

his

products, marketed through JPMS (then Paul Mitchell Systems, Inc.),

would be sold only through professional salons.

Mr. Mitchell's

promise carried credibility due to his stature in the professional

beauty industry.

The promise to remain "professional-only" was

important

successful

to

the

marketing

of

the

Paul

Mitchell

products.

Mr.

Mitchell

was

the

heart

of

JPMS'

connection

to

hair

stylists, who were the foundation for JPMS' marketing strategy of

promoting and selling products that Mr. Mitchell developed.

Mr.

Mitchell was JPMS' creative trendsetter, and his hair sculpting

technique revolutionized hair styling.

In order to further promote its products, JPMS developed the

"Associates Program" to train hair stylists in the Paul Mitchell

system.

This program became an integral part of JPMS' marketing

effort.

JPMS associates underwent special training in both hair

styling and JPMS products.

Once trained, the associates went to

salons to teach the proper techniques to promote the products.

By April 21, 1989, JPMS had 700 associates.

The associates

were paid by the distributors, and they were involved with JPMS

- 13 because they sought professional advancement and financial rewards.

The associates program played a large part in JPMS' success.

Mr. Mitchell was a popular "draw" at industry hair shows,

performing on a regular basis from 1980 until July 1988.

During

the show season, Mr. Mitchell, along with his stage partner, Jeanne

Braa,

would

travel

to

as

many

as

approximately 3 months at a time.

four

cities

a

week

for

This included shows for each

distributor as well as demonstrations through in-salon classes.

Mr. Mitchell traveled with distributors' salesmen who assisted in

the introduction and sale of JPMS products.

Mr.

campaign.

Mitchell

was

the

focal

point

of

JPMS'

advertising

In 1986, JPMS came up with the "Creative" concept

campaign, putting Mr. Mitchell literally behind the product, using

photographs

of

photographer.

him

taken

by

Irving

Penn,

This

campaign,

which

ran

a

noted

through

fashion

1987,

was

bifurcated into a consumer version for Vogue, Mademoiselle, and

Glamour magazines with the caption "Can you say 'Paul Mitchell does

my hair?'", as well as a trade version for Modern Salon and

American Salon magazines with the caption "Paul Mitchell works for

me".

A

similar

1988

advertising

campaign

also

featured

Mr.

Mitchell.

F.

Mr. Mitchell's Illness and Death

Mr. Mitchell's health had been good until approximately May

1988, when he returned from a series of hair shows in Japan and

- 14 began to experience loss of appetite, weight loss, and the onset of

jaundice. On July 18, 1988, he was admitted to Cedars Sinai

Hospital in Los Angeles and was diagnosed as having pancreatic

cancer.

Four days later his pancreas, spleen, gall bladder, and a

portion of his stomach were surgically removed. He remained in the

hospital until September 30, 1988, undergoing additional surgeries

and medical procedures, including radiation therapy. Upon release,

he returned to his home in Hawaii, where he had full-time private

duty nursing.

Throughout this period, Mr. Mitchell continued his

roles as the JPMS creative force, company spokesman, and executive.

Following his hospitalization, Mr. Mitchell was required to

take insulin to control diabetes. In October and November 1988, he

consulted with and received treatment from doctors in Hawaii, Los

Angeles, and New York. Although he continued experiencing bouts of

nausea, his medical condition improved, and he gained weight.

Mr.

Mitchell

his

began

receiving

acupuncture

medication intake at a minimum.

treatments,

keeping

Although follow-up tests revealed

no evidence of metastasis, a November 1988 blood test raised a

possibility of a recurrence of cancer but was inconclusive.

Mr. Mitchell's medical condition prevented him from working or

performing at hair shows until approximately January 1989, when he

performed at a hair styling show in New York City and participated

in the JPMS distributors meeting in Vail, Colorado.

During this

time, he also continued his role in product development, meeting

- 15 with

an

independent

chemist

regarding

his

ideas

for

future

products. In February 1989, tests revealed a recurrence of cancer.

Physicians in Hawaii encouraged Mr. Mitchell to begin chemotherapy,

but he refused.

Mr. DeJoria avoided disclosing the severity of Mr. Mitchell's

illness to quell any fears about the uncertainty of JPMS' future

without

Mr.

Mitchell.

Upon

Mr.

DeJoria's

instruction,

Mr.

Mitchell's illness was portrayed as bacterial food poisoning.

Rumors circulated that Mr. Mitchell was suffering from AIDS or

cancer.

To a degree, the 1989 advertising campaign (which was shot in

November or December 1988) still focused on Mr. Mitchell. However,

Mr. DeJoria and JPMS began shifting emphasis away from Mr. Mitchell

as an individual and towards the products themselves. In fact, one

campaign attempted to focus on Mr. DeJoria, featuring him and his

daughter in an advertising campaign for "Baby Don't Cry" shampoo.

After

performing

at

the

West

Coast

Beauty

show

in

San

Francisco in March 1989, Mr. Mitchell returned to Honolulu, where

he visited physicians.

Later that month he traveled to Mexico to

begin receiving laetrile treatments.

He remained in Mexico until

his return to Cedars Sinai Hospital, where he died on April 21,

1989, at the age of 53.

The cause of death was listed as liver

failure due to liver and pancreatic cancer.

As of the time of his

- 16 death, the public at large was generally unaware of who Paul

Mitchell was or that he had died.

Following Mr. Mitchell's death, the hair care industry widely

perceived that JPMS had lost its creative and artistic leader.

Rumors about JPMS becoming a mass marketer resurfaced, and there

was uncertainty whether JPMS would become just another company.

Distributors (both exclusively JPMS and multiline) feared that the

loss of Paul Mitchell's creative force would at least slow product

sales.

However, they did not consider dropping the JPMS product

line, primarily because of its profitability.

G.

JPMS' Operations and Management

As

of

April

21,

1989,

JPMS

had

some

50

employees,

approximately 21 of whom worked in a 90,000-square-foot warehouse

space, with an additional 10,000 square feet of office space, in

Santa Clarita, California, owned by Mr. DeJoria and the Trust as

tenants in common and leased by JPMS.

As of April 21, 1989, the

warehouse space was not in compliance with the local fire code and

had no environmental controls for drainage of waste or runoff water

in the event of fire or disposal of poor-quality product. (Some

materials used to make hair care products are categorized as

hazardous waste.)

JPMS had no useful inventory controls. By April 21, 1989, the

warehouse was in disarray, and there was a several-months' supply

of products stacked up in JPMS' parking lot.

In fact, JPMS tracked

- 17 its sales by manually recording them on a blackboard.

None of the

JPMS staff knew how to use computers.

As of April 21, 1989, JPMS' products were formulated by

independent chemists and manufactured at independent laboratories.5

JPMS did not have the formulas for many of its products.

Relying

on unrelated contract manufacturers to supply the products prior to

Mr.

Mitchell's

death,

JPMS

generally

had

no

confidentiality

agreements with the contract manufacturers covering the proprietary

nature of the formulas.

Prior

to

Mr.

Mitchell's

death,

JPMS

was

managed

as

a

partnership wherein each partner had a unique role. Mr. Mitchell's

strength was his artistry, creativity, and relationship with hair

stylists, and JPMS relied on his foresight and artistry to develop

products.

Mr. DeJoria's strength was in sales, distribution, and

promotion.

Mr. DeJoria ran the daily operations at JPMS, making all

management decisions and having all managers reporting directly to

him (because

JPMS

had

no

middle

management).

Mr.

Mitchell,

however, was the "senior partner", having the last word on all

5

From September 1983 through August 1988, Star

Laboratories of California (Star), an independent contract

manufacturer, produced most of JPMS' products. In August 1988,

JPMS' relationship with Star ended, and JPMS' manufacturing was

switched to Sun Laboratories (Sun). JPMS' relationship with Sun

was terminated in April 1989; thereafter, JPMS' manufacturer

became Bocchi Laboratories, a corporation in which Mr. DeJoria

was a 50-percent owner.

- 18 policy matters.

Following

Mr. Mitchell's death, Mr. DeJoria

became critical to JPMS' future.

H.

JPMS' Position in the Industry

JPMS was known for its styling products. Over the years, JPMS

developed into a major force in the hair care industry, with brand

recognition by the consuming public, a sophisticated distribution

network, and hundreds of hair stylists trained in the use of the

company's products.

From 1982 through April 21, 1989, JPMS' share

of the salon-only market, in comparison with those of its chief

competitors, improved every year.

In April 1989, JPMS was among

the top five companies in the salon-only market.

The success of

the salon-only product companies attracted the attention of the

large, well-capitalized mass-market companies, which competed in

the premium-price market with products that attempted to capture

the salon-only aura but were in reality mass marketed.

I.

Compensation

From JPMS' inception until Paul Mitchell's death, neither Mr.

Mitchell

nor

Mr.

DeJoria

regarding compensation.

had

any

formal

contract

with

JPMS

Instead, they set sales and profitability

goals for JPMS at the beginning of each fiscal year.

Thereafter,

in September or October of each year, they divided equally the

company's available income.

- 19 For fiscal years ended July 31, 1984 through 1988, Messrs.

Mitchell and DeJoria each received the following payments from

JPMS:

For Year Ended

Salary

Management Fees

7/31/84

7/31/85

7/31/86

7/31/87

7/31/88

------$185,125

1,308,000

------$8,565,000

10,500,000

Total

1

$1,086,500

1

2,305,000

1

4,162,525

8,750,125

11,808,000

1

Payments to Messrs. Mitchell and DeJoria for this year

were not broken down into salary or management fees.

JPMS characterized these payments as compensation for services

rendered.

Between August 1, 1988, and April 21, 1989, JPMS paid Mr.

Mitchell $10,758,046 (which JPMS characterized as compensation for

services rendered). For fiscal year 1989, Messrs. Mitchell and

DeJoria agreed that each of them would receive a $2 million annual

salary and a $15 million management fee.

The JPMS Board approved

these compensation amounts on October 21, 1988.

From the inception of JPMS until the moment of Mr. Mitchell's

death, the only dividend declared by JPMS was for its fiscal year

ended July 31, 1988. The dividend was originally set at $1.4

million but was subsequently raised to $2.5 million.

During the latter part of Mr. Mitchell's illness, Messrs.

DeJoria and Mitchell discussed Mr. DeJoria's future compensation.

Mr.

DeJoria

promised

Mr.

Mitchell

that

in

the

event

of

Mr.

Mitchell's death, he would reduce his management fee from $15

- 20 million to $10 million for JPMS' fiscal year ending July 31, 1990.

Mr. DeJoria's $2 million salary for that year was to remain intact.

J.

Discussions and Agreement With Gillette

In

1987,

the

Gillette

Co.

(Gillette)

was

interested

in

entering the salon-only (or professional-only) products segment of

the hair care market.

JPMS was one of the primary candidates that

Gillette considered purchasing.

In the fall of 1987, Gillette and Messrs. DeJoria and Mitchell

discussed a potential joint venture between Gillette and JPMS to

distribute a Gillette permanent wave product through the JPMS

distribution system.

Gillette also sought an option to purchase

JPMS, but Messrs. DeJoria and Mitchell would agree only to grant

Gillette a right of first refusal.

Accordingly, on December 18, 1987, Aapri Cosmetics, Inc., a

wholly owned subsidiary of Gillette, and JPMS entered a joint

venture, which began on January 1, 1988, and was to last for an

initial 2-year period.

The joint venture agreement provided

Gillette with a right of first refusal to purchase JPMS at a

formula price of 10 times JPMS' prior 12 months' operating income,

after deducting the maximum Federal and State corporate income

taxes (assumed to be 50 percent of income), and excluding from

JPMS' operating income officers' salaries and car expenses.

Until

July 1988, the price payable pursuant to the right of first refusal

was capped at $150 million. Gillette's ultimate goal in entering

- 21 into the joint venture was to acquire JPMS; Gillette had no

interest in a minority shareholder position.

Gillette neither exercised nor waived its right to exercise

its

right

of

first

refusal

contained

in

the

joint

venture

agreement. During the pendency of the joint venture, Gillette

received no notification concerning any offers by third parties to

purchase the stock or assets of JPMS.

Only

Gillette's

board

acquisition the size of JPMS.

of

directors

could

approve

an

No formal proposal was ever made to

Gillette's board of directors to approve the acquisition of JPMS.6

The permanent wave product marketed through the joint venture

agreement was not well received in the salon market.

The joint

venture lost $1 million in the first 2 years and was unsuccessful.

Accordingly, the joint venture agreement was terminated in December

1989.

6

According to Mr. DeJoria, a Gillette representative

orally proposed the acquisition of JPMS for $150 million and a 1percent royalty payment to each of Messrs. Mitchell and DeJoria.

Mr. DeJoria responded that he thought JPMS was worth more.

However, Roland L. Loper, Gillette's vice president and

controller of the personal care division from 1987 through 1988,

and vice president for finance and strategic planning of the

personal care group in 1989, insisted that no such offer was

made.

- 22 K.

Sale Discussions With Minnetonka

Another suitor of JPMS was Minnetonka Corp. (Minnetonka), a

publicly traded company.

Robert Taylor was Minnetonka's president

and chief executive officer.

Mr. Taylor co-founded Minnetonka in

1961 and took the company public in 1968.

Minnetonka was involved in consumer product brands, primarily

those that were sold through the department store, gift, or beauty

trade.

Minnetonka was the licensee for Calvin Klein and created

Obsession and Eternity women's fragrances. In addition, Minnetonka

created Foltene, a treatment used in the beauty salon business for

fine and thinning hair, a product line for home fragrance, and a

gift soap product line for department stores.

In

1990,

Mr.

Taylor

started

a

salon-only

hair

products

company, Graham Webb International, which grew to $25 million in

sales in 5 years. From 1992 or 1993 to approximately 1995, Mr.

Taylor was on the board of directors of Banker's Trust Venture

Capital Fund in New York (Bankers Trust), which specializes in

providing funds for small businesses or recapitalization funds.7

7

Bankers Trust had $200 million to invest in

recapitalizations or buyouts that it used primarily for companies

in the $5 million to $100 million range. During his tenure with

Bankers Trust, Mr. Taylor reviewed approximately 100 proposals

for the use of this money.

- 23 As chairman, Mr. Taylor was responsible for Minnetonka's

strategic acquisitions.8

In 1985, when JPMS' sales approximated

$10 million, a financial adviser to JPMS solicited Mr. Taylor's

interest in acquiring JPMS.

However, Minnetonka determined that

JPMS was too small and that the Paul Mitchell brand name was not

strong enough to stand on its own; accordingly, Mr. Taylor declined

to enter discussions at that time.

Two years later, Minnetonka targeted the salon industry for

acquisition candidates, and Mr. Taylor contacted Redken, Sebastian,

and JPMS.

During this time, the annual sales of these companies

were approximately $120 million, $60 million, and $50 million,

respectively.

Although Minnetonka agreed to acquire Sebastian for

$100 million in late 1987, the sale was not consummated.

Mr. Taylor initiated discussions with Mr. DeJoria in the fall

of

1987

(JPMS'

1988

fiscal

approximately $50 million.

8

year)

when

JPMS'

sales

were

Mr. Taylor informed Mr. DeJoria that

Mr. Taylor was involved in the August 1987 sale of

Minnetonka's liquid soap business to Colgate-Palmolive Co. for

$60 million, the November 1988 acquisition of the Vitabath

business from Quintessence for $38 million, and the July 1989

sale of Minnetonka to Unilever for $376 million at approximately

two times sales. When the Unilever acquisition was announced the

price of Minnetonka stock was at $14 per share, and the

transaction was consummated at $22.50 a share, a 60-percent

premium over the freely traded value.

Mr. Taylor used two "rules of thumb" with regard to the

valuation of a company under consideration for acquisition: two

times sales and/or five times operating income. Mr. Taylor

measured these rules against other standards, such as potential

for future growth, quality of management, capital requirements,

and strength of brand name.

- 24 Minnetonka was willing to pay $100 million to acquire all of the

JPMS stock, assuming officers' salaries were revised.9

insisted on a $125 million acquisition price.

Mr. DeJoria

Mr. Taylor refused

to raise Minnetonka's bid, and the negotiations were terminated.

In the fall of 1988, Mr. Taylor again approached Messrs.

DeJoria and Mitchell.

million range.)

(At the time, JPMS' sales were in the $65

Mr. Taylor offered $125 million10 to acquire all

of the JPMS stock. (At this time, Mr. Taylor was unaware that Mr.

Mitchell was seriously ill.)

The proposed acquisition price

assumed that: (1) Mr. DeJoria would continue managing JPMS; (2)

Mr. Mitchell would continue promoting the products for at least 18

months to 2 years as a transition period; and (3) both Messrs.

Mitchell and DeJoria would be compensated in salary and stock at a

level paid to officers of other Minnetonka subsidiaries, such as

Calvin Klein.

Mr. DeJoria did not accept Minnetonka's $125 million offer; he

believed that Minnetonka was "just a little short every time".

(Mr. DeJoria represented to Mr. Taylor that he had received from

9

Minnetonka would not have been interested in purchasing

a 49-percent interest in JPMS.

Mr. Taylor regarded the level of compensation for

Messrs. Mitchell and DeJoria as too high; he considered a more

appropriate level of compensation to be in the $500,000 to $1

million range, including performance bonuses.

10

In determining the value of JPMS, Mr. Taylor considered

the company's growth potential. In the fall of 1988, he thought

that JPMS could perhaps double or triple in size within 5 years.

- 25 Gillette a $150 million offer plus a royalty of 2 percent of sales

for lifetime.

Mr. Taylor informed Mr. DeJoria that he could not

match Gillette's offer.)

Sales discussions with Minnetonka thus

ended.

L.

Financial Information Available at Date of Death

JPMS adopted a fiscal year ending July 31. Beginning with the

fiscal

year

ended

July

31,

1984,

the

shareholders

elected

subchapter S status for Federal income tax purposes. JPMS remained

a subchapter C corporation for State of California income tax

purposes until the 1988 fiscal year, when the shareholders elected

subchapter S status for California.

KPMG

Peat

Marwick

(KPMG)

(or

one

of

certified JPMS' audited financial statements.

its

predecessors)

JPMS' net sales and

net income after taxes for fiscal years ended July 31, 1982 through

1988, inclusive, were as follows:

Fiscal Year Ended 7/31

Net Sales

Net Income After Taxes

1982

1983

1984

1985

1986

1987

1988

$1,369,316

3,590,641

5,349,152

1

11,266,610

24,131,739

41,371,318

60,693,857

$142,375

159,947

4,004

207,777

2,265,875

281,777

2,569,297

1

The audited financial statements for the years ended July

31, 1986 and 1985, state this amount as $10,918,252.

At Mr. Mitchell's death, the most recent available certified

financial statements were for JPMS' fiscal year ended July 31,

- 26 1988.

The most recent interim financial statements available were

for the 6 months ended January 31, 1989.

(In addition to the

annual audited financial statements, KPMG also prepared unaudited

financial statements on a quarterly basis.)

Except for motivational sales goals announced at semiannual

distributors meetings as of April 21, 1989, JPMS did not project

future revenues, expenses, costs of maintaining the Paul Mitchell

brand name, or income.

Between December 1989 and January 1990

KPMG prepared projections of JPMS' revenues and expenses for fiscal

years 1990-94.

M.

Post-Death Events

1.

Mr. Fujieki's Request for JPMS Documents

On June 29, 1989, Patrick Fujieki, trustee of the Trust, and

Michaeline Re11 were elected to the JPMS Board.

(The Board was thus

comprised of Mr. DeJoria, Ms. Braa, Mr. Fujieki, and Ms. Re.)

At

this time, the Trust was the shareholder of record of 49.04 percent

of the outstanding common shares of JPMS, of which 1 percent was to

be transferred to Mr. DeJoria in accordance with the terms of Mr.

Mitchell's Will and Trust.

Mr. Fujieki (in his capacities as director of JPMS, trustee

for the Trust, and executor of Paul Mitchell's estate) asked to

11

Ms. Re, an attorney, joined JPMS on Jan. 1, 1989, as

vice president and general counsel, to oversee the correction of

certain operational problems. On Mar. 1, 1989, she became JPMS'

chief operating officer.

- 27 inspect the JPMS corporate records and financial information at the

June 29, 1989, JPMS Board meeting and in later correspondence with

Ms. Re, Mr. DeJoria, and other JPMS employees.

Through December

19, 1989, Mr. Fujieki was not provided with financial statements

for the JPMS fiscal year ended July 31, 1989. On April 10, 1992,

representatives of Mr. Fujieki were permitted to review JPMS'

financial records but were not allowed to make copies.

Before

permitting Mr. Fujieki's representatives to review its financial

records, JPMS required Mr. Fujieki and his representatives to

execute confidentiality agreements.

Mr. Fujieki continually questioned the actions of the JPMS

Board at its meetings and the accuracy of the corporate minutes.

Beginning July 30, 1992, through at least April 20, 1993, James

Ukropina, Esq., outside legal counsel for JPMS, attended the JPMS

Board meetings.

2.

Purchase Offer From Mr. DeJoria

On April 21, 1989, JPMS faced losing its subchapter S status

when the Trust ceased to qualify as a subchapter S shareholder.

Maintaining JPMS' subchapter S status would have been beneficial to

its shareholders because no corporate-level tax would be imposed on

JPMS' income. One option would have been for Mr. DeJoria to

purchase the Trust's shares of JPMS; however, Mr. DeJoria refused

to consider this option because it would have gone against Mr.

Mitchell's wishes of providing for his son Angus, for which reason

- 28 the Trust had been created. Gregg Ritchie, an accountant with KPMG

who oversaw the preparation of JPMS' annual audited financial

statements, began to explore various scenarios for maintaining

JPMS' subchapter S status.

On April 4, 1991, Mr. DeJoria offered, through Mr. Ritchie, to

purchase the Trust's share of JPMS common stock for $47 million.

Mr. DeJoria's offer included $4.7 million in cash on April 15,

1991, with the balance in 10 annual installments of $4.23 million

commencing April 15, 1992 (the unpaid principal balance would bear

interest at 8 percent per year, payable quarterly).

1991, Mr. Fujieki rejected the offer.

On April 10,

Mr. Fujieki invited Mr.

DeJoria to make a higher bid; Mr. DeJoria refused, indicating that

his next offer would be $37 million ($10 million less than his

April 4, 1991, offer).

3.

Compensation Dispute

Mr.

DeJoria

assumed

many

of

Mr.

Mitchell's

responsibilities following Mr. Mitchell's death.

corporate

Between April 22

and July 31, 1989, JPMS paid Mr. DeJoria $4,901,537 as compensation

for services rendered to JPMS.

For JPMS' fiscal year ended July

31, 1990, Mr. DeJoria agreed to reduce his management fee from $15

million to $10 million, as promised to Mr. Mitchell.

also received $2 million in salary for that year.

Mr. DeJoria

In summary, JPMS

paid Mr. DeJoria the following amounts for fiscal years ended July

31, 1990 through 1994:

- 29 For Year Ended

Amount

7/31/90

7/31/91

7/31/92

7/31/93

7/31/94

$12,000,000

17,025,000

17,025,568

17,000,000

17,000,000

JPMS characterized these payments as compensation for services

rendered.

From August 1, 1989 through 1992, Mr. Fujieki repeatedly

requested in letters and at Board meetings that the Board retain an

independent compensation consultant to consider the reasonableness

of Mr. DeJoria's compensation.

requests.

The Board rejected Mr. Fujieki's

At this time, tension began to mount among members of

the Board.

In late 1990, Mr. Fujieki retained Coopers & Lybrand to

determine a reasonable level of compensation for Mr. DeJoria.

On

January 11, 1991, Coopers & Lybrand preliminarily determined that

a reasonable level of compensation was within the range of $600,000

to $1 million, with a possible $2 million ceiling.

At the January

10,

Mr.

1992,

Board

meeting,

the

Board

approved

DeJoria's

compensation at 13 percent of JPMS' gross sales, not to exceed $17

million per year, for JPMS' fiscal years ended July 31, 1992

through 1996.

Mr. Fujieki objected to this approval by the Board.

Mr. Fujieki proposed to have the compensation dispute resolved

by arbitration, but Mr. DeJoria refused.

Accordingly, in June

1993, Mr. Fujieki brought suit against Mr. DeJoria, Ms. Re, and

- 30 JPMS

on

the

Trust's

behalf,

compensation was excessive.

alleging

that

Mr.

DeJoria's

The suit was filed in both the

Superior Court for the State of California and the U.S. District

Court for the Central District of California.

In

response

to

Mr.

Fujieki's

allegations

of

shareholder

derivative claims, JPMS formed a Special Litigation Committee (SLC)

comprising JPMS' outside directors: Kenin Spivak, Paul Rupert, and

David Tisdale.

Among other things, the SLC was to evaluate Mr.

Fujieki's allegations to decide whether to pursue the derivative

claims on JPMS' behalf.

The SLC hired Towers Perrin as executive

compensation consultants to assist the SLC.

In April 1995, the litigation between the Trust and JPMS was

settled; the SLC determined that the settlement agreement was in

JPMS' best interests.

The JPMS Board and shareholders, as well as

the court, approved the settlement agreement. Neither the SLC, the

JPMS

Board,

nor

the

court

determined

that

Mr.

DeJoria's

compensation was unreasonable.

N.

The Estate Tax Return, Notice of Deficiency, and Petition

On its estate tax return, petitioner valued the Trust's

interest in the 1,226 shares of JPMS common stock at the moment of

decedent's death at $28.5 million.

This figure was based upon a

KPMG valuation analysis prepared at Mr. Fujieki's request. (KPMG

utilized both the comparable companies and discounted cash-flow

analyses.)

- 31 In

the

notice

of

deficiency,

respondent

determined,

in

pertinent part, that petitioner had undervalued the JPMS common

stock.

Respondent determined that the fair market value of the

Trust's interest in the 1,226 shares of JPMS common stock at the

moment

of

death

was

$105

million.

Accordingly,

respondent

determined that the value of the gross estate should be increased

by $76.5 million.

The notice also determined section 6662(g) and

(h) penalties.

Petitioner

filed

a

petition

in

this

Court

challenging

respondent's moment-of-death valuation for the Trust's 1,226 shares

of JPMS common stock, essentially restating the position taken on

the estate tax return.

In the original answer to petitioner's

petition, respondent restated the position taken in the notice of

deficiency.

Following the trial in this case, petitioner filed an

amended petition alleging that the value of the 1,226 shares of

JPMS common stock as of April 21, 1989, was $23,062,000, rather

than the $28.5 million reflected on both the estate tax return and

the original petition. In the answer to the amended petition,

respondent denied the allegations contained in petitioner's amended

petition.

ULTIMATE FINDING OF FACT

The moment-of-death value of the 1,226 shares of JPMS common

stock held by the Trust and includable in decedent's gross estate

was $41,532,600.

- 32 OPINION

Issue 1.

Moment-of-Death Value of JPMS Stock

The primary issue for decision is the moment-of-death value of

1,226 shares of JPMS common stock held by the Trust.

Petitioner

now contends that the stock was worth between $23,062,000 and $29

million.

Respondent now asserts the value to be $81 million, or

$24 million less than that determined in the notice of deficiency.

Section 2031(a) requires a decedent's "gross estate" to be

determined for Federal estate tax purposes "by including * * * the

value at the time of his death of all property, real or personal,

tangible or intangible, wherever situated." Value is determined at

the moment of death.12

Ahmanson Found. v. United States, 674 F.2d

12

The following statements made by the Court of Appeals

for the Fifth Circuit in United States v. Land, 303 F.2d 170, 172

(5th Cir. 1962), are, in our opinion, pertinent to our

determination that the valuation of the 1,226 shares of JPMS

common stock held by the Trust must be pinpointed to the moment

of Mr. Mitchell's death:

Brief as is the instant of death, the

court must pinpoint its valuation at this

instant--the moment of truth, when the

ownership of the decedent ends and the

ownership of the successors begins. It is a

fallacy, therefore, to argue value before-or--after death on the notion that valuation

must be determined by the value either of the

interest that ceases or of the interest that

begins. Instead, the valuation is determined

by the interest that passes, and the value of

the interest before or after death is

pertinent only as it serves to indicate the

value at death. In the usual case death

brings no change in the value of property.

(continued...)

- 33 761, 767 (9th Cir. 1981); Estate of McClatchy v. Commissioner, 106

T.C. 206, 210 (1996).

The standard for valuation is fair market

value, defined as "'the price at which the property would change

hands between a willing buyer and a willing seller, neither being

under any compulsion to buy or to sell and both having reasonable

United States v. Cartwright, 411

knowledge of relevant facts.'"

U.S. 546, 551 (1973) (quoting section 20.3031-1(b), Estate Tax

Regs.); Collins v. Commissioner, 3 F.3d 625, 633 (2d Cir. 1993),

affg. T.C. Memo. 1992-478.

This objective test requires property

to be valued from the viewpoint of a hypothetical buyer and seller,

each of whom would seek to maximize his or her profit from any

transaction

involving

the

property.

See

Estate

of

Watts

v.

Commissioner, 823 F.2d 483, 486 (11th Cir. 1987), affg. T.C. Memo.

1985-595; Estate of Bright v. United States, 658 F.2d 999, 10051006 (5th Cir. 1981).

The value of property is a question of fact,

and

we

Ahmanson

consider

all

relevant

Found.

v.

United

facts

States,

and

circumstances.

supra

at

769;

E.g.,

Hamm

v.

Commissioner, 325 F.2d 934, 938 (8th Cir. 1963), affg. T.C. Memo.

1961-347; Estate of Jung v. Commissioner, 101 T.C. 412, 423-424

12

(...continued)

It is only in the few cases where death

alters value, as well as ownership, that it

is necessary to determine whether the value

at the time of death reflects the change

caused by death, for example, loss of

services of a valuable partner to a small

business.

- 34 (1993);

Messing v. Commissioner, 48 T.C. 502, 512 (1967); sec.

20.2031-1(b), Estate Tax Regs.

Fair market value may be affected

by future events that were reasonably foreseeable at the valuation

date. Estate of Gilford v. Commissioner, 88 T.C. 38, 52 (1987);

Gray v. Commissioner, 2 B.T.A. 672, 682 (1925); Estate of Livermore

v. Commissioner, T.C. Memo. 1988-503.

Determining

corporation's

the

fair

market

capital

stock

is

value

difficult

property that has no public market.

of

a

because

closely

it

held

involves

The best method for valuing

closely held stock is by reference to an actual arm's-length sale

of the stock in the normal course of business within a reasonable

time before or after the valuation date.

See Estate of Andrews v.

Commissioner, 79 T.C. 938, 940 (1982); Estate of Campbell v.

Commissioner, T.C. Memo. 1991-615; sec. 20.2031-2(b), Estate Tax

Regs.

In the absence of an arm's-length sale, the fair market

value of closely held stock must be determined indirectly by

considering, inter alia:

(a) The nature of the business

enterprise from its inception.

and

the

history

of

the

(b) The economic outlook in general and the condition and

outlook of the specific industry in particular.

(c) The book value of the stock and the financial

condition of the business.

(d)

The earning capacity of the company.

(e)

The dividend paying capacity [of the company].

- 35 (f) Whether or not the enterprise has goodwill or other

intangible value.

(g)

* * * the size of the block of stock to be valued.

(h) The market price of stocks of corporations engaged

in the same line or similar line of business having their

stocks actively traded in a free and open market, either

on an exchange or over-the-counter.

Rev. Rul. 59-60, sec. 4.01, 1959-1 C.B. 237, 238-239; see also sec.

20.2031-2(f), Estate Tax Regs.

These factors cannot be applied

with mathematical precision. See Rev. Rul. 59-60, supra, 1959-1

C.B. at 238.

Rather, the weight accorded each factor must be

tailored to account for the particular facts under consideration.

See Messing v. Commissioner, supra.

Both parties relied upon expert valuations.

testimony

aids

the

Court

instances, it does not.

in

determining

At times, expert

valuation;

in

other

See Laureys v. Commissioner, 92 T.C. 101,

129 (1989).

We are not bound by an expert's formulae and opinions,

especially

when

they

run

contrary

to

Commissioner, 84 T.C. 722, 734 (1985).

our

judgment.

Chiu

v.

Instead, we may reach a

decision as to the value of the property based on our own analysis

of all the evidence in the record, Hamm v. Commissioner, supra at

941, using all of one party's expert opinion, Buffalo Tool & Die

Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980), or

selectively using any portion of such an opinion, see Parker v.

Commissioner, 86 T.C. 547, 562 (1986).

- 36 In sum, we will consider expert opinion testimony to the

extent it assists our fair market value determination.

Valuation

is an approximation, and the figure we reach need not be one as to

which there is specific testimony. Our role is to approximate fair

market value as closely as possible, within the range of figures

that may properly be deduced from the evidence.

Silverman v.

Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), affg. T.C. Memo.

1974-285.

A.

Valuations of Petitioner's Experts

1.

The Weiksner Report

Petitioner's first expert, George B. Weiksner, is a managing

director and senior adviser of CS First Boston, an investment

banking firm.

Mr. Weiksner has 25 years of investment banking

experience.

Mr.

Weiksner's

report

valued

the

Trust's

49.04

percent

interest in JPMS common stock (1,226 shares) at $20,634,000 to

$25,489,000, with a midpoint value of $23,062,000. Mr. Weiksner's

report

13

began

with

a

comparable

companies

analysis13

that

(1)

Comparable companies analysis is a public market

valuation tool that values a company by reference to publicly

traded companies with similar operating and financial

characteristics. The first step involves identifying appropriate

comparable companies and measuring their enterprise and equity

values as multiples of financial benchmarks. Mr. Weiksner

considered seven comparable companies.

The second step in the comparable companies analysis

involves applying the derived multiples to the corresponding

actual and projected financial benchmarks of the company subject

(continued...)

- 37 selected five standard multiples (net sales, operating cash-flow-EBITDA, operating income--EBIT, net income, and cash flow), (2)

determined the ranges of applicable multiples from the comparable

companies data, and (3) applied the multiple ranges to JPMS'

"normalized" financial data (making adjustments to the financial

data generated in the earnings model).14 From the value ranges thus

derived, Mr. Weiksner determined a comparable companies value range

for JPMS of $85 million to $105 million.

He then determined JPMS'

public value15 of $76.5 million to $94.5 million by subtracting from

JPMS' comparable companies value a 10-percent extraordinary risk

discount. This discount accounted for: (1) The approximate cost of

replacing

Mr.

projections

Mitchell's

of

JPMS'

services

operating

that

was

expenses;

estimated

(2)

in

the

operational

13

(...continued)

to valuation. In order to create that set of financial

benchmarks, Mr. Weiksner developed an earnings model for JPMS,

which forecast the company's results for a 5-year period and

"normalized" the actual and projected financial results to

reflect JPMS' profile going forward.

14

Mr. Weiksner used the earnings model to portray how a

hypothetical buyer or seller of the JPMS stock would perceive

JPMS as of the moment of decedent's death, given the information

available at that date. Among other things, Mr. Weiksner's

adjustments to JPMS' historical financial data included: (1) The

removal of Mr. Mitchell's compensation as an expense; (2) adding

an amount equal to 8 percent of net sales as additional sales,

general, and administrative expenses in lieu of Mr. Mitchell's

compensation; and (3) the adjustment of Mr. DeJoria's

compensation to $16 million to reflect his average anticipated

compensation.

15

Public value refers to the estimated value of liquid,

freely trading shares of JPMS as if it had been a public company.

- 38 difficulties; (3) dependence on Mr. DeJoria; and (4) difficulty in

maintaining future growth.

Mr. Weiksner believed that these risks

were unique to JPMS at the valuation date and warranted the

discount of the stock.

Mr. Weiksner subsequently calculated the proportionate public

value of the shares and adjusted that value by a 45-percent

discount to reflect minority interest and lack of marketability,16

to arrive at a $20,634,000 to $25,489,000 private value17 for the

1,226 JPMS shares.

At trial, Mr. Weiksner suggested a 30- to 50-

percent range for these discounts.

In addition to the comparable companies analysis, Mr. Weiksner

utilized the

comparable

acquisitions

analyses as confirming methodologies.

through

the

comparable

acquisitions

and

discounted

Mr. Weiksner valued JPMS

analysis

by

reference

private market sales of similar businesses, thereby

control values.18

cash-flow

to

generating

Mr. Weiksner identified appropriate comparable

transactions and measured the enterprise and equity values of

16

A minority shareholder discount reflects the decreased

value of shares that do not convey control of a closely held

corporation. A lack of marketability discount reflects the fact

that there is no ready market for shares in a closely held

corporation.

17

Private value refers to the value of a minority

interest in stock for which no liquid public trading market

exists.

18

Control value is the value of a company in a

transaction in which the acquirer acquires the controlling stock.

- 39 target companies as multiples of financial benchmarks.

Then he

applied those multiples to the corresponding actual and projected

financial benchmarks of JPMS.

Accordingly, Mr. Weiksner applied

his comparable acquisitions multiples to the normalized data for

JPMS that he created from his earnings model to determine a range

of control values for JPMS.

control

value

that

he

The $110 million to $135 million

determined

exceeded

JPMS'

comparable

companies value by approximately 29 percent and exceeded JPMS'

public value by approximately 43 percent, within his expectations

of an appropriate control premium.

In his discounted cash-flow analysis, Mr. Weiksner valued

JPMS as the sum of its projected cash-flows before financing costs

over several years plus an estimated value of the company at the

end of the forecast period, all discounted to present value.

He

determined a range of terminal values through his comparable

companies analysis and a range of appropriate discount rates

through an adjusted weighted average cost of capital analysis. The

$115 million to $140 million control value that Mr. Weiksner

determined for JPMS through this analysis exceeded JPMS' comparable

companies value by approximately 34 percent and JPMS' public value

by

approximately

49

percent,

within

his

expectation

of

an

appropriate premium.

We note that at trial, Mr. Weiksner suggested a $110 million

to $135 million range of control values for JPMS on April 21, 1989.

- 40 2.

The McGraw Report

Petitioner's second expert, Kenneth W. McGraw, is managing

director of Patricof & Co. Capital Corp., an investment banking

firm. He has approximately 36 years of experience in finance

markets and investment banking.

Utilizing a comparative companies analysis, Mr. McGraw valued

the 1,226 shares of JPMS common stock at approximately $29 million.

(In this analysis, he used virtually the same group of comparable

public companies as Mr. Weiksner.) Mr. McGraw adjusted JPMS'

financial data in deriving an earnings model to which he applied

his comparable companies analysis.

To represent the amount JPMS

would have to spend to replace the benefits of Mr. Mitchell's

services, Mr. McGraw estimated that additional expenditures for

advertising

and

administrative

advertising

and

promotional

expenses

expenses

to

would

16

increase

percent

of

JPMS'

total

revenues. He also removed Mr. Mitchell's compensation expense from

the financial data.19

Mr. McGraw reduced his approximate $109 million theoretical

publicly traded value for JPMS by an extraordinary risk discount,

through a 15-percent reduction to his average EBIT and average

EBITDA.

19

Mr.

McGraw

then

applied

a

45-percent

marketability

Mr. McGraw did not believe that a reduction in Mr.

DeJoria's compensation was a circumstance upon which a

prospective purchaser of the shares could reasonably depend.

Thus, he did not adjust Mr. DeJoria's historical compensation for

purposes of this analysis.

- 41 discount20 to the value he determined through the comparative

companies analysis, resulting in a $29.5 million value for the

1,226 shares of JPMS common stock.

In addition to his comparative companies analysis, Mr. McGraw

utilized a discounted cash-flow analysis, determining a pro rata

equity value of $49.5 million.

In this analysis, he also applied

a 45-percent discount for lack of marketability, yielding a $27.2

million value for the 1,226 shares of JPMS common stock.

Mr. McGraw weighed his comparative companies analysis more

heavily than his discounted cash-flow analysis; in his opinion, the

comparative companies analysis was the "more reliable indicator of

value".

Accordingly,

relying

on

this

analysis,

Mr.

McGraw

concluded that the fair market value of the 1,226 shares of JPMS

common stock was approximately $29 million.

B.

Valuations of Respondent's Experts

1.

The Hanan Report

Respondent offered Martin D. Hanan, president of Business

Valuation Services, Inc. (BVS), as an expert witness.

He has

worked as an appraiser for many years. Mr. Hanan valued the 1,226

shares of JPMS common stock at $81 million, relying on both the

comparable companies21 and discounted cash-flow analyses.

20

On the basis of Mr. McGraw's methodology, no discount

for minority interest was taken.

21

Mr. Hanan refers to this approach as the "guideline

company" approach.

- 42 In his comparable companies analysis, Mr. Hanan utilized

practically the same group of comparable public companies used by

Mr. Weiksner.

Mr. Hanan began with normalizing JPMS' financial

results. For instance, Mr. Hanan concluded that the combined

compensation paid to Messrs. Mitchell and DeJoria would not have

exceeded

$2.5

conditions;

Mr.

million

if

Hanan

thus

they

were

adjusted

paid

the

under

historical

performance to reflect arm's-length rates.

shareholder

of

the

49-percent

block

arm's-length

financial

He believed that a

would

likely

reach

an

accommodation with Mr. DeJoria regarding his compensation before

agreeing to a price for those shares.

For purposes of this

analysis, Mr. Hanan accordingly assumed Mr. DeJoria's compensation

would be set at $5 million per year after the valuation date.

Mr. Hanan's comparable companies analysis indicated a $272

million value for JPMS on a publicly traded, minority interest

basis.

He subsequently applied a 30-percent discount for lack of

marketability

(concluding

that

JPMS'

size,

profitability,

shareholder rights, dividend paying capacity and policy, as well as

transfer restrictions, all favored a below-average marketability

discount, while Mr. DeJoria's anticipated intention to continue

drawing

excessive

compensation

marketability discount).

favored

an

above-average

By applying the 30-percent discount to

his $272 million value for JPMS, Mr. Hanan determined an $81

million fair market value for the 1,226 shares of JPMS common stock

as of April 21, 1989.

- 43 In his discounted cash-flow analysis, Mr. Hanan projected

JPMS' anticipated cash-flows for 5 years after 1989, and discounted

the cash-flows to a present value at the valuation date.

For

purposes of this analysis, Mr. Hanan again assumed executive

compensation would be set at $5 million.

Accordingly, Mr. Hanan

determined that as of April 21, 1989, the discounted cash-flow

control value of JPMS was $295 million, while the discounted cashflow value of JPMS' equity was $218 million on a publicly traded,

minority-interest basis.

Finally, although Mr. Hanan proposed an $81 million fair

market value for the 1,226 shares of JPMS common stock, he concedes

that "because of a likely disagreement between the buyer/seller and

[Mr.] DeJoria over [Mr.] DeJoria's compensation and the possibility

of litigation, the value of the subject stock could be as high as

$165.3 million and as low as $57.7 million."22

2.

The Brennan Report

Respondent also offered the expert report of E. James Brennan

III,23 president of Brennan, Thomsen Associates, Inc.

regularly

testifies

as

an

expert

witness

Mr. Brennan

regarding

personnel

management and pay practices, particularly in the area of executive

compensation.

22

Mr. Hanan reached the $57.7 million figure by assuming

that Mr. DeJoria's compensation would be set at $12 million for

fiscal year 1990 and $17 million per year thereafter.

23

stand.

Respondent chose not to put E. James Brennan III on the

- 44 Mr.

Brennan's

report

evaluated

the

reasonable

level

of

compensation for services provided by Messrs. Mitchell and DeJoria

prior

to

Mr.

Mitchell's

death

and

made

an

estimate

of

the

reasonable level of compensation for Mr. DeJoria for the 5 fiscal

years following Mr. Mitchell's death.

Mr. Brennan opined that the

amounts Messrs. Mitchell and DeJoria paid themselves for the 198489 fiscal years were far in excess of the maximum amounts paid to

comparable top executives at equivalent enterprises for employee

services.

Mr.

Brennan

concluded

that

the

maximum

level

of

reasonable compensation for Mr. DeJoria for 1990-94 would range

between

$820,300

and

$1,159,420,

based

on

projections

of

an

increase in sales revenue for those years.

C.

Critique of Experts

Not unexpectedly, each party criticized the opposing experts'

analyses.

The

following

points

highlight

these

disparate

perspectives.

1.

Respondent's Arguments

Respondent

criticizes

Messrs.

Weiksner's

and

McGraw's

valuations as based on the mistaken assumption that JPMS was a

fragile, disorganized, mismanaged, problem-ridden company on the

verge of collapse as of April 21, 1989.

Moreover, respondent

criticizes

comparable

three

aspects

of

petitioner's

companies

analyses: (1) The kinds of multiples selected, the time periods to

which

the

multiples

relate,

and

their

weighting;

(2)

the

adjustments made to JPMS' financial data; and (3) the adjustments

- 45 for risk and illiquidity.

Respondent argues that petitioner's

experts' analyses were essentially based upon subjective judgment.

In fact, respondent believes that petitioners' experts failed to

offer a credible basis for their extraordinary risk or illiquidity

discounts.

Respondent further argues that Mr. Weiksner's "normalized"

earnings

model,

which

he

applies

over

a

3-year

period,

is

inaccurate and misleading because 2 of the 3 years ended after the

valuation date; thus, the figures for those years are essentially

a projection rather than an analysis of actual results.

With regard to Messrs. Weiksner's and McGraw's discounted

cash-flow analyses, respondent first argues that these analyses

fail to confirm the comparative companies method values these

experts

determined.

Respondent

posits

that

Mr.

Weiksner's

discounted cash-flow analysis assumes that Mr. DeJoria's future

compensation will conform to Mr. DeJoria's expectation of $12

million in fiscal year 1990 and $17 million per year thereafter.

However, according to respondent, Mr. Weiksner's discounted cashflow analysis actually presumes no control over Mr. DeJoria's

compensation or any other element of JPMS' cash-flows.

Thus,

respondent argues that Mr. Weiksner's result is a minority interest

value rather than a control value.

2.

Petitioner's Arguments

Petitioner

counters

that

Mr.

Hanan's

valuation

has

four

erroneous bases: (1) Nonexistent "projections" of Mr. DeJoria; (2)

- 46 an unreasonable assumption that Mr. DeJoria would unilaterally

reduce his compensation to $5 million as of the valuation date; (3)

a nonexistent "transition plan"; and (4) financial information not

available as of Mr. Mitchell's date of death. (In fact, petitioner

asserts that both Mr. Hanan's discounted cash-flow and comparable

companies analyses improperly rely on KPMG's projections of JPMS'

operating results following Mr. Mitchell's death.)

More specifically, petitioner first argues that the "DeJoria

projections"

referred

to

by

respondent

are

the

projections

developed by KPMG with the benefit of 8 months of hindsight and

yearend audited financial data not available on April 21, 1989.

Petitioner contends that the projections did not exist at the

valuation date and would not have been knowable to a hypothetical

buyer or seller.

Second, petitioner contends that it would be unreasonable and

unrealistic

to

assume,

as

Mr.

Hanan

did,

that

Mr.

DeJoria's

compensation could be reduced by any means short of litigation.

Petitioner

contends

that

most

buyers

are

litigation

averse.

Therefore, petitioner posits, the only reasonable assumption is

that Mr. DeJoria would receive compensation in the amounts of $12

million for JPMS' 1990 fiscal year and $17 million per year

thereafter.

Third,

according

to

petitioner,

respondent

refers

to

a

"transition plan" Mr. DeJoria developed when he learned of Mr.

- 47 Mitchell's illness. Petitioner suggests that no concrete plan ever

existed.

Fourth, petitioner argues that Mr. Hanan relied on post-April

21, 1989, information in developing his discounted cash-flow model.

He used data from fiscal year ended July 31, 1989 (taken from JPMS'

annual certified financial statements) in deriving his April 21,

1989, base year. However, this information was not available until

the late fall of 1989. Thus, petitioner argues, Mr. Hanan premised

his base year data on JPMS' actual financial results that, by

definition, could not have been available at the valuation date.

Furthermore, petitioner contends that Mr. Hanan mechanically used

the

KPMG

projections

(which

he

referred

to

as

the

"DeJoria

Mr.

Hanan's

projections") to compute his discounted cash-flow.

In

short,

petitioner

contends

that

while

discounted cash-flow purports to be a minority interest discounted

cash-flow,

in

reality

it

is

a

control

discounted

cash-flow.

According to petitioner, Mr. Hanan improperly changed the capital

structure of JPMS, adding long-term debt on the assumption that a

minority shareholder could influence capital structure.

Finally,

petitioner

opines

that

Mr.

Hanan's

exorbitant

control value is irreconcilable with Minnetonka's $125 million

offer for all of the JPMS stock.

Petitioner urges the Court to

dismiss Mr. Hanan's conclusions as unrealistic.

- 48 D.

Court's Analysis and Conclusion

We have considered all of the testimony before us, as well as

the expert witness reports, and have weighed all other relevant

factors. As articulated by the parties, each expert witness report

is susceptible to criticism.

We are unable to accept the moment-

of-death valuations given to the 1,226 shares of JPMS common stock

by any of the expert witnesses.

Instead, we rely on our own

analysis, based on all the evidence in the record.

We begin our analysis by placing a $150 million value on JPMS

at

the

moment

immediately

prior

to

Mr.

Mitchell's

death.

In

determining this value, we considered all the evidence but gave the

greatest consideration to Minnetonka's "real world" $125 million

offer in the fall of 1988 (which Mr. DeJoria found "a little

short") and Mr. DeJoria's representation to Mr. Taylor that he had

received from Gillette a $150 million offer plus a royalty of 2

percent of sales for a lifetime (which Mr. Taylor found to be an

offer he could not match).

We next consider the impact of Mr. Mitchell's death on JPMS.

Mr. Mitchell embodied JPMS to distributors, hair stylists, and

salon owners. He was vitally important to its product development,

marketing, and training.

Moreover, he possessed a unique vision

that enabled him to foresee fashion trends in the hair styling

industry.

It is clear that the loss of Mr. Mitchell, along with

the structural inadequacies of JPMS, created uncertainties as to

the future of JPMS at the moment of death.

- 49 In particular, a hypothetical buyer or seller would have to

consider the following factors in valuing the 1,226 shares of JPMS

common stock at the moment of Mr. Mitchell's death:

(1) Whether it

would be necessary to increase JPMS' advertising and marketing

expenses;24

(2)

whether

litigation

concerning

Mr.

DeJoria's

compensation would ensue; (3) whether the lack of a ready or

available market for the stock would affect its fair market value;

(4) whether and how JPMS would continue its history of successful

product development and styling leadership; (5) whether rumors

concerning

JPMS

"going

retail"

would

adversely

affect

its

relationships with salons; (6) whether JPMS' history of unreliable

suppliers

would

continue;

(7)

whether

JPMS

would

solve

its

inventory control and financial information reporting problems; and

(8) whether JPMS' thin management and total reliance on Mr. DeJoria

would hinder its performance.

Nonetheless, Mr. DeJoria stepped in to single-handedly run

JPMS upon Mr. Mitchell's death.

JPMS' marketing.

Mr. DeJoria had always overseen

Indeed, despite his reputation for creativity,

Mr. Mitchell had not succeeded in marketing his product line in the

late 1970's.

Although there is no doubt that Mr. Mitchell's fame

was an important component in launching JPMS in the early 1980's,

24

William E. Peplow, vice president of salon relations

for Redken, wrote a report and testified on petitioner's behalf.

He foresaw that JPMS would have to increase its advertising

budget to sustain sales after Mr. Mitchell's death.

- 50 Mr. DeJoria's salesmanship, marketing savvy, and construction of

the distribution network were also vitally important.

In addition, Mr. Taylor, whom we found extremely credible,

testified that Mr. Mitchell was not as essential to Minnetonka's

interest in JPMS as Mr. DeJoria.

Mr. Taylor also observed that the

deaths of fashion designers Perry Ellis and Anne Klein did not

affect their ongoing businesses to any significant degree "because

the consumer somehow is so far removed from the actual * * *

involvement of that designer * * * they're still buying the

product."

In our opinion, the $150 million value for JPMS at the moment

immediately prior to Mr. Mitchell's death should be discounted by

10 percent to reflect the loss of Mr. Mitchell to JPMS.

Thus, we

believe that at the moment of Mr. Mitchell's death, JPMS had a

value of $135 million.

We

further

believe:

appropriate,

reflecting

marketability

and

discount,

(1)

minority

reflecting

the

A

total

combined

35-percent

discounts

interest;

and

(2)

possibility

of

a

DeJoria's compensation, should be applied.

discount

for

a

lack

$1.5

lawsuit

is

of

million

over

Mr.

Taking these factors

into consideration, we find, and thus hold, that the value of

- 51 decedent's interest was $41,532,60025 as of the moment of his death.

Issue 2.

Section 6662(g) Penalty

The final issue is whether petitioner is liable for the

section

6662(g)

penalty.

A

substantial

estate

tax

valuation

understatement occurs if the value of property claimed on a return

is 50 percent or less of the amount determined to be its correct

value, and the portion of the underpayment attributable to the

understatement exceeds $5,000.

Sec. 6662(g).

The penalty equals

20 percent of the portion of the underpayment attributable to the

understatement.

25

Sec. 6662(a).

The penalty does not apply to any

This amount is calculated as follows:

Value of JPMS at the moment immediately

prior to Mr. Mitchell's death

$150,000,000

Less: Discount to reflect the loss of

Mr. Mitchell to JPMS

(15,000,000)

Value of JPMS at the moment of Mr.

Mitchell's death

135,000,000

Percent of Trust's interest in JPMS

x

Value of Trust's interest in JPMS prior

to discounts

66,204,000

Discount for lack of marketability and

minority interest (35%)

(23,171,400)

49.04

43,032,600

Discount for possibility of lawsuit

(1,500,000)

Value of Trust's interest in JPMS after

discounts

41,532,600

- 52 portion of the underpayment for which the taxpayer shows that he or

she: (1) Had reasonable cause, and (2) acted in good faith with

respect thereto.

Sec. 6664(c); see also United States v. Boyle,

469 U.S. 241, 242 (1985).

Whether a taxpayer had reasonable cause

and acted with good faith is a factual determination. Sec. 1.66644(b), Income Tax Regs.

The

parties

agree

that

the

section

6662(g)

penalty

is

inapplicable unless the Court decides that the moment-of-death

value of the 1,226 shares of JPMS common stock was $57 million or

more.26

On the basis of our determination that the fair market

value of the 1,226 shares of JPMS stock as of April 21, 1989, was

$41,532,600, the section 6662(g) penalty does not apply.

In light of the foregoing, and to reflect concessions and

settled issues,

Decision will be

entered under Rule 155.

26

The Federal estate tax return valued the stock at $28.5

million. For sec. 6662(g) to apply, the value reported on the

return must not be more than 50 percent of the correct value.