T.C. Memo. 2014-26
UNITED STATES TAX COURT
ESTATE OF HELEN P. RICHMOND, DECEASED, AMANDA ZERBEY,
EXECUTRIX, Petitioner v. COMMISSIONER OF INTERNAL REVENUE,
Respondent
Docket No. 21448-09. Filed February 11, 2014.
At the time of her death, D owned a 23.44% interest in a
family-owned personal holding company (“PHC”), whose assets
consisted primarily of publicly traded stock. D’s estate tax return
reported the fair market value of D’s interest in PHC as $3,149,767,
using a capitalization-of-dividends method to value the asset. R used
instead a net asset value (“NAV”) method and determined a
deficiency in D’s estate tax as well as an accuracy-related penalty
under I.R.C. sec. 6662.
Held: The fair market value of D’s 23.44% interest in PHC is
better determined by an NAV method and is $6,503,804.
Held, further, P is liable for a 20% accuracy-related penalty
under I.R.C. sec. 6662(a), (b)(5), and (g).
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[*2] Peter Samuel Gordon and John W. Porter, for petitioner.
Warren P. Simonsen, for respondent.
CONTENTS
FINDINGS OF FACT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Pearson Holding Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
PHC’s maximizing of dividends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
PHC’s BICG tax liability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
PHC stock transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Ms. Richmond’s ownership and bequest of PHC stock. . . . . . . . . . . . . . . . . 9
Financial information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
The estate tax return. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
The notice of deficiency and the petition. . . . . . . . . . . . . . . . . . . . . . . . . . . 14
The Commissioner’s expert. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
The estate’s expert.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Ultimate findings.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
OPINION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
I. Introduction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
II. General principles of estate tax valuation. . . . . . . . . . . . . . . . . . . . . 20
III. Choice of valuation method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
IV. The value of the decedent’s interest in PHC. . . . . . . . . . . . . . . . . . . 27
A. Discount for BICG liability. . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1. Notice of deficiency: a zero discount. . . . . . . . . . . . . . 28
2. The estate’s expert: 100% of the BICG tax. . . . . . . . . 29
3. The Commissioner’s expert:
43% of the BICG tax. . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4. Our conclusion:
present value of the BICG tax liability. . . . . . . . . . . . . 35
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[*3] B. Discount for lack of control. . . . . . . . . . . . . . . . . . . . . . . . . . . 39
C. Discount for lack of marketability. . . . . . . . . . . . . . . . . . . . . . 42
D. Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
V. Accuracy-related penalty. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
MEMORANDUM FINDINGS OF FACT AND OPINION
GUSTAFSON, Judge: By a statutory notice of deficiency dated June 12,
2009, the Internal Revenue Service (“IRS”) determined a deficiency of $2,854,729
in Federal estate tax due from the Estate of Helen P. Richmond. The IRS also
determined an accuracy-related penalty of $1,141,892 due under section 6662.1
The estate commenced this suit by filing its petition to challenge those
determinations. The issues for decision are:
(1) whether the 23.44% interest (consisting of 548 shares) in Pearson
Holding Co. (“PHC”) that was included in the value of the gross estate for
purposes of Federal estate tax had a fair market value of $5,046,500 (as the estate
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code (26 U.S.C.) in effect at the date of the decedent’s death, and all
Rule references are to the Tax Court Rules of Practice and Procedure. Numerical
amounts appearing in this opinion are sometimes rounded.
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[*4] now asserts) or any other amount less than the $7,330,000 that the
Commissioner now asserts (we find it had a value of $6,503,804);2 and
(2) whether there is an underpayment of estate tax attributable to a
substantial estate tax valuation understatement for purposes of the 20% accuracy-
related penalty imposed by section 6662(a), (b)(5), and (g),3 and, if so, whether
any portion of the underpayment was attributable to “reasonable cause” under
section 6664(c) (we find a substantial valuation understatement for which there
was no reasonable cause).
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. At the time of her
death, Ms. Richmond resided in Pennsylvania. At the time the petition was filed,
2
The IRS’s notice of deficiency determined that the asset at issue had a fair
market value not of $3,149,767 as the estate had reported on its return but rather
$9,223,658--i.e., an increase of $6,073,891. The Commissioner now contends it
had a value of $7,330,000 (i.e., about 20% less than on the notice of deficiency,
and a concession of about 31% of the original increase). The estate tax return
reported a value of $3,149,767, but the estate now contends it had a value of
$5,046,500 (i.e., about 60% more than on the return).
3
In the notice of deficiency, the IRS calculated the amount of the penalty
using the 40% rate that generally applies to gross valuation misstatements. See
sec. 6662(h). On brief, however, the Commissioner concedes that the 40% gross
valuation misstatement penalty does not apply; and he asserts instead that the
underpayment is attributable to a substantial valuation understatement under
section 6662(b)(5) and (g), thus incurring a 20% penalty.
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[*5] the two co-executors of the estate resided in Pennsylvania (where the will was
probated) and New Jersey.4
Pearson Holding Company
PHC was incorporated in Delaware in January 1928. It originated as and
continues to be a family-owned investment holding company. PHC is a
subchapter C corporation. Its business purpose as stated in its certificate of
incorporation is “to guarantee, purchase, hold, sell, assign, transfer, mortgage,
pledge or otherwise dispose of shares of capital stock, or any bonds, securities or
other evidence of indebtedness created by anyone in the corporation or
corporations organized under the law of the state of government”. PHC’s
approach, as described by its current chairman and president, is “to preserve
4
Under section 7482(b)(1)(A) this case would be reviewed on appeal by “the
United States court of appeals for the circuit in which is located * * * the legal
residence of the petitioner”. To the extent the estate “reside[s]” where its co-
executors reside or where the will was probated, this case would be reviewed on
appeal by the Court of Appeals for the Third Circuit. Neither party has suggested
any reason that appeal might lie in the Court of Appeals for the Fifth Circuit or the
Court of Appeals for the Eleventh Circuit, both of which, see Estate of Jelke v.
Commissioner, 507 F.3d 1317 (11th Cir. 2010), vacating and remanding T.C.
Memo. 2005-131; Estate of Dunn v. Commissioner, 301 F.3d 339, 353 (5th Cir.
2002), rev’g and remanding T.C. Memo. 2000-12, have held that a holding
company’s net asset value should be discounted by 100% of the built-in capital
gains tax for which the holding company would eventually be liable. See
part IV.A.2 below.
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[*6] capital, to grow capital where possible, and to maximize dividend income for
the family shareholders”.
As of December 2005 PHC had 2,338 shares of common stock outstanding.
Those shares were held by 25 members whose interests ranged from 0.17% to
23.61%. The three largest shareholders (which included the decedent) owned a
total of 59.20% of the shares.
PHC’s maximizing of dividends
Through the date of the decedent’s death, PHC followed its stated
philosophy of maximizing dividend income. As a holding company subject to tax
on undistributed income, see sec. 541, PHC has a strong incentive to pay out most
of the dividend income generated by the securities held in its portfolio, and the
ultimate objective of the company was to provide a steady stream of income to the
descendants of Frederick Pearson while minimizing taxes and preserving capital.
PHC has paid dividends reliably at a rate that, in the years from 1970 through
2005, had grown slightly more than 5% per year. In the seven years preceding the
decedent’s death, PHC paid out dividend distributions as follows:
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[*7]
Year Dividend distribution Decedent’s share
2005 $1,077,000 $252,436
2004 1,047,658 245,559
2003 1,016,469 238,248
2002 947,030 221,973
2001 922,575 216,241
2000 1,185,974 277,979
1999 835,578 195,850
The turnover of PHC’s securities has been slow--for the period from 2000 to
2005, 1.1% per year; and for the 10-year period ending December 31, 2005, 1.4%
per year. At that 1.4% rate, a complete turnover of the securities would take 70
years.
However, in 2005 a potential investor would have observed that, with the
passing decades, the ownership of PHC stock had become more diffuse--and
would continue to become more diffuse--among heirs and legatees with less and
less identification with Frederick Pearson and his philosophy and goals, and with
less and less knowledge of and affinity for one another. The mindset of the
shareholders as owning a family company would more and more give way to an
attitude that regards the PHC shares simply as an investment, and the company
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[*8] would be increasingly likely to follow the financial advice of diversifying its
holdings. We find that, as the Commissioner’s expert witness testified, a potential
investor who considered purchasing PHC would likely expect that approximately
20-30 years would pass before a complete turnover of the portfolio or a liquidation
of the company would occur.
PHC’s BICG tax liability
When securities or any other assets appreciate in value, the owner becomes
liable for tax--but only upon the occurrence of an income tax recognition event,
such as the sale of the assets. A holding company that owns securities that both
produce dividends and appreciate may prefer to hold the securities, rather than sell
them, because it can thereby defer payment of the tax and accrue dividends from a
larger portfolio, undiminished by payment of tax liabilities. This has been PHC’s
approach. As a result, the value of its portfolio has grown to consist more and
more of untaxed appreciation. As of December 2005, 87.5% of the value of
PHC’s portfolio consisted of appreciation on which capital gain tax had not yet
been paid but would eventually become due upon sale of the appreciated
securities. (This deferred liability that inheres in appreciated assets is referred to
as “built-in capital gain tax” (“BICG tax”).)
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[*9] From time to time, Wilmington Trust Co., as PHC’s financial adviser, has
suggested that PHC sell substantial amounts of its securities in order to diversify
its portfolio. However, PHC never acted on this advice because of the large BICG
tax attributable to the appreciation of its securities. PHC has preferred not to incur
that tax liability, the payment of which would diminish its total assets and
therefore its ability to generate dividends.
PHC stock transactions
From 1971 through 1993, there were nine transactions involving the sale or
redemption of PHC stock by a shareholder. It appears that the value of the stock
for those transactions was determined using the dividend model. In addition,
when another shareholder died in 1999, the estate used the dividend model to
value his interest in PHC.
Ms. Richmond’s ownership and bequest of PHC stock
As of December 2005, Helen P. Richmond owned 548 shares in PHC. She
was PHC’s second largest shareholder, holding a 23.44% interest. As the owner
of less than a majority of PHC’s stock, Ms. Richmond could not unilaterally
change the management or investment philosophy of the company; nor could she
unilaterally gain access to the corporate books, increase distributions from the
company, or cause the company to redeem its stock. She could not force PHC to
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[*10] make an S election or to diversify its holdings. She had no rights to “put”
her stock to the company (i.e., to force it to buy her shares), and the company
could not “call” her stock (i.e., could not demand to buy it).
On February 10, 2004, Ms. Richmond executed a codicil to her will that
named John W. Lyle and Amanda Zerbey as co-executors of her estate. Mr. Lyle
graduated in the 1950s from LaSalle University in Philadelphia and was a certified
public accountant (C.P.A.) in the State of Delaware. Mr. Lyle served as an
accountant for PHC from 1970 until 2008. Before working at PHC, Mr. Lyle had
been employed as an accountant at Haskin & Sells in their Philadelphia office.
Ms. Zerbey attended business school at the Keystone School of Business from
1977 to 1978. Ms. Zerbey has been employed as an Internet operations quality
control manager at Eastwood Co. in Pottstown, Pennsylvania, since 1993. Before
her position at Eastwood Co., Ms. Zerbey was employed from 1973 to 1993 in
Malvern, Pennsylvania, as a buyer for Cottage Craft, where she met
Ms. Richmond.
Ms. Richmond died on December 10, 2005. The parties stipulate that on
that date she still owned her PHC stock, so it is not disputed that the value of that
stock is included in her taxable estate.
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[*11] Financial information
The parties have stipulated that, as of December 10, 2005, PHC held a
portfolio with a value of $52,159,430, as follows:
Asset Fair market value
Government bonds and notes $976,939
Preferred stocks 188,449
Common stocks1 50,690,504
Cash and equivalents 294,161
Receivables 8,868
Security deposit 509
Total 52,159,430
1
PHC’s common stocks were invested in 10 major industries with 42.8% of
the stock concentrated in four companies: Exxon Mobil (15.7%), Merck & Co.,
Inc. (11%), General Electric Co. (8.1%), and Pfizer, Inc. (8%).
As is noted above, approximately 87.5% of the $52,159,430 of PHC’s total
assets--i.e., $45,576,677--consists of unrealized appreciation. The parties agree
that the capital gain tax liability “built in” to that appreciation (but not yet due)
was $18,113,083.
As of the date of the decedent’s death, PHC had outstanding liabilities
(apart from any BICG tax liability) of $45,389. Accordingly, PHC had a net asset
value (“NAV”) of $52,114,041 (i.e., $52,159,430 in total assets less $45,389 in
liabilities).
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[*12] The estate tax return
On September 20, 2006, the co-executors of the decedent’s estate, Amanda
Zerbey and John W. Lyle,5 filed a Form 706, “United States Estate (and
Generation-Skipping Transfer) Tax Return”. Before doing so, the estate retained a
law firm to prepare the estate tax return and retained the certified public
accounting firm of Belfint, Lyons & Shuman, P.A. (“Belfint”), to value the PHC
stock for purposes of the estate tax return. The accountant who did the valuation
was Peter Winnington.
Mr. Winnington graduated with a bachelor of science degree in accounting
from the University of Delaware in 1971, and he received his master of science
degree in taxation from Widener University in 1983. Mr. Winnington has been
employed as an accountant with Belfint since October 1986, and he currently
chairs the firm’s corporate service department and sits on the firm’s executive
committee. Mr. Winnington has experience in public accounting involving audits,
management advisory, litigation support and tax planning, and preparation
services. Mr. Winnington became a C.P.A. in the State of Delaware in 1975 and a
certified financial planner in 1988, and is a member of the American Institute of
5
Ms. Zerbey is the surviving executrix of the decedent’s estate as Mr. Lyle
died on January 8, 2010.
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[*13] Certified Public Accountants (AICPA), the Delaware Society of Certified
Public Accountants (DSCPA), and the Wilmington Tax Group. Mr. Winnington
has appraisal experience (i.e., having written 10-20 valuation reports and having
testified in court), but he does not have any appraiser certifications.
The co-executors provided to Mr. Winnington information about stock
transactions in the 1990s, as well as some valuations for prior estates that included
PHC stock, which Mr. Winnington used to value the decedent’s interest in PHC.
Using this information, together with additional information already in Belfint’s
possession (i.e., audit reports, corporate tax returns, and investment reports of
PHC, as well as knowledge of the history of the company and the pattern for its
shareholders to hold their stock long term), Mr. Winnington prepared a draft
report that valued the decedent’s interest in PHC at $3,149,767, using a
capitalization-of-dividends method. He provided the unsigned draft of the
valuation report to the executors and to the return preparer, and he was never
asked to finalize his report. Without further consultation with Mr. Winnington,
the estate reported the value of Ms. Richmond’s interest in PHC as $3,149,767 on
the Federal estate tax return filed with the IRS.
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[*14] The notice of deficiency and the petition
On June 12, 2009, the IRS issued a statutory notice of deficiency to the
estate, determining an upward valuation of the decedent’s interest in PHC to
$9,223,658.6 This adjustment increased the estate tax liability by $2,854,729. In
addition, the notice of deficiency determined a 40% gross valuation misstatement
penalty of $1,141,892 pursuant to section 6662(h). The notice of deficiency made
no other adjustments to the gross estate besides the valuation of the decedent’s
interest in PHC.
The estate timely filed a petition with this Court, seeking a redetermination
of the deficiency and the penalty determined in the notice of deficiency.
The Commissioner’s expert
At trial the Commissioner offered John A. Thomson as an expert in business
valuation. The Court accepted Mr. Thomson as a business valuation expert and
received his written report into evidence as his direct testimony. Mr. Thomson
valued the decedent’s interest in PHC by the cost approach, using a discounted net
asset method. Using PHC’s stipulated NAV of $52,114,041, Mr. Thomson
6
The notice of deficiency does not specify what valuation method the IRS
auditor used to value the decedent’s interest in PHC and does not explain to what
extent, if any, his method allowed discounts (for tax attributable to built-in gain,
for lack of control, or for lack of marketability).
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[*15] calculated the decedent’s 23.44% interest of PHC’s NAV to be $12,214,9257
(i.e., 23.44% of the total NAV). He then applied a discount of 6% to adjust for the
fact that the decedent held only a minority interest, and he applied a discount of
36% to adjust both for the lack of marketability of non-publicly traded shares and
for the BICG tax.8 Overall, Mr. Thomson applied a 40% discount,9 resulting in the
value of the decedent’s 23.44% interest in PHC being reduced to $7,330,000.10
7
Although the Court independently calculates the decedent’s 23.44%
interest to be $12,215,531 (i.e., $52,114,041 times 0.2344) instead of $12,214,925,
we ignore this difference as de minimis.
8
Of Mr. Thomson’s 36% “marketability” discount, 15% was a discount for
BICG tax. In his report prepared before trial, Mr. Thomson’s discount for lack of
marketability (including BICG tax) was set at 35%, but at trial he increased it to
36%.
9
Mr. Thomson’s overall discount can be expressed by this equation:
discount for lack of control + [(1 - discount for lack of control) x (discount for
lack of marketability)] = 0.06 + [(1-0.06) x (0.36)] = 0.3984, or 40%.
10
The Commissioner’s expert report asserts a value of $7,451,104, rounded
to $7,450,000. However, the adjustment in the lack of marketability discount
made at trial (i.e., increasing it from 35% to 36%) reduced the Commissioner’s
asserted value of the decedent’s 23.44% interest in PHC to $7,330,000.
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[*16] The estate’s expert
The estate offered Robert Schweihs as an expert in valuation.11 The Court
accepted him as an expert in business valuation and received his written report
into evidence as his direct testimony. Mr. Schweihs valued the decedent’s interest
in PHC by relying primarily on the capitalization-of-dividends method, an income
approach.12 In so doing, Mr. Schweihs used a dividend growth model, which
computes a principal value (“PV”) as follows:
PV = E0 (1 + g) / [k - g]
where:
E0 = Expected amount of economic income in the period
immediately past
k = Discount rate (or required rate of return)
g = Expected growth rate of earnings, annually compounded
into perpetuity
11
In addition to calling Mr. Schweihs as an expert witness, the estate also
called as a fact witness Mr. Winnington, the accountant who prepared PHC’s
valuation report for the estate tax return. Although Mr. Winnington gave factual
testimony about his valuation report, which formed the basis for the value reported
on the estate tax return, the estate did not proffer Mr. Winnington as a valuation
expert and instead requests that we adopt Mr. Schweihs’s appraised value.
12
The Commissioner does not dispute that the capitalization-of-dividends
method can sometimes be used to value stock, and does not dispute
Mr. Schweihs’s equation, but does dispute both the appropriateness of using that
method in this instance and the appropriateness of some of the values
Mr. Schweihs used. See part III below.
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[*17] Using a discount rate (k) of 10.25%, a long-term growth rate (g) of 5%, and
the decedent’s share of PHC’s dividends in 2005, see p. 6 above, as the E0,
Mr. Schweihs valued the decedent’s interest in PHC as of December 10, 2005, to
be $5,046,500, as follows:
PV = $252,436 (1 + 0.05) / [0.1025 -0.05]
= $265,058 / .0525
= $5,048,72413
Therefore, notwithstanding the estate’s starting valuation of $3,149,767 (as
reported on the estate tax return) and the Commissioner’s starting valuation of
$9,223,658 (as determined in the notice of deficiency)--with a difference of more
than $6 million--by the time of trial, the difference in valuations had narrowed
considerably: The decedent’s interest in PHC was worth $5,046,500 according to
the estate and $7,330,000 according to the Commissioner--a difference of not
quite $2.3 million.
As an alternative to his capitalization-of-dividends valuation, Mr. Schweihs
also valued the decedent’s interest in PHC using the net asset valuation method
(i.e., proposing corrections to Mr. Thomson’s net asset valuation) and reached a
13
We are unable to reconcile Mr. Schweihs’s value of $5,046,500 with the
calculation above of $5,048,724. We assume that the discrepancy is due at least in
part to rounding, and we do not consider it to be material.
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[*18] value of only $4,721,962. Starting with the same NAV as the
Commissioner’s expert--$52,114,041--Mr. Schweihs reduced PHC’s NAV by
$18,113,083--i.e., 100% of PHC’s BICG tax (rather than the BICG discount of
$7,817,106--i.e., 15% of $52,114,041--that Mr. Thomson allowed). Mr. Schweihs
then applied an 8% discount for lack of control (as compared to Mr. Thomson’s
6%), as well as a 35.6% discount for lack of marketability (as compared to
Mr. Thomson’s 21%). This method valued PHC’s net assets, after these discounts
and the dollar-for-dollar reduction for BICG tax, at $20,144,888. The decedent’s
23.44% interest was therefore valued by the estate’s expert at $4,721,962 using the
net asset value method.
Ultimate findings
We find that, in order to account for the capital gain tax liability built in to
its assets, PHC’s net asset value of $52,114,041 should be discounted by
$7,817,106 (i.e., the Commissioner’s concession of 15% of PHC’s NAV) to
$44,296,935. We further find that the decedent’s 23.44% interest therein (i.e.,
$10,383,202) should be further discounted by 7.75% for lack of control and by
32.1% for lack of marketability, so that the decedent’s interest in PHC had a fair
market value of $6,503,804 at the decedent’s date of death.
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[*19] OPINION
I. Introduction
We must determine the fair market value of the decedent’s interest in PHC
as of the date of her death. The value of the decedent’s interest was included in
the value of her gross estate and was reported on the estate tax return at
$3,149,767. Relying on Mr. Schweihs’ testimony, the estate now concedes a
higher amount and argues that the correct fair market value is $5,046,500 (almost
$2 million more).
In his notice of deficiency, the Commissioner valued the decedent’s interest
in PHC at $9,223,658. Relying on Mr. Thomson’s expert testimony, the
Commissioner now argues that the fair market value is $7,330,000 (almost
$2 million less), which we regard as a partial concession. See Estate of Hinz v.
Commissioner, T.C. Memo. 2000-6 (finding that the Commissioner conceded his
valuation position as determined in the notice of deficiency by arguing for a lower
fair market value on brief).
In general, the IRS’s notice of deficiency is presumed correct, “and the
petitioner has the burden of proving it to be wrong”, Welch v. Helvering, 290 U.S.
111, 115 (1933); see also Rule 142(a); Crispin v. Commissioner, 708 F.3d 507,
514 (3d Cir. 2013), aff’g T.C. Memo. 2012-70; but in this case the estate argues
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[*20] that the burden of proof has shifted. However, both sides put on expert
testimony as to the value of the property at issue, and we are able to decide that
value on the preponderance of the evidence. We therefore need not address the
allocation of the burden of proof with respect to the valuation issue.
II. General principles of estate tax valuation
Section 2001(a) imposes a tax on “the transfer of” a decedent’s taxable
estate, and section 2001(b) provides that the tax is imposed on “the amount of the
taxable estate”. The value of the gross estate includes the value “at the time of his
death of all [the decedent’s] property, real or personal, tangible or intangible,
wherever situated.” Sec. 2031(a); United States v. Cartwright, 411 U.S. 546, 550-
551 (1973). For this purpose, “value” means “fair market value”, which is defined
as “the price at which the property would change hands between a willing buyer
and a willing seller, neither being under any compulsion to buy or to sell and both
having reasonable knowledge of relevant facts.” 26 C.F.R. sec. 20.2031-1(b),
Estate Tax Regs.
Valuation is ultimately a question of fact. Estate of Newhouse v.
Commissioner, 94 T.C. 193, 217 (1990). If the property to be valued is stock of a
closely held corporation, “actual arm’s-length sales of such stock in the normal
course of business within a reasonable time before or after the valuation date are
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[*21] the best criteria of market value.” Estate of Andrews v. Commissioner, 79
T.C. 938, 940 (1982); see also 26 C.F.R. sec. 20.2031-2(a) through (c). If it is not
possible to value the stock by such sales, “then the fair market value is to be
determined by taking * * * into consideration * * * the company’s net worth,
prospective earning power and dividend-paying capacity, and other relevant
factors”; and “the weight to be accorded such * * * evidentiary factors * * *
depends upon the facts of each case.” Id. para. (f)(2). “[I]n general, an
asset-based method of valuation applies in the case of corporations that are
essentially holding corporations, while an earnings-based method applies for
corporations that are going concerns.” Estate of Smith v. Commissioner, T.C.
Memo. 1999-368; see also Rev. Rul. 59-60, sec. 5(a), 1959-1 C.B. 237, 242. The
parties disagree about whether that generality is correct in this case.
The parties rely principally on expert testimony to establish the fair market
value of the decedent’s interest in PHC. Courts routinely consider expert
witnesses’ opinions in deciding such issues; however, we are not bound by the
opinion of any expert witness and may accept or reject such testimony in the
exercise of our sound judgment. Helvering v. Nat’l Grocery Co., 304 U.S. 282,
295 (1938); Estate of Newhouse v. Commissioner, 94 T.C. at 217. Although we
may accept an expert’s opinion in its entirety, we may instead select what portions
-22-
[*22] of the opinion, if any, to accept. Parker v. Commissioner, 86 T.C. 547, 562
(1986); Buffalo Tool & Die Mfg. Co. v. Commissioner, 74 T.C. 441, 452 (1980).
Because valuation involves an approximation, “the figure at which we arrive need
not be directly traceable to specific testimony if it is within the range of values that
may be properly derived from consideration of all the evidence.” Estate of Heck
v. Commissioner, T.C. Memo. 2002-34.
The parties disagree over: (1) the appropriate valuation method to be used--
either the capitalization-of-dividends approach or the NAV approach--and (2) the
appropriate discounts if the NAV approach is used. We now address those issues.
III. Choice of valuation method
To value the decedent’s interest in PHC, the Commissioner used the net-
asset-value approach and the estate used the capitalization-of-dividends approach.
We believe that the NAV approach better determines PHC’s value.
The theory behind the income capitalization valuation method is that if an
asset produces a predictable income stream, the market value of the asset can be
ascertained by calculating the present value of that future income stream. PHC did
have a history of reliably paying out dividends, and over the preceding 35 years its
distributions had increased by about 5% per year. Predictable annual dividend
payments were PHC’s stated goal (and would presumably be the subjective
-23-
[*23] primary investment goal of someone purchasing a minority interest in PHC),
so the estate used this method. The estate’s expert assumed that that 5% annual
increase in dividend payments would continue indefinitely. He determined that
the market rate of return for a company with a comparable risk profile was 10.27%
(rounded to 10.25%), and he assumed that PHC would realize that rate of return
indefinitely. The estate’s expert calculated the capitalization rate of 5.25% by
subtracting the 5% annual dividend growth rate from the 10.25% market rate of
return for a comparable risk investment. The estate’s expert then divided the
decedent’s expected dividend return for the following year (i.e., $265,000
($252,400 x 1.05)) by the capitalization rate (i.e., 5.25%), to calculate, for those
future dividends, a present value of $5,046,500.
Dividend capitalization is one method for valuing a business; and this
method may be entirely appropriate where a company’s assets are difficult to
value. For example, a company that does not hold a portfolio of publicly traded
securities but instead operates a business may have assets--i.e., a conglomeration
of tangible assets acquired and depreciated over a period of years and intangible
assets (customer lists, assembled work force, know-how, etc.)--that are difficult to
value. The business may seem to be more than the sum of its parts. In such a
-24-
[*24] case, the value of the business may be better determined by projecting its
income stream (and discounting it to present value).
However, by definition, the capitalization-of-dividends valuation method is
based entirely on estimates about the future--the future of the general economy,
the future performance of PHC, and the future dividend payouts by PHC--and
even small variations in those estimates can have substantial effects on the value
determined.14 The estate’s valuation method therefore ignores the most concrete
and reliable data of value that are available--i.e., the actual market prices of the
publicly traded securities that constituted PHC’s portfolio. Of course, the net-
asset-value method comes with its own difficulties and uncertainties (in this case,
determining the amounts of the discounts discussed below), but the NAV method
does begin by standing on firm ground--stock values that one can simply look up.
14
In Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a
Business: The Analysis and Appraisal 210 (4th ed. 2000), Mr. Schweihs and his
colleagues state that the dividend capitalization approach to value is sensitive to
the “constant annual income stream in perpetuity or a constant annualized rate of
growth (or decline) in the economic income variable being capitalized in
perpetuity. Obviously, this constant growth rate projection is rarely met in the real
world.” They observe, id. at 208, that the Gordon growth model is extremely
sensitive to growth rate assumptions and that “[c]hanges in the growth rate
projected, sometimes seemingly small, can result in striking changes.” In the
example given in the estate’s expert’s book, a 1% change in assumed growth rate
can result in more than an 11% change in the indicated value.
-25-
[*25] Moreover, the estate’s valuation method assumes that the only thing a
potential investor will consider when contemplating whether to buy PHC stock is
the present value of the dividend stream that the stockholder can expect to receive.
However, in December 2005 a potential investor would have known that--as the
parties have stipulated--PHC’s portfolio consisted primarily of securities whose
values could have been computed without controversy to total $52 million, i.e.,
PHC’s net asset value (before discounts) with which the Commissioner’s method
begins. Where the assets themselves are thus easily valued, valuing the holding
company instead by the income approach would essentially overlook that fact,
surely a relevant and helpful fact, which we think an investor was not likely to
overlook but was instead likely to take as his starting point.
In addition, the Commissioner criticized the estate’s use of a 10.25%
expected rate of return, because the Ibbotson’s study from which he derived that
rate used a period (i.e., 1926-2004) that was different from the period
Mr. Schweihs had used to calculate PHC’s dividend growth rate (i.e., 1970-2004),
and we believe the criticism is valid. To correct for this discrepancy, the Court
independently calculated the actual rate of return (i.e., asset growth plus dividends
paid) for PHC using PHC’s historic data and found the compound annual growth
rate to be not 10.25% but rather only 9.414%. We believe that in December 2005
-26-
[*26] a potential investor in PHC would have considered the post-1970 data most
relevant and would have expected this rate of return, not the 10.25% rate of return
assumed by the estate. When we correct the estate’s calculation by using an
expected rate of return of 9.414% and keeping the annual dividend growth rate
constant at 5%, the present value of future dividends is about $1 million higher--
i.e., $6,005,000 (rounded)15--than as calculated by the estate. This confirms the
sensitivity inherent in using the capitalization-of-dividends valuation method,
which in our opinion makes it less reliable.
For such reasons, courts are overwhelmingly inclined to use the NAV
method for holding companies whose assets are marketable securities. See, e.g.,
Estate of Litchfield v. Commissioner, T.C. Memo. 2009-21 (“With respect to stock
in closely held real estate holding companies and investment companies such as
LRC and LSC, the net asset valuation method is often accepted as the preferred
method. Estate of Smith v. Commissioner, T.C. Memo. 1999-368; Estate of Ford
v. Commissioner, T.C. Memo. 1993-580, affd. 53 F.3d 924 (8th Cir. 1995); Rev.
Rul. 59-60 at sec. 5(b), 1959-1 C.B. 243”).
15
We note that the value of the decedent’s interest in PHC calculated using
the net asset value method ($6,354,519), as discussed below, is relatively close to
the value of the decedent’s interest in PHC using the capitalization-of-dividends
method ($6,005,000), using the rate of return as corrected by the Court.
-27-
[*27] The estate cites three cases to support its income capitalization valuation of
holding companies--Kohler v. Commissioner, T.C. Memo. 2006-152; Barnes v.
Commissioner, T.C. Memo. 1998-413; and Estate of Campbell v. Commissioner,
T.C. Memo. 1991-615--but those cases are clearly distinguishable from the instant
case. In each of those cases, the company to be valued held stock in a closely held
operating company (not publicly traded stock) or was itself an operating company.
As a result, the underlying assets of those companies were difficult to value.
PHC’s primary assets, on the other hand, are marketable securities, which
have ascertainable market values. Moreover, those market values inherently
reflect the market’s judgment as to the projected income streams of each stock and
therefore reflect the future income stream of PHC. For that reason, a properly
discounted net asset valuation of PHC indirectly takes into account the expected
dividend stream that underlies the estate’s valuation method. We therefore follow
this Court’s consistent precedent of using net asset valuations for companies with
holdings like PHC.
IV. The value of the decedent’s interest in PHC
The parties agree on the $52 million net asset value of PHC in
December 2005; and although the estate does not agree that the NAV method is
the more appropriate method, both parties agree in principle that, if the NAV
-28-
[*28] method is used, there must be discounts from that $52 million net asset
value to account for (a) the BICG tax for which PHC would eventually be liable,
(b) the lack of marketability of PHC’s non-publicly traded shares, and (c) the lack
of control inherent in the decedent’s 23.44% interest in PHC.
A. Discount for BICG liability
The parties agree that PHC’s unrealized appreciation on its assets was
$45,576,677, which if the assets had been sold on the date of death would have
given rise to a capital gain tax liability of $18,113,083, assuming a 39.74%
combined Federal and State tax rate. The parties further agree that the value of
PHC should be discounted to some extent to account for the BICG tax attributable
to that unrealized appreciation. However, the quantum of that discount is in
dispute.
1. Notice of deficiency: a zero discount
The IRS’s notice of deficiency seems to make no discount for the BICG
tax--a position that the Commissioner does not defend, and for good reason: An
investor could have easily replicated PHC in December 2005 by contributing
$52 million to his own new holding company and then having it purchase the very
same types of securities that were in PHC’s portfolio. No investor interested in
owning such a company would have been indifferent to the fact that acquiring
-29-
[*29] PHC meant acquiring an eventual liability of $18.1 million. An investor
would therefore have insisted on paying less than $52 million to acquire PHC; if
PHC had offered no discount, an investor would simply buy the stocks and be
better off. That is, the market would have required a discount, and any fair market
valuation must reflect a discount.
2. The estate’s expert: 100% of the BICG tax
On the other end of the spectrum, the estate contends that PHC’s value
should be discounted by 100% of the $18,113,083 BICG liability. To support this
contention the estate relies on opinions by the Courts of Appeals for the Fifth and
Eleventh Circuits16 that have held that in a net asset valuation the value should be
reduced dollar for dollar by the amount of a BICG tax liability. The Court of
Appeals for the Fifth Circuit reasoned that “the starting point for the asset-based
approach in this case is the assumption that the assets are sold, the starting point
for the earnings-based approach is that the Corporation’s assets are retained--are
not sold”, so consistent with that asset-based starting point, the built-in gain would
16
See Estate of Jelke v. Commissioner, 507 F.3d 1317; Estate of Dunn v.
Commissioner, 301 F.3d at 353; Estate of Jameson v. Commissioner, 267 F.3d 366
(5th Cir. 2001) (finding that the Tax Court improperly determined only a partial
discount for capital gains tax liability inherent in a bequest of stock because the
Tax Court failed to use a truly hypothetical willing buyer), vacating and
remanding T.C. Memo. 1999-43.
-30-
[*30] give rise to a current tax liability reducing value. Estate of Dunn v.
Commissioner, 301 F.3d 339, 353 (5th Cir. 2002), rev’g and remanding T.C.
Memo. 2000-12.
However, other Courts of Appeals17 and this Court18 have not followed this
100% discount approach, and we consider it plainly wrong in a case like the
present one. The relevant inquiry is, of course, what price a willing buyer and
seller would agree to; and it is clear that they would not agree to a 100% discount.
To demonstrate this fact, PHC (with assets worth $52 million but burdened by an
$18.1 million BICG tax) can be compared to a hypothetical holding company
(“HHC”) that is identical to PHC except that HHC is burdened not by any BICG
tax but by an $18.1 million note payable that is due tomorrow. No investor would
be indifferent to this distinction and treat PHC and HHC as if they were
equivalent. The investor knows that, if he buys HHC, then tomorrow he must pay
17
Estate of Eisenberg v. Commissioner, 155 F.3d 50, 59 n.16 (2d Cir. 1998)
(“Where there is a relatively sizable number of potential buyers who can avoid or
defer the tax, the fair market value of the shares might well approach the pre-tax
market value of the real estate”), vacating and remanding T.C. Memo. 1997-483;
Estate of Welch v. Commissioner, 208 F.3d 213, 2000 WL 263309, at *6 (6th Cir.
2000) (approving “the Eisenberg method of valuation”), rev’g and remanding
without published opinion T.C. Memo. 1998-167.
18
See e.g., Estate of Davis v. Commissioner, 110 T.C. 530 (1998); Estate of
Jensen v. Commissioner, T.C. Memo. 2010-182.
-31-
[*31] off the $18.1 million note and have a portfolio not of $52 million worth of
stock but only $34 million; and in the future--beginning tomorrow--he will receive
the capital gains and the dividends generated by that smaller $34 million portfolio.
On the other hand, the investor also knows that if instead he buys PHC, then he
may defer the payment of the $18.1 million BICG tax as long as he retains the
appreciated stock; in the future--until he sells off the appreciated stock over time
and incurs the tax piecemeal over that period--he will receive the capital gains and
dividends generated by the entire $52 million portfolio. PHC is simply worth
more than HHC, because a prospective BICG tax liability is not the same as a debt
that really does immediately reduce the value of a company dollar for dollar. A
100% discount, on the other hand, illogically treats a potential liability that is
susceptible of indefinite postponement as if it were the same as an accrued liability
due immediately. We do not adopt this approach.19
19
We do not face here a circumstance in which the facts about the assets and
the market would make it inevitable that any informed buyer would expect to
liquidate the company immediately and thus immediately bear the tax liability for
the built-in gain. Even if, in such a hypothetical case, the appropriate discount
might be argued to be as much as 100% of the BICG tax, the facts in this case
show that a rational buyer might intend (as PHC did intend) to continue to hold at
least some the portfolio for a period of years, in order to benefit from the divi-
dends generated by and the further appreciation experienced by the appreciated
stock. In a case like this one, therefore, a dollar-for-dollar discount is
unwarranted.
-32-
[*32] It stands to reason that a potential buyer would be willing to pay more for a
company with a contingent liability of $18.1 million than he would pay for a
company otherwise equivalent but that had an unconditional liability of
$18.1 million payable now. Likewise, the seller of the company with the
contingent future liability would demand a higher price than the seller of a
company with the unconditional current liability. As a result, despite contrary
holdings by some courts, we find that a 100% discount would be unreasonable,
because it would not reflect the economic realities of PHC’s situation.
3. The Commissioner’s expert: 43% of the BICG tax
The Commissioner’s expert (Mr. Thomson) proposes a 15% discount for
BICG tax, which at the entity level equates to $7,817,106 (i.e., 15% of the net
asset value of $52,114,041 and 43% of the BICG tax liability of $18,113,083).20
20
We note that the Commissioner’s expert included the BICG discount as
part of the lack of marketability discount that was applied at the individual level.
We do not find that approach especially helpful in this case. As the BICG tax
liability is a liability of the entity, which affects its net asset value, we find it
appropriate to determine the BICG tax liability at the entity level. When
subsequently applying the other discounts, we apply them seriatim (as
Mr. Thompson did and as we approved in Estate of Magnin v. Commissioner,
T.C. Memo. 2001-31, 81 T.C.M. (CCH) 1126, 1141 & n.35 (2001)), rather than
simply adding the discount percentages together as a combined discount (as
Mr. Schweihs did).
-33-
[*33] For reasons we now explain, we find his method21 to be problematic, but we
find his $7.8 million bottom line--which we take as a concession by the
Commissioner--to be reasonable, for reasons different from those he advances.
To reach this $7.8 million BICG tax discount, Mr. Thomson analyzed the
correlation between unrealized appreciation (i.e., built-in gain) and NAV
discounts for closed-end funds as of December 31, 2004. He compiled data from
closed-end funds with unrealized appreciation accounting for 11% to 46% of the
total net asset value, and he was unable to find any statistical correlation between
the BICG discount that could be observed on sales and the unrealized appreciation
of the seven closed-end funds he examined. He therefore concluded that in the
case of companies with unrealized appreciation that consists of as much as 46% of
the company’s value (which he rounds up to 50%), buyers are indifferent to the
BICG tax liabilities on that appreciation when purchasing an interest in a
closed-end fund. By Mr. Thomson’s reckoning, then, a potential buyer would be
indifferent to PHC’s BICG tax to the extent it is attributable to the portion of its
21
The Commissioner characterizes Mr. Thomson’s method as “the method
that was accepted in Estate of Davis” v. Commissioner, 110 T.C. 530 (1998).
Mr. Thomson was the expert in Estate of Davis; he did use there a formula similar
to what he uses here; and in Estate of Davis the Court did ultimately adopt a
valuation close to that offered by Mr. Thomson. However, we see nothing in the
Estate of Davis Opinion to endorse the particulars of Mr. Thomson’s method.
-34-
[*34] unrealized appreciation that is equal to 50% of its $52,114,041 NAV (i.e.,
tax attributable to $26,057,021). PHC’s unrealized appreciation accounts for
$45,576,677 of its value (i.e., approximately 87.5% of the total NAV of
$52,114,041), so the remaining appreciation (i.e., the amount of unrealized
appreciation above 50% of NAV, or $45,576,677 less $26,057,021) is
$19,519,656 (i.e., approximately 37.5% of NAV).
Mr. Thomson concluded that “a dollar-for-dollar discount over 50% of the
tax exposure” was appropriate. This seems to mean that Mr. Thomson allowed a
dollar-for-dollar discount for the tax attributable to the appreciation over 50% of
PHC’s NAV (i.e., a dollar-for-dollar discount for the tax attributable to
$19,519,656 in appreciation, i.e., a discount of $7,757,111 when using a 39.74%
combined Federal and State capital gains tax rate). Applying an effective tax rate
of 39.74% to this gain equal to 37.5% of PHC’s NAV (i.e., the portion of PHC’s
unrealized appreciation for which the tax liability would be afforded a dollar-for-
dollar discount), Mr. Thomson figured that the allowable discount for BICG
should be 14.9% (i.e., 39.74% times 37.5%), rounded up to 15%.22
22
Since Mr. Thomson rounded this discount to 15%, we treat a BICG
discount equal to 15% of PHC’s NAV--or $7.8 million--as the Commissioner’s
concession.
-35-
[*35] This reasoning is not supported by the evidence. We are unconvinced that a
buyer would be wholly indifferent to the tax implications of built-in gain that
constitutes up to half of a company’s assets. Furthermore, Mr. Thomson points to
no data to show that, once a fund’s unrealized appreciation exceeds 50% of its
NAV, there would then begin to be a correlation between NAV discount and the
unrealized appreciation above 50%; nor is there evidence that the discount would
simply be dollar for dollar for the portion in excess of 50% and not something
more--e.g., an increase in elasticity (price sensitivity) for BICG liability once it
reaches a certain point. He presented no data at all concerning funds with built-in
gain constituting more than 50% of NAV. As a result, we cannot endorse
Mr. Thomson’s approach to calculating the BICG discount, but we view the
resulting discount amount--$7,817,106--to be a concession on the Commissioner’s
part.
4. Our conclusion: present value of the BICG tax liability
If (as we hold) the BICG tax liability cannot be disregarded in valuing PHC,
but if (as we also hold) PHC’s value cannot be reasonably discounted by that
liability dollar for dollar, then the most reasonable discount is the present value of
the cost of paying off that liability in the future. See Estate of Jensen v.
Commissioner, T.C. Memo. 2010-182; Estate of Litchfield v. Commissioner, T.C.
-36-
[*36] Memo. 2009-21. The Commissioner’s expert did not use this present value
approach, because he observed that at PHC’s historic rate for turning over its
securities, it would take 70 years before all the stock had been sold and all the
built-in gain had been taxed. If the $18.1 million of BICG tax were discounted
over that period, on the assumption that PHC’s stocks would be gradually sold and
its BICG tax would be gradually incurred over 70 years (on an average of
$258,758 per year), then the present value of the $18.1 million liability would be
only $3,664,119 (assuming a 7% discount rate). However, this 70-year
assumption would mistakenly allow PHC’s unique, subjective investment goals to
dictate the value of the company, whereas what we seek is a fair market value--the
price at which PHC would change hands between a willing buyer and a willing
seller, not the price that a particular seller might demand or that a particular buyer
might be willing to pay, and therefore not a price that assumes subsequent
management of the company by a specific owner.23 As the estate rightly
23
Admittedly, what we ultimately value here is not the entirety of PHC but
rather a minority 23.44% interest in it; and it can be observed that the acquirer of a
mere minority interest is bound to the investment decisions of the majority, and he
might therefore suppose that PHC’s philosophy and history portended a 70-year
turnover period (and therefore a long deferral of the BICG tax, yielding a very
small discount). However, this observation about the minority shareholder’s being
bound to the majority’s investment decisions properly pertains to the quantum of
the discount that must be made on account of the lack of control that a minority
(continued...)
-37-
[*37] acknowledged, “The willing buyer and the willing seller are hypothetical,
not actual persons, and each is a rational economic actor; that is, each seeks to
maximize his advantage in the context of the market that exists at the valuation
date.”24 The advice that PHC received to diversify its portfolio (i.e., to sell stock
more quickly than its 70-year trend would call for) indicates that a rational actor
would expect a turnover period shorter than 70 years. PHC’s decision not to
follow that advice was not irrational, but it was particular to PHC’s subjective
goals. Even assuming that the PHC management would indefinitely follow its
traditional philosophy and would sell stock only at the 70-year pace, and assuming
that PHC shareholders would refuse to sell at prices that presumed a shorter
turnover, that refusal would not affect the fair market value of PHC; it would
23
(...continued)
owner will experience (discussed below). The BICG tax for which we now
determine a discount is, on the other hand, an entity-level attribute of PHC as a
whole, and not of a particular interest in PHC. A purchaser of PHC stock might
later owe capital gains tax if he sells that stock at a gain; but he will never be
liable for tax on PHC’s gains from the sale of its holdings.
24
The Commissioner similarly explained: “For this purpose, fair market
value is the price that a hypothetical willing buyer would pay a hypothetical
willing seller * * *. The particular characteristics of these hypothetical persons
are not necessarily the same as those of any specific individual or entity, and are
not necessarily the same as those of the actual buyer or the actual seller.”
-38-
[*38] instead indicate that PHC’s particular managers and owners were willing to
forfeit or forgo some of PHC’s fair market value in order to pursue other aims.
The estate put on no evidence as to the length of the period that a typical
investor would consider likely or optimal for turning over PHC’s stock (apart from
the general fact that PHC’s advisors repeatedly suggested that PHC sell stock in
order to diversify) but asserted only PHC’s particular historic rate (yielding a
70-year turnover period and, to the estate’s detriment, a relatively small
$3.6 million BICG tax liability discount). Mr. Thomson’s testimony on this
score--i.e., that, notwithstanding PHC’s historic turnover rate, a potential investor
would expect that a portfolio like PHC’s would turn over within a period of 20 to
30 years--is not rebutted, and we find it reasonable. A present-value approach that
uses either a 20-year or a 30-year holding period and uses the different discount
rates employed in various contexts in this case yields the following range of
present values for the $18.1 million BICG:
-39-
[*39]
Discount rate 20 years 30 years
10.27%
(as calculated by P using
Ibbotson’s data) $7,570,358 $5,565,937
10.25%
(as used by P in the
capitalization of
dividend model)
7,580,584
5,575,086
9.414%
(as calculated by the
Court using PHC’s
historic data) 8,029,070 5,982,097
7%
(generally accepted rate
of return) 9,594,513 7,492,200
Since the Commissioner’s $7.8 million concession falls comfortably within this
range of $5.5 to 9.6 million, we use that figure. As a result, on the basis of these
findings and the record before us, we find a $7,817,106 BICG discount to be
reasonable in this case.
B. Discount for lack of control
A minority discount is a discount that a buyer would demand for the lack of
control the buyer will have over how his investment will be managed (e.g.,
-40-
[*40] disposition of assets,25 payment of distributions, or appointment of
management). The parties agree that a discount for lack of control is proper if a
net asset valuation is used in this case. However, the measure of that discount
remains in dispute.
The Commissioner’s expert used a data set consisting of the net asset values
and trading prices of 59 closed-end funds for the week of December 9, 2005. He
then analyzed the percentage difference between the net asset value and trading
price (if negative, a discount; if positive, a premium). Overall, this methodology is
sound and appears to be a reasonable way to calculate an appropriate discount
associated with lack of control (though we find a correctable flaw in the data set
itself).
The Commissioner’s expert found the mean (i.e., the average) of the
premiums and discounts of all 59 data points to be -6.7%. However, he did not
use this number as the discount. Rather, he observed that the decedent and one
25
A potential purchaser of a minority interest in PHC would observe certain
disadvantages that might result from lack of control, such as an inability to
overcome PHC’s historic devotion to maximizing dividends when that approach
might cause it to miss other opportunities that would produce not steady dividends
but capital growth. Likewise, a minority shareholder in PHC would be unable to
compel the company to follow professional advice and diversify optimally (though
this approach has the corresponding advantage of deferring the BICG tax on
PHC’s appreciated holdings).
-41-
[*41] other owner each owned about 23% of PHC, and that the next largest
holding was only about 12%. His expert report therefore concluded that, even
though the decedent did not control the company, the decedent’s 23.44% interest
was a large and influential block of PHC’s stock, so that its lack of control was
somewhat mitigated, and he reduced the discount to -6.0% because of the “low
dispersion of the remaining ownership interest [in PHC] and ease of
management”.26 He did not explain how he chose -0.7% as the amount of the
appropriate reduction, and it appears to be simply a visceral reduction, for which
we do not see the justification.
The estate’s expert used the same data but simply selected the median (i.e.,
the middle value) of the data set, -8.0%, as the appropriate discount because the
Commissioner’s expert “incorrectly selected a number based upon
misinterpretation of the Factors identified in [Mr. Thomson’s] * * * report”, for
which he cited as a supposed example that “the holder of this interest cannot be a
26
The phrase “ease of management” in his report may be shorthand for
Mr. Thompson’s reckoning (as explained in his testimony) that, because PHC
engaged Wilmington Trust as its investment advisor, “we have a professional
management here [at PHC] too, so it’s not as if we just have a family doing
everything by themselves”. However, in pursuit of its distinctive (not to say
eccentric) investment philosophy, PHC disregarded Wilmington Trust’s
professional advice to further diversify. It therefore appears that lack of control of
PHC might indeed have had visible, continuing effects that might concern an
investor (and might require a greater discount).
-42-
[*42] Director.” However, this example apparently reflects the estate’s expert’s
erroneous assumption--corrected by the time of trial--that a PHC director must be
a member of the Pearson family. Such a restriction might indeed aggravate lack of
control (and might increase the appropriate discount), but it did not exist here.
An examination of the data set shows that among the 59 funds there are
three outliers that skew the mean and whose relevance or reliability Mr. Thomson
did not show. Removing these outliers--i.e., the highest two values and the lowest
value27 --yields a mean minority discount of -7.75%, which is comfortably close to
the estate’s 8.0% median. As a result, we conclude that a discount for lack of
control of 7.75% is reasonable in this case.
C. Discount for lack of marketability
A prospective investor is likely to pay more for an asset that will be easy to
sell and less for an asset that may be difficult to sell. In this case, PHC owns easy-
to-sell publicly traded stocks; but we value an interest in PHC itself, which is a
27
The highest two values reflect premiums of 28.3% and 38.2%, with the
next highest premium being only 10.9%. These two remarkable premiums are
unexplained in our record, and we cannot tell how they relate to the remainder of
the data set nor what, if anything, they could suggest about the appropriate
minority discount for a company like PHC. We therefore disregard them as
outliers. At the other end of the spectrum, the lowest value reflects a discount of
25.9%. We disregard it as an outlier, since the next highest discounts are 17.1%,
17.0%, 16.7%, 16.5%, 16.4%, and 15.3%.
-43-
[*43] family-owned, non-publicly traded company the stock of which has no ready
market. The parties agree that a marketability discount--i.e., a discount
attributable to the cost and difficulty of finding a willing buyer for a non-traded
closely held interest--is appropriate here if PHC is valued by a net asset valuation
method. However, the quantum of that discount remains in dispute.
To determine the appropriate discount for lack of marketability, the
Commissioner’s expert examined seven studies of restricted stock, which is
identical to freely traded stock of a public company except that it is restricted from
being traded on an open market for a certain period of time.28 The studies
compared two types of data: (1) the selling prices of the restricted stocks with the
selling prices of the corresponding unrestricted shares, and (2) the selling prices of
shares in closely held companies at their pre-IPO level versus their subsequent
post-IPO price, and measured the difference between its restricted value and its
28
The Commissioner’s expert also examined but did not rely on studies
comparing the sale price of closely held company shares to the prices of shares at
subsequent initial public offerings of the same companies. The estate argues that
the Commissioner’s expert is therefore subject to criticism as in Estate of Davis v.
Commissioner, 110 T.C. 530, in which we discussed the limitations of restricted
stock studies and gave more weight to IPO studies. However, there is no absolute
rule that, for purposes of determining a marketability discount, IPO studies are
superior to restricted stock studies, since in other circumstances we have preferred
the latter. See Estate of Giustina v. Commissioner, T.C. Memo. 2011-141. The
estate’s expert presented no analysis of IPO studies or of what discount they might
suggest here, so the estate’s argument does not convince us.
-44-
[*44] non-restricted value to quantify a discount for lack of marketability. The
seven studies produce lack-of-marketability discounts ranging from 26.4% to
35.6%, with an average discount of 32.1%.
Mr. Thomson chose to use the very bottom of this range--26.4%--as his
starting point for determining lack of marketability for PHC stock, because most
of the studies dealt with stock in operating companies (inherently more risky than
stock in a company that holds publicly traded shares). Mr. Thomson then further
reduced the discount to 21% for various reasons--e.g., PHC paid consistent
dividends; PHC had a very small amount of debt; and PHC was managed by
professional investors. Although these reasons would likely warrant
consideration, Mr. Thomson provided no basis for the quantum of the adjustment
attributable to each. Furthermore, we are unconvinced that Mr. Thomson’s low
starting point--26.4%--was warranted because of his summary observation that
most of the studies dealt with riskier operating companies.
Again, the estate’s expert did not perform an independent analysis for lack
of marketability. Instead, Mr. Schweihs accepted Mr. Thomson’s general
approach and data, but he simply chose the very top of the range of the study’s
marketability discounts--i.e., 35.6%--arguing that the seven studies that were used
to derive this discount are based on entities whose stock (unlike PHC’s) would
-45-
[*45] relatively soon be freely marketable. He contended that stock (like that in
the seven studies) whose public trading is restricted for only a defined period
(during which private trades may be made) may be less discounted in value than
stock (like PHC’s) whose non-public status is of indefinite duration.
The parties seem to agree that the general range of marketability discounts
relevant for consideration in this case is 26.4 to 35.6%, with an average discount
of 32.1%, and we are unconvinced by either party’s rationale for deviating from
this generality. We therefore find that a marketability discount of 32.1%--i.e., the
average of the data sets--is reasonable in this case.
D. Conclusion
On the basis of the foregoing, we find that the value of the decedent’s
23.44% interest in PHC at the time of her death is $6,503,804, figured thus:
-46-
[*46]
Assets of PHC $52,159,430
Less: Liabilities - 45,389
Less: BICG discount - 7,817,106
NAV of PHC 44,296,935
23.44% Interest in NAV 10,383,202
Less: LOC discount
(7.75% of $10,383,202) - 804,698
9,578,504
Less: LOM discount
(32.1% of $9,578,504) - 3,074,700
Value of decedent’s
interest in PHC 6,503,804
V. Accuracy-related penalty
Generally, a 20% penalty is imposed on “any portion of an underpayment of
tax required to be shown on a return” where the underpayment is attributable to a
substantial estate tax valuation understatement. Sec. 6662(a), (b)(5). An estate
tax valuation understatement is treated as “substantial” where the value of any
property required to be reported on an estate tax return is reported at 65%29 or less
29
The estate tax return at issue here was filed on September 20, 2006.
Section 6662(g)(1) was amended for returns filed after August 17, 2006, to
provide that a valuation understatement is substantial if the value of any property
(continued...)
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[*47] of the correct value. Sec. 6662(g)(1). The Commissioner bears the burden
of production with respect to the penalty determined under section 6662. See sec.
7491(c); Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
The estate reported the value of the decedent’s interest in PHC to be
$3,149,767 on the estate tax return. Given that we have determined the proper
value of the decedent’s interest in PHC was $6,503,804, the amount reported on
the estate tax return was less than 65% of the proper value, and a “substantial”
valuation understatement therefore exists for purposes of section 6662(g)(1).
Therefore, the Commissioner has met his burden under section 7491(c).
However, the 20% penalty under section 6662(a), (b)(5), and (g) will not
apply to any portion of an underpayment “if it is shown that there was a reasonable
cause for such portion and that the taxpayer acted in good faith with respect to
such portion.” See sec. 6664(c)(1) (emphasis added). The regulations provide
that whether an underpayment of tax is made in good faith and due to reasonable
cause will depend upon the facts and circumstances of each case. 26 C.F.R. sec.
1.6664-4(b)(i), Income Tax Regs. Reasonable cause may involve reliance on a
29
(...continued)
required to be reported on an estate tax return is reported at 65% or less of the
correct value. Before August 17, 2006, that figure was 50%. See Pension
Protection Act of 2006, Pub. L. No. 109-280, sec. 1219(a)(1)(B), 120 Stat. at
1083.
-48-
[*48] professional tax advisor, but such reliance does not necessarily demonstrate
reasonable cause and good faith, and “[r]easonable cause and good faith ordinarily
is not indicated by the mere fact that there is an appraisal of the value of property.”
Id.
In determining whether a taxpayer acted reasonably and in good faith with
regard to the valuation of property, factors to be considered include: (1) the
methodology and assumptions underlying the appraisal; (2) the appraised value;
(3) the circumstances under which the appraisal was obtained; and (4) the
appraiser’s relationship to the taxpayer or to the activity in which the property is
used. Id. To establish good faith, taxpayers cannot rely blindly on advice from
advisers or on an appraisal. Bergquist v. Commissioner, 131 T.C. 8, 23 (2008)
(citing Kellahan v. Commissioner, T.C. Memo. 1999-210; and Estate of Goldman
v. Commissioner, T.C. Memo. 1996-29).
Mr. Lyle, who was deceased at the time of trial, was the co-executor of the
estate, was a C.P.A., and was primarily responsible for obtaining the valuation.
Ms. Zerbey, the other co-executor, who attended business school and had some
modest experience in financial matters, allowed Mr. Lyle to be the principal
contact with the accountant (Mr. Winnington at the Belfint firm) who was retained
to value the decedent’s interest in PHC. Ms. Zerbey testified that Mr. Lyle kept
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[*49] her informed, and she knew that Mr. Winnington was selected to value the
decedent’s interest in PHC and that two prior valuations were being used as
guidelines. According to Mr. Winnington, Mr. Lyle provided him with sufficient
information to value the decedent’s interest in PHC.
Mr. Winnington is a C.P.A. who is knowledgeable about PHC.
Mr. Winnington testified that his fee was not contingent on the value he reached
and that Mr. Lyle did not influence the value ultimately reported on the estate tax
return. Although Mr. Winnington has some appraisal experience (i.e., having
written 10-20 valuation reports and having testified in court), he does not have any
appraiser certifications. The estate did not proffer him as an expert witness and
did not demonstrate that he is qualified as an expert in valuation.
On the record before us, we cannot say that the estate acted with reasonable
cause and in good faith in using an unsigned draft report prepared by its
accountant as its basis for reporting the value of the decedent’s interest in PHC on
the estate tax return. Mr. Winnington is not a certified appraiser. The estate never
demonstrated or discussed how Mr. Winnington arrived at the value reported on
the estate return except to say that two prior estate transactions involving PHC
stock used the capitalization-of-dividends method for valuation. Furthermore, the
estate did not explain--much less excuse--whatever defects in Mr. Winnington’s
-50-
[*50] valuation resulted in that initial $3.1 million value’s being abandoned in
favor of the higher $5 million value for which the estate contended at trial.
Consequently, the value reported on the estate tax return is essentially
unexplained.
The estate observes that four substantially different values were reached by
four professionals--Mr. Winnington ($3.1 million), the estate’s expert ($5 million),
the Commissioner’s expert ($7.3 million), and the IRS auditor ($9.2 million)--and
the estate argues that this fact demonstrates the difficulty of valuing the decedent’s
interest in PHC. While we do not disagree with the estate’s assertion that the
decedent’s interest in PHC may be difficult to value, we believe that this further
supports the importance of hiring a qualified appraiser. In order to be able to
invoke “reasonable cause” in a case of this difficulty and magnitude, the estate
needed to have the decedent’s interest in PHC appraised by a certified appraiser.
It did not. Instead, the estate relied on the valuation by Mr. Winnington but did
not show that he was really qualified to value the decedent’s interest in the
company. The $3.1 million value reported on the estate tax return was less than
65% of even the $5 million value defended by the estate’s own expert; and if the
Court had adopted the $5 million value, the return would still reflect a substantial
valuation understatement that would warrant the accuracy-related penalty; that is,
-51-
[*51] even by the estate’s lights, the value on the estate tax return needed
explaining, but no explanation was given.
Given that the Commissioner has met his burden to show that the accuracy-
related penalty applies, the burden shifted to the estate to show why it should be
excused from the penalty. The estate failed to make such a showing. As a result,
we find that the estate has not demonstrated that it acted with reasonable cause and
in good faith in reporting the value of the decedent’s interest in PHC on the estate
tax return. As a result, the Commissioner’s imposition of an accuracy-related
penalty under section 6662(a), (b)(5), and (g) will be sustained.
Decision will be entered under
Rule 155.