T.C. Memo. 2000-191
UNITED STATES TAX COURT
ESTATE OF EMILY F. KLAUSS, DECEASED, JOHN G. KLAUSS,
INDEPENDENT EXECUTOR, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5578-97. Filed June 27, 2000.
Wayne R. Mathis, for petitioner.
Gerald L. Brantley, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Judge: Respondent determined a deficiency in
petitioner’s estate tax of $1,801,053.
After concessions, the sole issue for decision is whether
the fair market value of 184 shares of Green Light Chemical Co.,
Inc., owned by Emily F. Klauss (decedent) on February 1, 1993,
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was $1,810,000, as petitioner contends; $2,713,000, as respondent
contends; or some other amount. We hold that it was $2,150,000.
Section references are to the Internal Revenue Code as in
effect when decedent died. Rule references are to the Tax Court
Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
A. Decedent
Decedent died on February 1, 1993 (the valuation date), in
San Antonio, Texas. Her husband, William J. Klauss, predeceased
her. Decedent’s son, John G. Klauss (John Klauss), is the
independent executor of decedent’s estate. He lived in Helotes,
Texas, when he filed the petition in this case.
B. Green Light Chemical Co., Inc.
1. Formation
William J. Klauss cofounded the Klauss-White Co. in 1946.
It changed its name to the Green Light Co., Inc. (Green Light),
in 1960. He ran the company until the mid-1970's, and he died in
1982.
John Klauss worked for Green Light for 38 years. He began
running the company in the mid-1970's, and he was the chairman of
the board on February 1, 1993. He retired in 1994.
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2. Ownership
Green Light is a closely held corporation. Of the 460
outstanding shares of stock in Green Light, 184 shares were
included in decedent’s gross estate under section 2044.
Decedent’s children owned the remaining shares of Green Light
stock when she died.
Green Light has never paid dividends.
3. Products and Operations
Green Light formulates and markets (but does not
manufacture) insecticides, weed killers, fungicides, plant foods,
and other products for home and garden use. Green Light sells
its products to distributors, who sell them to retailers, such as
Walmart and grocery and hardware stores. Green Light’s primary
market in 1993 was the home and garden market. It did not sell
to farms, ranches, or golf courses. Green Light’s sales volumes
vary greatly according to weather conditions and the planting
season. Its products are manufactured primarily in the fourth
quarter of the calendar year, and it ships most of its products
in December and January. Green Light bills its customers 90 days
after shipment and receives most of its revenue in May and June.
In 1993, Green Light sold its products primarily in Texas,
Oklahoma, Louisiana, New Mexico, Colorado, and Arizona. Its top
five customers accounted for about 71 percent of its sales in its
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1992 fiscal year.1 More than 36 percent of Green Light’s sales
in fiscal year 1992 were to Central Garden.
4. Green Light’s Environmental Claims, Products Liability
Insurance, and Risks of Litigation
The Texas Water Commission (later the Texas Natural
Resources Conservation Commission (TNRCC)) told Green Light in
August 1991 that soil at its San Antonio facility was
contaminated with chlordane and xylene. The TNRCC ordered Green
Light to submit a corrective action plan within 30 days. Green
Light denied that its property was contaminated, and had not
submitted a plan as of the time of trial.
Green Light had $500,000 of products liability insurance in
1993, with a $50,000 deductible. It would have cost Green Light
about $250,000 more to increase its 1992 products liability
insurance coverage to $2 million, with a $1,000 deductible. As
of February 1, 1993, Green Light was a defendant in at least six
products liability lawsuits resulting from the alleged
misapplication of some of its products. Green Light faced
potential liability of more than $100 million in these lawsuits.
5. Sale of Green Light to Employee Stock Ownership Trust
On November 30, 1994, all of the stock of Green Light was
sold to an employee stock ownership trust created by the
employees of Green Light.
C. Decedent’s Estate Tax Return
1
Green Light used a fiscal year ending June 30.
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Petitioner attached to the estate’s Federal estate tax
return an appraisal of decedent’s minority interest in Green
Light prepared by Clark C. Munroe (Munroe). Munroe estimated,
and petitioner reported on that return, that the fair market
value of decedent’s 184 shares of Green Light stock was
$1,810,000 as of February 1, 1993.
D. Notice of Deficiency
Respondent determined in the notice of deficiency that the
fair market value of decedent’s 184 shares of Green Light stock
was $4,080,200. Respondent now concedes that the value of
decedent’s stock was not more than $2,713,000.
OPINION
The issue for decision is the fair market value of
decedent’s 184 shares of Green Light stock on the day decedent
died, February 1, 1993.
A. Fair Market Value
Fair market value is 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 the relevant facts. See United
States v. Cartwright, 411 U.S. 546, 551 (1973); sec. 20.2031-
1(b), Estate Tax Regs.; sec. 25.2512-1, Gift Tax Regs.2 If
2
Petitioner bears the burden of proving that respondent’s
determination in the notice of deficiency is erroneous. See Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
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selling prices for stock in a closely held corporation are not
available, then we decide its fair market value by considering
factors such as the company’s net worth, earning power, dividend-
paying capacity, management, goodwill, and position in the
industry, as well as the economic outlook in its industry and the
values of publicly traded stock of comparable corporations. See
Estate of Andrews v. Commissioner, 79 T.C. 938, 940 (1982); sec.
25.2512-2(f), Gift Tax Regs.
Both parties called expert witnesses to give their opinions
about the value of decedent’s Green Light stock on February 1,
1993. Bruce Johnson (Johnson) testified at trial for petitioner,
and David Fuller (Fuller) testified for respondent. The record
also contains the expert report of Munroe, who could not testify
because of illness. Petitioner based the value reported in the
estate tax return on Munroe’s appraisal, which is almost
identical to petitioner’s position at trial. The opinions of the
expert witnesses and the positions of the parties as to the fair
market value of decedent’s shares of Green Light stock are as
follows:
Petitioner’s Deficiency
return and Petitioner’s notice and Respondent’s
the petition expert Johnson answer expert Fuller
$1,810,000 $1,800,000 $4,080,200 $2,713,000
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The experts each used the income capitalization3 and market
or public guideline company4 methods to estimate the value of
decedent’s Green Light stock. Johnson and Fuller used the same
guideline companies: Scotts Co. (Scotts), American Vanguard
Corp. (American Vanguard), Lesco, Inc. (Lesco), and Vigoro Corp.
(Vigoro). Johnson and Fuller primarily disagree as to: (1)
Whether to apply a small-stock premium and (2) whether to adjust
the multiple for the growth rates of Green Light and the
guideline companies.
B. Stock Value Before Considering Discounts
1. The Small-Stock Premium
Johnson applied a small-stock premium of 5.2 percent in
calculating the discount rate5 he used to approximate the return
required by investors in the smallest quintile of the public
stock market. Respondent contends that Johnson was incorrect in
applying a small-stock premium. We disagree.
3
The income capitalization method is used to estimate the
fair market value of income-producing property by considering the
present value of the future stream of income to be produced by
that property. See Estate of Bennett v. Commissioner, T.C. Memo.
1989-681, affd. 935 F.2d 1285 (4th Cir. 1991).
4
The market or public guideline company method compares
the company being valued with similar, publicly traded (i.e.,
"guideline") companies.
5
The discount rate is the total of the risk-free rate, the
equity risk premium, the small-stock premium, and the specific
risk premium.
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Johnson reasonably based the small-stock premium he used in
his report on data from Ibbotson Associates.6 Later data from
Ibbotson Associates7 show that the small-stock premium has
declined since about 1983 or 1984, but that small capitalization
stocks were yielding higher average returns than large
capitalization stocks in 1993.
Respondent attached to respondent’s opening brief an
appendix which shows that large capitalization stocks have
outperformed small stocks since about 1988. We do not consider
the information in the appendix because respondent provided no
source for it.
Respondent relies on an article by Bajaj & Hakala,
“Valuation for Smaller Capitalization Companies”, published in
Financial Valuation: Businesses and Business Interests, ch. 12A
(Hanan & Sheeler ed. 1998), for the proposition that there is no
small-stock premium. We find Johnson’s analysis to be more
persuasive.
Fuller testified that it is appropriate to use the Ibbotson
Associates data from the 1978-92 period rather than from the
1926-92 period because small stocks did not consistently
6
See Ibbotson Associates, Stocks, Bonds, Bills &
Inflation, 1993 Yearbook 128 (Ibbotson 1993); see also Estate of
Hendrickson v. Commissioner, T.C. Memo. 1999-278 (citing id. at
125).
7
See Ibbotson Associates, Stocks, Bonds, Bills &
Inflation, 1999 Yearbook 121 (Ibbotson 1999).
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outperform large stocks during the 1980's and 1990's. We give
little weight to Fuller’s analysis. Fuller appeared to
selectively use data that favored his conclusion. He did not
consistently use Ibbotson Associates data from the 1978-92
period; he relied on data from 1978-92 to support his theory that
there is no small-stock premium8 but used an equity risk premium
of 7.3 percent from the 1926-92 data (rather than the equity risk
premium of 10.9 percent from the 1978-92 period). If he had used
data consistently, he would have derived a small-stock premium of
5.2 percent and an equity risk premium of 7.3 percent using the
1926-92 data, rather than a small-stock premium of 2.8 percent
and an equity risk premium of 10.9 percent using the 1978-92
data.
We conclude that Johnson appropriately applied a small-stock
premium in valuing the Green Light stock.
2. Growth Rate
Johnson derived price/earnings multiples from the guideline
companies that he adjusted to account for differences between
their expected growth rates and that of Green Light. He selected
a 5-percent growth rate for Green Light and used growth rates for
the guideline companies ranging from 14.3 to 15.5 percent.
8
The Ibbotson Associates data for 1978-92 show a 2.8-
percent small-stock premium. See Ibbotson Associates (1993),
supra at 128.
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Respondent contends that Johnson incorrectly assumed that
Green Light would grow at 5 percent. Shortly before trial, Green
Light’s management told Johnson that it had projected that Green
Light would grow at a rate of 5 to 10 percent in 1993.9 We
disagree with respondent’s contention that Johnson incorrectly
assumed that Green Light would grow at 5 percent because Fuller
also used a 5-percent growth rate for Green Light. Respondent
contends that Johnson selected incorrect growth rates for the
guideline companies because the sources of his data were
unreliable. We disagree in part. Johnson reasonably selected
growth rates for Green Light and the guideline companies other
than American Vanguard using financial data relating to periods
before the valuation date. See Estate of Jung v. Commissioner,
101 T.C. 412, 423-424 (1993); Estate of Newhouse v. Commissioner,
94 T.C. 193, 217 (1990).
Johnson chose a 15-percent growth rate for American Vanguard
in part because its earnings grew 33 percent annually from 1988
to 1992, and its export sales grew from $800,000 in 1990 to $4.7
million in 1993. However, in light of the fact that the earnings
of Green Light grew faster than those of the guideline companies
9
In 1999, Bruce Johnson (Johnson) interviewed Forrest Gray
(Gray), the secretary and treasurer of Green Light, about the
anticipated future growth rate of Green Light as of the valuation
date. Gray told Johnson that, in 1993, the management of Green
Light expected the company to grow at a rate of 5 to 10 percent
per year.
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from 1990 to 1992, Johnson’s use of a 15-percent growth rate for
American Vanguard was too generous. We believe Johnson should
have used a 5-percent growth rate for American Vanguard since
that is the growth rate he used for Green Light and its earnings
were growing faster than those of the guideline companies.
Johnson’s analysis was more persuasive than Fuller’s.
Fuller did not adequately consider the differences between Green
Light and American Vanguard, the guideline company he considered
to be the most comparable. For example, he gave little weight to
the facts that: Green Light does not manufacture products; its
product lines are far less diverse than those of the guideline
companies; its five largest customers accounted for more than 70
percent of its sales; it sells its products regionally, not
nationally; its primary market in 1993 was limited to the home
and garden market and did not include agribusinesses or golf
courses; and it had minimal insurance coverage for products
liability and environmental claims. He did not adjust the
multiples for American Vanguard for customer concentration,
product mix, geographic diversification, or market segment
factors. We think his failure to do so was improper given the
differences between Green Light and American Vanguard.
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3. Other Differences Between the Analyses of Johnson and
Fuller
a. Fuller’s Use of the CAPM Method
Fuller calculated his discount rate using the capital asset
pricing model (CAPM).10 In contrast, Johnson used a discount
rate based on the build-up method.11 We believe that Fuller
should not have used the CAPM in this case. Green Light should
not be valued by using the CAPM method because Johnson and Fuller
agreed that it had little possibility of going public. See
Estate of Maggos v. Commissioner, T.C. Memo. 2000-129; Estate of
Hendrickson v. Commissioner, T.C. Memo. 1999-278; Furman v.
Commissioner, T.C. Memo. 1998-157.
10
The capital asset pricing model (CAPM) is used to
estimate a discount rate by adding the risk-free rate, an
adjusted equity risk premium, and a specific risk or unsystematic
risk premium. The company’s debt-free cash-flow is then
multiplied by the discount rate to estimate the total return an
investor would demand compared to other investments. See Furman
v. Commissioner, T.C. Memo. 1998-157.
11
Under the build-up method, an appraiser selects an
interest rate based on the interest rate paid on governmental
obligations and increases that rate to compensate the investor
for the disadvantages of the proposed investment. See Estate of
English v. Commissioner, T.C. Memo. 1985-549.
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b. Fuller’s Selection of a Beta
In applying the CAPM method, Fuller chose a beta12 of .7 to
estimate Green Light’s systematic risk. An average amount of
risk is represented by a beta of 1. A beta of 70 percent would
be correct if an investment in Green Light were 30 percent less
risky than a composite investment of the Standard & Poor’s 500
Stock Composite Index (S&P 500). We disagree with Fuller’s use
of a .7 beta because Green Light was a small, regional company,
had customer concentrations, faced litigation and environmental
claims, had inadequate insurance, was not publicly traded, and
had never paid a dividend. A beta cannot be correctly calculated
for the stock in a closely held corporation; it can only be
correctly estimated on the basis of the betas of comparable
publicly traded companies. See Estate of Hendrickson v.
Commissioner, supra; Furman v. Commissioner, supra. Fuller
stated that he selected the beta based on a review of comparable
companies. However, he did not identify these comparable
companies or otherwise give any reason for his use of a .7 beta.
We believe Fuller’s use of a .7 beta improperly increased his
estimate of the value of the Green Light stock.
12
Beta is a measure of systematic risk; that is, risk that
is unavoidable and that affects the value of all assets. Beta
measures the volatility of a stock’s return as compared to the
market as a whole. See Furman v. Commissioner, supra; Pratt et
al., Valuing a Business 166 (3d ed. 1996).
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4. Risk of Litigation and Environmental Remediation
Johnson and Fuller substantially agreed about the potential
effects of products liability litigation and environmental claims
on the value of Green Light stock. Johnson reduced his estimate
of the value of Green Light by $921,000 on the basis of the
$252,000 cost to Green Light of increasing its products liability
insurance and John Klauss’ estimate that it would have cost Green
Light about $250,000 in 1993 to pay fines and remediation costs,
such as excavation, transportation, and capping costs, and lab
analysis, disposal, and environmental engineer’s and attorney’s
fees to resolve the TNRCC enforcement action. In contrast,
Fuller discounted his estimate by 10 percent, which had the
effect of reducing the stock value by $1,130,000, in part because
counsel for Green Light stated that its maximum liability for the
litigation claims would be 10 percent. We agree with Johnson’s
approach because we believe he more accurately accounted for the
effects on the value of Green Light of the litigation and
environmental claims.
5. Conclusion
We conclude that Johnson’s analysis was more persuasive than
Fuller’s, except for his use of a 15-percent growth rate for
American Vanguard.
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C. Conclusion
Johnson and Fuller agree that the appropriate discount for
lack of marketability is 30 percent. Taking into account the
adjustment made to the growth rate of American Vanguard, we
conclude that the fair market value of decedent’s 184 shares of
Green Light stock was $2,150,000 on February 1, 1993.
Decision will be entered
under Rule 155.