T.C. Memo. 2010-103
UNITED STATES TAX COURT
THE RINGGOLD TELEPHONE COMPANY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 22783-07. Filed May 10, 2010.
Timothy J. Peaden and Timothy L. Fallaw II, for petitioner.
Eric B. Jorgensen and James C. Lanning, Jr., for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Judge: Respondent determined a deficiency of
$925,260 in petitioner’s Federal income tax for tax year 2000 and
a penalty under section 6662(a)1 of $185,052. The issues to be
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all subchapter references are to ch. 1 of that Code. All Rule
(continued...)
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decided are: (1) For purposes of determining built-in gain under
section 1374, whether the fair market value of a partnership
interest petitioner owned as of January 1, 2000, was $2,980,000,
as petitioner contends, or $5,220,423, as respondent contends,
and (2) whether petitioner is liable for the accuracy-related
penalty respondent determined pursuant to section 6662.
FINDINGS OF FACT
Some of the facts and certain exhibits have been stipulated.
The stipulations of fact are incorporated in this opinion by
reference and are found as facts. Petitioner was a Georgia
corporation at the time the petition was filed.
Petitioner provides telecommunications services to customers
in Georgia and Tennessee.
Before tax year 2000, petitioner was taxed as a C
corporation for Federal income tax purposes. Petitioner made a
valid election to be classified as an S corporation for Federal
income tax purposes effective January 1, 2000.
Petitioner’s Interest in CRC and CHAT
On January 1, 2000, petitioner owned a 25-percent
partnership interest in Cellular Radio of Chattanooga (CRC)
(hereinafter we will refer to petitioner’s partnership interest
in CRC as the CRC interest). As of January 1, 2000, the other
1
(...continued)
references are to the Tax Court Rules of Practice and Procedure.
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partners in CRC, each with a 25-percent interest, were BellSouth
Mobility, Inc. (BellSouth), Trenton Telephone Co., and Bledsoe
Telephone Co.
As of January 1, 2000, CRC’s primary asset was a 29.54-
percent limited partnership interest in the Chattanooga MSA
Limited Partnership (CHAT), which provided wireless
telecommunications service in Chattanooga, Tennessee.
Before September 30, 2000, CHAT’s general partner was
Chattanooga CGSA, Inc. Effective October 1, 2000, CHAT’s general
partner was Chattanooga CGSA, L.L.C. Both of the successive
general partners were, at all times relevant to this proceeding,
wholly owned by BellSouth, and hereinafter they collectively are
referred to as Chattanooga CGSA. As the only general partner of
CHAT, Chattanooga CGSA was the only partner with the authority to
request additional capital contributions and make distributions
of partnership profits.
From January 1 through November 27, 2000, CHAT was owned as
follows:
Ownership Interest (percentage)
General Limited
Partnership partnership partnership Total
Chattanooga CGSA 40 15.31 55.31
Alltel Cellular
Associates of
South Carolina Limited
Partnership 15.15 15.15
CRC 29.54 29.54
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At all times between January 1 and November 27, 2000,
petitioner indirectly owned a 7.385-percent interest in CHAT as a
result of petitioner’s 25-percent partnership interest in CRC and
CRC’s 29.54-percent limited partnership interest in CHAT.
BellSouth acquired petitioner’s 25-percent interest in CRC
on November 27, 2000. Before that date, BellSouth owned 62.7
percent of CHAT--7.385 percent through its interest in CRC and
55.31 percent through its ownership of Chattanooga CGSA. Through
its ownership of Chattanooga CGSA, BellSouth controlled CHAT.
The interests of petitioner and BellSouth in CHAT by virtue
of their ownership of interests in CRC and Chattanooga CGSA
before November 27, 2000, were are as follows:
Ownership interest (percentage)
CHAT via
Chattanooga CGSA CHAT via CRC CHAT total
BellSouth 55.31 7.385 62.695
Petitioner -- 7.385 7.385
On January 1, 2000, CRC interests were not publicly traded,
and petitioner’s right to sell its 25-percent interest in CRC was
subject to a right of first refusal in favor of the other CRC
partners.
On January 1, 2000, partnership interests in CHAT were not
publicly traded.
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Reporting of Built-In Gain on the Sale of the CRC Interest
On September 30, 1999, at petitioner’s request, the
certified public accounting firm Warinner, Gesinger & Associates,
L.L.C. (Warinner), issued a report using 1998 financial data that
valued the CRC interest of petitioner at approximately $4,600,000
(September 1999 report).
In early 2000, Phil Erli (Mr. Erli), then the general
manager of petitioner, requested that Warinner prepare a revised
valuation report to correct arithmetical errors in the September
1999 report and to include more recent data in the valuation
analysis. On February 15, 2000, Warinner issued a revised report
on the basis of financial data through September 30, 1999, which
estimated the value of the CRC interest to be approximately
$2,600,000 (February 2000 report).
At the time that Mr. Erli requested the February 2000
report, he was not aware of the existence of the built-in gains
tax and the impact that the determination of fair market value
would have on that tax.
Petitioner’s management did not become aware of the
built-in gains tax until sometime in late 2000 or early 2001.
In March of 2000, petitioner engaged the investment banking
firm Robinson-Humphrey Co., L.L.C. (Robinson-Humphrey), to
identify potential buyers and to market the CRC interest.
Robinson-Humphrey prepared an offering memorandum, which was
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provided to prospective purchasers and listed the value of the
CRC interest as approximately $7 million. Robinson-Humphrey’s
compensation was contingent on the sale price of the CRC
interest; accordingly, it had an incentive to try to generate a
high sale price. The Robinson-Humphrey memorandum was prepared
for marketing purposes rather than as an objective assessment of
value.
Petitioner did not expect to get an offer of $7 million for
its interest. Indeed, petitioner’s management had decided that
it would accept as little as $2 million for the CRC interest.
On July 6, 2000, BellSouth offered to purchase the CRC
interest for $5,022,929, subject to working capital adjustments
as of the date of closing.
Petitioner received no other offers to purchase the CRC
interest. The other partners in CRC did not exercise their
rights of first refusal with respect to the offer made by
BellSouth.
Petitioner accepted BellSouth’s offer on July 11, 2000, and
the sale of the CRC interest to BellSouth was completed on
November 27, 2000, for $5,220,043.
Petitioner timely filed a Federal income tax return on Form
1120S, U.S. Income Tax Return for an S Corporation, for the 2000
tax year.
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On its 2000 Form 1120S, petitioner reported the amount of
recognized built-in gain attributable to the CRC interest using a
fair market value as of January 1, 2000 (the valuation date), of
$2,600,000, the amount determined by the February 2000 report.
Petitioner used the valuation of the CRC interest contained in
the February 2000 report on the advice of Stephen Henley, a
certified public accountant petitioner consulted to review its
2000 Federal income tax return.
Respondent sent petitioner a notice of deficiency dated
August 3, 2007, that determined a deficiency of $925,260 and a
penalty pursuant to section 6662(a) of $185,052. The deficiency
resulted from respondent’s determination that the fair market
value of the CRC interest was $5,243,6022 rather than the
$2,600,000 shown on petitioner’s 2000 Federal income tax return.
OPINION
I. Valuation of the CRC Interest
The issue we must decide is the fair market value of the CRC
interest on the valuation date; i.e. on January 1, 2000, the
effective date of petitioner’s subchapter S election.
2
We note that Schedule 2 to the notice of deficiency,
Explanation of Adjustments, states that the value of the CRC
interest is determined to be $5,220,423. However, Schedule 3 to
the notice of deficiency uses the value of $5,243,602 in
calculating the built-in gains tax.
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A. Built-In Gains Tax
Section 1374 imposes a tax on built-in gains--gains accrued
while an asset is held by a C corporation which later makes a
subchapter S election. An S corporation’s gain upon disposition
of an asset generally is treated as built-in gain to the extent
that the fair market value of that asset on the first day of the
first taxable year for which the corporation’s subchapter S
election is in effect exceeds that asset’s adjusted basis on such
date. Sec. 1374(d)(1). If an asset with built-in gain is sold
during the 10-year period beginning on such date, the S
corporation will be taxed on the built-in gain. Sec. 1374(a),
(d)(7).
The parties agree that petitioner is subject to built-in
gains tax under section 1374 on the sale of the CRC interest.
Respondent asserts that the fair market value of the CRC interest
on the valuation date was $5,220,423, the price for which the
interest was sold to BellSouth on November 27, 2000. Petitioner
contends that the value of the CRC interest on the valuation date
was $2,980,000.
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B. Fair Market Value Standard
The standard for valuation is fair market value, which is
defined as the price that a willing buyer would pay a willing
seller, both persons having reasonable knowledge of all relevant
facts and neither person being under a compulsion to buy or to
sell. See United States v. Cartwright, 411 U.S. 546, 551 (1973)
(applying the standard set forth in section 20.2031-1(b), Estate
Tax Regs.). The standard is objective, using a hypothetical
willing buyer and seller who are presumed to be dedicated to
achieving maximum economic advantage in any transaction involving
the property. See Estate of Newhouse v. Commissioner, 94 T.C.
193, 218 (1990). The objective willing buyer, willing seller
standard must be achieved in the context of market and economic
conditions on the valuation date. Id.
The valuation of stock is a question of fact resolved on the
basis of the entire record. See Ahmanson Found. v. United
States, 674 F.2d 761, 769 (9th Cir. 1981); Estate of Newhouse v.
Commissioner, supra at 217. The trier of fact must weigh all
relevant evidence to draw the appropriate inferences. See
Commissioner v. Scottish Am. Inv. Co., 323 U.S. 119, 123-125
(1944); Helvering v. Nat. Grocery Co., 304 U.S. 282, 294-295
(1938); Estate of Newhouse v. Commissioner, supra at 217.
In valuing unlisted securities, “actual arm’s length sales
of such stock in the normal course of business within a
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reasonable time before or after the valuation date are the best
criteria of market value”. Estate of Andrews v. Commissioner,
79 T.C. 938, 940 (1982); See also Estate of Davis v.
Commissioner, 110 T.C. 530, 535 (1998). Where the value of
unlisted stock cannot be determined from actual sale prices, its
value generally is to be determined by taking into consideration
a host of factors, including, among others, the company’s net
worth, prospective earning power, and dividend-paying capacity.
See, e.g., Estate of Davis v. Commissioner, supra at 536.
As is customary in valuation cases, the parties offered
expert opinion evidence to support their opposing valuation
positions. In such cases, we evaluate the opinions of experts in
the light of the demonstrated qualifications of each expert and
all other evidence in the record. See Estate of Christ v.
Commissioner, 480 F.2d 171, 174 (9th Cir. 1973), affg. 54 T.C.
493 (1970); Parker v. Commissioner, 86 T.C. 547, 561 (1986). We
have broad discretion to evaluate “‘the overall cogency of each
expert’s analysis.’” Sammons v. Commissioner, 838 F.2d 330, 334
(9th Cir. 1988) (quoting Ebben v. Commissioner, 783 F.2d 906, 909
(9th Cir. 1986), affg. in part and revg. in part T.C. Memo.
1983-200), affg. in part and revg. in part on another ground T.C.
Memo. 1986-318.
We are not bound by the formulas and opinions proffered by
an expert witness and may accept or reject expert testimony in
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the exercise of sound judgment. See Helvering v. Nat. Grocery
Co., supra at 295; Estate of Newhouse v. Commissioner, supra at
217. Where necessary, we may reach a determination of value on
the basis of our own examination of the evidence in the record.
See Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976),
affg. T.C. Memo. 1974-285; Estate of Davis v. Commissioner, supra
at 538. Where experts offer divergent estimates of fair market
value, we decide what weight to give these estimates by examining
the factors they used in arriving at their conclusions. See
Casey v. Commissioner, 38 T.C. 357, 381 (1962).
We have broad discretion in selecting valuation methods, see
Estate of O’Connell v. Commissioner, 640 F.2d 249, 251 (9th Cir.
1981), affg. on this issue and revg. in part T.C. Memo. 1978-191,
and in evaluating the weight to be given the facts in reaching
our conclusion because “finding market value is, after all,
something for judgment, experience, and reason”, Colonial
Fabrics, Inc. v. Commissioner, 202 F.2d 105, 107 (2d Cir. 1953),
affg. a Memorandum Opinion of this Court. Moreover, while we may
accept the opinion of an expert in its entirety, see Buffalo Tool
& Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980),
we may be selective in the use of any part of such opinion, or
reject the opinion in its entirety, see Parker v. Commissioner,
supra at 561. Because valuation necessarily results in an
approximation, the figure at which this Court arrives need not be
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one as to which there is specific testimony if it is within the
range of values that may properly be arrived at from
consideration of all the evidence. See Estate of O’Connell v.
Commissioner, supra at 252; Silverman v. Commissioner, supra at
933.
C. The Parties’ Expert Testimony
Petitioner’s expert witness, William E. King (Mr. King),
prepared a report (King report) that concludes that the value of
the CRC interest was $2,980,000 on the valuation date.
Respondent’s expert witness, Steven C. Hastings (Mr. Hastings),
prepared a report (Hastings report) that concludes that the value
of the CRC interest was $5,155,000 on the valuation date.
Mr. King is a certified public accountant and is accredited
in business valuation by the American Institute of Certified
Public Accountants. Mr. King has substantial experience in
valuing telecommunications entities. Since 1998 Mr. King’s work
has been focused on the telecommunications industry, and Mr.
King’s company provides, on average, between 35 and 45 valuations
per year related to telecommunications businesses. Mr. King
testified that in any given year he spends between 25 percent and
75 percent of his time working on telecommunications valuations.
On the basis of his experience in telecommunications valuation,
Mr. King was able to factor in the specific conditions and
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outlook of the telecommunications industry, as well as the
economic outlook in general, existing on the valuation date.
Mr. Hastings is a certified public accountant but is not
accredited specifically in business valuation. Mr. Hastings
worked in the area of business valuation during the late 1980s
and early 1990s before leaving to work in other areas of finance.
Mr. Hastings returned to business valuation work in 2006, and he
testified that about 95 percent of his billable hours are
currently spent on valuation issues. However, Mr. Hastings had
never valued a telecommunications company before preparing his
expert report in the instant case. Consequently, Mr. Hastings
took a more mechanical approach to the valuation of the CRC
interest, relying heavily on historical data without significant
adjustment to reflect prevailing market conditions in the
telecommunications industry on the valuation date.
Mr. King valued the CRC interest using both a business
enterprise value analysis and a distribution yield analysis. The
business enterprise value analysis incorporated four valuation
methods (capitalization of income method, discounted future
income method, guideline company method, and guideline
transaction method). The capitalization of income method applied
a capitalization rate of 13.6 percent to CHAT’s determined net
cashflows for four distinct periods preceding the valuation date.
The discounted future income method applied discount rates
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ranging from 14.33 percent to 17.03 percent to CHAT’s projected
annual net cashflows for each of the years during a 10-year
period ending on December 31, 2009, and a 17.03-percent discount
rate to CHAT’s residual value. The guideline company method
reflected prices paid for companies similar to CHAT and whose
stock was traded in a public market. The guideline transaction
analysis reflected transactions involving the acquisition of
privately held entities similar to CHAT. The resulting values
derived under these four enterprise valuation methods, and the
weights assigned to each, were as follows:
Weight
Method Value of CHAT (percentage)
Capitalization of income $44,902,000 50
Discounted future income 34,516,000 30
Guideline company 32,471,000 10
Guideline transaction 26,528,000 10
Concluded enterprise value 38,735,000
On the basis of the above, Mr. King determined in his report
that, on the valuation date, the total business enterprise value
of CHAT was $38,735,000, the fair market value of CRC’s interest
in CHAT was $11,442,000, and the fair market value of the CRC
interest was $2,861,000. In his report, Mr. King then applied a
5-percent lack of marketability discount and concluded that the
appropriate business enterprise valuation of the CRC interest was
$2,718,000.
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Using the distribution yield analysis, Mr. King estimated
the value of CHAT by applying a capitalization factor of 12.41
percent that reflected a 5-percent marketability discount to
CHAT’s net after-tax distributions for the 3 years before the
valuation date (1997 through 1999). On the basis of the
distribution yield analysis, Mr. King determined that the fair
market value of the CRC interest on the valuation date was
$3,243,000. In his report, Mr. King weighted the business
enterprise analysis and the distribution yield analysis equally
to arrive at a fair market value of $2,980,000 for the CRC
interest.
In his report, Mr. Hastings valued the CRC interest by
considering three business enterprise valuation methods
(discounted cashflow method, merger and acquisition method, and
guideline company method) to determine the fair market value of
CHAT. Using the discounted cashflow method, Mr. Hastings applied
a 14-percent discount rate to CHAT’s projected annual income for
each of the years during a 10-year period ending on December 31,
2009. Mr. Hastings used the merger and acquisition method to
reflect transactions involving acquisitions of privately held
entities comparable to CHAT. Mr. Hastings used the guideline
company method to reflect prices paid for companies which were
engaged in a business similar to CHAT and whose stock was
publicly traded. In his report, Mr. Hastings determined that the
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guideline company method potentially overstated the value of CHAT
and gave it no weight. Mr. Hastings concluded that the
discounted cashflow method and the merger and acquisition method
should be weighted equally. The resulting values derived under
these three methods were as follows:
Weight
Valuation Method Value of CHAT (percentage)
Discounted cashflow $98,900,000 50
Merger & acquisition 115,900,000 50
Guideline company 127,800,000 0
Concluded value 107,400,000
On the basis of the above, Mr. Hastings, in his report,
determined that the total value of CHAT was $107,400,000, applied
a 35-percent marketability discount, and concluded that the value
of a 7.385-percent equity interest in CHAT on January 1, 2000,
was $5,155,000. He also concluded that a multilevel discount was
not appropriate and concluded that the value of the CRC interest
on the valuation date was $5,155,000.
In his report, Mr. Hastings did not consider CHAT’s
distribution history when preparing his valuation analysis, and
respondent asserts that Mr. King’s use of a distribution yield
analysis in his report was inappropriate. Specifically,
respondent contends that a distribution yield analysis is
appropriate only where the company being valued has been
distributing almost all of its net income. Relying on section
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25.2512-2(f)(2), Gift Tax Regs., and Rev. Rul. 59-60, 1959-1 C.B.
237, respondent further asserts that dividend-paying capacity,
not dividends paid or distributed, should be used to value
closely held stock. Respondent contends that a distribution
yield analysis will understate the value of a company’s stock
when the company is not paying out all of the cash that it has
available for dividends. It is important to note that while
dividend-paying capacity may well be more important than actual
dividends paid or distributed when determining the value of a
controlling interest in a closely held business, this Court has
recognized that “Dividends paid can be more important than
dividend-paying capacity in appraising minority interests because
a minority shareholder cannot force the company to pay dividends
even if it has the capacity to do so”. Barnes v. Commissioner,
T.C. Memo. 1998-413 (citing Pratt, et al., Valuing a Business:
The Analysis and Appraisal of Closely Held Companies 227 (3d ed.
1996)).
D. Sale Price of the CRC Interest as Evidence of Fair
Market Value
Since a reasonably contemporaneous arm’s-length sale is the
best evidence of value, we must decide whether the sale of the
CRC interest to BellSouth meets that criterion. During July
2000, approximately 6 months after the valuation date, petitioner
and BellSouth entered into an agreement for the purchase of the
CRC interest. Petitioner sold the CRC interest to BellSouth on
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November 27, 2000, for $5,220,043. Respondent contends that the
best evidence of the value of the CRC interest on January 1,
2000, is the subsequent sale of that interest to BellSouth on
November 27, 2000. Petitioner contends that the sale of the CRC
interest to BellSouth did not reflect arm’s-length pricing
between a willing and informed hypothetical buyer and seller and
that the sale price must be disregarded or adjusted. Petitioner
further contends that BellSouth would have paid more than an
average hypothetical buyer for the CRC interest because BellSouth
already owned a controlling interest in CHAT, the primary asset
of CRC.
In deciding whether the sale of the CRC interest to
BellSouth is probative evidence of its value on the valuation
date, we first consider whether the sale was within a reasonable
time after the valuation date. The price at which the CRC
interest sold was fixed by a formula agreed to 6 months after the
valuation date. Petitioner has not established, and does not
argue, that there were intervening circumstances that would have
affected value between the valuation date and the sale date, and
neither party asserts that the sale date was not within a
reasonable time after the valuation date. We conclude, on the
basis of the record, that the sale of the CRC interest to
BellSouth occurred within a reasonable time after the valuation
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date and that there were no intervening events that would have
affected value between the valuation date and the sale date.
We next consider whether the sale to BellSouth was an arm’s-
length sale in the normal course of business. The evidence
indicates that BellSouth was an unrelated buyer acting in its own
self-interest when it purchased the CRC interest. Neither party
argues that the sale to BellSouth was not an arm’s-length
transaction. We conclude, on the basis of the record, that the
sale of the CRC interest was an arm’s-length sale in the normal
course of business.
Finally, even though we have concluded that the sale of the
CRC interest to BellSouth was an arm’s-length transaction, we
consider whether unique characteristics of the transaction
persuade us to adjust the sale price in our valuation analysis.
Petitioner argues that if we use the BellSouth purchase price as
evidence of the value of the CRC interest on the valuation date,
that purchase price must be adjusted to reflect “special
circumstances surrounding the buyer, the seller, or the
transaction generally that could have skewed the sale price from
a measure of true fair market value that would have been reached
between a hypothetical buyer and seller absent those
circumstances”. We agree with petitioner that in the instant
case we should consider the unique characteristics of the actual
buyer, seller, and transaction. See Epic Associates 84-III v.
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Commissioner, T.C. Memo. 2001-64; Hansen v. Commissioner, a
Memorandum Opinion of this Court dated July 28, 1952; sec.
20.2031-2(e), Estate Tax Regs.
Petitioner contends that the sale price must be adjusted
because “BellSouth was a truly unique buyer that would have
likely valued the CRC interest at a higher price than literally
anyone else in the world based on its unilateral control of
CHAT”. Additionally, petitioner contends that we must consider
BellSouth’s history of submitting “high bids” in order to
discourage exercise of rights of first refusal.
E. Whether the BellSouth Sale Price Included a Control
Premium
Petitioner argues that, as a matter of law, the fair market
value of a minority interest in a business cannot be ascertained
by reference to what a controlling interest holder would pay for
the interest because a controlling interest holder would place a
greater value on a minority interest than would a hypothetical
purchaser who lacks control. Petitioner therefore contends that
the BellSouth purchase price reflects a “control” value to
BellSouth and must be disregarded or discounted in determining
the fair market value of the CRC interest to a hypothetical buyer
who did not control CHAT as BellSouth did.
Respondent counters with the argument that BellSouth already
controlled CHAT before its acquisition of the CRC interest and
did not gain any additional measure of control over CHAT by
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virtue of its purchase of the CRC interest. Consequently,
respondent contends, BellSouth would not have paid a control
premium for the CRC interest but instead would have paid only
what any other buyer would have paid for a minority interest in
CRC. Respondent, therefore, argues that the BellSouth sale price
reflects a discount for lack of control.
According to petitioner, valuing the CRC interest by
reference to the BellSouth sale price, without applying a
discount for lack of control, would violate the precedent of this
Court and the Court of Appeals for the Eleventh Circuit.3
Petitioner contends that Estate of Bright v. Commissioner, 658
F.2d 999 (5th Cir. 1981) (en banc),4 and Estate of Andrews v.
Commissioner, 79 T.C. 938 (1982), prohibit the Commissioner from
valuing an interest on the basis of its value to a person who
3
The Tax Court follows the law of the Court of Appeals to
which an appeal would lie if the law of that circuit is on “all
fours”. Golsen v. Commissioner, 54 T.C. 742, 757 (1970), affd.
445 F.2d 985 (10th Cir. 1971). Absent stipulation to the
contrary, any appeal of the instant case would be to the Court of
Appeals for the Eleventh Circuit. See sec. 7482(b)(1)(B).
4
The Court of Appeals for the Eleventh Circuit has adopted
as binding precedent certain decisions of the former Court of
Appeals for the Fifth Circuit. See Bonner v. City of Prichard,
661 F.2d 1206, 1209 (11th Cir. 1981) (en banc); Stein v. Reynolds
Sec., Inc., 667 F.2d 33 (11th Cir. 1982). However, as discussed
below, because Estate of Bright v. Commissioner, 658 F.2d 999
(5th Cir. 1981), is not on “all fours” with the instant case, we
need not consider whether it would be binding precedent in the
Eleventh Circuit.
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already holds a controlling interest without applying a discount
for lack of control.
In Estate of Bright, the decedent and her husband owned, as
community property, a 55-percent interest in each of several
closely held corporations. The issue in Estate of Bright was the
valuation of the decedent’s one-half of that community property
interest. The Commissioner argued that the proper valuation
method was to value the entire 55-percent interest, including a
control premium, and then take one-half thereof. The Court of
Appeals for the Fifth Circuit held that family attribution did
not apply to lump the decedent’s minority interest with the
interest of her husband to create a controlling interest for
valuation purposes. Id.
In Estate of Andrews v. Commissioner, supra, the issue was
the valuation of a decedent’s 20-percent interest in each of four
closely held corporations. As there had been no sales of
interests in the corporations being valued within a reasonable
time before or after the valuation date, this Court valued the
stocks indirectly by weighing net worth, prospective earning
power, dividend-paying capacity, and other relevant factors. Id.
at 940. The portion of the Estate of Andrews Opinion on which
petitioner relies addresses whether a control discount should be
applied to that indirectly determined value. Id. at 951. The
Commissioner’s position in Estate of Andrews was that a control
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discount should not be applied if family members control a
corporation. Id. at 952. Because all the shareholders,
including the decedent, were family members and shared in
control, the Commissioner argued that no discount should be
allowed in valuing the decedent’s 20-percent interest. Id.
Citing Estate of Bright v. Commissioner, supra, this Court
rejected the family attribution argument and applied a minority
discount in determining the value of the decedent’s minority
interests. Id. at 956.
We do not agree that either Estate of Bright or Estate of
Andrews controls the valuation issue in the instant case as a
matter of law. In both Estate of Bright and Estate of Andrews,
the question was not whether a majority shareholder would pay a
premium for a minority interest in an entity that it controlled
but whether family attribution should apply to prevent the
application of a lack of control discount even though the
interest being valued was a minority interest. Neither Estate of
Andrews nor Estate of Bright involved an actual, contemporaneous
sale of an interest in any of the entities being valued as is
present in the instant case. In both Estate of Bright and Estate
of Andrews, the Commissioner’s position was that a minority
interest in a closely held corporation should be valued with a
control premium. Those are not the circumstances of the instant
case. Respondent concedes that the CRC interest was a minority
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interest and that a minority discount is appropriate in valuing
that interest.5 As discussed above, respondent contends that the
minority discount is reflected in the BellSouth sale price.
For the foregoing reasons, we conclude that neither Estate
of Bright v. Commissioner, supra, nor Estate of Andrews v.
Commissioner, supra, establishes that a controlling shareholder
would necessarily be willing to pay a premium for a minority
interest in a corporation that it already controlled.
Accordingly, we do not agree with petitioner that we must, as a
matter of law, apply a lack of control discount to the actual
sale price of the CRC interest because the buyer, BellSouth,
controlled CHAT.
We next consider whether petitioner has proved that, under
the particular circumstances present, the CRC interest would have
been more valuable to BellSouth than to another investor who was
merely acquiring a minority interest. We find nothing in the
record to support petitioner’s assertion. To the contrary,
petitioner’s own expert, Mr. King, indicated that BellSouth had
no incentive, from a control perspective, to buy the CRC
interest. Mr. King testified at trial that “it’s already been
indicated that BellSouth had no reason to buy this. There was no
control element that * * * was associated with this.” He further
5
The parties disagree as to what the appropriate minority
discount is and as to when and how that discount should be
reflected in the different valuation methodologies.
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stated that “there’s no reason for it, they already had control.
They already had operating control of the partnership.”
Accordingly, we conclude that petitioner has not established that
BellSouth paid a control premium for the CRC interest.
F. Whether Rights of First Refusal Affected the Sale Price
We next consider whether, as petitioner contends, there is
evidence that BellSouth paid a premium for the CRC interest in
order to discourage the exercise by the other CRC partners of
their rights of first refusal. The sale of the CRC interest was
subject to a right of first refusal in favor of the three
nonselling partners of CRC. Mr. King testified that, in his
extensive prior experience dealing with BellSouth and its
successor entities, once BellSouth determines that a transaction
is strategic it will “do whatever it takes to win” including
submitting high bids to discourage exercise of rights of first
refusal. Regarding the CRC purchase, Mr. King stated that “In
other words, they wanted to make sure that they put an offer out
that was sufficient enough to essentially discourage Bledsoe
Telephone Company and Trenton Telephone Company from exercising
their right of first refusal.”
We found Mr. King’s testimony to be credible, and there is
no evidence contradicting his testimony in that regard.
Consequently, we conclude that the BellSouth sale price should be
adjusted to reflect the likelihood that BellSouth viewed the CRC
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interest as a strategic acquisition and was willing to pay a
premium to avoid exercise of the rights of first refusal of the
other CRC partners. For the foregoing reasons, we conclude that
the BellSouth sale price is probative, but not conclusive,
evidence of the value of the CRC interest on the valuation date.
G. Fair Market Value of the CRC Interest
Because we find that the BellSouth sale price is probative,
but not conclusive, evidence of the value of the CRC interest on
the valuation date, we have also carefully considered all of the
other evidence in the record in arriving at a determination of
the fair market value of the CRC interest. In making a
determination of value, we have considered the sale of the CRC
interest to BellSouth and the valuation reports of Mr. King and
Mr. Hastings, as well as all the other relevant factors,
including the unique characteristics of BellSouth as a purchaser,
the business climate on the valuation date, the double-tiered
partnership structure, and the dividend and capital call history
of CRC.
We found petitioner’s expert, Mr. King, to be the more
persuasive of the two expert witnesses. As discussed above, his
experience in the field of telecommunications valuation allowed
him to tailor his analyses to reflect industry conditions
existing on the valuation date. Additionally, Mr. King’s
analysis considered the distribution history of CHAT, a factor
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ignored by Mr. Hastings but likely to be an important
consideration for a purchaser of a minority interest. Finally,
the Court found Mr. King’s testimony at trial to be credible and
persuasive. Accordingly, we place great weight on Mr. King’s
expert report. However, we do believe that Mr. King failed to
adequately consider the sale to BellSouth in his analysis, and we
take that sale into account in reaching a determination of value.
We accept the values determined by Mr. King in his business
enterprise valuation analysis and his distribution yield analysis
and his decision to weight those factors equally in valuing the
CRC interest. However, we have also determined that it is
appropriate to include a third factor in the analysis; i.e., the
BellSouth sale price. After considering all of the evidence in
the record, we conclude that the values yielded by the business
enterprise analysis ($2,718,000), the distribution yield analysis
($3,243,000), and the BellSouth sale price ($5,220,423) should be
weighted equally in arriving at the value of the CRC interest.
Weighting each of those numbers equally results in a value of
$3,727,141. On the basis of the foregoing considerations and the
entire record, we conclude that the fair market of the CRC
interest as of the valuation date was $3,727,142.
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II. Substantial Understatement Penalty
A taxpayer may be subject to an accuracy-related penalty of
20 percent of any underpayment which is attributable to a
substantial understatement of income tax. Sec. 6662(a) and
(b)(2). For an S corporation, there is a substantial
understatement of income tax if the amount of the understatement
for the tax year exceeds the greater of 10 percent of the amount
required to be shown on the return or $5,000. Sec.
6662(d)(1)(A). Pursuant to section 7491(c), the Commissioner
generally bears the burden of production for any penalty, but the
taxpayer bears the ultimate burden of proof. Higbee v.
Commissioner, 116 T.C. 438, 446 (2001).
The accuracy-related penalty does not apply where it is
shown that there was substantial authority for the position taken
by the taxpayer. Sec. 6662(d)(2)(B)(i). The accuracy-related
penalty also does not apply to any part of an underpayment of tax
if it is shown that the taxpayer acted with reasonable cause and
in good faith. Sec. 6664(c)(1). That determination is made on a
case-by-case basis, taking into account all the pertinent facts
and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
Taxpayers bear the burden of proving that they had reasonable
cause and acted in good faith. See Higbee v. Commissioner, supra
at 446; Dollander v. Commissioner, T.C. Memo. 2009-187. Relevant
factors include a taxpayer’s efforts to assess his proper tax
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liability, including the taxpayer’s reasonable and good-faith
reliance on the advice of a professional such as an accountant.
Sec. 1.6664-4(b)(1), Income Tax Regs.
Respondent determined that petitioner is liable for a
substantial understatement penalty pursuant to section 6662 of
$185,052. Because we conclude below that petitioner acted with
reasonable cause and in good faith, it is unnecessary to
determine the precise amount of the understatement resulting from
our determination of the value of the CRC interest.
Petitioner contends that it is not liable for an accuracy-
related penalty because it acted in good faith and reasonably
relied on the advice of Mr. Henley in reporting the value of the
CRC interest. Respondent asserts that petitioner did not act
reasonably and in good faith because it disregarded two
appraisals and the actual sale price, all of which would have
resulted in a value for the CRC interest higher than that which
was reported on petitioner’s 2000 income tax return.
Mr. Erli, who was petitioner’s general manager in 2000,
testified that he was not an expert in tax matters, and that, in
fact, tax was one of his areas of weakness. For that reason, Mr.
Erli suggested that petitioner should bring in someone to consult
on its tax returns. Consequently, Mr. Henley, a certified public
accountant specializing in tax, was hired to review petitioner’s
tax returns. It was Mr. Henley who first raised the issue of
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built-in gains tax. Mr. Erli’s uncontradicted testimony
establishes that the decision to use the $2.6 million valuation
of the CRC interest from the February 2000 report was based on
the advice of Mr. Henley. We conclude that it was reasonable for
petitioner to rely on the advice of Mr. Henley in determining the
valuation of the CRC interest to report on its income tax return
Mr. Henley testified that he was made aware of the sale to
BellSouth, but that he did not recommend that petitioner use the
sale price in determining the value of the CRC interest on the
valuation date. On the basis of the testimony of Mr. Erli and
Mr. Henley, it appears that petitioner did not provide Mr. Henley
with the September 1999 report or the Robinson-Humphrey
memorandum. All of the evidence indicates that the February 2000
report was an update of the September 1999 report to correct
errors and incorporate more current data. Respondent does not
dispute that the September report contained errors, nor does
respondent contend that the February 2000 report did anything
more than correct errors and incorporate more recent financial
information. We conclude that there was no reason for petitioner
to have provided Mr. Henley with an appraisal that contained
errors and outdated financial information when a more current
version of that same report was available. Furthermore, we
conclude that the Robinson-Humphrey memorandum was prepared
primarily as a marketing tool, not as an objective valuation of
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the CRC interest. Consequently, we conclude that petitioner did
not act in bad faith when it failed to provide Mr. Henley with
the September 1999 report and the Robinson-Humphrey memorandum.
For the foregoing reasons we conclude that petitioner acted
with reasonable cause and in good faith in relying on the advice
of Mr. Henley regarding the valuation of the CRC interest.
Because we so conclude, we need not reach the question of whether
petitioner’s position was supported by substantial authority. We
hold that petitioner is not liable for a substantial
understatement penalty under section 6662.
III. Conclusion
On the basis of the foregoing, we conclude that the value of
the CRC interest on January 1, 2000, was $3,727,142 and that
petitioner is not liable for a substantial understatement
penalty.
We have considered all of the contentions and arguments of
the parties that are not discussed herein, and we find them to be
without merit, irrelevant, or moot.
To reflect the foregoing,
Decision will be entered
under Rule 155.