Estate of Harriet R. Mellinger, Hugh v. Hunter and Wells Fargo Bank, Co-Executors v. Commissioner , 112 T.C. No. 4 ( 1999 )

112 T.C. No. 4
UNITED STATES TAX COURT
ESTATE OF HARRIETT R. MELLINGER, DECEASED,
HUGH V. HUNTER AND WELLS FARGO BANK, CO-EXECUTORS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 6663-97. Filed January 26, 1999.
P died owning 2,460,580 shares of stock that were
held in her revocable trust. The stock was included in
her estate pursuant to sec. 2033, I.R.C. Also included
in her estate, pursuant to sec. 2044, I.R.C., were
2,460,580 shares of the same stock held in a QTIP trust
established by decedent's predeceased spouse. Held:
The shares of stock should not merge or be aggregated
for Federal estate tax valuation purposes.
Robert B. Martin, Jr., for petitioner.
Donna F. Herbert and Mark A. Weiner, for respondent.
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COHEN, Chief Judge: Respondent determined a deficiency of
$10,574,983 in the Federal estate tax of the estate of
Harriett R. Mellinger (decedent). After concessions by the
parties, the issues remaining for decision are:
(1) Whether section 2044 requires aggregation, for valuation
purposes, of the stock held in a trust established by decedent's
predeceased spouse under section 2056(b)(7) with stock held in
decedent's revocable trust and with stock held outright by
decedent; and
(2) if section 2044 does not require aggregation, the fair
market value of the stock at decedent's death.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect as of the date of decedent's
death, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the facts set
forth in the stipulation are incorporated in our findings by this
reference. Decedent died testate on April 18, 1993 (the
valuation date), a resident of Los Angeles, California. Decedent
was the widow of Frederick N. Mellinger (Mr. Mellinger), founder
of Frederick's of Hollywood, Inc. (FOH).
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Stock Ownership and Valuations
Prior to Mr. Mellinger's death, decedent and Mr. Mellinger
were husband and wife and owned as community property 4,921,160
shares of the common stock of FOH. Such shares were held under
the terms of a revocable inter vivos trust known as the
Frederick N. Mellinger Family Trust (the family trust).
On the death of Mr. Mellinger, under the terms of the family
trust, Mr. Mellinger left his community property interest of
2,460,580 shares of FOH stock in an irrevocable marital trust
(the QTIP trust) for the benefit of decedent during her lifetime.
Property in the QTIP trust was treated in Mr. Mellinger's estate
as "qualified terminable interest property" (QTIP property) for
which a marital deduction was claimed pursuant to section
2056(b)(7). Hugh V. Hunter (Hunter) and Wells Fargo Bank
(referred to collectively as cotrustees and coexecutors herein)
were the cotrustees of the QTIP trust after decedent's death.
Under the terms of the QTIP trust, decedent received a qualified
income interest for her lifetime. Upon decedent's death, the
QTIP trust provided for the payment of certain periodic and lump
sums to the adult children of Mr. Mellinger and decedent, until
they attained the age of 65, in addition to certain periodic
lump-sum payments to the grandchildren of Mr. Mellinger and
decedent, until they attained the age of 30. Upon the final
payment to the children and grandchildren, the QTIP trust
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property was to be distributed equally to certain tax-exempt
charitable organizations. On the valuation date, the QTIP trust
held 2,460,580 shares of FOH stock, which then constituted
27.8671 percent of the issued and outstanding stock of FOH.
After Mr. Mellinger's death, decedent removed her share of
the community property, 2,460,580 common shares of FOH, from the
family trust and contributed it to the revocable trust that she
established to be known as the Harriett R. Mellinger Revocable
Trust (the Harriett trust). The stock that was held by the
Harriett trust also constituted 27.8671 percent of the issued and
outstanding stock of FOH. Hunter and Wells Fargo Bank were
designated as cotrustees. Under the terms of the Harriett trust,
upon the death of decedent, the cotrustees were directed to make
certain specific gifts and to sell decedent's personal residence
and distribute the sales proceeds to decedent's children. The
balance of the Harriett trust was to be held for distribution
with certain annual and periodic cash amounts to be made to the
children and specified grandchildren. Upon the death of such
children and grandchildren, the remaining trust estate was to be
distributed equally to certain charitable organizations. At the
valuation date, decedent also owned 50 shares of FOH outright.
Hunter and Wells Fargo Bank (coexecutors) filed a United
States Estate (and Generation-Skipping Transfer) Tax Return, Form
706, for decedent's estate on January 18, 1994. On the return,
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the FOH shares in the Harriett trust were reported at a value of
$11,786,178 or $4.79 per share, and the FOH shares in the QTIP
trust, includable in decedent's estate pursuant to section 2044,
were reported at a value of $11,786,178 or $4.79 per share. In
valuing the shares of FOH, the coexecutors consulted legal
counsel and obtained two appraisals. The appraisers that were
employed by the coexecutors were the investment firm of Janney
Montgomery Scott, Inc. (JMS), and the appraisal firm of
Willamette Management Associates (WMA). Each appraisal valued
the shares as separate 27.8671-percent interests in FOH. The
appraisals concluded that, because of the size of the blocks
under consideration in relation to the trading volume, petitioner
would not be able to sell the holdings in the public market
without incurring a blockage discount. The WMA appraisal valued
the shares at $4.85 per share, after applying a 30-percent
discount, and the JMS appraisal valued the shares at $4.79, after
applying a 31-percent discount. Based on the appraisals, the
estate valued the shares on its United States Estate Tax Return
at $4.79 per share.
In October 1993, FOH filed an Amendment to its Certificate
of Incorporation (amendment) resulting in a redesignation of the
existing capital stock as class A capital stock and the creation
of a new class of nonvoting capital stock designated as class B
capital stock. In connection with the amendment, the existing
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FOH capital stock was split at the rate of one share for every
three shares outstanding. At the same time, FOH declared a
distribution in the form of a dividend of two shares of class B
capital stock for every one share of class A capital stock
outstanding on October 15, 1993. The effect of the amendment,
split, and dividend was to convert each three existing shares of
FOH capital stock into one share of class A capital stock and two
shares of class B capital stock. As a consequence of the
recapitalization of FOH, except as set forth below, all rights to
vote were exclusively vested in the class A capital stock. The
holders of class B capital stock were entitled to vote separately
as a class only with respect to designated issues. In addition,
the trusts were prohibited from selling any of the class B
capital stock for a 2-year period at a price of less than $7.00
per share.
Subsequently, the coexecutors undertook efforts to sell the
FOH stock that was held by the trusts in order to raise funds for
the payment of Federal estate tax and to provide funds for the
required distributions. Accordingly, pursuant to a stock
purchase agreement dated January 12, 1994, the FOH Employee Stock
Ownership Plan (FOH ESOP) purchased 357,143 shares of FOH class A
capital stock from the Harriett trust for $4.20 per share, a
30-percent discount from the closing price of such stock on the
New York Stock Exchange (NYSE) on January 10, 1994. In
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establishing the value of these shares, the FOH ESOP relied on an
appraisal by JMS that expressed an opinion that the appropriate
discount for the transaction was between 29 and 31 percent.
Thereafter, on February 18, 1994, the Harriett trust sold, in a
market transaction on the NYSE, in conformity with Securities and
Exchange Commission (SEC) Rule 144, 29,500 shares of FOH class B
capital stock at a price of $4.875 per share. The aggregate
gross proceeds of the sale received by the Harriett trust were
$147,492.71.
On June 14, 1996, FOH, the Harriett trust, and the QTIP
trust jointly announced their employment of JMS to sell the FOH
stock owned by the trusts and possibly to sell all of the shares
of FOH. After holding discussions with numerous prospective
purchasers, Knightsbridge Capital Corporation (Knightsbridge)
submitted a formal offer to purchase all of the outstanding
shares of FOH for not less than $6.00 and not more than $6.25 per
share and to merge with FOH. The offer was dated April 9, 1997.
The board of directors of FOH determined that this merger was in
the best interest of FOH and the stockholders and approved the
transaction. Thereafter, the board of directors mailed consent
agreements to all shareholders requesting approval for the
proposed merger. Approximately 88 percent of FOH stockholders,
including the trusts, voted in favor of the merger. After
negotiating the price, Knightsbridge and FOH entered into an
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agreement dated September 25, 1997. Pursuant to this agreement,
Knightsbridge purchased from the Harriett trust and the QTIP
trust, all of the FOH shares that were held by the trusts for
$6.90 per share. Immediately thereafter, pursuant to the merger
agreement, Knightsbridge acquired the remaining outstanding
shares of FOH from the remaining shareholders for $7.75 per
share.
On examination, respondent determined that the FOH shares
that were held by the Harriett trust and the QTIP trust should be
merged for valuation purposes, and, in the January 15, 1997,
notice of deficiency, respondent indicated that the FOH shares in
each trust should be valued at $20,820,159.39 or $8.46 per share.
Overview of FOH
Founded in 1946 by Mr. Mellinger and incorporated in
Delaware in 1962, FOH began as a small mail-order operation
selling an assortment of intimate women's apparel. In 1947, the
business was moved to Hollywood, California, opening its first
retail store there in 1952. In its beginning, FOH's name was
synonymous with risque lingerie. The company's original market
was American GI's who, after spending time abroad, were eager to
get for their wives or girlfriends the lingerie that was
fashionable in Europe. FOH pioneered many trends in the industry
including the extensive use of black, the pointy snow-cone bras
of the 1950's, and the revival of garter belts in the 1980's.
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The company's products had the reputation of being "slightly
naughty" but not offensive, and this style proved to be highly
successful in the 1960's and 1970's.
By the early 1980's, however, the risque look of FOH's
products began losing appeal. These trends caught FOH off guard,
and the company's operations began to falter. At the same time,
Mr. Mellinger developed Alzheimer's disease. He retired in 1984
with FOH's profits dwindling. Under new management, FOH enacted
a plan to turn the company around. The company's catalogs were
purged of nudity, and the black and white pictures were replaced
with color photographs of models. On the retail store side, a
major overhaul was also enacted. The company spent heavily to
upgrade store ambience and to improve the merchandise mix.
All of these steps successfully repositioned FOH as a
specialty retailer of intimate apparel. The company operates 206
specialty boutiques in 39 States with the highest concentration
of stores in California. FOH developed a mail-order subsidiary
to engage in extensive operations in all 50 States, with catalogs
published 11 times a year.
For convenience, the following chart shows the net sales,
net earnings, earnings per share, total assets, and equity of FOH
for the fiscal years ended September 1, 1990; August 31, 1991;
August 29, 1992; and August 28, 1993.
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Year Net Sales Net Sales Net Earnings Total
End Retail Catalog Earnings Per Share Assets Equity
1990 $98,573,000* $4,242,000 $.50 $35,031,000 $21,855,000
1991 70,938,000 $43,196,000 5,197,000 .58 39,935,000 26,992,000
1992 71,320,000 45,710,000 5,073,000 .57 45,790,000 32,304,000
1993 73,202,000 55,314,000 4,737,000 .53 50,838,000 36,615,000
*Total Net Sales for 1990
At the valuation date, FOH had one class of stock
outstanding that traded on the NYSE, and those shares were
unregistered with the SEC. Additionally, on the valuation date,
the average price of FOH stock on the NYSE was $6.9375 per share.
Economic Conditions at the Valuation Date
At the valuation date, the American economy was experiencing
a transition from recession to a recovery. The United States
gross domestic product (GDP) grew 2.1 percent in 1992 following
the 1991 recession. Economic improvements had generally been
fueled by low interest rates, increasing corporate profits and
strong productivity growth. Despite these positive factors,
structural problems, including excessive debt, corporate
restructuring and related uncertainties regarding job growth,
overvalued real estate, weak banks, defense spending reductions,
and consumer confidence continued to hamper the strength and
speed of the recovery.
A survey of economists by the Wall Street Journal in early
1993 revealed a consensus estimate of 3-percent GDP growth rate
for 1993, with 2.8-percent growth rate expected in the first
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half. This rate represents continued moderate growth but is
below that normally experienced in postrecessionary years.
Nondurable goods expenditures advanced 5.9 percent in 1992 after
falling 5.6 percent in 1991.
The California marketplace did not experience the rebound
seen in the majority of the nation in 1992. Its economy
continued to be impacted negatively by defense industry layoffs
and a declining housing market. The Wall Street Journal reported
that the California economy was expected to continue to trail far
behind the rest of the United States in 1993.
ULTIMATE FINDINGS OF FACT
The fair market value of FOH shares includable in decedent's
gross estate should reflect a 25-percent discount for lack of
marketability. On the valuation date, the fair market value of
each of the two 27.8671-percent interests in FOH that were held
by the trusts was $12,802,705, or $5.2031 per share.
OPINION
Issue 1
Section 2031 generally provides that the value of a
decedent's gross estate includes the value of property described
in sections 2033 through 2044. See sec. 20.2031-1(a), Estate Tax
Regs. Under section 2033, the value of a decedent's gross estate
includes the value of all property beneficially owned by the
decedent at the time of death. See sec. 20.2033-1(a), Estate Tax
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Regs. Section 2044(a) includes in the gross estate the value of
property in which the decedent had a qualified income interest
for life and for which a marital deduction was allowed to the
estate of a predeceased spouse under section 2056(b)(7) (QTIP
property). Accordingly, at the death of the second spouse, QTIP
property is taxed as part of the surviving spouse's estate.
Sec. 2044(c).
Property includable in the gross estate is generally
included at its fair market value on the date of a decedent's
death. Sec. 2031(a); sec. 20.2031-1(b), Estate Tax Regs. Fair
market value is defined as the price that a willing buyer would
pay a willing seller, both persons having reasonable knowledge of
all of the relevant facts and neither person being under a
compulsion to buy or sell. United States v. Cartwright, 411 U.S.
546, 551 (1973); sec. 20.2031-1(b), Estate Tax Regs. The willing
buyer and the willing seller are hypothetical persons, rather
than specific individuals or entities, and the individual
characteristics of these hypothetical persons are not necessarily
the same as the individual characteristics of the actual seller
or the actual buyer. Propstra v. United States, 680 F.2d 1248,
1252 (9th Cir. 1982). The issue in this case is whether FOH
shares in the Harriett trust should be aggregated with FOH shares
in the QTIP trust for purposes of ascertaining the fair market
value of property passing from decedent.
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Historically, undivided fractional interests in property
included in an estate have been valued at a discount to reflect
lack of marketability and minority interest holdings. See Estate
of Andrews v. Commissioner, 79 T.C. 938, 952-953 (1982) (minority
interests); Estate of Piper v. Commissioner, 72 T.C. 1062, 1084-
1086 (1979) (marketability discount). Respondent, however, has
long opposed such discounts and has argued for unity of ownership
principles in estate tax cases. See, e.g., Estate of Bonner v.
United States, 84 F.3d 196, 198 (5th Cir. 1996); Propstra v.
United States, supra at 1251; Estate of Bright v. United States,
658 F.2d 999, 1001 (5th Cir. 1981); Estate of Andrews v.
Commissioner, supra at 952-956. Specifically, respondent has
argued that a decedent's fractional interest in property should
be aggregated with fractional interests owned by family members
in the same property for purposes of valuing the property in the
estate. Propstra v. United States, supra at 1251; Estate of
Bright v. United States, supra at 1001; Estate of Andrews v.
Commissioner, supra at 952. Respondent's basis for this position
was that such undivided fractional interests should be valued by
taking into consideration family cooperation and the likelihood
that fractional interests will be sold together rather than
separately. See Propstra v. United States, supra at 1251; Estate
of Andrews v. Commissioner, supra at 952. Respondent relied on
this argument despite section 20.2031-1(b), Estate Tax Regs.,
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which ignores subjective factors of ownership in valuing estate
assets. Estate of Bonner v. United States, supra at 198.
Ultimately, respondent reviewed this position and conceded that,
for estate tax purposes, respondent would follow Estate of Bright
v. United States, supra, and Propstra v. United States, supra,
where family attribution had been rejected. See Rev. Rul. 93-12,
1993-1 C.B. 202.
The Court of Appeals for the Ninth Circuit addressed
respondent's aggregation theory in Propstra v. United States,
supra. In Propstra, the decedent died with an undivided one-half
interest in several parcels of real estate owned by him and his
wife as community property. These parcels of community property
had an undisputed fair market value of $4,002,000, but, in
valuing the property for estate tax purposes, the executrix
discounted the fair market value of the decedent's one-half
interest by 15 percent to account for the relative
unmarketability of the decedent's undivided fractional interest.
The Commissioner disallowed the 15-percent discount, arguing that
the decedent's interest in the property should be valued together
with the interest owned by the surviving spouse. "[O]ne can
reasonably assume that the interest held by the estate will
ultimately be sold with the other undivided interest and that
interest's proportionate share of the market value of the whole
will thereby by realized." Id. at 1251.
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The Court of Appeals for the Ninth Circuit considered the
language of sections 2031 and 2033, along with the accompanying
regulations, and decided that Congress did not intend to have
"unity of ownership" principles apply to property valuation for
estate tax purposes. Id. The court stated:
By no means is * * * [the language of section 20.2031-
1(b)] an explicit directive from Congress to apply
unity of ownership principles to estate valuations. In
comparison, Congress has made explicit its desire to
have unity of ownership or family attribution
principles apply in other areas of the federal tax law.
See, e.g., I.R.C. secs. 267, 318, and 544. In the
absence of similarly explicit directives in the estate
tax area, we shall not apply these principles when
computing the value of assets in the decedent's estate.
[Id. at 1251.]
The court concluded that the decedent's fractional interest in
the subject property should be valued separately from the
accompanying fractional interest held by the surviving spouse,
upholding the 15-percent discount. Id. at 1253.
Respondent argues that decedent's situation is
distinguishable from Propstra because all of the property to be
aggregated in this case is included in decedent's estate. The
FOH shares in the Harriett trust are included pursuant to section
2033, and FOH shares in the QTIP trust are included pursuant to
section 2044. Thus, respondent contends that decedent is
considered to be the owner of all of these shares outright for
purposes of valuation, in which case the shares should be valued
as one 55.7-percent ownership block. Respondent concludes that,
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because the aggregate ownership in decedent's estate represents a
controlling interest in FOH, the shares should be valued at a
premium rather than at a discount.
Section 2044 was added to the Code in conjunction with
section 2056(b)(7) in 1981. Economic Recovery Tax Act of 1981,
Pub. L. 97-34, sec. 403(d), 95 Stat. 172, 302. Under section
2056(b)(7), the decedent is entitled to a marital deduction for
transfers of QTIP property to the surviving spouse at the
decedent's death. The surviving spouse has a lifetime interest
in the QTIP property, and, upon the death of the surviving
spouse, the property passes to beneficiaries designated by the
decedent. Accordingly, the first spouse to die can postpone
Federal estate tax that would otherwise be due on the QTIP
property while also retaining control over the ultimate
disposition of it. Sec. 2056(b)(7). Inclusion in the estate of
the second spouse to die, however, is the quid pro quo for
allowing the marital deduction for the estate of the first spouse
to die.
The purpose of section 2044 is to provide for the taxation
of QTIP property upon the death of the second spouse. That
section provides, in pertinent part, that "The value of the
[surviving spouse's] gross estate shall include the value of
property * * * [for which a deduction was allowed with respect to
the transfer of such property to the surviving spouse under
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section 2056(b)(7) and in] which the * * * [surviving spouse] had
a qualifying income interest for life." Sec. 2044(a). This
property is "treated as property passing from the" surviving
spouse, sec. 2044(c), and is taxed as part of the surviving
spouse's estate at death, but QTIP property does not actually
pass to or from the surviving spouse.
Respondent argues that decedent should be treated as the
owner of QTIP property for valuation purposes. Respondent has
identified nothing in the statute that indicates that Congress
intended that result or that QTIP assets should be aggregated
with other property in the estate for valuation purposes. Cf.
secs. 267, 318, 544 (indicating aggregation of interests in terms
of ownership). Furthermore, at no time did decedent possess,
control, or have any power of disposition over the FOH shares in
the QTIP trust. Cf. secs. 2035, 2036, 2041 (requiring inclusion
in the gross estate where a decedent had control over the assets
at some time during her life).
Section 2044 was amended by the Technical Corrections Act of
1982, Pub. L. 97-448, sec. 104(a)(1)(B), 96 Stat. 2365, 2380.
The legislative history accompanying that amendment provides no
additional guidance on whether the interests involved in this
case should be aggregated. Rather, "The bill clarifies that QTIP
property included in a deceased donee spouse's estate is treated
as passing from that spouse, for purposes of the estate tax,
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including the charitable and marital deductions." S. Rept.
97-592, at 20 (1982), 1983-1 C.B. 475, 483. In addition, the
legislative history to the amendment does not suggest that
Congress intended that section 2044 property be treated as being
owned by the second spouse to die for purposes of aggregation and
does not provide for aggregation with other fractional interests
in the same property included in the decedent's estate under
section 2033. Neither section 2044 nor the legislative history
indicates that decedent should be treated as the owner of QTIP
property for this purpose.
In Estate of Bonner v. United States, 84 F.3d at 198, the
decedent died owning fractional shares in several pieces of real
property with the remaining ownership interests being held in a
QTIP trust established by his wife at her death. As provided in
section 2044, the interest that was held by the QTIP trust was
included in the decedent's estate. The fractional shares that
were owned outright by the decedent were also included in the
decedent's estate pursuant to section 2033. The executor of the
decedent's estate, however, valued each interest separately with
a 45-percent discount. The Government argued that the fractional
interests in the real property should be aggregated for valuation
purposes.
The Court of Appeals, relying on its prior holding in Estate
of Bright v. United States, 658 F.2d at 1001, concluded that the
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fractional interests in the assets should not merge into a
100-percent fee ownership by the estate. The court stated that
"the statute does not require, nor logically contemplate that in
so passing, the QTIP assets would merge with other assets."
Estate of Bonner v. United States, supra at 198. The court also
relied on the decedent's lack of control over the disposition of
property. Id. at 198-199. The court stated:
The estate of each decedent should be required to pay
taxes on those assets whose disposition that decedent
directs and controls, in spite of the labyrinth of
federal tax fictions. * * * Mrs. Bonner controlled
the disposition of her assets, first into a trust with
a life interest for Bonner and later to the objects of
her largesse. The assets, although taxed as if they
passed through Bonner's estate, in fact were controlled
at every step by Mrs. Bonner, which a tax valuation
with a fractional interest discount would reflect. At
the time of Bonner's death, his estate did not have
control over Mrs. Bonner's interests in the assets such
that it could act as a hypothetical seller negotiating
with willing buyers free of the handicaps associated
with fractional undivided interests. The valuation of
the assets should reflect that reality. [Id. at 199.]
Respondent also argues that, in enacting sections 2056(b)(7)
and 2044, Congress did not intend to alter the estate tax
consequences that would otherwise arise if a decedent had
transferred property to his or her surviving spouse outright.
See H. Rept. 97-201, at 160 (1981), 1981-2 C.B. 352, 378 ("tax
laws should be neutral and * * * tax consequences should not
control an individual's disposition of property"). Prior to the
enactment of sections 2056(b)(7) and 2044, for the first spouse
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to get the full marital deduction, the decedent had to leave
property to the surviving spouse outright or had to leave
property to the surviving spouse in trust with a general power of
appointment. In either situation, the decedent's property was
aggregated with the property of the surviving spouse for
valuation purposes when the surviving spouse died. Accordingly,
respondent concludes that property in the QTIP trust should be
aggregated with the FOH shares in the Harriett trust for purposes
of determining the fair market value of the FOH stock.
Section 2044 was designed to prevent QTIP property from
escaping taxation by including it in the estate of the second
spouse to die. There is, however, no indication that section
2044 mandated identical tax consequences as an outright transfer
to the surviving spouse.
Finally, respondent argues that section 2044(c) is a
valuation section, rather than just an inclusion section. See
Estate of Young v. Commissioner, 110 T.C. 297, 308-309 (1998).
In Estate of Young, we held that section 2040 provides an
"artificial inclusion" of joint tenancy property, the entire
value less any contribution by the surviving joint tenant. Id.
at 315. We rejected the taxpayer's contention that section 2040
was merely an includability section because Congress had provided
an explicit approach to valuing joint tenancy property to be
included in the decedent's gross estate. Id. at 315-316. Thus,
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the entire value of the joint tenancy was included in the estate
except for that portion attributable to the consideration
supplied by the surviving joint tenant. Respondent argues that
section 2044 provides a similar "artificial inclusion" for the
assets held in the QTIP trust, concluding that the analysis in
Estate of Young compels a valuation of the FOH shares as if
decedent owned the whole block.
Section 2040(b) explicitly sets forth a special rule of
valuation for joint tenancy property, but this special rule only
applies to section 2040; section 2044 contains no such directive.
The absence of such language in section 2044, which was enacted
in the same tax act as section 2040(b), belies respondent's
argument that Congress mandated or intended a special rule of
valuation to apply to property included in a decedent's estate
pursuant to section 2044(a).
Issue 2
Based on our conclusion that the two blocks of FOH shares
should not be aggregated, we must determine the fair market value
of the FOH stock at decedent's death.
Valuation is a question of fact, so we must weigh all
relevant evidence to draw the appropriate inferences. Ahmanson
Found. v. United States, 674 F.2d 761, 769 (9th Cir. 1981);
Estate of Andrews v. Commissioner, 79 T.C. 940. The fair
market value of stock listed on an established securities market
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is the mean between the highest and lowest selling prices on the
valuation date. Sec. 20.2031-2(b)(1), Estate Tax Regs. A
blockage discount may, however, be applied when the block of
stock to be valued is so large that it cannot be liquidated in a
reasonable time without depressing the market. Sec. 20.2031-
2(e), Estate Tax Regs. The concept of blockage is essentially
one of timing. See Estate of Smith v. Commissioner, 57 T.C. 650,
657-658 (1972), affd. 510 F.2d 479 (2d Cir. 1975).
Petitioner has the burden of proof as to the correctness and
amount of the discount. Rule 142(a); Estate of Van Horne v.
Commissioner, 720 F.2d 1114, 1117 (9th Cir. 1983), affg. 78 T.C.
728 (1982). This burden is a burden of persuasion, requiring
petitioner to prove the merits of its claim by at least a
preponderance of the evidence. Rockwell v. Commissioner, 512
F.2d 882, 885 (9th Cir. 1975), affg. T.C. Memo. 1972-133;
Brumley-Donaldson Co. v. Commissioner, 443 F.2d 501, 504 n.4 (9th
Cir. 1971), affg. T.C. Memo. 1969-183.
Both parties rely extensively on expert testimony to
establish the amount of the discount. Expert opinions are
admissible if they will assist the trier of fact to understand
evidence that will determine a fact in issue. Fed. R. Evid. 702.
We evaluate the opinions of experts in light of the demonstrated
qualifications of each expert and all other evidence in the
record. Parker v. Commissioner, 86 T.C. 547, 561 (1986).
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However, we are not bound by the opinion of an expert witness,
especially when such opinions are contrary to our judgment. IT&S
of Iowa, Inc. v. Commissioner, 97 T.C. 496, 508 (1991). Where
experts offer divergent estimates of fair market value, we decide
what weight to give those estimates by examining the factors used
by those experts to arrive at their conclusions. Casey v.
Commissioner, 38 T.C. 357, 381 (1962). While we may accept the
opinion of an expert in its entirety, Buffalo Tool & Die
Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980), we
may be selective and use only part of such an opinion. Parker v.
Commissioner, supra. We may also reach a determination of value
based on our own examination of the evidence in the record.
Estate of Davis v. Commissioner, 110 T.C. 530, 538 (1998).
The parties in this case agree that the undiscounted fair
market value of the FOH shares on the valuation date is $6.9375
per share. The parties also agree that a marketability discount
is necessary if the shares are not to be aggregated. They
disagree, however, as to the appropriate marketability discount
to be applied. Respondent contends that the minority blocks of
FOH should be valued at $5.8969 per share, a 15-percent discount.
Petitioner argues that the shares of FOH have a value of $4.786
per share, a 31-percent discount. Petitioner supports its
conclusion with the testimony of Curtis R. Kimball (Kimball) and
Ira M. Cotler (Cotler).
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Kimball focused on the following methods of disposition to
determine the fair market value of the minority blocks of FOH
stock: (1) "Synthetic" put option analysis, (2) public secondary
offering, and (3) private placement analysis. Kimball explained
that the holder of a significant block of shares, such as the FOH
block, would be exposed to significant risks when attempting to
dispose of the shares in the public market. According to
Kimball, the blocks may represent several weeks or months of
trading volume, exposing the seller to fluctuations in the market
stock price. He explained that a method of eliminating such risk
is to buy put option contracts granting the seller the right to
sell the shares at a fixed price over a predetermined period.
Hence, for a price, the seller would eliminate the risk of
downward stock price movement over the disposition period. This
approach is called a synthetic option analysis because FOH stock
had no actual public market for any options or warrants in
existence on the valuation date. Kimball estimated the expense
necessary to enter into such options for blocks of FOH stock
using several econometrics and theoretic option pricing models,
including the Black-Scholes model, the Noreen-Wolfson model, and
the Shelton model. He settled on $4.50 per share, a discount of
roughly 35 percent, as the most appropriate value. In coming to
his conclusion, Kimball indicated that he placed more weight on
the Shelton model because of his greater confidence in the
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ability of that model to deal with longer holding period option
values.
Kimball admitted at trial that his synthetic put option
analysis was flawed. In his report, he concluded that the price
of FOH shares should be valued in a range of $3.545 to $5.166 per
share. However, cross-examination of Kimball indicated several
mathematical errors in his calculations of the Black-Scholes and
Noreen-Wolfson models that are intended to estimate the expense
necessary to enter into put options. Respondent also pointed out
that there was an alternative calculation of the Shelton model.
After the adjustments, the new range in price for FOH shares
using the put option methodology was between $5.689 and $5.9372,
indicating a discount range of between 14.4 and 18 percent.
Second, Kimball analyzed the secondary offering approach to
valuation. As part of his research, Kimball reviewed various
studies that were performed to analyze the costs of a secondary
offering and similar transactions. Using this approach, Kimball
concluded that the fair market value for the subject FOH shares
was between $5.286 and $5.037 per share. He noted that the risks
of an unsuccessful secondary offering factored into his
determination of where, within this range, FOH shares would be
priced. He selected a fair market value of $5.10 per share, a
discount of about 26.5 percent, as the appropriate value under
this approach.
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Kimball made no effort to compare the subject transaction to
transactions within the secondary offering studies that have
similar characteristics, such as where the stock is traded,
revenues, sales, and similar factors indicating analogous
transactions. Instead, he relied primarily on the mean and
median discounts of each study. Petitioner admits on brief that
Kimball relied very little on the secondary offering approach and
concedes that Kimball relied most heavily on the private
placement analysis in coming to his conclusion.
Kimball used the primary body of empirical evidence
concerning private placement data, as found in studies of
restricted stocks, to analyze the private placement market.
Kimball concluded that various surveys reviewed by him indicated
a cumulative average discount of 35 percent for restricted stock
in a publicly traded company. He ultimately concluded that a
32-percent discount was appropriate considering the combined
influences of all of the relevant factors under this approach.
Applying the 32-percent discount to the market price on the
valuation date results in a fair market value of $4.72 per share.
Petitioner also offered the expert testimony of Cotler to
establish the applicable discount. Cotler testified that he
analyzed numerous studies to determine the appropriate discount
for lack of marketability. From these studies, Cotler observed
that there was a mean discount of 34.73 percent for lack of
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marketability. Cotler indicated that the discount is most
sensitive to block size. For example, a block of stock that
represented 39 percent of the outstanding shares averaged a
38.7-percent discount. Cotler further testified that, in order
to value properly the FOH stock, there must be a thorough
analysis of FOH's operations, the markets it serves, and the
characteristics of the FOH stock held by the trusts.
Cotler expressed an opinion that, at the valuation date, FOH
was experiencing an accelerating negative financial performance.
Cotler also noted that a large factor influencing the negative
results of FOH could be related to the U.S. economy and the
recession in California at the valuation date. Cotler also
testified that consumer confidence was dropping in the fourth
quarter of 1992 and that the retail sector was anticipating a
difficult year with continued discounting of merchandise likely
in order for retailers to maintain sales levels.
Cotler opined that the declining interest in FOH common
stock was likely attributable to a number of factors, the most
significant being the continuing decline in FOH's operating
performance and the low expectations of a near-term turnaround.
From an analysis of the common stock trading patterns, he
concluded that there was a relatively low level of investor
interest in FOH, and selling a large block of FOH common stock
would be very difficult. Cotler further observed that the FOH
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stock in issue represented a significant percentage of the
then-outstanding shares, 27.8 percent. With the average volume
during the first 6 months of 1993 at 5,197, Cotler concluded that
it was improbable that the FOH stock could have been sold in the
public market within a reasonable time frame.
Cotler pointed to the size of the block, FOH's recent and
expected financial performance, and the overall trading
characteristics of the FOH common stock as reasons why it would
be difficult to sell the FOH stock at a price equal to the
publicly traded common stock. Based upon this analysis, his
experience as an investment banker, and other information
available to him, Cotler concluded that the fair market value of
the FOH stock at the valuation date should be $4.79, a 31-percent
discount.
Respondent determined that the value of the blocks of FOH
shares that were held in the trusts must be discounted between
10 and 17 percent to reflect the lack of marketability.
Respondent supports this determination with the expert testimony
of David N. Fuller (Fuller).
Fuller agreed with petitioner's experts that a discount for
lack of marketability was appropriate when disposing of the
separate minority interests in FOH. He testified that there were
three viable options for selling the separate blocks of FOH
stock: (1) A registered secondary offering, (2) a private
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placement of the stock, or (3) a periodic sale subject to volume
restrictions under SEC rule 144. With respect to the registered
secondary offering, Fuller testified that a discount between
10 and 13 percent was warranted. He also testified that, under a
periodic sale subject to SEC rule 144, the minority interests in
FOH should be discounted between 13 and 17 percent. However,
Fuller ultimately dismissed these options concluding that none
were viable and that the private placement analysis was the
exclusive means by which to value the blocks of FOH stock.
Specifically, Fuller testified that a secondary offering was not
feasible because it would require the consent of FOH management.
Likewise, he concluded that it would take 7 years to liquidate
the stock under the periodic sales method, rendering that means
of disposition inadequate.
Instead, he concluded that a private placement was the
likely means of disposition. In calculating the discount for a
private placement of FOH stock, Fuller indicated that holding
period restrictions were the primary reason for the discount. To
ascertain the applicable discount, Fuller reviewed several
restricted stock studies on private placement transactions.
Fuller recognized that the combined results of these studies
indicated a 35-percent marketability discount. He, however,
concluded that the studies suffer because they review only
restricted share transactions and do not include a sample of
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similar private placement block sales of registered shares. In
contrast, Fuller relied on a study that analyzed 106 private
placement transactions of both restricted and registered shares.
This study concluded that discounts were required by private
placement investors because of information costs that they bore
in investigating the value of shares in the issuing firms as well
as from anticipating "monitoring costs" associated with the
investment (i.e., assistance in the formulation of management
policy and oversight of existing management). He noted that the
sale of restricted shares rather than registered shares in
private placements resulted in a discount of 13.5 percent.
Fuller also used a study being conducted by Business
Valuation Services, Inc. (BVS), his firm, as a "sanity check".
The study analyzed private placement transactions and revealed,
after an analysis of 51 transactions, a mean discount of
16.2 percent. Fuller pointed out that, for private placements of
companies with market capitalizations greater than $50 million,
BVS observed an average discount of 11.1 percent, and, as of the
valuation date, the market capitalization of FOH was
$61.3 million. For companies with annual sales greater than
$100 million, BVS observed an average discount of 7.2 percent,
and, for the 12-month period ended February 27, 1993, FOH had
sales of $125.5 million.
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Fuller concluded that a prudent investor would select the
private placement alternative and that, under that analysis, the
FOH shares should be valued at $5.8969 per share, a blockage
discount of 15 percent. Accordingly, each block of 2,460,580
shares of FOH would be valued at $14,509,794.
Fuller relied almost exclusively on the private placement
analysis that hinged on a single study. In so doing, he rejected
an entire body of restricted stock studies covering an extensive
time span. Fuller applied a 13.5-percent discount to the market
price of freely tradeable stock sold on the public market. The
study on which he relied, however, found that the discount for
restricted stock, when compared with freely tradeable stock sold
in a public market, averaged 42 percent of the market price.
Petitioner points to the subsequent sales of FOH shares by
the trusts, arguing that, although fair market value is
determined as of the date of death, consideration is given to
comparable sales occurring subsequent to the valuation date for
purposes of determining fair market value. Estate of Jung v.
Commissioner, 101 T.C. 412, 431 (1993). Petitioner concludes
that, because the sales by the trusts were consistent with the
valuations by Kimball and Cotler, the sales corroborate the value
claimed by petitioner and are substantial evidence of the fair
market value of the FOH stock on the valuation date.
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The sale of FOH stock by the Harriett trust to the FOH ESOP
for a price of $4.20 per share, which represented a discount of
30 percent from its then-closing price on the NYSE, occurred
9 months after the valuation date. Respondent argues that this
was not a sale to a third party, so it should not be taken into
consideration in valuing the stock. In any event, this sale was
of class A capital stock after the amendment to the articles of
incorporation that altered the capital structure of FOH. After
the amendment, there were two classes of stock, one with voting
rights and the other without. Neither party addressed how this
fact affects the valuation. Thus, we are cautious in assigning
weight to this transaction.
The market transaction in which the Harriett trust sold
29,500 shares of FOH stock at $4.875 per share on February 18,
1994, does not support petitioner's contentions, because those
shares sold for the undiscounted price at which the stock was
trading on the NYSE on that day.
On the record before us, we are satisfied that the
respective discounts as determined by the experts set the
appropriate range from which we may determine the marketability
discount. We also conclude, however, that each expert excluded
information that contradicted his result. Only Cotler addressed
the specifics of FOH's financial situation in detail, but he
relied on mean discounts without relating them to those details.
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Fuller relied on a single method, and we are not persuaded that
his method is the only one that would be considered by
hypothetical buyers and sellers. Kimball provided several
logical methods but failed to implement them correctly. On
cross-examination, he made several concessions about his use of
survey data as well as his errors in application of the formulas
he used.
We conclude that the discount claimed by petitioner is
necessarily overstated, but the discount asserted by respondent
is inadequate. Weighing the expert opinions and the evidence on
which they rely, we have more confidence in the methods of
petitioner's experts but must adjust their conclusions to reflect
their weaknesses. We bear in mind that valuation is necessarily
an approximation and a matter of judgment rather than
mathematics. Estate of Davis v. Commissioner, 110 T.C. 530, 554
(1998). Based on our examination of the entire record in this
case, we conclude that the marketability discount should be
25 percent. We thus have found that, on the valuation date, the
fair market value of each of the two 27.8671-percent interests in
FOH that were held by the trusts was $12,802,705, or $5.2031 per
share.
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To reflect the foregoing,
Decision will be entered
under Rule 155.