Estate of Renier v. Commissioner ( 2000 )

T.C. Memo. 2000-298
UNITED STATES TAX COURT
ESTATE OF JAMES J. RENIER, DECEASED, KENT L. RENIER AND DUBUQUE
BANK & TRUST COMPANY, CO-EXECUTORS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2976-98. Filed September 25, 2000.
James L. Malone III and Sheri L. Everson, for petitioner.
James S. Stanis and David S. Weiner, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GALE, Judge: Respondent determined a deficiency in Federal
estate tax of $326,382.08 and an addition to tax under section
6662(a) of $64,471.42 against the Estate of James J. Renier
(estate).
After concessions, we must decide the following:
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1. What was the fair market value of the 22,100 shares of
stock in the Renier Company held by James J. Renier (decedent) at
his death on April 10, 1994 (valuation date).
2. Whether the estate is liable for an addition to tax
under section 6662(a) for a substantial estate or gift tax
valuation understatement.1
Unless otherwise noted, 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 are so found. We
incorporate by this reference the stipulation of facts and
attached exhibits. At the time of filing the petition, co-
executor Kent L. Renier resided, and co-executor Dubuque Bank &
Trust Company had its principal place of business, in Dubuque,
Iowa. Decedent resided in Dubuque, Iowa, on the date of his
death, and his will was probated in the Iowa District Court for
Dubuque County.
1
The estate also alleged in the petition that respondent
erred in disallowing a deduction by the estate for charitable
bequests totaling $12,500. However, the estate made no argument
at trial or on brief concerning that allegation, and we consider
it abandoned. See Rybak v. Commissioner, 91 T.C. 524, 566 n.19
(1988); Bowman v. Commissioner, T.C. Memo. 1997-52 n.1, affd.
without published opinion 149 F.3d 1167 (4th Cir. 1998).
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Since 1899, the Renier family has conducted a retail
business in Dubuque. Beginning in the 1950's, the Renier Company
(Renier) switched its business focus from musical instruments to
the sale of televisions and stereo equipment. In the 1980's, it
expanded its product mix to include video camcorders and VCR’s.
On the valuation date, televisions and VCR’s comprised 47
percent of Renier’s sales, with audio systems and components
making up another 40 percent, and camcorders and car stereos
constituting 10 percent. Another 2 percent of Renier’s sales
consisted of batteries and electronic accessories, while the
remaining 1 percent consisted of cordless telephones. The
national annual compound rate of growth from 1989 through 1993
for televisions and VCR’s was 4.99 percent; for audio systems and
components, 3.07 percent; for camcorders and car stereos, 3.27
percent; for batteries and electronic accessories, 9.44 percent;
and for cordless telephones, 5.95 percent. When weighted to
reflect the percentage of sales by Renier for each product area,
the national annual compound rate of growth for Renier’s product
mix from 1989 through 1993 was 4.15 percent. Renier’s actual
sales increased at a compound rate of 8.3 percent from July 1988
through June 1993. However, the majority of Renier’s growth
during that period occurred between July 1, 1992, and June 30,
1993, during which time sales increased 22.7 percent in part as a
result of a major flood in the area that caused many residents to
replace their consumer electronic products. Considering only
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July 1988 through June 1992, Renier’s compound annual growth was
just 3.8 percent.
Renier’s retail operation consisted of a single 7,200-
square-foot store located in a strip mall in Dubuque. Renier was
open for business 68 hours per week: 11 hours a day on Monday
through Friday, 8 hours on Saturday, and 5 hours on Sunday. In
1994, the city of Dubuque had an estimated population of 57,840.
Dubuque’s population had declined over 7 percent since 1980 and
was not expected to grow rapidly after the valuation date.
On the valuation date, Renier had seven employees, including
Kent and Maria Renier, decedent’s son and daughter-in-law (Kent
and Maria). Kent served as store manager and as a salesperson,
and Maria performed clerical and bookkeeping functions. Kent was
also responsible for about one-third of Renier’s total sales. At
various times during the 5 years and approximately 9 months
preceding the valuation date, decedent and five other members of
his family were employed by Renier. Until September 1993,
decedent remained active in the business, meeting customers and
handling Renier’s advertising and finances. After September
1993, health problems prevented decedent from working the sales
floor, but he continued to be involved in Renier’s advertising
and finances.
Renier’s primary competition consisted of national retail
chains which operated stores in the Dubuque area. These chain
stores offered a much broader consumer electronics product
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selection than did Renier and included such stores as Wards, Wal-
Mart, K-Mart, Target, Radio Shack, and Sears. Additional
competition came from local independent businesses in Dubuque
that sold consumer electronic products.
The Dubuque area retail environment became more competitive
in the 1980's and early 1990's as large discount stores, chain
stores, and warehouse clubs increased product offerings and
offered low prices to gain market share. These larger businesses
purchased inventory at low prices due to volume purchases,
utilized sophisticated inventory control systems to manage
inventory, and effectively leveraged advertising expenditures due
to the operation of numerous retail outlets.
Although Renier could not purchase inventory at the prices
available to the chains and discount stores, it was able to
achieve some discounts through participation in a buying
cooperative made up of independent retailers. In addition,
because Renier was not highly leveraged and maintained ample
working capital, it was further able to reduce its inventory
costs by taking advantage of prompt payment discounts offered by
many vendors.
Renier computed its income for tax and financial reporting
purposes on the basis of a fiscal year ending June 30. Renier’s
pretax profit margin from July 1, 1988, through the valuation
date substantially exceeded the national industry average for
retailers of consumer electronics. However, no meaningful growth
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trend during this period is discernible, because for some time
prior to its fiscal year ended June 30, 1993, Renier
overestimated its cost of goods sold as the result of an error in
its inventory accounting system and, consequently, underreported
its net income. This error was addressed in 1996, at which time
Renier filed amended corporate income tax returns for 1993 and
1994, reporting increased taxable income for those years. These
changes resulted in Renier’s having additional income tax
liabilities totaling $137,038 for the period beginning July 1,
1992, and ending on the valuation date,2 which Renier paid in
1996. Renier also revised its financial statements to reflect
the changes. After the revisions, Renier had total pretax net
income from July 1, 1988 through the valuation date of $879,597,
and after-tax net income of $579,367.
Decedent became president of Renier in the 1960's and served
in that position until his death. At his death, decedent owned
22,100 of the 25,000 outstanding shares of Renier’s common stock.
Renier’s shares have never been listed on any stock exchange or
available on any over-the-counter market and have never been
publicly traded or privately traded.
The co-executors hired Jules Steinberg to appraise Renier’s
shares for estate tax purposes. Based on Mr. Steinberg’s
2
Renier had increased tax liability for its 1993 fiscal
year of $108,495 and increased tax liability of $28,543, on a
prorated basis, for the first 9.33 months of Renier’s 1994 fiscal
year that occurred prior to the valuation date.
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appraisal, the estate reported decedent’s interest in Renier at a
value of $729,742, or $33.02 per share, on the valuation date.
In the notice of deficiency, respondent valued decedent’s
interest in Renier at $1,633,000, or $73.89 per share, on the
valuation date.
ULTIMATE FINDING OF FACT
The fair market value of decedent’s 22,100 shares of Renier
on the valuation date was $952,000, or $43.08 per share.
OPINION
I. Renier’s Fair Market Value
We must decide the fair market value of decedent’s shares of
stock in Renier on the valuation date. Both parties rely on
expert opinions to support their claimed values.
Fair market value is defined as “‘the price at which the
property would change hands between a willing buyer and a willing
seller, neither being under any compulsion to buy or to sell and
both having reasonable knowledge of relevant facts.’” United
States v. Cartwright, 411 U.S. 546, 551 (1973)(quoting sec.
20.2031-1(b), Estate Tax Regs.). The best method to value a
corporation’s stock is to rely on actual arm’s-length sales of
the stock within a reasonable period of the valuation date. See
Estate of Andrews v. Commissioner, 79 T.C. 938, 940 (1982).
Since Renier’s stock was never publicly or privately traded, all
the experts used less direct methods of valuation.
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Expert opinions sometimes aid the Court in determining
valuation; other times, they do not. See Laureys v.
Commissioner, 92 T.C. 101, 129 (1989). We evaluate such opinions
in light of each expert’s qualifications and all other evidence
of value in the record. See Estate of Newhouse v. Commissioner,
94 T.C. 193, 217 (1990). We are not bound, however, to accept
any expert opinion when that opinion contravenes our judgment.
See id. We may accept an expert opinion in its entirety, see
Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C.
441, 452 (1980), or we may selectively use any portion thereof,
see Parker v. Commissioner, 86 T.C. 547, 562 (1986).
A. The Experts
Respondent presented the testimony and expert report of
Leonard J. Sliwoski to support the deficiency determination. The
estate presented the testimony and expert reports of Yale Kramer,
of McGladrey & Pullen, LLP, and Allan L. R. Lannom, of Houlihan
Valuation Advisors, to support the reported value of Renier’s
stock.
Respondent’s expert, Mr. Sliwoski, considered an asset,
income, and market approach to value Renier and concluded that an
income approach, using the capitalized value of expected future
earnings, should be used exclusively. Based on this approach,
Mr. Sliwoski concluded that Renier had a total value of
$1,847,698 and that decedent’s 88.4 percent interest therein had
an approximate value of $1,633,000 on the valuation date.
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The estate’s first expert, Mr. Kramer, also considered an
asset, income, and market approach and ultimately concluded that
Renier’s valuation should be based on an average of the results
indicated by the income and market approaches. Through this
averaging process, Mr. Kramer concluded that Renier’s shares had
an estimated value of $36.89 per share and that decedent’s 22,100
shares therefore had a total value of $815,158.50 on the
valuation date.
The estate’s second expert, Mr. Lannom, did not use an asset
or income approach but made two market approach calculations
using data on the sales of privately held companies supplied by
the Institute of Business Appraisers. In addition, Mr. Lannom
applied four different “rules of thumb” to value Renier. Using
his market approach and rules of thumb, Mr. Lannom arrived at
various values for Renier ranging from a low of $946,000 to a
high of $1,100,000. Mr. Lannom then added a “key-man” discount
equal to 10 percent of the value of the operating assets.
Finally, Mr. Lannom concluded that decedent’s 88.4-percent
interest in Renier was worth approximately $852,000 on the
valuation date.3
3
Although Mr. Lannom testified that his estimate of the
value of decedent’s interest in Renier was $825,000, the
calculations in his report, as amended in his trial testimony,
indicate that he actually concluded that decedent’s interest was
worth $852,000 and apparently made a transposing error.
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We place no weight on Mr. Lannom’s opinion. His report
contains no explanation of, or analytical support for, the
various “rules of thumb” employed in reaching several of its
valuation estimates. Thus, we are largely unable to assess the
merits of Mr. Lannom’s conclusions. See Rule 143(f)(1). To the
extent we are able to form a judgment, we find his analysis
unpersuasive. One of his market approach calculations and three
of his rules of thumb used gross revenue as the primary
determinative factor, without taking profitability into account.
This raises doubts about the basis for his conclusions, given
that Renier’s profitability was high in relation to the industry
average. Furthermore, while Mr. Lannom’s second market approach
calculation used Renier’s earnings and one of his rules of thumb
used Renier’s cash-flow, Mr. Lannom provided no justification for
the earnings and cash-flow figures he used. Finally, Mr.
Lannom’s report provided no factual support for his “key-man”
discount. Because of the summary nature and obvious shortcomings
of Mr. Lannom’s report, we give it no further consideration.
Both Mr. Sliwoski and Mr. Kramer ultimately concluded that
their asset approaches did not account for the goodwill inherent
in Renier as a going concern. We therefore restrict our analysis
to the income and market approaches as applied to Renier by Mr.
Sliwoski and Mr. Kramer. We now consider each in turn.
B. Income Approach
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In connection with their respective income approaches to
valuation, both Mr. Sliwoski and Mr. Kramer concluded that some
of Renier’s assets were not necessary for its core retail
operation. After excluding the income and expenses associated
with these “nonoperating” assets, both experts estimated the
value of Renier’s “operating” assets on the valuation date by
capitalizing an estimate of Renier’s expected future income.
Each expert then added his income-based valuation of Renier’s
operating assets to an asset-based estimate of the nonoperating
assets to produce a total valuation figure.
As part of their income capitalization approaches, the
experts agreed that the appropriate starting point for estimating
Renier’s expected future income was to take an average of
Renier’s historical reported net income.4 The experts further
agreed that it was necessary to make certain adjustments to
4
Although Mr. Sliwoski believed that cash-flow, rather than
net income, was the appropriate income base to capitalize, he
concluded that net income was an adequate approximation for cash-
flow. In reaching this conclusion, he assumed that Renier’s
accounts receivable and inventory levels were sufficient as of
the valuation date to sustain probable future growth, that
required equipment additions would equal Renier’s depreciation
expense, and that no interest-bearing liabilities, other than
short-term liabilities, would be required to finance probable
future sales growth. In addition, as discussed infra, since Mr.
Sliwoski used a capitalization rate based on returns to both
equity and debt, it was necessary for him to add back Renier’s
interest expense to the income base used in his capitalization
formula.
Mr. Kramer used net income as his base for capitalization
but believed that an adjustment to the capitalization rate was
required to account for the fact that he was employing net income
rather than cash-flow as his base.
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reported net income in order to “normalize” it; that is, to
convert Renier’s historical average net income into income that a
hypothetical purchaser could expect in the future, by eliminating
anomalous transactions and capital structures. However, the
experts exhibited significant differences regarding the necessary
“normalizing” adjustments. They also had significant differences
in computing the capitalization rate that should be applied to
normalized income and, to a lesser extent, differences in the
methodology for valuing Renier’s nonoperating assets. The
foregoing differences produced dramatically different results.
Mr. Sliwoski valued Renier’s operating assets at $1,293,760, to
which he added his estimate of the value of Renier’s nonoperating
assets of $553,938,5 for a total value of $1,847,698 on the
valuation date. Mr. Kramer’s income approach, by contrast,
resulted in a value for Renier’s operating assets of $450,104;
i.e., an amount approximately two-thirds lower than Mr.
Sliwoski’s computation. The difference in Mr. Kramer’s estimate
for Renier’s nonoperating assets was not as dramatic; Mr.
Kramer’s estimate was $470,9256 versus Mr. Sliwoski’s $553,938.
5
Although Mr. Sliwoski recognized he had double counted a
liability of $137,038, he did not modify his computations to
correct for this error. Had he done so, Renier’s nonoperating
assets would have increased by $137,038, and its total value
would have equaled $1,984,736. In any event, respondent has not
sought an increase in his deficiency determination in connection
with this error.
6
Unlike Mr. Sliwoski’s value for nonoperating assets, this
(continued...)
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Mr. Kramer’s value estimates for Renier’s operating and
nonoperating assets produced a total value of $921,029 on the
valuation date.
We shall consider their differences.
1. Computation of Normalized Income
The experts agreed that the starting point for computing
normalized income should be the average of Renier’s reported net
income7 for the 69.33-month period preceding the valuation date,
July 1, 1988,8 through April 10, 1994 (base period9). Further,
to avoid “unwarranted controversy”, Mr. Kramer adopted several of
Mr. Sliwoski’s normalizing adjustments. Prior to normalizing,
6
(...continued)
number is corrected to account for the double counting of a
$137,038 liability in Mr. Kramer’s original report.
7
Mr. Sliwoski started with pretax net income and, after
making his normalizing adjustments, subtracted Federal and State
income taxes at an estimated combined rate of approximately 38
percent. Mr. Kramer started with after-tax net income and, when
making normalizing adjustments, also accounted for the income tax
impact of the normalizing adjustments, at an estimated income tax
rate of 34 percent. Except for the difference in assumed income
tax rates, their respective methodologies to account for taxes
would produce the same result.
8
Although Mr. Kramer’s report states that he used the
period from July 1, 1989, through the valuation date, an
examination of the data in the exhibits to his report shows that
the period used included the fiscal year starting July 1, 1988,
as well.
9
Although Mr. Sliwoski treats the period from July 1, 1988,
through the valuation date as consisting of 5.778 years, and Mr.
Kramer uses at various times 69.33 and 69.333 months to describe
this period, for the sake of consistency, we have adopted (and
treat the experts as having adopted) a base period of 69.33
months.
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Renier had pretax net income of $879,597 during the base period
and after-tax net income of $579,367. The experts had
differences in their normalizing adjustments as follows.
a. Reasonable Compensation for Related-Party
Employees
There is a large difference in the experts’ approaches in
accounting for excess compensation paid to related-party
employees. During the base period, Renier employed decedent and
several members of his family, including Kent and Maria on the
valuation date. Both Mr. Sliwoski and Mr. Kramer concluded that
related-party employees were overcompensated, necessitating a
normalizing adjustment to reported net income to approximate
income if only arm’s-length amounts had been paid for the
services rendered. The experts dispute, however, the amount of
overcompensation.
To compute a reasonable compensation amount for the services
provided by related parties, Mr. Sliwoski assumed that during the
base period Renier required the services of only two family
members, one providing management and sales services and the
other serving as bookkeeper and office manager. Kent and Maria,
respectively, were providing these services on the valuation
date. Using data from a 1991 Dubuque area wage survey, Mr.
Sliwoski concluded that for Renier’s fiscal year ended June 30,
1991, the retail manager/salesperson would earn approximately
$19.23 per hour and work 2,080 hours per year (40 hours per
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week), for an annual salary of $39,998. He further concluded
that a bookkeeper/office manager for Renier with Maria’s
qualifications reasonably would have been paid $7.37 per hour and
worked 2,080 hours per year, for a total annual salary of
$15,330. To these amounts, Mr. Sliwoski added a fringe benefit
equal to 20 percent of base wages for each employee. Finally,
Mr. Sliwoski adjusted these results using changes in the consumer
price index for 1989 through 1994 to determine reasonable
compensation for each year in the base period. Mr. Sliwoski then
treated all compensation to related employees that exceeded the
foregoing amounts, plus associated payroll taxes, as excess
compensation that should be added back to produce normalized
income. This resulted in increases to Renier’s reported net
income for the base period of $357,789, or an average of $61,925
per year.
Mr. Kramer, by contrast, calculated the excess compensation
to related employees to be only $15,000 per year, which he
divided by 12 and then multiplied by 69.33 to arrive at a total
excess compensation of $86,663 during the base period. In
reaching the $15,000 per year figure, Mr. Kramer concluded that
approximately 15 percent of the time devoted to management duties
by related parties was attributable to duplicated effort and
therefore constituted excess compensation.
After considering the reasonable compensation adjustments
proposed by each expert, we conclude that neither accurately
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accounts for Renier’s related-party excess compensation. Mr.
Kramer’s method was unsupported by any objective criteria; his
report’s assertion that there was a duplication of effort equal
to 15 percent of the amounts paid to related-party management
appears to be no more than a conclusory guess. The estate cites
no data to support the claim that the sales, management, and
bookkeeping functions being performed by related parties were
actually worth $120,000 per year in the Dubuque area. In
addition, the estate concedes on brief that in Renier’s fiscal
year ended June 30, 1990, Mark Renier, decedent’s other son, was
paid $100,000 in excess compensation. Mr. Kramer’s report,
however, fails to account for this figure. For these reasons, we
find more reliable Mr. Sliwoski’s approach based on actual data
from a Dubuque area wage survey.
While we find satisfactory Mr. Sliwoski’s basic methodology
of attempting to estimate the “market” replacement cost of the
necessary services that were provided by related parties, and
treating the excess of the amounts actually paid over their
market value as a normalizing add-back to income, we nevertheless
believe that Mr. Sliwoski’s estimate of the replacement cost of
the sales and management services provided by related parties
significantly understates the services’ value. Mr. Sliwoski
assumed that the sales and management functions being performed
by Kent could be accomplished in a 40-hour work week. Kent
testified that he worked in excess of 70 hours per week. While
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this claim might be inflated, the record establishes that Renier
was open 68 hours per week. We do not believe that Kent’s sales
and management functions could be duplicated with a 40-hour work
week at $19.23 per hour, plus 20 percent in fringe benefits (or
total annual compensation of approximately $48,000), as Mr.
Sliwoski’s postulates. If one considers only Kent’s sales
function, his annual compensation would exceed $40,000,10 before
considering his multiple management and administrative duties.
In addition, Mr. Sliwoski failed to consider that except for the
last approximately 7 months of the base period, decedent also
actively assisted in Renier’s operation. We therefore do not
believe Mr. Sliwoski’s computations of reasonable compensation
for the sales and management functions performed by related
parties are reliable.
On this record, we have no alternative but to substitute our
best judgment of the value of the sales and management services
that were performed by Kent as of the valuation date (and various
other family members during the base period). Taking into
account the hours claimed in Kent’s testimony, it is our judgment
that the sales and management functions performed by him could be
accomplished in a 60-hour work week. Using Mr. Sliwoski’s
10
Respondent conceded that Kent was responsible for
approximately one-third of Renier’s annual sales of $1.5 million.
If Kent received a commission of 6 to 8 percent on those sales, a
commission which Mr. Sliwoski himself conceded was reasonable in
the business, plus benefits equal to 20 percent of this amount,
his compensation as a salesman would have exceeded $40,000.
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documented wage and benefit figures, this assumption produces an
annual compensation package of $71,997 (60 hours at $19.23 per
hour times 52 weeks plus 20-percent fringe benefits). If this
amount is adjusted for inflation for each of the years in the
base period,11 the total for the period is $418,117. When added
to Mr. Sliwoski’s reasonable compensation estimate for the
bookkeeping/office manager functions performed by Maria
($106,832) (the rate and hours assumptions for which we find
satisfactory), and increased by Renier’s average payroll tax
expense of 6.76 percent,12 the total reasonable compensation
expense for related-party employees for the base period is
$560,436. When this amount is subtracted from Renier’s actual
compensation to related-party employees during the base period of
$788,889,13 the excess compensation to related-party employees
equals $228,453, or an average of $39,540 per year. Thus, we
conclude that a normalizing adjustment in this amount to Renier’s
11
Mr. Sliwoski used the consumer price index (CPI)
published by the U.S. Census Bureau to adjust for inflation. We
make a similar adjustment in our computation. See U.S. Census
Bureau, Statistical Abstract of the United States, The National
Data Book 495 (119th ed., 1999).
12
Renier’s average payroll tax expense was derived from the
average payroll tax rate incurred by Renier during the base
period. The difference between this rate and the statutory rate
of 7.65 percent applicable during most of the base period is
presumably due to fringe benefits not subject to payroll tax.
See secs. 3111, 3121(a).
13
Actual related-party compensation figures were taken from
Mr. Sliwoski’s report; Mr. Kramer provided no comparable figures.
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reported net income is appropriate.
b. Adjustment for Income From Excess Working
Capital
Both experts agreed that Renier’s cash and short-term
investments exceeded its working capital needs, that the excess
should be treated as a nonoperating asset, and consequently that
the interest earned by the excess should be subtracted from
reported net income as a normalizing adjustment. They disagreed,
however, on the size of Renier’s excess working capital and the
method of its calculation.
Mr. Sliwoski concluded that Renier only required working
capital equal to 7 days of annual sales (7/365 of annual sales),
which resulted in estimated working capital needs during the base
period ranging from $24,417 for 1989 to $35,152 for the partial
year ending on the valuation date. Consequently, Mr. Sliwoski
made a normalizing adjustment that subtracted all interest earned
by Renier during the base period and added back an estimated
amount of interest14 that would have been generated by the
working capital he estimated was needed.
Mr. Kramer concluded that Renier required working capital
equal to 2 months of average operating expenses during the base
period, plus 1.5 times average monthly inventory purchases in
1994, or $259,205 on the valuation date, leaving $362,038 in
14
Mr. Sliwoski computed interest for this purpose at a rate
of 5 percent. To avoid “unwarranted controversy”, Mr. Kramer
adopted the same rate for purposes of his computations.
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excess working capital on that date. To account for the interest
generated by this excess working capital, Mr. Kramer took the
excess working capital amount on the valuation date, multiplied
it by 5 percent,15 divided the result by 12 (to get a monthly
figure) and then multiplied that amount by 69.33 months. The
result was then subtracted from reported net income as a
normalizing adjustment. Using this formula, Renier’s excess
working capital generated $104,584 in interest over the base
period.16
As to which expert’s methodology best adjusts for excess
working capital, we believe that Mr. Sliwoski’s formula
substantially underestimates Renier’s working capital needs. For
example, for the year ended June 30, 1989, Mr. Sliwoski estimated
Renier would require working capital of just $24,417. However,
Renier’s financial statement for that year indicates that it
15
See supra note 14.
16
In his report, Mr. Kramer assumed Renier had only
$225,000 in excess working capital, which would have generated
approximately $65,000 in interest over the base period. Mr.
Kramer’s computation of excess working capital, however, does not
account for the double-counted liability of $137,038 conceded
during trial by both experts. When this double counting is
corrected, it results in a reduction in Renier’s liabilities of
$137,038 and a corresponding increase in total assets. Because
Renier’s working capital requirements using Mr. Kramer’s formula
are unaffected by this correction, Mr. Kramer’s computation of
excess working capital would increase by $137,038 as a result,
from $225,000 to $362,038. Therefore, under Mr. Kramer’s
formula, the interest generated over the base period from the
increased figure for excess working capital is $104,584, rather
than $65,000.
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spent $920,861 on inventory purchases and had operating expenses
of $363,304, for total expenditures of $1,284,165. Thus,
although Renier had outlays averaging over $107,000 per month in
fiscal 1989, Mr. Sliwoski assumed Renier would require less than
one-fourth of that amount as working capital. This estimate is
unduly low, particularly in light of the fact that Renier paid
for its inventory with cash in order to take advantage of early
payment cash discounts offered by trade creditors. Mr.
Sliwoski’s estimates for the other years are no more reasonable.
Given the obvious shortcomings of Mr. Sliwoski’s working capital
estimates, we reject his methodology in favor of that used by Mr.
Kramer, which not only left sufficient working capital to cover
Renier’s operating expenses but also provided additional working
capital to purchase inventory with cash. Based on Mr. Kramer’s
formula, as adjusted to account for the double-counted liability
of $137,038, we conclude that $104,584 should be subtracted from
Renier’s reported net income as a normalizing adjustment to
account for the interest generated by its excess working capital.
c. Spread for Cost-of-Goods-Sold Adjustment
The parties agree that for a number of years Renier had used
an incorrect inventory accounting system that overstated cost of
goods sold. The errors in cost of goods sold were corrected by
means of adjustments to the 1993 and 1994 fiscal years, which
resulted in reported net income for those years that
substantially exceeded amounts in the preceding 4 years. The
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experts disagree on the appropriate normalizing adjustment for
the correction of the inventory error.
Mr. Sliwoski believed that, since average income for the
69.33-month base period (including the correction years) was
being used, no further adjustment was necessary. The averaging
of the correction years’ income with the income of the 4
precorrection years (which income was almost certainly
understated) would produce an accurate average for the 69.33-
month period, in his view. This position effectively “spread”
the cost of goods sold adjustment over the 69.33-month base
period.
Mr. Kramer, however, believed that the cost-of-goods-sold
adjustment should be spread over 10 years, on the grounds that
Renier had sold the same product line for approximately 20 years
and “it was estimated” that the erroneous inventory method had
been used “for at least half of that period”. As a result, Mr.
Kramer spread the cost-of-goods-sold adjustment over a 10-year
period and excluded from normalized income some 50.67 months’
worth of the adjustment which fell outside the base period.
With respect to the cost-of-goods-sold adjustment, we
conclude that the estate has failed to show error in respondent’s
approach. The estate has offered scant evidence of the nature of
the inventory adjustment; there is no evidence in the record of
the exact nature or duration of the error in accounting for cost
of goods sold. Such evidence was presumably available to the
- 23 -
estate or executors. On this record, we do not believe the
estate has shown that a 10-year spread of the inventory
adjustment is appropriate. We accordingly conclude that Mr.
Sliwoski’s treatment of the cost-of-goods-sold adjustment in
computing normalized income is the appropriate one.
- 24 -
d. Adjustment for Partial Year
The experts also disagree on how to “annualize” the income
from the partial fiscal year from July 1, 1993, through the April
10, 1994, valuation date for purposes of computing average income
for the base period. Mr. Sliwoski extended the partial year
income data pro rata to a full fiscal year, added this amount to
the net income from the previous 5 years and divided the result
by 6. Mr. Kramer, on the other hand, simply added the net income
from the 9.33 months of the partial fiscal year to the income
from the previous 5 years, divided the result by 69.33 months,
and multiplied the result by 12 to compute the average.
The estate finds fault with Mr. Sliwoski’s approach, and we
agree. By simply extending the results of the 9.33 months of the
partial fiscal year pro rata into 12 months, Mr. Sliwoski
effectively postulates level income over each month of the fiscal
year. We agree with the estate that this approach distorts
Renier’s income. The first 9.33 months of Renier’s fiscal year
include the holiday season, a period of high retail volume. The
assumption that the average of the first 9 months of the fiscal
year would be replicated in the last 3 is highly unlikely. In
addition, both sides have conceded that 1994 income was
anomalous, due to the correction of the inventory error. As a
result, we believe a more accurate average is achieved by
averaging the actual results of the first 9.33 months of fiscal
1994 with the preceding 5 fiscal years, as Mr. Kramer has done.
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e. Inclusion of Interest Expense
Because Mr. Sliwoski used a capitalization rate that
incorporated an assumed cost of debt that a purchaser of
decedent’s interest would incur to effect the purchase, he was
required for consistency to add back Renier’s interest expense to
his income base, so that normalized income would approximate the
investment return available to both equity and debt. Mr. Kramer
used a simpler “return on equity” to formulate the capitalization
rate he employed. As more fully discussed infra, we conclude
that the appropriate capitalization rate is a simple return on
equity as used by Mr. Kramer, since the interest being valued
here is an equity interest. Accordingly, it is not appropriate
to add back Renier’s interest expense when computing expected
future income available to equity alone.
f. Adjustment for Income Taxes
Both experts account for the effect of income taxes as part
of normalizing Renier’s income. Mr. Sliwoski normalized reported
pretax net income and then adjusted for Federal and State income
taxes at an assumed combined rate of approximately 38 percent,
whereas Mr. Kramer used reported after-tax net income, and then
adjusted for income taxes associated with the net impact of the
normalizing adjustments using the average of the actual combined
Federal and State income taxes paid by Renier over the base
period. Mr. Sliwoski provided no justification for his assumed
rate, while Mr. Kramer’s rate reflected Renier’s historic
- 26 -
average. Because Mr. Kramer’s approach is consistent with
Renier’s actual income tax liabilities over the base period, we
believe it is more accurate. We therefore adopt his method of
using after-tax net income and taking account of the income tax
effect of normalizing adjustments at Renier’s historic average
rate of 34 percent.
g. Conclusion
Based on the foregoing, we conclude that the following
normalizing adjustments should be made to Renier’s reported net
income after taxes for the base period:
Adjustments to Base Period Net Income
(negative amounts in parentheses)
Excess related-party compensation $228,453
Interest generated by Renier’s excess working (104,584)
capital
Depreciation1 35,012
Property taxes1 1,782
Automotive expenses1 6,650
Capital loss1 9,219
Rental income1 (6,000)
Total adjustments before tax 170,532
Tax on adjustments (at blended Federal and State (57,981)
rate of 34 percent)
Total adjustments after tax 112,551
1
The experts agreed to the normalizing adjustment amounts with
respect to depreciation, property taxes, automotive expenses,
capital loss, and rental income.
- 27 -
By adding $112,551 in adjustments to Renier’s after-tax net
income for the base period of $579,367, we arrive at normalized
income for the period of $691,918. By dividing this figure by
the 69.33 months in the base period and multiplying the result by
12, we calculate Renier’s expected future annual income available
to equity at $119,761.
2. Calculating the Capitalization Rate
The experts reached widely divergent conclusions regarding
the appropriate rate to use in capitalizing Renier’s expected
future income. Mr. Sliwoski concluded that the rate should be 10
percent, whereas Mr. Kramer set it at 22 percent. The principal
source of this difference concerns whether the capitalization
rate should be computed based on the return on equity that a
hypothetical buyer would require (Mr. Kramer’s view) or should
consist of a weighted average of the return on equity as well as
the return on an assumed amount of debt that a hypothetical buyer
would incur to acquire decedent’s interest in Renier (Mr.
Sliwoski’s view). In addition, the experts disagreed regarding
the estimate of the rate of growth in Renier’s future earnings
that should be factored into the computation of the
capitalization rate.
a. Weighted Average Cost of Capital or Return
on Equity
Mr. Sliwoski estimated the return on equity that a
hypothetical buyer would require in calculating a value for
- 28 -
Renier at 24.76 percent, quite close to Mr. Kramer’s estimate of
24.90 percent. Mr. Sliwoski then reduced this required rate of
return by 6 percent to account for Renier’s estimated growth
after the valuation date.17 Mr. Sliwoski also believed that the
capitalization rate should reflect a “weighted average cost of
capital”; that is, a blending of the rate of return on equity
with the cost of debt incurred in a hypothetical purchase, which
rate he estimated would be 2 percent above prime, or 8.45
percent, on the valuation date. Mr. Sliwoski further computed an
after-tax cost of the debt by discounting it 38 percent. Using
the assumption that a purchase of decedent’s interest would be
financed 65.5 percent with debt and 34.5 percent with equity, Mr.
Sliwoski computed the weighted average cost of capital as
follows:
Weighted Average Cost of Capital Per Mr. Sliwoski
Before Tax After Tax
Percentage of Cost of Cost of
Financing Financing Financing Income Tax Financing
Component Component Component Adjustment Component
Debt 65.5% 8.45% 62.0% 3.43%
Equity 34.5% 18.76% NA 6.47%
Total 9.90%
or
approximately
10%
Thus, the effect of Mr. Sliwoski’s weighted average is to reduce
the capitalization rate from 18.76 percent (24.76 percent
17
Mr. Kramer also believed that Renier’s estimated growth
rate should reduce its capitalization rate.
- 29 -
estimated return on equity less 6-percent growth rate in
earnings) to 10 percent.
We are not persuaded by Mr. Sliwoski’s approach. This Court
has often rejected the use of a weighted average cost of capital
in valuing an equity interest in a closely held corporation.
See, e.g., Estate of Hall v. Commissioner, 92 T.C. 312, 341
(1989); 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. This approach has
also been criticized in valuation commentary. See Bogdanski,
Federal Tax Valuation, par. 3.05[5][b] (1996 & Supp. 1999), and
authorities therein cited. Although respondent cites Gross v.
Commissioner, T.C. Memo. 1999-254, as support for the use of this
method, we note that in that case, the corporation’s actual
borrowing costs were incorporated in the formula. Here, Mr.
Sliwoski has relied entirely on a set of assumptions about the
cost and amount of debt that a hypothetical purchaser of Renier
would incur. The estate argues, and presented evidence, that
these assumptions were unrealistic. We agree. A local banker
testified that financial institutions in the area would not have
extended an acquisition loan with respect to a retail business
like Renier at anywhere near the amount postulated by Mr.
Sliwoski and, further, would have required personal guaranties.
Such guaranties raise the effective cost of borrowing. See Pratt
et al., Valuing Small Businesses and Professional Practices 220
- 30 -
(3d ed. 1998) (“it seems reasonable to recognize a premium of
upwards of three percentage points to the face value interest
rate if personal guarantees are required.”). We do not have
confidence that Mr. Sliwoski’s attempt to estimate a weighted
cost of capital is reliable, even if we were satisfied that it
represents an appropriate approach for valuing an equity
interest. Consequently, we reject the capitalization rate
proposed by Mr. Sliwoski and conclude instead that the
appropriate capitalization rate is one based upon a return to
equity alone, as proposed by Mr. Kramer.
b. Computation of Capitalization Rate Based on
Equity Return
As previously noted, Mr. Sliwoski and Mr. Kramer largely
agreed on the rate of return on equity that a purchaser of Renier
would require. Mr. Sliwoski concluded that an equity investor
would require a 24.76-percent rate of return, while Mr. Kramer
concluded that an equity investor would require a 24.90-percent
return. The discrepancy between the two figures can be
attributed to the risk-free rate of return employed by each
expert.18 Mr. Sliwoski chose as his risk-free rate the 7.26-
percent return from 30-year U.S. Treasury bonds on the valuation
date, while Mr. Kramer utilized the 7.40-percent rate of return
on 20-year U.S. Treasury bonds. This 0.14-percent rate
18
While the experts’ other assumptions also differ, these
differences are exactly offsetting.
- 31 -
difference equals the difference between Mr. Sliwoski’s required
rate of return on equity of 24.76 percent and Mr. Kramer’s rate
of 24.90 percent. In the instant case, the correct risk-free
rate is that of 20-year U.S. Treasury bonds used by Mr. Kramer.
We so conclude because both experts developed their estimates of
the required rate of return on equity using data from Ibbotson
Associates, which publishes equity risk premium data related to
20-year coupon bond maturities, but no such risk premium data for
30-year maturities.19 For this reason, we find more appropriate
Mr. Kramer’s required rate of return on equity of 24.90 percent.
c. Estimate of Earnings Growth Rate
Both experts agreed that the required rate of return on
equity used to convert expected future earnings into a value
figure should be adjusted to account for the estimated rate of
growth in Renier’s earnings after the valuation date. The
experts disagreed, however, in their estimates of Renier’s long-
term growth rate. Mr. Sliwoski reduced his required rate of
return on equity by 6 percent to account for expected growth in
Renier’s future income stream, while Mr. Kramer reduced his
required rate of return by only 3 percent.
We do not believe either expert used a reasonable estimate
of the rate of growth. Mr. Sliwoski derived his 6-percent growth
19
See Ibbotson Associates, Stocks, Bonds, Bills &
Inflation: 1994 Yearbook, 146; see also Pratt et al., Valuing a
Business, The Analysis and Appraisal of Closely Held Companies
163, n.10 (3d ed. 1996).
- 32 -
rate based on growth within the consumer electronic products
industry and normal inflationary price increases, while Mr.
Kramer limited his growth rate to the rate of inflation. Neither
of these estimates finds support in the record. Mr. Sliwoski’s
6-percent growth rate is based on the consumer electronics
industry as a whole and is not tailored to Renier’s specific
product mix. Renier did not sell personal computers or cellular
telephones, both of which exhibited very high growth rates and
were included in Mr. Sliwoski’s growth-rate estimate. As our
findings indicate, the national annual compound growth rate for
the items in Renier’s product mix, weighted to reflect the
percentage of sales of each, was only 4.15 percent from 1989
through 1993. Although Renier’s actual sales increased at a
compound rate of 8.3 percent from July 1988 through June 1993,
the majority of that increase occurred in Renier’s fiscal year
ended June 30, 1993. Sales in that year, however, were
substantially boosted as a result of a major flood in the spring
of 1993.20 If Renier’s fiscal year ended June 30, 1993, is
excluded, Renier’s compound growth rate equals just 3.8 percent,
or slightly less than the national average for Renier’s product
mix. We are thus faced with the problem of how to account for
Renier’s bumper sales during 1993, only a portion of which should
20
Although the flood likely also boosted sales in the
fiscal year that began on July 1, 1993, Mr. Sliwoski did not
factor any of this period into his estimate of Renier’s growth
rate.
- 33 -
be projected into the future as sustainable growth. Mr. Kramer
addressed this issue by adding 5 percent to Renier’s expected
future annual income prior to capitalization. We agree that this
method correctly accounts for the recent strength in Dubuque’s
retail economy, while excluding growth attributable to the area’s
1993 flood. We therefore conclude that the most accurate long-
term growth assumption for Renier is 4.15 percent. However, we
also believe it is appropriate to adopt Mr. Kramer’s methodology
of adding 5 percent to Renier’s expected future annual income to
account for the recent strength in Dubuque’s retail economy. In
further support of this conclusion, we note that Renier faced
stiff competition from a number of much larger chain retailers,
including K-Mart, Radio Shack, Sears, and Wal-Mart, putting in
doubt Renier’s ability to sustain a high sales growth rate after
the valuation date.
d. Conclusion: Income Valuation of Renier’s
Operating Assets
Based on the foregoing, we conclude that the appropriate
capitalization rate on the valuation date equaled 20.75 percent;
namely, Mr. Kramer’s discount rate of 24.9 percent, less an
estimated long-term growth rate of 4.15 percent. Furthermore, as
previously discussed, this capitalization rate should be applied
to 105 percent of Renier’s expected future annual income, or
$125,749. Dividing this amount by the capitalization rate, we
- 34 -
conclude that Renier’s operating assets had a value of $606,019
on the valuation date.
3. Valuing Renier’s Nonoperating Assets
Finally, to arrive at a total value for Renier, each expert
added to his income valuation of Renier’s operating assets his
estimate of the asset value of Renier’s nonoperating assets. The
biggest discrepancy in the experts’ valuation of the nonoperating
assets concerns their computation of Renier’s excess working
capital. (Under both experts’ methodology, their estimate of
excess working capital is added to nonoperating assets.) Because
we previously rejected Mr. Sliwoski’s estimate of Renier’s
working capital requirements, we adopt Mr. Kramer’s figure and
conclude that Renier had excess working capital of $362,038. The
experts largely agreed with respect to the value of Renier’s
remaining nonoperating assets, which Mr. Sliwoski valued at
$105,036 and which Mr. Kramer, using primarily Mr. Sliwoski’s
figures, valued at $108,887.21 To the extent Mr. Kramer’s value
exceeds Mr. Sliwoski’s, we consider the amount conceded by the
estate and therefore conclude that Renier had nonoperating assets
totaling $470,925.
21
The remaining nonoperating assets consisted of a
residence and two cars. Mr. Sliwoski valued the residence at
$81,686 and the two cars at $9,500 and $13,850, respectively, for
a total of $105,036. Mr. Kramer valued the residence at $86,975
and the two cars at $8,938 and $12,974, respectively, for a total
of $108,887.
- 35 -
C. Market Approach
Mr. Kramer also used a market approach to value Renier,
while Mr. Sliwoski considered but ultimately rejected this
approach. Typically, a market approach valuing the stock of a
closely held company involves three considerations: Past
transactions in the company’s stock, past offers to purchase the
company, or, if neither of these is available, the market values
of stocks of comparable companies. See sec. 20.2031-2(a)-(f),
Estate Tax Regs.; Rev. Rul. 59-60, 1959-1 C.B. 237.
Mr. Kramer concluded that a market approach comparing Renier
to publicly traded companies was inappropriate because there were
no publicly traded companies sufficiently similar to Renier to
provide an adequate basis for comparison. Instead, Mr. Kramer
utilized a market approach which he termed the “business broker
method”. In Mr. Kramer’s analysis, the business broker method
postulates that the purchase price of a business equals the
market value of the inventory and fixed assets plus a multiple of
the seller’s discretionary cash-flow, defined as the total cash-
flow available to the owner of the business. Seller’s
discretionary cash-flow is computed by adding owner’s
compensation, depreciation, and interest expense to pretax
income. The multiple applied to seller’s discretionary cash-flow
is determined based on the strengths and risks associated with a
particular business; such multiples commonly range between 1 and
- 36 -
2. In Mr. Kramer’s judgment, the appropriate multiple for
valuing Renier was 1.5.
We do not find Mr. Kramer’s application of the business
broker method helpful in valuing Renier. Mr. Kramer provided no
justification for the multiple he chose to apply to Renier’s
discretionary cash other than his own judgment. In the absence
of any underlying data supporting Mr. Kramer’s selection of a
multiple, we are unable to assess its appropriateness. See Rule
143(f)(1). Thus, on this record the reliability of the business
broker method has not been established.
D. Conclusion
Both experts used an asset approach to value Renier’s
nonoperating assets and concede that such an approach would be
inappropriate to value Renier’s operating assets. We agree with
their conclusions in this regard. As Mr. Sliwoski also
disregarded his market approach and as we have rejected Mr.
Kramer’s business broker method, we conclude that the income
approach provides the best method for valuing Renier’s operating
assets. Therefore, with nonoperating assets of $470,925, using
an asset approach, and operating assets of $606,019, using an
income approach, we find Renier had a fair market value on the
valuation date of $1,076,944, or $43.08 per share. Consequently,
we further conclude that decedent’s 22,100 shares in Renier on
that valuation date had a value of $952,000.
II. Addition to Tax
- 37 -
Respondent also determined that the estate was liable for an
addition to tax under section 6662(a), which imposes a 20-percent
addition for certain underpayments of tax. The addition is
imposed where there is an underpayment of estate tax resulting
from a substantial estate tax valuation understatement. See sec.
6662(b)(5). A substantial tax estate valuation understatement
occurs if the value of any property claimed on an estate tax
return is 50 percent or less of the amount determined to be
correct. See sec. 6662(g)(1). In the instant case, the estate
reported Renier’s stock on its return as having a value of $33.02
per share. As we have found that the correct value is $43.08 per
share, no substantial estate or gift tax valuation understatement
has occurred. Given our conclusion, we need not address whether
the estate qualifies for the reasonable cause exception contained
in section 6664(c)(1).
To reflect the foregoing,
Decision will be entered
under Rule 155.