Pierson M. Grieve v. Commissioner ( 2020 )

T.C. Memo. 2020-28UNITED STATES TAX COURT
PIERSON M. GRIEVE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8249-18. Filed March 2, 2020.
William D. Thomson and James G. Bullard, for petitioner.
Randall L. Eager, Jr., and Christina L. Cook, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
KERRIGAN, Judge: Respondent determined a deficiency in petitioner’s
2013 Federal gift tax of $4,399,032 and an accuracy-related penalty pursuant to
section 6662(a) and (b)(5) of $628,199 for a substantial gift tax valuation
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[*2] understatement. After concessions,1 the remaining issues for consideration
are the fair market values of petitioner’s 99.8% member interest in Rabbit 1, LLC
(Rabbit), transferred to the Pierson M. Grieve 2013 Grantor Retained Annuity
Trust (GRAT) on October 9, 2013,2 and his 99.8% member interest in Angus
MacDonald, LLC (Angus), transferred to the Grieve 2012 Family Irrevocable
Trust (Irrevocable Trust) on November 1, 2013.
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the year in issue, 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 stipulation of facts is
incorporated in our findings by this reference. Petitioner resided in Florida when
he timely filed his petition.
1
Respondent conceded that petitioner is not liable for the accuracy-related
penalty pursuant to sec. 6662(a), (b)(5), and (g). Petitioner conceded that he
underestimated his total taxable gifts from prior periods by $188,991.
2
The parties stipulated that petitioner will not owe additional gift tax if we
determine that he understated the initial fair market value of assets transferred to
the GRAT if, within a reasonable time, the GRAT pays to petitioner, or to his
personal representative in the event of his passing, an amount equal to the
difference of the properly payable annuity and the annuity actually paid.
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[*3] I. Petitioner’s Background
Petitioner was married to Florence Grieve, and they had three children.
Florence died suddenly on October 1, 2012. Margaret Grieve was their eldest
child, and she practiced law in the financial services industry and served as chair
of the board of the Central Asia American Enterprise Fund.
At the end of petitioner’s career he was the chairman and chief executive
officer of Ecolab, Inc. (Ecolab), from 1983 to 1996. Ecolab is a public corporation
listed on the New York Stock Exchange and headquartered in St. Paul, Minnesota.
Throughout his career petitioner accumulated wealth. While at Ecolab he acquired
the corporation’s stock that he and his family continued to own.
In the late 1980s or early 1990s petitioner established the Grieve Family
Limited Partnership. Pierson M. Grieve Management Corp. (PMG) was the
general partner of the Grieve Family Limited Partnership. Petitioner consolidated
management of his assets in PMG. These entities were created to preserve and
manage petitioner’s family wealth.
In the early 2000s Margaret became involved in helping petitioner manage
the family wealth. In 2008 she purchased PMG from petitioner for $6,200 and
became its president. Since 2008 Margaret has owned all of the outstanding
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[*4] shares of PMG. Additionally, she has managed the Grieve family office
through PMG and has not been compensated.
Petitioner and Florence had engaged a law firm to handle their business and
estate planning needs. In 2012 they decided to update their estate plan. Petitioner
requested that the law firm perform a top-to-bottom analysis of his assets to
address how best to achieve the family’s wealth-management goals in a tax-
efficient manner. Florence died before the updated estate plan was finalized. As
part of their updated estate plan petitioner and Florence asked Margaret to assume
full-time responsibility for managing the family wealth. Since 2012 Margaret has
been responsible for investing and managing the family wealth.
PMG held a controlling ownership interest in closely held entities with
approximately $70 million in assets. The portfolio of assets was held in an
investment account at Goldman Sachs. Margaret selected the wealth management
group at Goldman Sachs as PMG’s investment adviser and asset manager.
Although the family’s Ecolab stock was held in custody accounts at
Goldman Sachs’ San Francisco office, Margaret made the investment decisions
pertaining to the Ecolab stock. Goldman Sachs neither managed nor charged a
management fee on the Ecolab stock held in its custody accounts. Margaret
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[*5] decided to maintain a concentrated position in the Ecolab stock because of its
low cost basis.
Margaret worked with the law firm to develop petitioner’s updated estate
plan. In order to accomplish petitioner’s goal, two entities were created: Rabbit
and Angus.
II. Rabbit
Rabbit was formed as a limited liability company (LLC) under the laws of
Delaware on July 31, 2013. At its inception Rabbit had two members: PMG and
the Pierson M. Grieve Revocable Trust (Grieve Revocable Trust). On August 28,
2013, PMG contributed $2 and the Grieve Revocable Trust contributed $998 to a
brokerage account in Rabbit’s name. The following chart reflects member
contributions and the ownership structure of Rabbit as of July 31, 2013:
Initial Class A Class B Ownership
Member contribution voting units nonvoting units interest
PMG $2 20 -0- 0.2%
Grieve Revocable
Trust 998 -0- 9,980 99.8%
On September 3, 2013, petitioner transferred to Rabbit’s brokerage account
82,984 Ecolab shares with a fair market value of $7,682,659. Petitioner deposited
$1 million in cash into Rabbit’s brokerage account on September 18, 2013. As of
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[*6] October 9, 2013, Rabbit had no debt and its brokerage account had a fair
market value of $9,102,757.3
On October 6, 2013, petitioner and Margaret, in her capacity as trustee of
the Grieve Revocable Trust, executed the GRAT agreement. Petitioner structured
the GRAT according to Internal Revenue Service guidance to avoid incurring gift
tax liability.4 The GRAT agreement provided that the trustee shall pay to
petitioner an annuity equal to the fair market value of assets transferred to the trust
for Federal gift tax purposes as follows: (1) 47.14757% to be paid within 105
days of October 9, 2014, and (2) 56.57708% to be paid within 105 days of October
9, 2015.
On October 9, 2013, Margaret, as trustee of the Grieve Revocable Trust,
assigned 9,980 class B nonvoting units of Rabbit to the GRAT. Petitioner
determined that the fair market value of the 9,980 class B units of Rabbit was
$5,903,769 as of October 9, 2013, resulting in annuity payments pursuant to terms
of the GRAT of $2,783,485 and $3,340,180.
3
The parties stipulated that the fair market value as of October 9, 2013, was
$9,067,074.
4
Generally, under sec. 2702 and its corresponding regulations, where
property is transferred in trust with the donor retaining an interest in the property,
the value of the gift is the value of the property transferred, less the value of the
donor’s retained interest. See also sec. 25.2702-1, Gift Tax Regs.
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[*7] III. Angus
Angus was formed as an LLC under the laws of Delaware on August 13,
2012.5 At its inception Angus had two members: PMG and Florence. On
September 7, 2012, PMG contributed $200 and Florence contributed $99,800 to a
brokerage account in Angus’ name. Florence transferred her interest in Angus to
petitioner on September 26, 2012. The following table reflects member
contributions and the ownership structure of Angus as of September 7, 2012:
Initial Class A Class B Ownership
Member contribution voting units nonvoting units interest
PMG $200 20 -0- 0.2%
F. Grieve 99,800 -0- 9,980 99.8%
As of November 1, 2013, Angus had no debt and its brokerage account held
the following assets with the following fair market values:
5
Angus was originally formed as “Grieve 1, LLC”, and changed its name to
Angus on September 6, 2012.
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[*8] Fair market
Assets value
Cash and short-term investments (brokerage account) $20,665,824
Limited partnership interests (Palladium Investments) 7,316,882
Investments in venture capital funds (Grossman Investments) 406,406
Promissory notes 3,581,571
Total 31,970,683
On November 1, 2013, petitioner and South Dakota Trust Co., LLC, as
trustee of the Irrevocable Trust, executed a single-life private annuity agreement.
Petitioner created the Irrevocable Trust in 2012 for the benefit of the Grieve
children. Under the terms of the single-life private annuity agreement petitioner
assigned his 9,980 class B units in Angus to the Irrevocable Trust in exchange for
a single-life annuity that paid an annual sum of $1,420,000. On November 1,
2013, the single-life private annuity had a fair market value of $8,043,675.
Through this transaction petitioner intended to make a net taxable gift to the
Irrevocable Trust to the extent that the fair market value of his interest in Angus
exceeded the fair market value of the single-life private annuity.
IV. Operations of Rabbit and Angus
PMG owned the class A voting units, a 0.2% ownership interest, in both
Rabbit and Angus. These entities were managed similarly. Margaret was the sole
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[*9] owner of PMG and was chief manager of both Rabbit and Angus. The LLC
agreements of both Rabbit and Angus gave her a lifetime appointment as chief
manager. The agreements allowed her to be removed for cause and also provided
her with the right to designate a successor chief manager.
Pursuant to the agreements the chief manager was entitled to reasonable
compensation; however, Margaret chose not to receive compensation. Members
had the right to approve compensation, but if the chief manager was a member or
an affiliate of a member, he or she could not participate in the compensation
approval process. The agreements defined “member” as the holder or holders of
the issued and outstanding membership units which were divided into class A
voting membership units and class B nonvoting membership units. They defined
“affiliate” to include a person who controls or is controlled by a member.
Holders of class A units possessed all of the voting powers for all purposes,
whereas holders of class B units had no voting power. Class B units could not
vote on or participate in any proceedings in which the entity or its members took
action.
The LLC agreements contained provisions about transferring membership
units to a person other than the initial members. They required the full consent of
all members owning class A units before a member could transfer all or part of
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[*10] their units, unless the person to whom the units were being transferred was a
“permitted transferee”. “Permitted transferee” was defined to include any lineal
descendant of petitioner or Florence, a trust created for the exclusive benefit of
any one or more such lineal descendants and/or their spouses, and, in the case of
Rabbit, a charitable organization.
Neither the Rabbit nor the Angus class B units have been sold since their
assignment to the GRAT and the Irrevocable Trust, respectively. They have never
been offered for sale.
V. Gift Tax Return and Notice of Deficiency
Petitioner timely filed his 2013 Form 709, United States Gift (and
Generation-Skipping Transfer) Tax Return, along with valuation appraisal reports
prepared by Value Consulting Group (VCG). Under the GRAT agreement
petitioner’s annuity payments equaled the fair market value of assets transferred to
the GRAT plus the required statutory interest. On Schedule A, Computation of
Taxable Gifts, he reported a total taxable gift of zero from the transfer of the 9,980
Rabbit class B units to the GRAT. For the transfer of the 9,980 class B units of
Angus to the Irrevocable Trust, he reported a total taxable gift of $9,966,659 on
Schedule A. Petitioner computed the net taxable gift resulting from the single-life
private annuity using the values VCG estimated for the Angus class B units.
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[*11] VCG’s appraisal reports provided the following valuations of each entity:
Valuation of Rabbit Fair market value
Value estimate of 100% controlling interest
(as of October 9, 2013) $9,102,757.00
Divided by: Total units outstanding 10,000
Value per unit (controlling ownership basis) $910.28
Less: Lack of control discount (13.4%) ($121.53)
Value per unit (marketable, minority ownership basis) $788.75
Less: Lack of marketability discount (25%) ($197.19)
Nonmarketable, minority fair market value per class B
nonvoting membership unit $591.56
Value of 9,980 class B nonvoting units $5,903,768.80
Valuation of Angus Fair market value
Value estimate of 100% controlling interest
(as of November 1, 2013) $31,970,683.00
Divided by: Total units outstanding 10,000
Value per unit (controlling ownership basis) $3,197.07
Less: Lack of control discount (12.7%) ($406.03)
Value per unit (marketable, minority ownership basis) $2,791.04
Less: Lack of marketability discount (25%) ($697.76)
Nonmarketable, minority fair market value per class B
nonvoting membership unit $2,093.28
Value of 9,980 class B nonvoting units $20,890,934.40
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[*12] VCG used the adjusted net-asset method under the cost approach to
determine the values of Rabbit and of Angus as of their respective appraisal
valuation dates. Since the submission of petitioner’s tax return, the parties have
stipulated that the fair market value of assets held in Rabbit as of October 9, 2013,
is $9,067,074. To determine the nonmarketable, minority fair market value per
class B unit for each of Rabbit and Angus, VCG concluded that it was necessary to
consider discounts for lack of control and lack of marketability.
To determine the lack of control discount for Rabbit the VCG report looked
at a study that compiles control-premium data and minority stock interests held in
publicly owned closed-end mutual funds investing in publicly traded securities.
Because of Rabbit’s small size and lack of diversification, VCG’s report selected a
lack of control discount of 13.4%, which was at the high end of the range of
discounts indicated for closed-end mutual fund data that VCG considered.
To determine the lack of control discount for Angus the VCG report looked
at a study that compiles control-premium data and closed-end mutual funds. The
report concluded that the lack of control discount was 12.7%.
To determine the lack of marketability discount for Rabbit the VCG report
looked at various studies that addressed the appropriate discounts for lack of
marketability of closely held equity interests, including restricted stock studies.
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[*13] VCG’s report concluded that the lack of marketability discount for Rabbit
was 25%. The report used a similar method for Angus and concluded that the lack
of marketability discount was 25%.
On January 29, 2018, respondent issued a notice of deficiency determining
that petitioner had understated the fair market value of the 9,980 class B units of
Rabbit transferred to the GRAT and increasing the fair market value from
$5,903,769 to $9,048,866. Respondent also determined that petitioner had
understated the fair market value of the 9,980 class B units of Angus transferred to
the Irrevocable Trust and increased the fair market value from $20,890,934 to
$31,884,403. Respondent correspondingly increased the net value of the gift from
$9,966,659 to $17,819,139.
OPINION
I. Burden of Proof
Generally, the Commissioner’s determinations in a notice of deficiency are
presumed correct, and the taxpayer bears the burden of proving those
determinations erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115
(1933). The burden of proof may shift to the Commissioner if the taxpayer
establishes that he or she complied with the requirements of section 7491(a)(2)(A)
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[*14] and (B) to substantiate items, to maintain required records, and to cooperate
fully with the Commissioner’s reasonable requests.
Petitioner contends that he meets the requirements of section 7491(a) and
thus the burden of proof shifts to respondent regarding the fair market value of his
gifts. The determination of fair market value is a question of fact. Estate of
Newhouse v. Commissioner, 94 T.C. 193, 217 (1990). The parties’ experts offer
contrasting conclusions of value of the transferred interests based on differing
interpretations of the relevant facts. However, we are not bound by the opinion of
any expert witness when that opinion is contrary to our own judgment. Estate of
Hall v. Commissioner, 92 T.C. 312, 338 (1989). We resolve the valuation issue on
the preponderance of the evidence in the record with the guidance of those expert
opinions that we find most helpful. See Estate of Bongard v. Commissioner, 124
T.C. 95, 111 (2005).
II. Evidentiary Issue
In accordance with the Court’s standing pretrial order and Rule 143(g),
respondent provided to petitioner and submitted to this Court Mark Mitchell’s
expert reports. In his reports Mr. Mitchell opines on what he considers to be the
fair market values of the 9,980 class B units of both Rabbit and Angus.
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[*15] During trial petitioner objected to Mr. Mitchell’s expert reports’ being
admitted into evidence. The Court deferred ruling on his objection. The Mitchell
reports were marked, and testimony of respondent’s expert was heard.6 Whether
the reports and testimony will be received into evidence and considered in
determining the valuations of Rabbit and Angus depends on the application of
principles expressed in Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579 (1993),
and rule 702 of the Federal Rules of Evidence.7
Rule 702 of the Federal Rules of Evidence provides:
A witness who is qualified as an expert by knowledge, skill,
experience, training, or education may testify in the form of an
opinion or otherwise if:
(a) the expert’s scientific, technical, or other specialized
knowledge will help the trier of fact to understand the evidence or to
determine a fact in issue;
(b) the testimony is based on sufficient facts or data;
(c) the testimony is the product of reliable principles and
methods; and
6
With agreement of the parties we directed the expert witnesses to testify
concurrently. The procedure was implemented in substantially the same way as in
Rovakat, LLC v. Commissioner, T.C. Memo. 2011-225. The concurrent expert
testimony was in addition to the Court’s customary practices regarding expert
witnesses consistent with Rule 143(g).
7
Proceedings of this Court are conducted in accordance with the Federal
Rules of Evidence. See sec. 7453.
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[*16] (d) the expert has reliably applied the principles and methods to
the facts of the case.
In Daubert, 509 U.S. at 592-593, the Supreme Court stressed the trial
court’s role as a “gatekeeper” in excluding at the outset evidence that is unreliable
or irrelevant. The reliability and relevancy standards are embodied in rule 702 of
the Federal Rules of Evidence, and they apply equally to expert testimony that is
not “scientific”. Kumho Tire Co. v. Carmichael, 526 U.S. 137, 148 (1999).
Mr. Mitchell was qualified, without objection from petitioner, as an expert
in business valuation, including the valuation of noncontrolling membership
interests in family investment holding companies. Petitioner contends that the
Mitchell reports are “irrelevant, speculative, and unreliable”. Petitioner further
contends that the Mitchell reports’ valuations are inconsistent with the applicable
Treasury guidelines and that instead they applied a novel valuation approach.
Since there is no dispute about the qualifications of Mr. Mitchell, we focus
on the relevancy and the reliability of his valuation approach. Rule 702 of the
Federal Rules of Evidence is viewed as a rule of admissibility rather than
exclusion. Arcoren v. United States, 929 F.2d 1235, 1239 (8th Cir. 1991). When
an expert’s methodology, not qualifications, is in dispute, exclusion of the expert
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[*17] report is not warranted. See Synergetics, Inc. v. Hurst, 477 F.3d 949, 956
(8th Cir. 2007).
The Mitchell reports set forth the facts and data relied upon, the
methodology employed, and the manner in which the methodology was applied to
the facts and data. Petitioner had the opportunity during cross-examination to
challenge Mr. Mitchell’s assumptions. See id. at 955-956. Accordingly, the
Mitchell reports are admitted into evidence.
III. Gift Tax Valuation Principles
Section 2501(a) imposes a tax on the transfer of property by gift made
during that taxable year by an individual. The donor is primarily responsible for
paying the gift tax. Sec. 2502(c). The amount of gift tax is based on the aggregate
value of taxable gifts made during the year, among other things. See sec. 2502(a)
(imposing the gift tax on a cumulative basis). Taxable gifts are the total amount of
gifts made during the year, less certain deductions. Sec. 2503(a). The total
amount of gifts in the year is the sum of the values of the gifts made in the year in
excess of the exclusion amount in section 2503(b). Sec. 25.2503-1, Gift Tax Regs.
The value of a gift of property is generally the value of the property on the
date of the gift. See sec. 2512(a). The fair market value of the property is the
price at which the property would change hands between a willing buyer and a
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[*18] willing seller, neither being under any compulsion to buy or to sell and both
having reasonable knowledge of the relevant facts. See United States v.
Cartwright, 411 U.S. 546, 551 (1973); sec. 25.2512-1, Gift Tax Regs. The willing
buyer and 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 buyer or the
actual seller. Estate of Bright v. United States, 658 F.2d 999, 1005-1006 (5th Cir.
1981); Estate of Kahn v. Commissioner, 125 T.C. 227, 231 (2005); Estate of Davis
v. Commissioner, 110 T.C. 530, 535 (1998).
The hypothetical willing buyer and the hypothetical willing seller are
presumed to be dedicated to achieving the maximum economic advantage. Estate
of Davis v. Commissioner, 110 T.C. at 535. Transactions that are unlikely and
plainly contrary to the economic interests of a hypothetical willing buyer or a
hypothetical willing seller are not reflective of fair market value. See Estate of
Newhouse v. Commissioner, 94 T.C. at 232. In valuing an LLC interest the rights,
restrictions, and limitations of the various classes of interests must be considered.
Id. at 218.
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[*19] IV. Experts’ Valuations
Petitioner relies on the valuation determinations of Mr. Frazier, and
respondent relies on the valuation determinations of Mr. Mitchell. Both experts
prepared reports containing their respective analyses and conclusions of the fair
market values for the 9,980 class B units of both Rabbit and Angus. We may
adopt or reject an expert’s opinion in whole or in part. Estate of Davis v.
Commissioner, 110 T.C. at 538; see also Buffalo Tool & Die Mfg. Co. v.
Commissioner, 74 T.C. 441, 452 (1980). Where experts offer divergent estimates
of fair market value, we weigh each estimate by analyzing the factors which those
experts used to arrive at their conclusions. Estate of Davis v. Commissioner, 110
T.C. at 538; Casey v. Commissioner, 38 T.C. 357, 381 (1962).
Mr. Frazier used a combination of the market approach and the income
approach. He concluded that on October 9, 2013, the 9,980 class B units of Rabbit
were worth $5,884,000 on a noncontrolling, nonmarketable basis, after
adjustments and discounts. He valued each unit at $589.58. Mr. Frazier
concluded that on November 1, 2013, the 9,980 class B units of Angus were worth
$19,854,000 on a noncontrolling, nonmarketable basis, after adjustments and
discounts. He valued each unit at $1,989.39.
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[*20] In his analysis Mr. Mitchell relied on the net asset value (NAV) of Rabbit
that was stipulated by the parties and of Angus as determined by VCG. He
concluded that any willing seller of the class B units would look to acquire control
of the 0.2% interest held by the class A unit holder to avoid the large discounts
that a willing buyer would seek. Mr. Mitchell calculated $130,000 and $450,000
as the reasonable premiums a hypothetical seller could pay PMG for its 0.2%
interests in Rabbit and Angus, respectively.
Mr. Mitchell concluded that on October 9, 2013, the 9,980 class B units of
Rabbit were worth $8,918,940 and each unit was worth $893.68. He concluded
that on November 1, 2013, the 9,980 class B units of Angus were worth
$31,456,742 and each unit was worth $3,151.98.
A. NAV
Mr. Frazier assessed independently the assets contributed to Rabbit and
determined a combined NAV of $9,066,659 as of October 9, 2013. The parties
stipulated that the NAV was $9,067,074 as of October 9, 2013.8 As of the date of
valuation Rabbit’s assets included cash and cash equivalents and Ecolab stock.
Mr. Frazier looked at the average high and low price per share of Ecolab stock on
October 9, 2013, to determine the fair market value as of the valuation date.
8
This is amount is lower than the $9,102,757 reported on the VCG report.
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[*21] Mr. Mitchell used the NAV stipulated by the parties. Mr. Frazier’s
valuation is $415 less than the value which the parties stipulated. We conclude
that the NAV as of October 9, 2013, was $9,067,074. We do not see a reason to
change the NAV from that which was stipulated by the parties.
Mr. Frazier assessed independently the assets contributed to Angus and
determined a combined NAV of $30,930,099 as of November 1, 2013. VCG
concluded that the NAV was $31,970,683 as of November 1, 2013, and that value
was reported in VCG’s appraisal report attached to petitioner’s 2013 Form 709.
Mr. Frazier computed the values of Palladium Investments and Grossman
Investments but did not reach the same results as VCG. Palladium Investments
held investments in a portfolio of companies that were in transition and required a
new financial or operational strategy. Grossman Investments held investments in
venture capital funds. Mr. Frazier started with VCG’s valuations of $7,316,882
for Palladium Investments and $406,406 for Grossman Investments. He then
applied a minority interest discount of 15% and marketability discount of 20%
which resulted in a valuation of $5,125,880 for Palladium Investments and
$276,356 for Grossman Investments. Respondent opposes these adjustments and
contends that the adjustments result in multiple tiers of discounts if the Frazier
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[*22] report’s valuation of Angus is accepted since his valuation includes further
discounts.
Mr. Mitchell used the same NAV determined by VCG in its appraisal report.
Mr. Frazier’s valuation is $1,040,584 less than the value petitioner reported on the
schedules and attachments to his 2013 Form 709. We conclude that the NAV of
Angus as of November 1, 2013, was $31,970,683. We find no justification to
lower the NAV of Angus to a value that is significantly lower than the value to
which petitioner previously admitted. See Estate of Hall v. Commissioner, 92
T.C. at 337-338 (“[T]he reported values are an admission by * * * [the taxpayer],
so that lower values cannot be substituted without cogent proof that the reported
values were erroneous.”).
B. Frazier Reports’ Valuations
After Mr. Frazier determined the NAVs of Rabbit and Angus, he used the
market approach and the income approach to determine the value of the class B
units of both Rabbit and Angus.
1. Valuation of Rabbit
Mr. Frazier used the market approach and looked at available data from
empirical studies. In his report he analyzed closed-end funds to determine the lack
of control discount and restricted stock studies to determine the lack of
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[*23] marketability discount. Then he performed a valuation using the income
approach. Each analysis reached a different conclusion, and the report weighted
both equally to determine the fair market value.
a. Market Approach
Mr. Frazier selected and analyzed 33 closed-end funds from a database
provided by Morningstar, Inc. (Morningstar). According to Mr. Frazier, closed-
end funds have sold historically at a discount because of the noncontrolling nature
of an investment in a closed-end fund. In his report Mr. Frazier explains that the
lack of control over day-to-day operations and investment decisions, and the
inability to liquidate assets of the entity are investment characteristics shared by
investors in publicly traded closed-end funds. He highlights differences between
an investment in Rabbit and an investment in a closed-end fund. For example, an
investment in Rabbit is illiquid, and investors in a closed-end fund are protected
by Securities and Exchange Commission regulations.
To determine the lack of control discount Mr. Frazier considered the
day-to-day management of Rabbit and the ability of the owner of the class B units
to influence liquidation of the company’s assets. He determined that the median
and average discounts for lack of control of the 33 closed-end funds were 11.2%
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[*24] and 10.8%, respectively. He also determined that the low-payout, domestic
equity closed-end funds traded at a median discount of 15.5% for lack of control.
On the basis of his analysis of the 33 closed-end funds Mr. Frazier
concluded that a 16.4% lack of control discount should apply to the portion of
Rabbit’s NAV consisting of marketable equity securities and a nominal 5%
discount should apply to its NAV consisting of cash and short-term investments.
He applied an overall weighted discount of 15.1% for lack of control.
Next, Mr. Frazier used restricted stock studies to determine a lack of
marketability discount. Restricted stock studies compare publicly traded stock
prices to the price of the same stock sold in private placement. In his analysis he
took into consideration the terms of the LLC agreement and focused on the
likelihood of dissolution, likelihood of distributions, ability to withdraw funds,
and restrictions on transfers. His analysis considered factors that we outlined in
Mandelbaum v. Commissioner, T.C. Memo. 1995-255, aff’d, 91 F.3d 124 (3d Cir.
1996), which he described as the holding period, the risk of the underlying assets,
and the company’s distribution policy. He concluded that Rabbit’s lack of
marketability discount was 25%. Using the market approach the Frazier report
concluded that the fair market value of Rabbit’s 9,980 class B units was
$5,761,649.
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[*25] b. Income Approach
Mr. Frazier used the nonmarketable investment company evaluation (NICE)
method which he developed as a valuation technique applicable to entities that
hold a portfolio of investment assets. The NICE method determines a price that an
investor would pay for the subject interest that lacks control and marketability by
taking into consideration the investment risks and expected returns. In applying
the NICE method, empirical studies were used to determine the incremental
required rates of return in the light of information asymmetry (lack of control) and
the cost of illiquidity (lack of marketability). Using the NICE method Mr. Frazier
determined that Rabbit’s 9,980 class B units had a fair market value of
$6,006,659.
c. Fair Market Value Conclusion
In his report Mr. Frazier weighted equally the outcomes of the market and
income approaches and concluded that the fair market value of Rabbit’s 9,980
class B units was $5,884,000. The analysis resulted in a total discount to Rabbit’s
NAV of approximately 34.97%. His analysis is summarized in the following
table:
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[*26]
Approach Fair market value Weight (percent) Total
Market approach $5,761,649 50 $2,880,824.50
Income approach 6,006,659 50 3,003,329.50
Fair market value 5,884,154.00
Rounded 5,884,000.00
Per-unit value 589.58
2. Valuation of Angus
Mr. Frazier used the same methodology for the valuation of Angus as he did
for the valuation of Rabbit.
a. Market Approach
In his report Mr. Frazier analyzed the maximum, minimum, and mean
discounts for each asset type Angus held. For the marketable securities he
identified 33 closed-end domestic equity funds, using Morningstar information,
comparable to a majority of Angus’ assets and concluded that the maximum
discount was 21.1%, the minimum discount was 10.1%, and the mean discount
was 15.6%. He determined that the lack of control discount applicable to the
marketable securities held by Angus was 15.6%. He determined a 9% discount to
the nonmarketable securities held by Palladium Investments and Grossman
Investments, which was the lower quartile discount of the 13 closed-end corporate
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[*27] bond funds that had similar investment criteria. He further determined a
12.3% discount to the promissory notes. A 5% lack of control discount was
applied to the cash and cash equivalents held by Angus. He concluded that a lack
of control discount for class B units was 12.6%. His analysis is summarized in the
following table:
Selected Weighted
Fair market Percent of discount discount
Assets value1 total assets (percent) (percent)
Cash and cash
equivalents $3,832,184 12.4 5.0 0.6
Marketable equity
securities 16,833,641 54.4 15.6 8.5
Palladium Investments 5,125,880 16.6 9.0 1.5
Grossman Investments 276,356 0.9 9.0 0.1
Promissory notes 4,862,038 15.7 12.3 1.9
Total 30,930,099 100.0 12.6
Overall selected
discount 12.6
1
The fair market values listed in this column differ from the fair market
values determined in the VCG report because Mr. Frazier independently valued
Angus’ assets.
Next, Mr. Frazier used restricted stock studies to determine a lack of
marketability discount. He concluded that restricted stock studies indicate a
discount for lack of marketability applicable to the class B units in the range of
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[*28] 23% to 34%. After analyzing attributes of the class B units with a focus on
the holding period and lack of discretionary distributions, he determined a 25%
discount for lack of marketability. His market approach valuation resulted in a fair
market value of $20,234,131 for 9,980 class B units.
b. Income Approach
As with Rabbit Mr. Frazier used the NICE method in his analysis of Angus.
This method determines the annual required rate of return of the Angus class B
units by looking for the one price that best satisfies the financial parameters of the
willing buyer and the willing seller for all periods examined by the model. On the
basis of the model he concluded that the 9,980 class B units had a fair market
value of $19,474,526.
c. Fair Market Value Conclusion
Mr. Frazier weighted equally the outcomes of the market and income
approaches and concluded that the fair market value of the 9,980 class B units was
$19,854,000. His valuation resulted in a total discount to Angus’ NAV of
approximately 35.68%. Mr. Frazier’s analysis is summarized in the following
table:
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[*29]
Approach Fair market value Weight (percent) Total
Market approach $20,234,131 50 $10,117,066.00
Income approach 19,474,526 50 9,737,263.00
Fair market value 19,854,329.00
Rounded 19,854,000.00
Per-unit value 1,989.38
C. Mitchell Reports’ Valuations
In his valuation reports Mr. Mitchell sought the price at which a 99.8%
noncontrolling interest would actually be bought or sold. According to Mr.
Mitchell there was no empirical data on the sale of a 99.8% noncontrolling
interest. His valuations were based upon the premise that the reasonable buyer of
a 99.8% interest could be expected to seek to maximize his or her economic
interest by consolidating ownership through the purchase of the 0.2% interest. Mr.
Mitchell also contends that a willing buyer would consider the likelihood of
purchasing the 0.2% interest.
Mr. Mitchell determined that a hypothetical willing seller would seek first
to acquire the class A units for a premium. According to his reports and
testimony, purchasing the class A units would result in consolidated control and
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[*30] further maximize the value of the class B units by reducing any discount
sought by a hypothetical willing buyer.
His valuation for Rabbit began with the NAV stipulated by the parties, and
his valuation for Angus began with the NAV determined in the VCG report. To
arrive at the appropriate premiums for the class A units of Rabbit and Angus he
developed a theoretical application of the discounted NAV approach. He assigned
to each entity’s NAV a 10% lack of control discount and a 20% lack of
marketability discount. This theoretical approach produced a 28% total discount
from the NAVs. The discounted values were then used to estimate reasonable
premiums that a person would pay to acquire the class A units. The reasonable
premium amounts were deducted from the undiscounted NAV to determine the
fair market valuation of the class B units.
1. Valuation of Rabbit
Using his theoretical application of a discounted NAV Mr. Mitchell
determined that Rabbit’s class B units had a fair market value of $6,515,237. He
stated that the undiscounted values were $18,134 for the class A units and
$9,048,940 for the class B units. He calculated the theoretical discount by
subtracting the discounted value from the undiscounted value. The theoretical
discount of $2,533,703 was greater than the undiscounted value of $18,134
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[*31] attributable to the class A units. According to Mr. Mitchell a willing seller
of the 99.8% interest would be expected to seek to limit the dollar amount of any
discount sought by a willing buyer by consolidating ownership. He further
contends that a willing buyer would be willing to purchase the 99.8% interest for
more than $6,515,237 because he or she would reasonably believe that he or she
could pay a premium to acquire the class A units after acquiring the class B units.
In his reports Mr. Mitchell estimated that the purchase premium would be
5% of the theoretical dollar discount of $2,533,703. The 5% purchase premium
equaled approximately $127,000, which he rounded to $130,000. He reduced
Rabbit’s class B units’ undiscounted NAV of $9,048,940 by the $130,000
purchase premium to arrive at a value of $8,918,940 with a per-unit price of
$893.68.
2. Valuation of Angus
For the valuation of Angus Mr. Mitchell used the same reasoning and
methodology that he used to analyze Rabbit. Mr. Mitchell relied on the NAV of
Angus determined by the VCG report. Using his theoretical application of a
discounted NAV Mr. Mitchell determined that the Angus class B units had a fair
market value of $22,972,854. He stated that the undiscounted values were
$63,941 for the class A units and $31,906,742 for the class B units. He calculated
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[*32] the theoretical discount as $8,933,888, which was greater than the
undiscounted value of $63,941 attributable to the class A units.
Mr. Mitchell estimated that the purchase premium would be 5% of the
theoretical dollar discount of $8,933,888. The 5% purchase premium equaled
approximately $447,000, which he rounded to $450,000. He reduced the class B
units’ undiscounted NAV of $31,906,7429 by the $450,000 purchase premium to
arrive at a value of $31,456,742 with a per-unit price of $3,151.98.
V. Analysis
When a gift of property is made, its value at the date of the gift shall be
considered the amount of the gift. Sec. 25.2512-1, Gift Tax Regs. We do not
engage in imaginary scenarios as to who a purchaser might be. Estate of Giustina
v. Commissioner, 586 F. App’x 417, 418 (9th Cir. 2014), rev’g and remanding
T.C. Memo. 2011-141. In Olson v. United States, 292 U.S. 246, 257 (1934), the
Supreme Court explained:
Elements affecting value that depend upon events or combinations of
occurrences which, while within the realm of possibility, are not
fairly shown to be reasonably probable should be excluded from
consideration for that would be to allow mere speculation and
conjecture to become a guide for the ascertainment of value--a thing
to be condemned in business transactions as well as in judicial
ascertainment of truth. * * *
9
This value is 99.80% of the NAV of $31,970,683.
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[*33] Respondent’s expert relies upon an additional action, the purchase of the
class A units. Mr. Mitchell contends that the economic realities have to be taken
into consideration and that the economic stake of the holder of a 99.8% interest of
the class B units “dwarfs” that of the holder of the class A units. However,
Margaret, the sole owner of the class A units, testified that she had no intention of
selling the units. She further testified that if she ever sold the units she would
demand a premium much higher than what was estimated in the Mitchell reports.
If the class B units were ever sold outside the family, Margaret explained that she
would require that she be paid a management fee.
We are looking at the value of the class B units on the date of the gifts and
not the value of the class B units on the basis of subsequent events that, while
within the realm of possibilities, are not reasonably probable, nor the value of the
class A units. See id. In Succession of McCord v. Commissioner, 461 F.3d 614,
629 (5th Cir. 2006), rev’g and remanding McCord v. Commissioner, 120 T.C. 358(2003), the Court of Appeals for the Fifth Circuit reasoned that there are three
types of conditions along the “speculative” continuum: (1) a future event that is
absolutely certain to occur; (2) a future event “that is not absolutely certain to
occur, but nevertheless may be a ‘more . . . certain prophec[y]’”; and (3) “a
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[*34] possible, but low-odds, future event” which is “undeniably a ‘less . . . certain
prophec[y]’”.
Mr. Mitchell’s valuations relied on an additional action. He concluded that
to determine the value of what a willing buyer would pay and what a willing seller
would seek for the class B units, a premium to purchase the class A units has to be
taken into account. Elements affecting the value that depend upon events within
the realm of possibility should not be considered if the events are not shown to be
reasonably probable. Olson, 292 U.S. at 257. The facts do not show that it is
reasonably probable that a willing seller or a willing buyer of the class B units
would also buy the class A units and that the class A units would be available to
purchase. To determine the fair market values of the class B units we look at the
willing buyer and willing seller of the class B units, and not the willing buyer and
willing seller of the class A units.
Neither respondent nor Mr. Mitchell provided evidence to show support for
his valuations. His reports did not include empirical data which back up his
calculation of the 5% premium to purchase the class A units of either entity. He
provided no evidence showing that his methodology was subject to peer review.
Respondent cited no caselaw in support of Mr. Mitchell’s methodology.
Accordingly, we reject Mr. Mitchell’s valuations of the class B units of Rabbit and
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[*35] Angus. See Estate of Hall v. Commissioner, 92 T.C. at 340; Estate of
Deputy v. Commissioner, T.C. Memo. 2003-176, slip op. at 20; Estate of Smith v.
Commissioner, T.C. Memo. 1999-368, slip op. at 40.
In prior instances this Court has accepted the traditional asset-based
methodology in valuing a minority interest. In Estate of Kelley v. Commissioner,
T.C. Memo. 2005-235, we approved a lack of control discount of 12% and lack of
marketability discount of 23% for a 94.83% noncontrolling interest in a family-
owned limited partnership whose assets were cash and certificates of deposit. In
Estate of Strangi v. Commissioner, 115 T.C. 478 (2000), aff’d in part, rev’d in part
on other grounds, 293 F.3d 279 (5th Cir. 2002), we concluded that a 99%
noncontrolling interest in a limited partnership with investments in cash and
securities had a lack of control discount of 8% and a lack of marketability discount
of 25%.
In his reports Mr. Mitchell theorized about the discounted NAV approach
for the class B units of both Rabbit and Angus and concluded that the lack of
control discounts were 10% and the lack of marketability discounts were 20%.
Mr. Mitchell stated in his reports that these discounts were illustrative estimates.
However, he further stated in his reports that these discounts were “not
inconsistent with relevant market data and quantitative methodologies”. However,
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[*36] the reports provided no details on how the discounts were determined. We
realize that these discounts were used only as part of the methodology in the
Mitchell valuations. Without more information on how Mr. Mitchell arrived at his
illustrative estimates, we do not believe that respondent provided enough evidence
to support adopting such estimates for a lack of control discount of 10% and a lack
of marketability discount of 20%.
Mr. Frazier combined two methodologies: the market approach and the
income approach. The values of the class B units of Rabbit and Angus in the
VCG reports were calculated using the market approach. The VCG reports
determined a lack of control discount of 13.4% and 12.7% for Rabbit and Angus,
respectively, and a lack of marketability discount of 25% for both Rabbit and
Angus, which are within the range of several cases. See Estate of Strangi v.
Commissioner, 115 T.C. 478; Estate of Kelley v. Commissioner, T.C. Memo.
2005-235; Peracchio v. Commissioner, T.C. Memo. 2003-280; Estate of Murphy
v. United States, No. 07-CV-1013, 2009 WL 3366099 (W.D. Ark. Oct. 2, 2009).
The methodology used in the VCG reports is similar to the methodology that Mr.
Frazier used for his market-approach valuations. We are not convinced that the
higher discount for lack of control for Rabbit and lower values in the Frazier
reports should be substituted for the values that the parties stipulated and the
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[*37] discounts petitioner provided in the VCG reports. See Estate of Hall v.
Commissioner, 92 T.C. at 337-338; Estate of Deputy v. Commissioner, slip op.
at 12 n.6. Furthermore, we conclude that the market approach is a reasonable
method.
VI. Conclusion
For Rabbit the NAV is the NAV stipulated by the parties. For Angus the
NAV is the value determined in the VCG report. We are persuaded that those
valuations are the most reliable. We have no reason to object to the discounts in
VCG’s reports. Therefore, we adopt the above-described valuations and lack of
control discounts of 13.4% and 12.7% for Rabbit and Angus, respectively, and
lack of marketability discounts of 25% for Rabbit and Angus.
We have considered all of the arguments raised by the parties, including the
criticisms of each expert’s reports, and, to the extent they are not addressed, we
find them without merit.
Decision will be entered
under Rule 155.