Morton v. Commissioner , 73 T.C.M. 2520 ( 1997 )

T.C. Memo. 1997-166
UNITED STATES TAX COURT
NATHAN P. AND GERALDINE V. MORTON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26651-93. Filed April 1, 1997.
James L. Kissire and Bob J. Shelton, for petitioners.
John Repsis, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WHALEN, Judge: Respondent determined the following
deficiency in, and penalty on, petitioners' Federal income
tax for 1989:
Deficiency Sec. 6662 Penalty
$296,702 $59,340
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Unless stated otherwise, all section references are to
the Internal Revenue Code as in effect for 1989. After
concessions, the issues remaining for decision
are: (1) Whether the fair market value of the capital
stock of Soft Warehouse, Inc. ("SWI"), on June 30, 1989,
was $60.98 per share as petitioners contend, or $1,739.82
per share as determined by respondent; and (2) whether
petitioners are liable for the accuracy-related penalty
prescribed by section 6662(a).
Respondent's Motion in Limine
As a preliminary matter, we must decide respondent's
motion in limine wherein she asks the Court to overrule
certain evidentiary objections reserved by petitioners in
the stipulation of facts. Petitioners object to the
admission of the following joint exhibits:
1. A memorandum prepared by Dubin Clark &
Co., Inc. ("Dubin Clark"), describing
its 1989 purchase of SWI;
2. A memorandum prepared by Continental
Illinois National Bank and Trust Co. of
Chicago ("Continental Bank") for the
purpose of approving financing for
Dubin Clark's purchase and subsequent
expansion of SWI;
3. A valuation of a noncontrolling equity
interest in SWI as of March 31, 1990,
prepared by KPMG Peat Marwick and dated
June 14, 1990;
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4. A confidential private placement
memorandum dated October 1, 1990,
prepared by Goldman, Sachs & Co. and
Alex. Brown & Sons, Inc.; and
5. A prospectus for CompUSA (the successor
company of SWI) dated December 17,
1991, prepared by Kidder, Peabody &
Co., Inc., and the First Boston Corp.
Petitioners argue that these documents are irrelevant
to our determination of the value of SWI stock as of
June 30, 1989, insofar as they relate to events or
conditions arising after that date. Petitioners maintain
that only events or conditions which are reasonably
foreseeable to a hypothetical buyer and seller on the
valuation date can be considered in determining the value
of the subject property on that date. Petitioners also
argue that even if the documents are relevant, they should
not be admitted into evidence because they create an undue
risk of prejudice and confusion of the issues which
outweighs their probative value. Respondent, on the other
hand, contends that the documents are relevant because they
represent subsequent evidence of the value of SWI stock on
the valuation date. Respondent points out that all of the
documents were drafted by disinterested third parties
incident to a sale or issuance of SWI stock, and that
they were drafted for purposes other than litigation.
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Respondent also maintains that the documents do not create
an undue risk of prejudice.
The primary issue in this case is the fair market
value of SWI stock as of June 30, 1989. Fair market value
is generally defined as the price at which property would
change hands between a willing buyer and a willing seller
on a fixed date, neither being under any compulsion to buy
or sell, and both having reasonable knowledge of relevant
facts. See sec. 20.2031-1(b), Estate Tax Regs.; United
States v. Cartwright, 411 U.S. 546, 551 (1973); Krapf v.
United States, 977 F.2d 1454, 1457 (Fed. Cir. 1992);
Estate of Kaplin v. Commissioner, 748 F.2d 1109, 1111
(6th Cir. 1984), revg. T.C. Memo. 1982-440; Estate of
Brown v. Commissioner, 425 F.2d 1406, 1406-1407 (5th Cir.
1970), affg. T.C. Memo. 1969-91; Estate of Andrews v.
Commissioner, 79 T.C. 938, 940 (1982); Duncan Indus.
v. Commissioner, 73 T.C. 266, 276 (1979); Culp v.
Commissioner, T.C. Memo. 1989-517 (applying this standard
to section 83(b) election).
Evidence is relevant if it has "any tendency to make
the existence of any fact that is of consequence to the
determination of the action more probable or less probable
than it would be without the evidence." Fed. R. Evid. 401.
We agree with petitioners that unforeseeable events
occurring after the hypothetical date of sale which alter
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the value of the property should not be considered in
fixing fair market value. See First Natl. Bank of Kenosha
v. United States, 763 F.2d 891, 893-894 (7th Cir. 1985).
However, this Court has drawn a distinction between
subsequent events which affect the value of the property
and those which merely provide evidence of such value on
the valuation date. See Estate of Jung v. Commissioner,
101 T.C. 412, 431 (1993).
Subsequent events or conditions which affect the value
of the property can be taken into account only if they are
reasonably foreseeable on the valuation date. Id. For
example, the discovery of oil on real property after the
valuation date could affect what a willing buyer would pay
and what a willing seller would demand for the property on
the valuation date if the buyer and seller could foresee
the discovery. If the discovery was unforeseeable on the
valuation date, then it could not affect the value of the
property on the valuation date and should not be considered
in determining the value of the property on that date. See
id.; Estate of Hillebrandt v. Commissioner, T.C. Memo.
1986-560.
Conversely, subsequent events which merely provide
evidence of the value of the property on the valuation
date can be taken into account regardless whether they
are foreseeable on the valuation date. See id. Estate of
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Jung v. Commissioner, supra. In considering such events,
appropriate adjustments must be made for changes in
inflation, general economic conditions in the industry,
technological advances, and similar factors. Id. For
example, a subsequent arm's-length sale of the property
appropriately adjusted to take account of general economic
differences between the valuation date and the date of the
sale is relevant because it provides evidence of the value
of the property on the valuation date. See id. at 431-432.
Indeed, this and other courts have recognized on many
occasions that:
In determining the value of unlisted stocks,
actual sales made in reasonable amounts at arm's
length, in the normal course of business within
a reasonable time before or after the valuation
date are the best criteria of market value.
[Duncan Indus. v. Commissioner, 73 T.C. 266, 276
(1979) (citing Fitts' Estate v. Commissioner, 237
F.2d 729 (8th Cir. 1956), affg. T.C. Memo. 1955-
269. See also Estate of Jung v. Commissioner,
supra; Estate of Andrews v. Commissioner, 79
T.C. 938, 940 (1982); Estate of Campbell v.
Commissioner, T.C. Memo. 1991-615.]
In light of the foregoing, we find that each of the
items at issue except for the CompUSA prospectus is
relevant to our determination of the value of SWI stock as
of June 30, 1989. The Dubin Clark memorandum describing
the terms of its purchase of SWI (item number 1 above) and
the memorandum prepared by Continental Bank for purposes
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of approving financing for that transaction (item number 2
above) were both prepared prior to the valuation date.
Both documents were prepared in connection with Dubin
Clark's purchase of SWI, and neither describes subsequent
events which affected the value of the stock. Accordingly,
these documents are directly relevant to our determination
of the value of SWI stock on the valuation date. See
Estate of Jung v. Commissioner, supra.
The valuation of a noncontrolling equity interest in
SWI prepared by KPMG Peat Marwick (item number 3 above) and
the confidential private placement memorandum prepared by
Goldman, Sachs & Co. and Alex. Brown & Sons, Inc. (item
number 4 above), were both prepared after the valuation
date. However, both of these documents contain information
regarding the value of SWI stock within a reasonable time
after that date, and neither describes subsequent events
which affected the value of SWI stock. Both documents also
represent valuations of SWI stock by third parties who were
not influenced by the biases of litigation. The fact that
they were prepared after the valuation date is a factor
that we must consider in determining the probative value of
the evidence, but does not automatically make the documents
irrelevant. See Krapf v. United States, 977 F.2d 1454,
1458-1459 (Fed. Cir. 1992).
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The CompUSA prospectus (item number 5 above), on the
other hand, is not relevant to our determination of the
value of the stock at issue. This document describes a
public offering of SWI stock almost 2-1/2 years after the
valuation date. Based upon the record of this case, we
cannot find that the public offering was sufficiently
foreseeable by the parties on the valuation date. Accord-
ingly, we will sustain petitioners' objection insofar as
the CompUSA prospectus is concerned.
We reject petitioners' argument that the items in
question should not be admitted into evidence because
Estate of Jung v. Commissioner, supra, and similar cases
only allow consideration of subsequent arm's-length sales
of the subject property. As noted above, the first two
items describe conditions existing prior to the valuation
date. Assuming that petitioners' restrictive reading of
Estate of Jung v. Commissioner, supra, is correct, the next
two items fit comfortably within that reading. The
confidential private placement memorandum (item number 4)
was in fact prepared in connection with an arm's-length
sale of SWI stock. Similarly, the valuation of a
noncontrolling equity interest in SWI (item number 3) was
requested by the board of directors to ascertain the price
at which SWI stock would change hands in an arm's-length
sale. Accordingly, we find that these documents are
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essentially indistinguishable from the events which were
determined to be relevant in Estate of Jung v.
Commissioner, supra.
We also find that the documents in question do not
create an undue risk of prejudice or confusion of the
issues. A court may exclude relevant evidence if "its
probative value is substantially outweighed by the danger
of unfair prejudice, confusion of the issues, or misleading
the jury, or by considerations of undue delay, waste of
time, or needless presentation of cumulative evidence."
Fed. R. Evid. 403. Petitioners do not point to any
specific facts which indicate that the evidence at issue
would create an undue risk of prejudice or confusion of the
issues if admitted. Rather, petitioners merely state that
"Respondent's documents would unduly prejudice Petitioners
and confuse the issues and should not be considered by this
Court in determining the value of the subject stock." We
find petitioners' conclusory statement in this regard both
unsupported and unpersuasive. The documents at issue are
highly probative and do not, in our estimation, create an
undue risk of prejudice or confusion of the issues.
Accordingly, we shall grant respondent's motion in limine
and overrule petitioners' objections to the admission of
the first four items listed above into evidence. We shall
overrule respondent's motion in limine and sustain
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petitioner's objection to the admission of the CompUSA
prospectus (item 5) into evidence.
FINDINGS OF FACT
Some of the facts have been stipulated and are so
found. The stipulation of facts, first supplemental
stipulation of facts, stipulation of settled issues, and
exhibits attached to each are incorporated herein by this
reference. At the time they filed their petition in this
case, petitioners resided in Dallas, Texas. References to
petitioner in this opinion are to Mr. Nathan P. Morton.
Petitioner is a business executive who specializes in
retail marketing. Prior to May 1989, he was senior vice
president of operations for Home Depot, Inc., a retailer
specializing in hardware and housewares. When petitioner
joined Home Depot in 1984, it operated 21 stores. When he
resigned in 1989, Home Depot had grown to approximately 100
stores.
SWI was formed in 1984 by Messrs. Errol Jacobson and
Michael Henochowicz. SWI sold computer hardware and
software through warehouse "superstore" outlets, by mail,
and through direct telemarketing. By January of 1989, SWI
was operating two stores, one in Dallas, Texas, and one in
Norcross, Georgia, and was planning to open more. Messrs.
Jacobson and Henochowicz believed that SWI could become a
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dominant force in its market and wanted to expand the
company. Although their corporate contacts and experience
in retail sales and distribution provided a significant
benefit to SWI, Messrs. Jacobson and Henochowicz were both
aware that they lacked the experience and capital necessary
to expand the company. Accordingly, Messrs. Jacobson and
Henochowicz sold their SWI stock to Dubin Clark in January
1989, although they continued working for the company after
Dubin Clark's acquisition.
Dubin Clark's purchase of SWI was structured as a
stock purchase followed by a merger. Old SWI was merged
into new SWI, and new SWI was the surviving entity. In
exchange for their stock in old SWI, the selling share-
holders were to receive a total of $5 million in cash, the
right to purchase approximately 27 percent of the stock of
new SWI for $60.98 per share, and contingent annual cash
payments for 5 years following the sale equal to 30 percent
of the company's operating profit in excess of $4 million
per year. One-half of the contingent payments was
designated as "incentive compensation" to insure the
continuing involvement of the selling shareholders in the
management of SWI. The other half was designated as "earn-
out" payments.
SWI calculated the $60.98 price per share that the
former owners paid for the stock of new SWI by dividing
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paid-in capital by the number of shares outstanding after
the acquisition (i.e., paid-in capital as of January 31,
1989, $439,056, divided by total shares outstanding on the
same date, 7,200). The cash portion of the purchase price
was paid with retained earnings from old SWI and the
proceeds of debt incurred by new SWI. Prior to the Dubin
Clark purchase, SWI had virtually no long-term debt. After
the buyout, SWI had approximately $5 million in outstanding
debt.
The Dubin Clark purchase was completed on January 31,
1989. Messrs. Jacobson and Henochowicz received a total of
$279,000 in contingent payments based upon operating income
for the fiscal year ended on June 30, 1990. In January
1991, SWI repurchased 1,423,787 of the shares held by
Messrs. Jacobson and Henochowicz for $4,416,000 in cash.
SWI also purchased Messrs. Jacobson's and Henochowicz's
rights to future contingent payments for a total of
$4,098,000 in cash.
Dubin Clark was a sophisticated investor with a
proven record of successfully managing the growth of its
acquisitions. After acquiring SWI, Dubin Clark implemented
a plan to expand the company. Dubin Clark's original plan
was to open one or two new stores per year and become
dominant in certain regional markets. This would have
allowed Dubin Clark to withdraw excess cash from the
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business over the time it managed the company. Dubin Clark
intended to take SWI public when sales reached $250 to $300
million, which they expected to take about 3 years.
An important aspect of Dubin Clark's plan to expand
SWI was hiring experienced management. In accordance with
this aspect of its plan, SWI approached petitioner in
March 1989 and offered him a position overseeing the
company's expansion. Dubin Clark believed that
petitioner's expertise in assembling management teams,
building corporate infrastructure, and establishing plans
to facilitate corporate growth was essential to its plan to
expand SWI.
Petitioner originally rejected Dubin Clark's offer
because he did not agree with its plan to make SWI a
dominant regional retailer. Rather, petitioner believed
that SWI would be most competitive if it expanded into a
variety of geographical markets. Dubin Clark eventually
agreed with petitioner's assessment and offered him the
position of president and chief operating officer of SWI.
Petitioner accepted Dubin Clark's offer in April 1989,
but did not join the company immediately because he had
previously committed to assist Home Depot in a debt
offering. Although he provided consulting services for a
short time before his actual starting date and attended the
opening of SWI's third store in Houston, Texas in April,
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petitioner did not officially begin working for SWI until
May 31, 1989. Because of his outstanding business
credentials, petitioner's employment with SWI increased the
value of SWI stock almost immediately.
Dubin Clark realized that to attract desirable
managers to SWI, it needed to offer management candidates
ownership interests in the company. Therefore, on June 1,
1989, SWI's board of directors adopted a "Share Compensa-
tion Plan" (hereinafter referred to as the stock plan).
This stock plan authorized the board of directors to allow
employees to purchase stock in SWI at a predetermined
price. The stock plan did not require that the stock be
sold at fair market value. In fact, Dubin Clark
contemplated that most of the shares would be sold for less
than fair market value. Under the terms of the stock plan,
the price was originally set at $60.98 per share, and
SWI's board of directors was authorized to make subsequent
adjustments to this price. Although the stock plan
provided that the price could not violate applicable State
law, it provided no other specific criteria for making
these adjustments. No valuation of SWI's stock was made
at the time the stock plan was adopted. At this time, it
appears that there were 7,100 shares of SWI capital stock
outstanding, and an additional 1,800 stock purchase
warrants held by two lending institutions.
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Petitioner believed that leaving a secure position
with Home Depot to join SWI was a risky move, and he would
not have joined SWI without obtaining a significant equity
interest in the company. On July 13, 1989, after some
negotiation concerning the amount of stock petitioner would
receive pursuant to the stock plan, he and Dubin Clark
entered into a "Stock Purchase Agreement" (hereinafter
referred to as the agreement) under which petitioner agreed
to purchase 500 shares of SWI stock for $60.98 per share.
This is the same price that Messrs. Jacobson and
Henochowicz paid for their shares, and is the initial
price established under the stock plan. Neither SWI nor
petitioner obtained an independent valuation of the stock
prior to or at the time of this purchase. Petitioner
believed that the shares were fairly valuable and would
have purchased more if he had been given the opportunity.
The stock petitioner purchased pursuant to the
agreement was subject to certain restrictions. Petitioner
could not sell, assign, transfer, pledge, or dispose of the
stock to any person or entity other than SWI. In addition,
all of the shares were initially "unvested". However, 20
percent of the shares received were to become vested on the
anniversary of the purchase each year, so that all of the
shares would be vested 5 years from the date of sale.
The agreement also required SWI to repurchase all of
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petitioner's shares within 90 days of any termination of
employment other than a voluntary termination by
petitioner. The repurchase price for vested shares was
equal to the adjusted book value per share. The price for
the unvested shares was set at the lesser of the adjusted
book value per share or the original purchase price.
On or before August 12, 1989, petitioners filed with
the Internal Revenue Service a timely election under
section 83(b) regarding the SWI stock petitioner purchased
pursuant to the agreement. In this election, petitioners
reported the fair market value of the SWI stock to be
$60.98 per share, the amount petitioner paid for the stock.
Thus, petitioners claimed that they realized no gross
income in 1989 from the purchase of the SWI shares.
Although petitioner received the subject stock on
July 13, 1989, the parties agree that June 30, 1989,
is the appropriate valuation date with regard to the
section 83(b) election.
SWI experienced moderate expansion during the first
half of 1989. Although it began the year with only two
superstores, it opened a third in Houston, Texas, in April,
and was preparing to open a fourth in Los Angeles by the
end of June. In addition, its most successful store,
located in Dallas, had to be moved several times into
larger facilities. Although the company was beginning to
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recruit experienced managers, petitioner was the only new
manager hired as of June 30, 1989. SWI was generally
financially healthy at this time, but it had some fiscal
concerns, including the significant amount of debt assumed
to finance the buyout and expansion. As of June 30, 1989,
SWI had long term debt of approximately $8.3 million and
current liabilities of approximately $13.2 million. SWI's
balance sheet as of June 30, 1989 was as follows:
Assets Liabilities
Current liabilities
Accounts payable $11,290,720
Current assets Accrued liabilities 1,502,966
Cash and equivalents $1,745,901 Income taxes payable 259,550
Net accounts receivable 6,730,874 Current portion of
Inventory 9,554,926 capital lease obligations 158,040
Prepaid Expenses 555,899 Total 13,211,276
Total 18,587,600
Capital lease obligations 326,255
Property and equipment,
at cost Bank credit agreement 3,070,462
Furniture, fixtures and
equipment 738,733 Senior subordinated notes 4,912,341
Leasehold improvements 392,462
Property under capital Total long-term
lease 634,268 liabilities 8,309,058
Capital projects in Total liabilities 99.81% 21,520,334
progress 35,633
Less accumulated depreciation (367,558)
Net property & equipment 1,433,538 Shareholders' Equity
Net intangible assets &
deferred charges, net 1,432,104 Warrants 125,526
Common stock 71
Deposits and other 108,583 Additional paid in capital 430,693
total assets 21,561,825 Retained Earnings 109,674
Total 666,054
Carryover basis adjustment (624,563)
Total shareholders' equity 0.19%
41,491
Liabilities + 21,561,825
Shareholders' equity
In the 5-month period ending on June 30, 1989, SWI
experienced total sales of $64 million, gross profit of
$16.9 million, and net income of $125,526. During this
same period, SWI's gross profit margin decreased from 12.8
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percent to 11.2 percent. SWI's future financial performance
was expected to be impacted by the approximately $1 million
in capital expenditures necessary to open each new store,
and the annual management fee that SWI was required to pay
Dubin Clark. On June 30, 1989, SWI had 7,100 shares of
capital stock outstanding. As mentioned above, an
additional 1,800 stock purchase warrants were held by two
lending institutions.
SWI's growth is evidenced by its income statements for
the fiscal years 1987, 1988, and 1989, which are set out
below:
Fiscal Year Ending 6/30 1987 1988 1989
Net sales $32,124,000 $66,566,000 $137,457,598
Cost of sales 29,450,000 58,072,000 122,016,440
Gross profit 2,674,000 8,494,000 15,441,158
Selling, general and administrative expenses
Salaries and employee benefits 11,812,357
Advertising 1,223,000 2,890,000
Rent 488,000 1,503,000
Other expenses 107,000 199,000
Depreciation and amortization 357,000 857,000
Total 8,000 89,000 370,170
2,183,000 5,538,000 12,182,527
Operating income
491,000 2,956,000 3,258,631
Other income/expense
Interest income
Other income 6,000 45,000 53,391
Interest expense 5,000 26,000 33,729
Total (3,000) (11,000) (454,939)
8,000 60,000 (367,819)
Earnings before income taxes
499,000 3,016,000 2,890,812
Income taxes
Current
Deferred 213,000 1,087,000 1,204,472
Total 5,000 (15,000) --
218,000 1,072,000 1,204,472
Net income
281,000 1,944,000 1,686,340
The above figures for 1987 and 1988 are taken from an audited statement attached to a
memorandum prepared by Dubin Clark describing its 1989 purchase of SWI. The figures for 1989
are a combination of old SWI's figures and new SWI's figures.
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On April 16, 1990, petitioners filed an application
for an automatic extension of time to file their
individual return for 1989 and paid the estimated tax
due. On August 14, 1990, petitioners requested an
additional extension of time to file their return until
September 25, 1990. Respondent granted this extension
application on August 30, 1990. Petitioners' Form 1040,
U.S. Individual Income Tax Return, was signed on
October 15, 1990, and stamped received by respondent's
Austin, Texas, Service Center on October 22, 1990. We
note that respondent did not determine an addition to tax
for late filing with respect to petitioners' 1989 return.
On their return, petitioners valued their SWI stock for
section 83(b) purposes at $60.98 per share. Thus,
petitioners did not report any income on their 1989
return with respect to petitioner's purchase of
500 shares of SWI stock.
On April 4, 1990, petitioner purchased an additional
25 shares of SWI stock for $60.98 per share. Petitioners
thereafter made a section 83(b) election with respect to
these additional shares, in which they reported the fair
market value of the stock to be $2,600 per share. This
second section 83(b) election is not at issue in this
case.
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In 1991, petitioners filed a Form 1040X, Amended
U.S. Individual Income Tax Return, with respect to their
1989 return. In the amended return, petitioners claim to
have overpaid their 1989 income tax due to an accounting
error for an S corporation in which petitioners owned
shares. This amendment is not at issue in this case.
SWI did not obtain an independent valuation of its
stock until June 14, 1990. Petitioner did not personally
obtain an appraisal of the subject stock until
preparation for trial. SWI stock was not publicly traded
at any time during 1989.
OPINION
The principal issue for decision in this case is
whether the value of the SWI stock petitioner purchased
was greater than the $60.98 per share he paid and
reported on his section 83(b) election. Section 83(a)
provides generally that the value of property transferred
in connection with the performance of services must be
included in the gross income of the taxpayer who performs
the services. The value of such property is included in
income in the first year in which the taxpayer's rights
in the property are transferable or are not subject to a
substantial risk of forfeiture, whichever is earlier. At
such time, the excess of the fair market value of the
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property over the amount, if any, that the taxpayer paid
for such property is included in the taxpayer's gross
income.
Section 83(b) allows a taxpayer to elect to include
in gross income in the year of receipt the value of the
property transferred in exchange for services regardless
of whether his or her rights in the property are trans-
ferable or subject to a substantial risk of forfeiture.
Section 83(b) provides as follows:
(b) ELECTION TO INCLUDE IN GROSS INCOME IN YEAR
OF TRANSFER.--
(1) In General.--Any person who performs
services in connection with which property is
transferred to any person may elect to include
in his gross income, for the taxable year in
which such property is transferred, the excess
of--
(A) the fair market value of
such property at the time of transfer
(determined without regard to any
restriction other than a restriction
which by its terms will never lapse),
over
(B) the amount (if any) paid for such
property.
If such election is made, subsection (a) shall
not apply with respect to the transfer of such
property, and if such property is subsequently
forfeited, no deduction shall be allowed in
respect of such forfeiture.
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The parties agree that petitioners were eligible to make
an election under section 83(b) with regard to their SWI
stock.
The sole dispute between the parties to this case is
over the fair market value of the stock at the time of the
purchase, June 30, 1989. In their section 83(b) election,
petitioners claimed that the fair market value of the stock
was $60.98 per share, the price petitioner paid for his 500
shares. In the notice of deficiency, respondent determined
that the fair market value of the stock was $1,739.82 per
share, and that petitioners' 1989 taxable income should
therefore be increased in the amount of $839,420 (i.e.,
$1,739.82 minus $60.98 times 500). In a report prepared
for trial, petitioners' expert valued the stock at $55 per
share. At trial, respondent's expert testified that the
stock was worth $1,798 per share.
Generally, fair market value is "the price at which
the property would change hands between a willing buyer
and a willing seller, neither being under any compulsion
to buy or sell, and both having reasonable knowledge of
the relevant facts." United States v. Cartwright, 411
U.S. 546, 551 (1973) (quoting section 20.2031-1(b),
Estate Tax Regs.); see also Culp v. Commissioner, T.C.
Memo. 1989-517 (applying this standard to a section 83(b)
election).
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The determination of fair market value is a question
of fact to be resolved from a consideration of all rele-
vant evidence in the record and appropriate inferences
therefrom. See Estate of Jung v. Commissioner, 101 T.C.
412, 423-424 (1993); Estate of Andrews v. Commissioner,
79 T.C. 938, 940 (1982); Duncan Indus. v. Commissioner,
73 T.C. 266, 276 (1979); Kaplan v. Commissioner, 43 T.C.
663, 665 (1965); Mandelbaum v. Commissioner, T.C. Memo.
1995-255, affd. without published opinion 91 F.3d 124
(3d Cir. 1996). Petitioners bear the burden of proving
that the fair market value determined by respondent is
incorrect. See Rule 142(a), Tax Court Rules of Practice
and Procedure; Estate of Jung v. Commissioner, supra at
424; Estate of Winkler v. Commissioner, T.C. Memo. 1989-
231. All Rule references hereinafter are to the Tax
Court Rules of Practice and Procedure.
Determining fair market value is often difficult
where, as here, the subject property is the capital stock
of a closely held corporation for which no public market
exists. In these circumstances, an actual arm's-length
sale of the stock in the normal course of business within
a reasonable time before or after the valuation date is
the best evidence of fair market value. See Estate of
Andrews v. Commissioner, supra at 940; Estate of Campbell
v. Commissioner, T.C. Memo. 1991-615, sec. 20.2031-2(b),
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Estate Tax Regs. In the absence of such sales, fair
market value is determined by considering, inter alia:
(a) The nature of the business and the history
of the enterprise from its inception;
(b) The economic outlook in general and
the condition and outlook of the
specific industry in particular;
(c) The book value of the stock and the
financial condition of the business;
(d) The earning capacity of the company;
(e) The dividend paying capacity [of the
company];
(f) Whether or not the enterprise has
goodwill or other intangible value;
(g) The size of the block of stock to be
valued; and
(h) The market price of stock of
corporations engaged in the same line
or similar line of business having
their stocks actively traded in a
free and open market, either on an
exchange or over-the-counter. [Rev.
Rul. 59-60, sec. 4.01, 1959-1 C.B. at
237, 238-239; see also sec. 20.2031-
2(f), Estate Tax Regs.]
These factors are not intended to be all-inclusive, and
cannot be applied with mathematical certainty. See Rev.
Rul. 59-60 sec. 3.01, 1959-1 C.B. at 238. Because
petitioners made a section 83(b) election with respect
to the subject stock, and because the restrictions on the
stock were not perpetual, the value of the SWI stock for
- 25 -
section 83 purposes must be determined as though the
restrictions did not exist. Sec. 83(b).
There are three generally accepted methods of
determining the value of stock: The market comparison
approach, the income approach, and the cost approach.
Fishman, "Valuation Termination and Methodology", in
Financial Valuation: Businesses and Business Interests
par. 2.7 (Zukin ed. 1990). Under the market comparison
approach, the value of stock is determined by comparison
to the stock of similar companies with publicly traded
stock. Id. at par. 2.8. Under the income approach, the
value of stock is equal to the present value of the
company's future income stream. Id. at par. 2.9. Under
the cost approach, the value of stock is equal to the
fair market value of the company's assets less the total
amount of liabilities. Id. at par. 2.10.
We note that we are not bound by the methods or
opinions of any of the experts who testify at trial, but
may use their opinions to assist in determining the value
of the subject property. Chiu v. Commissioner, 84 T.C.
722, 734 (1985); Estate of Campbell v. Commissioner, T.C.
Memo. 1991-615. One expert may be persuasive on a
particular element of valuation, and another may be
persuasive on another element. Parker v. Commissioner,
86 T.C. 547, 562 (1986). Thus, we may adopt some aspects
- 26 -
of an expert's testimony and reject others. Helvering v.
National Grocery Co., 304 U.S. 282 (1938).
Petitioners' expert, Mr. Robert Conklin of Ernst &
Young, relied solely on the income approach in valuing
the SWI stock. Mr. Conklin did not use the market
comparison approach because he believed that there were
no sufficiently comparable companies in existence as of
the valuation date. He did not use the cost approach
because he felt it "tends to minimize the value of assets
and fails to consider intangibles such as goodwill."
Mr. Conklin utilized a "discounted cash flow
analysis" to calculate the fair market value of SWI
stock. Under this analysis, the value of stock is equal
to the present value of the cash flow the company is
expected to generate in the future. Mr. Conklin began
his analysis by estimating SWI's net income for the 10-
year period from 1990 to 1999, and what he described as a
"terminal year". He calculated this net income figure by
estimating the total sales SWI could expect to generate
from each store and multiplying by the number of stores
SWI could be expected to operate each year. Mr. Conklin
assumed that SWI would expand its operations rapidly from
1989 to 1994, and that it would open a constant number of
new stores each year thereafter until 1999, reaching a
total of 271 stores in that year. He also assumed that
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newly opened stores would generate revenues of $25
million per year, while mature stores would generate
$35 million. Additionally, Mr. Conklin assumed that
SWI's gross profit margin would grow by 0.3 percent each
year, reaching an "industry norm" of 13 percent of sales
by 1999 to reflect improved management and economies of
scale.
Mr. Conklin next reduced SWI's estimated total sales
by operating, pre-opening, capital, interest, tax, and
other expenses to arrive at a projected net income for
each year. In calculating the amount of such expenses,
Mr. Conklin assumed that beginning operating expenses for
each store would equal 8.8 percent of net sales, and that
this figure would decrease by 0.1 percent per year over a
9-year period (beginning the second year) to reach a
minimum ratio of 8.0 percent. He also assumed that
each new store opening required capital expenditures of
$1 million and pre-opening expenditures of $400,000.
Mr. Conklin next estimated SWI's "debt-free residual
cash flow" for each year. He calculated this figure by
reducing net income by "incremental working capital",
which he described as the amount of working capital
required to support accounts receivables and inventory.
Mr. Conklin assumed that this figure for each year would
equal 7 percent of the increase in sales over the
- 28 -
previous year. He then added depreciation and deducted
capital expenditures to reach a final "debt-free residual
cash flow" for each year.
Next, Mr. Conklin reduced "debt-free residual cash
flow" each year to present value, applying a discount
rate of 35 percent. Mr. Conklin chose this discount rate
after examining the risk inherent in SWI's financial
structure and the risk associated with SWI's general
business enterprise. According to Mr. Conklin, the
discount rate reflects the rate of return an investor
would require before devoting money to a particular
enterprise, considering its particular economic, market,
and industry risks. In this regard, Mr. Conklin examined
the capital structure of the computer retailing industry,
as well as the economic, market, and industry risk on the
valuation date. He believed that SWI presented a
particularly risky investment due to difficulties in
obtaining financing for expansion and a high degree of
risk in the computer and related markets. Additionally,
Mr. Conklin believed that "The [discount] rates for
venture capital funds averaged between 30 to 60 percent
or more due to the business risk associated with SWI's
position." He did not cite any authority for this
conclusion either in his expert report or in his
testimony at trial, nor did he state whether this rate of
- 29 -
return is generally required for venture capitalists or
is specific to an investment in SWI. Mr. Conklin
believed that a 35-percent rate of return was necessary
not only to justify the high degree of risk involved in
Dubin Clark's investment in SWI, but also to allow Dubin
Clark to make an overall profit despite the failure of
other ventures.
After calculating the present value of SWI's "debt-
free residual cash flow" for each year, Mr. Conklin
reduced the sum of these values by the book value of debt
outstanding in 1989 to arrive at the "fair market value
of equity, enterprise basis." Finally, Mr. Conklin
divided this figure by the total number of shares
outstanding to reach the price per share. Mr. Conklin
computed this value assuming 6 percent, 7 percent, and 8
percent "terminal growth rates". This produced per share
values of ($72.38), $100.14, and $285.43, respectively.
Mr. Conklin then reduced these figures to reflect a
"minority and marketability discount" of 50 percent,
which he based on the Mergerstat Review 1989. This
produced a range of values of ($36.19), $50.07, and
$142.72 per share. Based on this range, Mr. Conklin
concluded that the fair market value of SWI stock as of
June 30, 1989, was $55 per share.
- 30 -
We find petitioners' expert's valuation
unpersuasive. First, the results of Mr. Conklin's
analysis fluctuate wildly with minor changes in basic
assumptions. For example, minor changes in what
Mr. Conklin terms "Incremental Working Capital" cause
drastic changes in the overall value of the stock under
his analysis. "Incremental Working Capital" is measured
as a percentage of the increase in sales over the prior
year. Throughout his analysis, Mr. Conklin assumed that
SWI would require working capital each year equal to 7
percent of the increase in sales over the previous year.
However, a change in this figure of just 1 percentage
point to 6 percent, leaving all of Mr. Conklin's other
assumptions unchanged and applying a 7-percent growth
rate, causes the price per share to increase, by our
calculation, to $1,748.17. This is troubling in light of
the fact that Mr. Conklin agreed on cross-examination
that 6 percent was a reasonable figure for incremental
working capital. Given the importance of incremental
working capital to Mr. Conklin's valuation model, and the
volatile effect this figure has on his overall valuation,
we find troubling Mr. Conklin's concession as to the
reasonableness of using 6 percent. Moreover, we note
that information contained in Mr. Conklin's report
suggests that SWI's incremental working capital had
- 31 -
fluctuated between 1.7 percent and 7.58 percent during
the 4-year period from 1986 to 1989. Our computation of
those percentages is as follows:
In Thousands 1985 1986 1987 1988 1989
Total sales $3,000 $11,739 $32,124 $66,566 $137,458
Change from previous year -- 8,739 20,385 34,442 70,892
Working capital -- 211 347 1,777 5,376
Incremental working capital -- 2.41% 1.70% 5.16% 7.58%
The discount rate employed in Mr. Conklin's valua-
tion model is also bothersome. Mr. Conklin testified that
he chose a discount rate of 35 percent to reflect the rate
of return required by venture capitalists before devoting
money to a particular enterprise. Mr. Conklin testified
that venture capitalists generally require between 30- and
60-percent return, and that his 35-percent discount rate
was "conservative". However, Mr. Conklin did not provide
any objective support, either at trial or in his expert
report, for selecting a discount rate in this range.
Moreover, the discount rate is another extremely
problematic variable in Mr. Conklin's model. Changing the
discount rate just 2 percentage points, from 35 to 33
percent, leaving all other variables the same and applying
a 7-percent growth rate, causes an increase in the overall
valuation from, by our calculation, $47.33 per share to
$1,161 per share. A discount rate of 30 percent produces
a final value of $3,551 per share. Once again, the
- 32 -
volatile nature of Mr. Conklin's valuation model, along
with the lack of objective support for his assumptions,
causes us concern about the accuracy of his final
calculation.
We are also not persuaded by petitioners' argument
that the $60.98 price per share established in the
original acquisition transaction and used in connection
with the Share Compensation Plan supports the accuracy of
petitioners' expert's valuation. In consideration for
their shares in old SWI, Dubin Clark gave Messrs.
Jacobson and Henochowicz $5 million in cash, the right
to contingent payments of 30 percent of the company's
operating profit in excess of $4 million for the next 5
years, and the right to purchase approximately 27 percent
of the stock of new SWI for $60.98 per share. We agree
with respondent that this price per share does not
accurately reflect the fair market value of the stock
after the acquisition transaction. Indeed, as mentioned
above, the $60.98 price for the new SWI shares was
computed by dividing paid-in capital as of January 31,
1989, $439,056, by the number of shares of new SWI stock
outstanding at that time, 7,200. It bears no necessary
correlation to the value of the SWI stock after the
acquisition transaction. Furthermore, there is no
evidence that it was intended to reflect the value of the
- 33 -
new SWI stock after the transaction. It was just one
component of the overall acquisition transaction in which
Dubin Clark acquired the interests of Messrs. Jacobson
and Henochowicz in old SWI, and was not a separate arm's-
length sale reflecting the fair market value of the
specific block of stock. Accordingly, the price
established in the acquisition transaction does not
necessarily reflect the fair market value of the stock at
that time, or 6 months later when petitioner acquired the
stock at issue.
Moreover, Dubin Clark established the Share
Compensation Plan for the express purpose of attracting
talented management to SWI. One way to accomplish this
purpose was to offer prospective managers a significant
discount on the shares made available for purchase. The
language of the stock plan itself confirms that the board
of directors contemplated selling stock at less than fair
market value. Paragraph 4(a) of the stock plan provides
as follows:
The purchase price for the shares of Common
Stock to be offered and sold from time to time
by the Company pursuant to this Plan shall be
initially $60.98 per share and thereafter as
determined from time to time by the Board. The
Board is authorized to offer and sell shares of
Common Stock pursuant to this plan at less than
fair market value in order to compensate
qualified employees, directors, officers,
consultants and advisers of the Company * * *
- 34 -
Thus, the language of the stock plan itself suggests that
the initial purchase price of $60.98 per share was less
than the fair market value of the stock at the time the
stock plan was adopted.
Further, petitioner himself testified at trial that
he believed the value of SWI increased at the moment he
joined the company. Because petitioner purchased the
subject stock after he officially joined the company, the
value of the stock was, by his own admission, greater
than it was at the time the $60.98 price per share was
established. Thus, we find that the price of $60.98 per
share established in the original acquisition transaction
and the Share Compensation Plan does not provide an
accurate measurement of the value of the stock.
Events occurring after the valuation date provide
additional evidence that petitioner's stock in SWI was
worth more than $60.98 per share on June 30, 1989.
First, in a letter dated June 14, 1990, KPMG Peat Marwick
valued a noncontrolling interest in SWI at $2,500 to
$2,700 per share as of March 31, 1990, only 9 months
after the valuation date. Second, in a confidential
private placement memorandum, Goldman Sachs & Co. and
Alex. Brown & Sons, Inc., determined this value to be
approximately $15,000 per share as of October 1, 1990.
- 35 -
Finally, petitioner himself reported the value of the
additional 25 shares of SWI stock he purchased on April
4, 1990, at $2,600 per share. Taking into account
changes in general economic and other circumstances
between June 30, 1989, and the dates of these subsequent
valuations, we find respondent's valuation much more
reasonable than petitioners'.
In light of the foregoing, we reject petitioners'
expert's valuation in its entirety. Cf. Buffalo Tool
& Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452
(1980); see also Neely v. Commissioner, 85 T.C. 934, 944
(1985). Accordingly, we find that petitioners have failed
to satisfy their burden of proving that respondent's
determination of the fair market value of the subject
stock is erroneous. See Rule 142(a). We thus accept
respondent's determination in its entirety and find that
the stock purchased by petitioner had a fair market value
of $1,739.82 per share as of June 30, 1989.
Next, we must decide whether petitioners are liable
for the accuracy-related penalty prescribed by section
6662. Respondent determined that petitioners are liable
for the penalty with regard to the deficiencies
attributable to both the SWI stock and an unrelated
transaction involving stock in Home Depot, Inc. Although
the amount of the deficiency arising from the transaction
- 36 -
in Home Depot stock was settled, the section 6662 penalty
was not.
Section 6662 imposes a penalty equal to 20 percent
of any portion of an underpayment of tax attributable to
negligence or disregard of rules or regulations, or to a
substantial understatement of income tax. Negligence is
defined as "any failure to make a reasonable attempt to
comply with the provisions of this title". Sec. 6662(c).
Disregard is defined as "any careless, reckless, or
intentional disregard." Sec. 6662(c). Petitioners
bear the burden of proving that respondent's determina-
tion of negligence or intentional disregard of rules or
regulations is erroneous. Rule 142(a); Forseth v.
Commissioner, 85 T.C. 127, 166 (1985), affd. 845 F.2d 746
(7th Cir. 1988), affd. sub nom. Mahoney v. Commissioner,
808 F.2d 1219 (6th Cir. 1987), affd. without published
opinions sub nom. Woolridge v. Commissioner, 800 F.2d 266
(11th Cir. 1986); affd. without published opinion sub
nom. Bramblett v. Commissioner, 810 F.2d 197 (5th Cir.
1987); affd. sub nom. Enrici v. Commissioner, 813 F.2d
293 (9th Cir. 1987).
With regard to the deficiency arising from the SWI
stock, petitioners point to the fact that petitioner
engaged in "extensive discussions" with Dubin Clark
regarding his employment with SWI and his purchase of SWI
- 37 -
stock. Petitioners argue that through these discussions,
petitioner made a reasonable effort to determine the
value of SWI, and that he had no reason to expect that
the stock was worth more than the $60.98 per share that
he paid. Petitioners also argue that given petitioner's
business experience and expertise, this determination was
reasonable. We disagree.
Although petitioner is a successful businessman,
he is neither an accountant nor an expert in property
valuation. The record indicates that petitioners
received professional assistance in preparing their tax
return for the year in issue. However, there is nothing
in the record to show that petitioners relied on expert
advice in valuing the SWI stock, or that they provided
the return preparer with all of the information needed to
value the stock. Under the circumstances, we find that
petitioners failed to do what a reasonable and ordinarily
prudent person would have done under the circumstances to
value the SWI stock. See generally Neely v. Commis-
sioner, 85 T.C. 934, 947 (1985). Accordingly, we find
that petitioners are liable for the penalty prescribed by
section 6662 for negligence with respect to the SWI
stock. Sec. 6662(b)(1). It is unnecessary to consider
whether they are liable for the same penalty by reason of
- 38 -
a substantial understatement of tax with respect to the
SWI stock. See sec. 6662(b)(2).
Petitioners have not challenged respondent's deter-
mination of negligence with respect to the understatement
attributable to the gains from a transaction involving
Home Depot stock. Although the Stipulation of Settled
Issues states that petitioners concede underreporting the
gain as determined in respondent's notice of deficiency,
the stipulation is silent on the issue of the section
6662 penalty. At trial, petitioners' counsel informed
the Court that this issue had not been resolved.
Petitioners bear the burden of proving that they are
not liable for the penalty as determined by respondent.
Rule 142(a). Petitioners have not met this burden with
respect to the understatement attributable to the
transaction involving Home Depot stock. They introduced
no evidence disputing the section 6662 penalty, and
failed to raise any argument during trial or on brief as
to why the penalty is inapplicable. Accordingly, we
sustain respondent's determination that petitioners are
liable for the section 6662 penalty with respect to such
understatement.
In light of the foregoing, and to reflect
concessions and settled issues,
- 39 -
An appropriate order will
be issued granting respondent's
motion in limine in part, and
denying respondent's motion in
limine in part, and decision
will be entered under Rule 155.