James C. Nelson v. Commissioner

T.C. Memo. 2020-81
UNITED STATES TAX COURT
JAMES C. NELSON, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
MARY P. NELSON, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 27313-13, 27321-13.1 Filed June 10, 2020.
Bradley G. Korell, Todd A. Kraft, Rachael E. Rubenstein, Farley P. Katz,
and Theodore J. Wu, for petitioners.
Bryan J. Dotson and Sheila R. Pattison, for respondent.
1
On July 14, 2014, we consolidated these cases for trial, briefing, and
opinion.
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[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
PUGH, Judge: In these consolidated cases respondent determined the
following deficiencies in gift tax and accuracy-related penalties in notices of
deficiency issued to Mr. and Mrs. Nelson on August 29, 2013:2
Penalty
Year Deficiency sec. 6662(a)
2008 $611,708 $122,342
2009 6,123,168 1,224,634
After respondent conceded the accuracy-related penalties, the issues for
decision are: (1) whether the interests in Longspar Partners, Ltd. (Longspar),
transferred on December 31, 2008, and January 2, 2009, were fixed dollar amounts
or percentage interests and (2) the fair market values of those interests.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulated
facts are incorporated in our findings by this reference. Petitioners were residents
of Texas when they timely filed their petitions.
2
Unless otherwise indicated, all section references are to the Internal
Revenue Code of 1986, as amended and in effect for the years in issue. Rule
references are to the Tax Court Rules of Practice and Procedure. All monetary
amounts are rounded to the nearest dollar.
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[*3] I. Warren Equipment Co.
A. Background
In 1971 Johnny Warren, Mrs. Nelson’s father, cofounded Compressor
Systems, Inc. (CSI), with another family. CSI sells and rents gas compression
equipment to the oil and gas industry and provides financing and maintenance
services in connection with that equipment.3 In 1975 Mr. Warren and his brother-
in-law purchased the other family’s portion of CSI, after which the company was
solely owned by the Warren family. In 1985 Mr. Warren purchased the assets of a
Caterpillar dealer operating in Abilene and Odessa, Texas, and Caterpillar
approved him as the principal dealer for that territory. Throughout the 1990s and
2000s Mr. Warren continued to expand his family businesses, many of which
focus on the oil and gas industries and operate throughout the Southwest United
States, the Rocky Mountains, and internationally in South America and Mexico.
As part of this expansion, on September 26, 1990, Warren Equipment Co.
(WEC) was organized as a Delaware corporation. WEC is a holding company that
owns 100% of each of its seven operating subsidiaries, including CSI.
3
For readability our findings of fact generally are stated in the present tense
but are as of December 31, 2008 (valuation date), unless otherwise stated.
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[*4] B. Operating Subsidiaries
The largest of WEC’s subsidiaries is Warren Power & Machinery, L.P.,
which does business as Warren Cat. It accounts for approximately 51% of WEC’s
value. Warren Cat is the exclusive dealer for Caterpillar engines and earth-
moving equipment and machinery in its territory, which includes almost all of
Oklahoma and a large area in West Texas. Warren Cat was required to enter into a
sales and service agreement with Caterpillar that authorizes it to sell Caterpillar
equipment and products. That agreement sets out the terms of their relationship as
well as their respective rights and responsibilities.
Because Warren Cat is a dealer, not a franchisee, it cannot sell the rights to
the Caterpillar dealership. When Caterpillar terminates a relationship with one of
its dealers, Caterpillar chooses a successor and the successor purchases the
previous dealer’s assets for their net asset value. After Mr. Warren’s death in
1999 Caterpillar gave notice that it was terminating its relationship with Warren
Cat as a dealer. Mr. Warren’s son-in-law, Mr. Nelson, applied for and was
approved as Warren Cat’s dealer principal in November 1999. Mr. Nelson and
Caterpillar subsequently agreed to expand Warren Cat’s territory to its current area
in April 2002 so that Warren Cat could purchase the assets of another Caterpillar
dealership, Darr Equipment Co.
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[*5] CSI, WEC’s next largest subsidiary, accounts for approximately 45% of
WEC’s value. Based in Midland, Texas, CSI employs about 700 people and
serves much of the Western United States. CSI is the sole owner of Pump Systems
International, Inc. (PSI), which designs and sells fluid pump systems to the oil
industry around the world. In addition, CSI is the sole owner of Rotary
Compressor Systems, Inc., and Engines, Parts, & Service, Inc.
WEC’s other subsidiaries are: Warren Administration Co. (Warren Admin),
which provides administrative services such as accounting, information
technology, risk management, and legal services for WEC’s operating companies;
Ignition Systems & Controls, L.P. (ISC), which is an authorized dealer of Altronic
ignition and control systems throughout the Central United States; North
American Power Systems, Inc. (NorAm), which sells small light towers and
generators; Perkins South Plains, Inc. (PSP), which is a distributor of Perkins
engines for industrial applications; and Warren Real Estate Holdings, Inc.
(WREH), which finances and holds all real estate used by the operating
companies, leasing it to each WEC operating company in exchange for rent
payments.
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[*6] C. Ownership and Shareholders Agreement
As of the valuation date, 237,407 shares of WEC common stock were
outstanding. Most of the common stock was held by Mrs. Nelson (indirectly
through Longspar as discussed below) and her siblings: Rick Warren, Walter
Stirling Warren, and Jeffrey Somers. WEC’s management and Carole Warren, Mr.
Warren’s wife, each held a small number of the remaining shares. Mrs. Warren
also held all of the outstanding shares of WEC preferred stock, with the same
voting rights as shares of common stock.
A shareholders agreement (WEC shareholders agreement) restricts the
transferability of WEC common stock.4 It provides that the WEC board of
directors must approve all transfers of WEC common stock, and any transfer made
in violation of the WEC shareholders agreement is null and void. The WEC
shareholders agreement provides two routes for a shareholder who wishes to sell
his or her shares. First, the shareholder can sell to a permitted transferee.
Permitted transferees include Mr. Warren’s lineal descendants and their spouses; a
trust, family partnership or other entity organized for the benefit of a lineal
descendant; a tax-exempt organization described in section 501(c)(3); or a bank to
4
Rick Warren, WEC’s nonfamily management, and Mrs. Warren are not
subject to the WEC shareholders agreement. However, they are subject to other
agreements imposing restrictions on the transferability of their WEC stock.
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[*7] which a security interest is granted for purposes of obtaining a loan. If shares
are transferred to a permitted transferee, the transferee will succeed to all of the
transferor’s rights and obligations with respect to the shares and will hold them
subject to the agreement. Second, the shareholder can exercise the put option
included in the WEC shareholders agreement, which allows a shareholder to sell a
portion of his or her shares to WEC at book value. The portion the shareholder
can sell is dependent on the shareholder’s age at the time he or she exercises the
put option. If a shareholder chooses to exercise the put option, the other
shareholders have the right to intervene and purchase the shares first.
II. Longspar Partners, Ltd.
Longspar was formed on October 1, 2008, as a Texas limited partnership
based in Midland, Texas. It was formed as part of a tax planning strategy to
(1) consolidate and protect assets, (2) establish a mechanism to make gifts without
fractionalizing interests, and (3) ensure that WEC remained in business and under
the control of the Warren family.
Mr. and Mrs. Nelson are Longspar’s sole general partners, each holding a
50% general partner interest (together holding a 1% interest in Longspar as
general partners). On the valuation date, Longspar’s limited partners and their
percentage interests were as follows:
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[*8] Limited partner Percentage interest
Mary P. Nelson 93.88
Mary P. Nelson, as custodian for
Carole A. Nelson under the Texas
Uniform Transfers to Minors Act 1.83
Mary P. Nelson, as custodian for Mary
C. Nelson under the Texas Uniform
Transfers to Minors Act 0.88
Mary P. Nelson, as custodian for Paige
F. Nelson under the Texas Uniform
Transfers to Minors Act 0.88
Steven C. Lindgren, as trustee of the
Mary Catherine Nelson 2000 Trust 0.51
Steven C. Lindgren, as trustee of the
Paige Francis Nelson 2000 Trust 0.51
Steven C. Lindgren, as trustee of the
Sarah Elizabeth Nelson 2000 trust 0.51
All partners made initial contributions of capital in the form of shares of WEC
common stock.
On the valuation date, Longspar owned 65,837 shares (approximately 27%)
of WEC common stock. It also owned the following:
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[*9] Asset Value
MyVest Account (Cash) $9,470
MyVest Account (Marketable
Securities) 158,344
Limited Partner Interest in Stevens &
Tull Opportunity Fund I, L.P. 14,411
Limited Partner Interest in Stevens &
Tull Opportunity Fund II, L.P. 368,411
Limited Partner Interest in Sanders
Opportunity Fund, L.P. 63,331
Note Receivable from Exponential,
Inc. 25,000
Accounts receivable 35,380
Total 674,347
Its only liability was accounts payable of $5,000.
Longspar’s partnership agreement grants its general partners full control
over all partnership activities. Their powers include, among others, determining
partnership activities, making expenditures and incurring indebtedness, using
partnership assets, making distributions, and hiring advisers. Certain powers are
subject to limitations and require approval by all partners, such as selling or
disposing of substantially all partnership assets, leasing a significant portion of
partnership assets for a term longer than 24 months, incurring indebtedness in
excess of $5 million, or doing anything making it impossible for Longspar to carry
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[*10] on its ordinary business. Limited partners are not authorized under the
partnership agreement to play any role in Longspar’s management beyond their
veto power over certain actions.
The partnership agreement restricts the general and limited partners’
transfer of their Longspar interests. It allows transfers of a limited partner interest
to family members and to third parties. If the transfer is to a third party, the
general partners have to consent in writing or the interest first must be offered to
Longspar and then to the other partners at equal or better terms. The third-party
transferee is treated as an assignee--entitled only to partnership allocations and
distributions--until substituted as a partner. The transfer of a general partner
interest in Longspar without written consent of all partners is prohibited. Any
transfers in violation of the terms of the partnership agreement are null and void.
III. Succession Plan and Transfers
On December 23, 2008, petitioners formed the Nelson 2008 Descendants
Trust (Trust) with Mrs. Nelson as settlor and Mr. Nelson as trustee. Mr. Nelson is
a beneficiary of the Trust, along with their four daughters.
Mrs. Nelson made two transfers of limited partner interests in Longspar to
the Trust. The first transfer was a gift on December 31, 2008. The Memorandum
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[*11] of Gift and Assignment of Limited Partner Interest (memorandum of gift)
provides:
[Mrs. Nelson] desires to make a gift and to assign to * * * [the Trust]
her right, title, and interest in a limited partner interest having a fair
market value of TWO MILLION NINETY-SIX THOUSAND AND
NO/100THS DOLLARS ($2,096,000.00) as of December 31, 2008
* * *, as determined by a qualified appraiser within ninety (90) days
of the effective date of this Assignment.
Petitioners structured the second transfer, on January 2, 2009, as a sale. The
Memorandum of Sale and Assignment of Limited Partner Interest (memorandum
of sale) provides:
[Mrs. Nelson] desires to sell and assign to * * * [the Trust] her right,
title, and interest in a limited partner interest having a fair market
value of TWENTY MILLION AND NO/100THS DOLLARS
($20,000,000.00) as of January 2, 2009 * * *, as determined by a
qualified appraiser within one hundred eighty (180) days of the
effective date of this Assignment * * *.
Neither the memorandum of gift nor the memorandum of sale (collectively transfer
instruments) contains clauses defining fair market value or subjecting the limited
partner interests to reallocation after the valuation date.
In connection with the second transfer, the Trust executed a promissory note
for $20 million (note). Mr. Nelson, as trustee, signed the note on behalf of the
Trust. The note provides for 2.06% interest on unpaid principal and 10% interest
on matured, unpaid amounts, compounded annually, and is secured by the limited
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[*12] partner interest that was sold. Annual interest payments on the note were
due to Mrs. Nelson through the end of 2017.
Petitioners retained Roy Shrode to complete an appraisal of Longspar in
connection with the transfers. Mr. Shrode concluded that, as of the valuation date,
the fair market value of a 1% limited partner interest in Longspar was $341,000.
In arriving at his conclusion, Mr. Shrode relied on a fair market valuation of
WEC’s common stock completed by Barbara Rayner of Ernst & Young.5 On the
basis of his valuation, Mr. Shrode calculated that Mrs. Nelson’s December 31,
2008, and January 2, 2009, transfers equated to the rounded amounts of 6.14% and
58.65% limited partner interests in Longspar, respectively. Because the transfers
were so close together, Ms. Rayner and Mr. Shrode used December 31, 2008, as
the valuation date. We likewise will use the same date for both transfers,
consistent with their testimony at trial and with that of respondent’s expert.
Longspar’s partnership agreement was amended effective January 2, 2009,
to reflect transfers of 6.14% and 58.65% limited partner interests from Mrs.
Nelson to the Trust. Longspar reported the reductions of Mrs. Nelson’s limited
partner interest and the increases of the Trust’s limited partner interests on the
5
Ms. Rayner valued WEC common stock as of December 31, 2008, and that
value did not change as of January 2, 2009.
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[*13] Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc.,
attached to its Forms 1065, U.S. Return of Partnership Income, for 2008 through
2013. Longspar also made a proportional cash distribution to its partners on
December 31, 2011. The Trust’s portion of the cash distribution--64.79%--was
based on Mr. Shrode’s valuation.
IV. Petitioners’ Tax Returns and Examination
Petitioners filed separate Forms 709, United States Gift (and Generation-
Skipping Transfer) Tax Returns, for 2008 and 2009. On their 2008 Forms 709
they each reported the gift to the Trust “having a fair market value of $2,096,000
as determined by independent appraisal to be a 6.1466275% limited partner
interest” in Longspar. They classified it as a split gift and reported that each
person was responsible for half ($1,048,000). They did not report the January 2,
2009, transfer of the Longspar limited partner interest on their 2009 Forms 709,
consistent with its treatment as a sale.
Respondent selected petitioners’ 2008 and 2009 Forms 709 for examination.
On May 21, 2012, petitioners entered into the administrative appeal process.
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[*14] Petitioners and the Internal Revenue Service (IRS) Office of Appeals (IRS
Appeals) negotiated a proposed settlement agreement, but it was never completed.6
On the basis of their settlement discussions with IRS Appeals, petitioners
amended Longspar’s partnership agreement to record the Trust’s limited partner
interest in Longspar as 38.55% and made corresponding adjustments to the books
for Longspar and the Trust. Longspar also adjusted prior distributions and made a
subsequent proportional cash distribution to its partners to reflect the newly
adjusted interests.
In the August 29, 2013, notices of deficiency respondent determined that
petitioners had undervalued the December 31, 2008, gift, and their halves of the
gift each were worth $1,761,009 rather than $1,048,000 as of the valuation date.
Respondent also determined that petitioners had undervalued the January 2, 2009,
transfer by $13,607,038, and therefore they each had made a split gift in 2009 of
$6,803,519.
6
Petitioners initially argued that the proposed settlement agreement was
completed and binding. They subsequently abandoned this argument.
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[*15] OPINION
I. Burden of Proof
Ordinarily, the burden of proof in cases before the Court is on the taxpayer.
Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under section
7491(a), in certain circumstances the burden of proof may shift from the taxpayer
to the Commissioner. At trial petitioners orally moved to shift the burden of
proof. We resolve these cases on the basis of a preponderance of the evidence in
the record. See Knudsen v. Commissioner, 131 T.C. 185, 189 (2008),
supplementing T.C. Memo. 2007-340; Schank v. Commissioner, T.C. Memo.
2015-235, at *16. We, therefore, will deny petitioners’ motion to shift the burden
of proof as moot.
II. General Gift Tax Principles
Section 2501(a) imposes a tax on the transfer of property by gift. When
“property is transferred for less than an adequate and full consideration * * * then
the amount by which the value of the property exceeded the value of the
consideration shall be deemed a gift”. Sec. 2512(b). Conversely, property
exchanged for “adequate and full consideration” does not constitute a gift for
Federal gift tax purposes. See id. The regulations confirm that “[t]he gift tax is
not applicable to a transfer for a full and adequate consideration in money or
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[*16] money’s worth, or to ordinary business transactions”. Sec. 25.2511-1(g)(1),
Gift Tax Regs. The regulations define a transfer in the ordinary course of business
as “a transaction which is bona fide, at arm’s length, and free from any donative
intent”. Sec. 25.2512-8, Gift Tax Regs.; see Weller v. Commissioner, 38 T.C.
790, 805-806 (1962). A transaction meeting this standard “will be considered as
made for an adequate and full consideration in money or money’s worth.” Sec.
25.2512-8, Gift Tax Regs. But a transaction between family members is “subject
to special scrutiny, and the presumption is that a transfer between family members
is a gift.” Frazee v. Commissioner, 98 T.C. 554, 561 (1992) (quoting Harwood v.
Commissioner, 82 T.C. 239, 258 (1984), aff’d without published opinion, 786
F.2d 1174 (9th Cir. 1986)).
Petitioners reported the first transfer of an interest in Longspar as a gift and
the second as a sale. To redetermine the amount of any gift tax due on all or part
of these transfers, we must decide the value of the interests transferred. But before
we can turn to valuation, we must decide the nature of the interests transferred.
III. Nature of the Interests Transferred
The parties agree that the transfers were complete once Mrs. Nelson
executed the transfer instruments parting with dominion and control over the
interests. See Burnet v. Guggenheim, 288 U.S. 280, 286 (1933); Carrington v.
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[*17] Commissioner, 476 F.2d 704 (5th Cir. 1973), aff’g T.C. Memo. 1971-222;
Estate of Metzger v. Commissioner, 100 T.C. 204, 208 (1993), aff’d, 38 F.3d 118
(4th Cir. 1994); sec. 25.2511-2(b), Gift Tax Regs. But they disagree over whether
Mrs. Nelson transferred Longspar limited partner interests of $2,096,000 and $20
million, as petitioners contend, or percentage interests of 6.14% and 58.65%, as
respondent contends.
We look to the transfer documents rather than subsequent events to decide
the amount of property given away by a taxpayer in a completed gift. See Estate
of Petter v. Commissioner, T.C. Memo. 2009-280, 2009 WL 4598137, at *12
(citing Succession of McCord v. Commissioner, 461 F.3d 614, 627 (5th Cir.
2006), rev’g and remanding 120 T.C. 358 (2003)), aff’d, 653 F.3d 1012 (9th Cir.
2011); see also Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944)
(disregarding the subsequent reallocation of property to the donor via a saving
clause as contrary to public policy), rev’g and remanding a Memorandum Opinion
of this Court. Petitioners argue that the transfer instruments show that Mrs.
Nelson transferred specific dollar amounts, not fixed percentages, citing a series of
cases that have respected formula clauses as transferring fixed dollar amounts of
ownership interests. In each of those cases we respected the terms of the formula,
even though the percentage amount was not known until fair market value was
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[*18] subsequently determined, because the dollar amount was known. Wandry v.
Commissioner, T.C. Memo. 2012-88, 2012 WL 998483, at *4; Hendrix v.
Commissioner, T.C. Memo. 2011-133, 2011 WL 2457401, at *5-*9; Estate of
Petter v. Commissioner, 2009 WL 4598137, at *11-*16.
Saving clauses have been treated differently. As we explained in Estate of
Petter and Wandry, courts have rejected saving clauses because they relied on
conditions subsequent to adjust the gifts or transfers so the size of the transfer (as
measured either in dollar amount or percentage) could not be known. Thus, for
example, in Commissioner v. Procter, 142 F.2d at 827, the Court of Appeals for
the Fourth Circuit rejected a clause adjusting part of a gift to “automatically be
deemed not to be included in the conveyance in trust hereunder and shall remain
the sole property of * * * [the taxpayer]” because the adjustment would be
triggered only by a “final judgment or order of a competent federal court of last
resort that any part of the transfer * * * is subject to gift tax.”
In Succession of McCord v. Commissioner, 461 F.3d at 618, the Court of
Appeals for the Fifth Circuit upheld a gift of an interest in a partnership expressed
as “a dollar amount of fair market value in interest” reduced by a transfer tax
obligation rather than a percentage interest that was determined in agreements
subsequent to the gift. It held that “a gift is valued as of the date that it is
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[*19] complete; the flip side of that maxim is that subsequent occurrences are off
limits.” Id. at 626. The formula clause in the initial transfer document did not
include qualifying language that fair market value was to be “as finally determined
for [Federal gift] tax purposes,” but the court did not find that omission fatal
because the value of the gift was ascertainable as of the date it was complete. Id.
at 627.
Petitioners argue that we should construe the transfer clauses here as more
akin to the formula clauses that were upheld in Succession of McCord, Estate of
Petter, and Wandry, that is, read them as transferring dollar amounts rather than
percentages. However, as part of their argument, they cite evidence of their intent,
which includes their settlement discussions with IRS Appeals and subsequent
adjustments to reflect changes in valuation to reflect those discussions. Of course,
as in Succession of McCord, we look to the terms of the transfer instruments and
not to the parties’ later actions except to the extent that we conclude the terms are
ambiguous and their actions reveal their understanding of those terms. Id. at 627-
628.
Therefore, to decide whether the transfers were of fixed dollar amounts or
fixed percentages, we start with the clauses themselves, rather than the parties’
subsequent actions. The gift is expressed in the memorandum of gift as a “limited
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[*20] partner interest having a fair market value of TWO MILLION NINETY-SIX
THOUSAND AND NO/100THS DOLLARS ($2,096,000.00) as of December 31,
2008 * * *, as determined by a qualified appraiser within ninety (90) days of the
effective date of this Assignment.” Similarly, the sale is expressed in the
memorandum of sale as a “limited partner interest having a fair market value of
TWENTY MILLION AND NO/100THS DOLLARS ($20,000,000.00) as of
January 2, 2009 * * *, as determined by a qualified appraiser within one hundred
eighty (180) days of the effective date of this Assignment.”
The transferred interests thus are expressed in the transfer instruments as an
interest having a fair market value of a specified amount as determined by an
appraiser within a fixed period. The clauses hang on the determination by an
appraiser within a fixed period; value is not qualified further, for example, as that
determined for Federal estate tax purposes. See, e.g., Estate of Christiansen v.
Commissioner, 130 T.C. 1, 14-18 (2008) (upholding gift clause providing fair
market value “as such value is finally determined for federal estate tax purposes”),
aff’d, 586 F.3d 1061 (8th Cir. 2009); Estate of Petter v. Commissioner, 2009 WL
4598137, at *11-*16 (upholding gift clause transferring the number of units of a
limited liability company “that equals one-half the minimum * * * dollar amount
that can pass free of federal gift tax by reason of Transferor’s applicable exclusion
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[*21] amount” along with a clause providing for an adjustment to the number of
units if the value “is finally determined for federal gift tax purposes to exceed the
amount described” in the first clause).
Unlike the clause in Succession of McCord, “fair market value” here already
is expressly qualified. By urging us to interpret the operative terms in the transfer
instruments as transferring dollar values of the limited partner interests on the
bases of fair market value as later determined for Federal gift and estate tax
purposes, petitioners ask us, in effect, to ignore “qualified appraiser * * * [here,
Mr. Shrode] within * * * [a fixed period]” and replace it with “for federal gift and
estate tax purposes.” While they may have intended this, they did not write this.
They are bound by what they wrote at the time. As the texts of the clauses
required the determination of an appraiser within a fixed period to ascertain the
interests being transferred, we conclude that Mrs. Nelson transferred 6.14% and
58.35% of limited partner interests in Longspar to the Trust as was determined by
Mr. Shrode within a fixed period.
IV. Values of the Transferred Interests
A. General Principles
The next question we must decide is the fair market values of the interests
that Mrs. Nelson transferred to the Trust. We start as we must with the statute,
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[*22] which provides: “If the gift is made in property, the value thereof at the date
of the gift shall be considered the amount of the gift.” Sec. 2512(a). Generally,
the “valuation of property for federal tax purpose is a question of fact”. Adams v.
United States, 218 F.3d 383, 385-386 (5th Cir. 2000); see also Whitehouse Hotel
Ltd. P’ship v. Commissioner, 615 F.3d 321, 333 (5th Cir. 2010) (holding that
valuation is a mixed question of fact and law; factual findings are “subject to
review on a clearly erroneous standard” and legal conclusions, such as the proper
fair-market valuation method, are “subject to de novo review”), vacating and
remanding 131 T.C. 112 (2008). The fair market value of property transferred is
the price at which it would change hands between a willing buyer and a willing
seller, neither 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); Estate of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990); sec.
25.2512-1, Gift Tax Regs. The willing buyer and willing seller are “purely
hypothetical figure[s] and valuation does not take into account the personal
characteristics of the actual recipients of the * * * [property being valued].” See
Estate of Newhouse v. Commissioner, 94 T.C. 218 (citing Estate of Bright v.
United States, 658 F.2d 999, 1006 (5th Cir. 1981)).
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[*23] With respect to a closely held entity, a determination of its fair market value
for Federal gift tax purposes depends upon all of the relevant facts and
circumstances. See Estate of Smith v. Commissioner, 198 F.3d 515, 526 (5th Cir.
1999) rev’g and remanding 108 T.C. 412 (1997). See generally Rev. Rul. 59-60,
1959-1 C.B. 237, 242. These relevant facts and circumstances include whether
discounts for lack of control and lack of marketability factor into the fair market
value of a closely held entity’s stock. See Estate of Newhouse v. Commissioner,
94 T.C. 249; Estate of Magnin v. Commissioner, T.C. Memo. 2001-31, 2001
WL 117645, at *6-*7.
B. Experts
To resolve valuation issues we may consider expert witness opinions
properly admitted into evidence. See Helvering v. Nat’l Grocery Co., 304 U.S.
282, 295 (1938). Both parties submitted expert reports and testimony to support
their valuation of a Longspar partnership interest.
Petitioners rely on Mr. Shrode, a partner at Shrode & Parham, PLLC, who
has performed over 50 appraisals of business interests in corporations and
partnerships for gift and estate tax purposes. Respondent relies upon Mark
Mitchell, a partner and director of valuation services at Peterson Sullivan, LLP.
Mr. Mitchell has been retained well over 100 times as an expert witness to
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[*24] determine valuations and appropriate discount rates for businesses,
including in Hoffman v. Commissioner, T.C. Memo. 2001-109, and in Grieve v.
Commissioner, T.C. Memo. 2020-28. Both in turn rely on a valuation of WEC
common stock by Ms. Rayner, a U.S. quality and risk management partner in Ernst
& Young’s transaction advisory services group with extensive experience in
conducting valuations who testified for petitioners, with Mr. Mitchell making
certain adjustments that we discuss below in our analysis of their testimony. We
recognized all three as valuation experts.
We weigh each expert’s opinion in the light of the expert’s qualifications
and other credible evidence. See Estate of Newhouse v. Commissioner, 94 T.C.
217. When considering an expert’s opinion, we have “broad discretion to evaluate
the cogency of * * * [the] expert’s analysis”. Davis v. Commissioner, T.C. Memo.
2015-88, at *40 (citing Gibson & Assocs., Inc. v. Commissioner, 136 T.C. 195,
229-230 (2011)). If we find one expert’s opinion persuasive, we may accept that
opinion in whole or in part over that of the opposing expert. Estate of Davis v.
Commissioner, 110 T.C. 530, 538 (1998); see also Buffalo Tool & Die Mfg. Co. v.
Commissioner, 74 T.C. 441, 452 (1980). Or we may reach “an intermediate
conclusion as to value” by drawing selectively from the testimony of various
experts. Parker v. Commissioner, 86 T.C. 547, 562 (1986); see also Gibson &
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[*25] Assocs., Inc. v. Commissioner, 136 T.C. 230 (holding that we “may
embrace or reject an expert’s opinion in toto, or we may pick and choose the
portions of the opinion we choose to adopt”). For a value (or discount) it is “not
necessary that the value arrived at by the trial court be a figure as to which there is
specific testimony, if it is within the range of figures that may properly be deduced
from the evidence.” Anderson v. Commissioner, 250 F.2d 242, 249 (5th Cir.
1957), aff’g in part, remanding in part T.C. Memo. 1956-178.
C. Arguments and Analysis
1. WEC Common Stock
The parties and their experts agree that the valuation of a Longspar limited
partnership interest requires a valuation of WEC common stock. We too will start
there.
Because WEC is a holding company that owns 100% of each of its
subsidiaries, Ms. Rayner calculated the estimated value for all WEC stock by
determining the fair market value for each WEC subsidiary. She combined those
values and subtracted WEC’s interest-bearing debt and preferred stock to
determine the total fair market value of WEC’s common equity to be $363.7
million on a controlling interest basis before any discounts. As of the valuation
date, there were 237,407 common shares outstanding, resulting in a fair market
- 26 -
[*26] value of $1,532 per share of WEC common stock before discounts. Ms.
Rayner then applied a 20% discount for lack of control and a 30% discount for
lack of marketability to determine a fair market value of $860 per share of WEC
common stock on a minority and nonmarketable basis.
Mr. Mitchell accepted Ms. Rayner’s per-share valuation of WEC’s common
stock of $1,532 before discounts and agreed with her 30% discount for lack of
marketability but contended that her valuation of each WEC subsidiary was on a
noncontrolling interest basis and therefore no discount for lack of control was
necessary or appropriate. He therefore calculated a fair market value of $1,072 per
share of WEC common stock on a nonmarketable basis. To resolve this dispute
between the experts we must dig into Ms. Rayner’s valuation of each subsidiary
and her discount for lack of control.
a. Warren Cat, ISC, and PSP
i. Ms. Rayner’s Cost Approach
To determine the fair market value of WEC’s largest subsidiary, Warren
Cat, and two smaller heavy-equipment-dealing subsidiaries, ISC and PSP, Ms.
Rayner used the cost approach. She had two reasons: First, the restrictive terms
of the applicable sales and service agreements for each subsidiary would not
permit use of the income or market approach, and second, the prices paid in actual
- 27 -
[*27] market transactions for other heavy-equipment dealers were determined
solely on their net asset values. Therefore, she used the net asset value method,
which involves valuing all of the subsidiary’s assets (including inventory,
property, buildings, and equipment), adding them together, and subtracting out all
outstanding liabilities (except interest-bearing debt). Her calculations resulted in
fair market values of approximately $388.6 million for Warren Cat, $11.2 million
for ISC, and $6.3 million for PSP.
ii. Mr. Mitchell’s Criticisms
Mr. Mitchell argued Ms. Rayner’s use of the cost approach to value Warren
Cat did not take into account intangible assets and therefore resulted in a
noncontrolling value.7 He noted that the authoritative text that both he and Ms.
Rayner cited throughout their reports, Shannon P. Pratt et al., Valuing a Business:
The Analysis and Appraisal of Closely Held Companies 374 (4th ed. 2000) (Pratt
treatise), describes the cost approach as follows with respect to the level of value:
The asset accumulation method--also called the adjusted net asset
value method--generally indicates a controlling ownership level of
value. This is because only a controlling stockholder could decide (1)
to replace or liquidate the subject assets or (2) to put the subject
assets to their highest and best use in a going-concern context. If the
economic value of all of the subject company intangible assets is
7
Mr. Mitchell noted that his analysis also applies to ISC and PSP, but he
did not conduct separate analyses.
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[*28] captured in the asset-based approach valuation, then noncontrolling
shares typically would sell at a lack of control discount from the
indicated value. In other words, if the application of the asset
accumulation method encompasses both (1) the value of all the
tangible assets (and their highest and best use) and (2) the economic
value of all the intangible assets, then the indicated lack of control
discount would normally need to be applied in order to indicate a
noncontrolling ownership interest level of value.
Mr. Mitchell noted that Ms. Rayner’s analysis encompassed only the value of
Warren Cat’s tangible assets. He examined Warren Cat’s past operating
performance and noted that the results indicated excess economic returns and the
presence of intangible asset value. He concluded that Ms. Rayner’s failure to
include that intangible asset value in her analysis resulted in a fair market value
for Warren Cat on a noncontrolling interest basis and precluded the use of a
minority interest discount.
iii. Analysis
We disagree with Mr. Mitchell’s contention that Ms. Rayner’s valuations of
Warren Cat resulted in a noncontrolling value merely because she failed to
account for intangible assets. Ms. Rayner explained that these values did not
include intangible assets because a heavy-equipment dealer would not convey
intangible assets as part of a net-asset-value-based transaction.
- 29 -
[*29] We previously have disregarded intangible assets such as goodwill under
similar circumstances. In Zorniger v. Commissioner, 62 T.C. 435, 444-445
(1974), we concluded that goodwill does not play a role in valuing a dealership.
We relied on Noyes-Buick Co. v. Nichols, 14 F.2d 548 (D. Mass. 1926), in which
the District Court concluded that a dealership doing extensive business in a
populous territory on the basis of personal relations between the dealership and the
manufacturer did not have valuable goodwill because it could not “believe that any
reasonable person would pay any substantial sum for good will, resting on such an
insecure and precarious foundation.” Zorniger v. Commissioner, 62 T.C. 445
(quoting Noyes-Buick Co., 14 F.2d at 549).
We also find that Ms. Rayner did consider Warren Cat’s intangible assets in
her valuation. She pointed out the restrictions in the sales agreements that
constituted a large portion of Warren Cat’s intangible assets. The Pratt treatise
states that an adjustment to the valuation of intangible assets may be necessary to
account for external obsolescence, which is the “reduction in value due to the
effects, events, or conditions that are external to--and not controlled by--the
current use or condition of the intangible.” Pratt et al., supra, at 330. Here, the
restrictive terms of the sales and service agreements for each subsidiary may
eliminate the value of the subsidiary’s intangible assets to a hypothetical buyer.
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[*30] Ms. Rayner argued that these valuations all reflected controlling interest
values because every comparable property transaction she considered involved a
sale of the entire entity. Because she valued all of each subsidiary’s remaining
tangible assets, her valuations resulted in fair market values on a controlling
interest basis.
b. CSI, PSI, and NorAm
i. Ms. Rayner’s Income and Market Approaches
To determine the fair market values for CSI, PSI, and NorAm, Ms. Rayner
used the income approach because that approach considered future earning
capacity. She used the discounted cashflow method (DCF method) to determine
each subsidiary’s future earning capacity, which required her to determine the
subsidiary’s cashflow for distribution and then project that estimated cashflow into
the future. She then ascertained the present value of the future cashflow and the
terminal value (the value of the subsidiary at the end of the estimating period)
using the appropriate discount rate, which is equal to the required rate of return on
the basis of the subsidiary’s estimated weighted average cost of capital. She added
the present value and the terminal value together, along with the subsidiary’s
depreciation and capital expenditure differential benefit, to estimate each
subsidiary’s fair market value.
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[*31] For her analysis, Ms. Rayner used cashflow projections that were based, in
part, on her discussions with management. She determined the discount rate to
apply to those cashflow projections in part by looking to comparable guideline
companies (discussed in greater detail below). She used this information to
calculate fair market values of approximately $335.1 million for CSI and PSI and
$6 million for NorAm.
Because she was valuing each subsidiary as a whole, her valuations resulted
in fair market values on a controlling interest basis. To determine whether a
discount for lack of control was necessary, Ms. Rayner analyzed other factors
related to CSI, PSI, and NorAm, such as operating margins, excess assets, and
excess salaries for management. She found that each subsidiary appeared to be
running at a very efficient level that was similar to the practices of a publicly
traded company. Since elements of control generally would not accrue to minority
shareholders of a publicly traded company, Ms. Rayner determined that a discount
for lack of control would be necessary.
In addition to the income approach, Ms. Rayner also valued CSI and PSI
using the market approach because she believed there were a sufficient number of
reasonably comparable publicly traded guideline companies from which to derive
- 32 -
[*32] operating data to create valuation multiples.8 She determined valuation
multiples by dividing a market price point for each guideline company, such as its
market value or total invested capital, by a specific item on its financial
statements, such as its book value or earnings before interest, taxes, depreciation,
and amortization (EBITDA).
Ms. Rayner initially chose, for comparison and computing valuation
multiples, four publicly traded guideline companies: Exterran Holdings, Inc.
(Exterran), BJ Services Co. (BJ Services), Weatherford International, Ltd., and
Tesco Corp. She found each valuation multiple represented a minority-marketable
multiple. Of the four guideline companies, Ms. Rayner determined that the
operations of CSI and PSI could be “considered to be similar” only to Exterran
and BJ Services. However, she decided that the difference in “size, business and
geographic concentration” between CSI and PSI versus Exterran and BJ Services
merited the use of a smaller valuation multiple in computing CSI’s and PSI’s fair
market values.
Ms. Rayner calculated four different valuation multiples for Exterran and BJ
Services, decreased the multiples to account for differences between the guideline
8
Ms. Rayner did not believe there were a sufficient number of reasonably
comparable publicly traded guideline companies to value NorAm using the market
approach.
- 33 -
[*33] companies and the subsidiaries, and applied the multiples to specific items
on CSI’s and PSI’s financial statements (i.e. book value, EBITDA). She
determined that these calculations resulted in a range of fair market values for CSI
and PSI of $236.5 million to $282.8 million. Ms. Rayner contended that the
values reflected a controlling interest because the decrease in multiples would be
offset by premiums for control.
Ms. Rayner also used the similar transactions method as part of her market
approach analysis, using her discussions with management to create a specialized
valuation multiple for comparison with available market data. After discussions
with CSI’s and PSI’s management, Ms. Rayner used a dollar-per-horsepower
transaction multiple. She was unable to find similar transactions for comparison,
so WEC’s management provided an estimated average market price per unit of
horsepower and information about CSI’s and PSI’s total fleet horsepower to help
her create a fair market value of $307.9 million.
Ms. Rayner examined the range of fair market values that she calculated for
CSI and PSI using the market approach and determined that the two subsidiaries’
combined fair market value was approximately $269.8 million. She then reviewed
the results of both the income and market approach and determined the fair market
value of CSI and PSI was “reasonably represented as $309.0 million”.
- 34 -
[*34] ii. Mr. Mitchell’s Criticisms
Mr. Mitchell argued that Ms. Rayner’s use of the income approach to value
CSI, PSI, and NorAm resulted in fair market values of noncontrolling interests.
He determined that the cashflow projections that Ms. Rayner used in determining
each subsidiary’s fair market value did not include specific assumptions about the
ability of a shareholder to realize more for a controlling interest than a
noncontrolling interest. Mr. Mitchell also determined that Ms. Rayner’s DCF
method analysis failed to consider the impact of factors such as increased profits
or changes in capital structure that would differentiate a controlling interest from a
noncontrolling interest. He concluded that Ms. Rayner’s failure to address these
issues resulted in fair market values for CSI, PSI, and NorAm that inherently
reflected a noncontrolling interest.
Mr. Mitchell also argued that Ms. Rayner’s valuation of CSI and PSI under
the market approach was flawed in that she should not have decreased the
multiples for CSI and PSI to reflect differences with the guideline companies and
then applied control premiums to offset the decrease. He noted that the multiples
for the guideline companies that Ms. Rayner used in her analysis already
represented minority-marketable multiples. He contended that any downward
adjustments to those multiples would still result in values of noncontrolling
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[*35] interests, so the application of a discount for lack of control to those values
would be improper.
iii. Analysis
As to Ms. Rayner’s valuation of CSI, PSI, and NorAm using the income
approach, we agree with Mr. Mitchell that she did not analyze certain factors that
would differentiate a controlling interest from a noncontrolling interest. But the
Pratt treatise states that “[e]ven minority shares can have some elements of
control. These elements of control may reduce, but rarely eliminate, the discount
for lack of control.” Pratt et al., supra, at 398-399. The Pratt treatise then lists
three scenarios where a discount for lack of control would not apply (blocking
power, swing vote, and takeover protection). Id. And in previous cases involving
these types of control we have recognized that a discount would not apply. See
Estate of Winkler v. Commissioner, T.C. Memo. 1989-231 (rejecting a discount
where a minority block of stock had “swing vote characteristics”); see also Estate
of Simplot v. Commissioner, 249 F.3d 1191, 1195-1196 (9th Cir. 2001) (rejecting
our decision to apply a control premium to a controlling block of nonvoting stock
because “[n]o ‘seat at the table’ was assured by this minority interest” that would
result in an economic advantage for which a premium would be necessary), rev’g
and remanding 112 T.C. 130 (1999); Estate of Bright, 658 F.2d at 1002-1008
 - 36 -
[*36] (rejecting the Government’s attempt to use family attribution principles to
apply a control premium to a controlling block of stock for estate valuation
purposes).
These types of control are not present here and thus cannot affect WEC’s
interests in CSI, PSI, and NorAm. Ms. Rayner’s failure to analyze these factors
does not render the values she computed noncontrolling. See Estate of Magnin v.
Commissioner, 2001 WL 117645, at *15-*16. We conclude that WEC’s interests
involve minority shares with elements of control for which a discount for lack of
control should be reduced but not eliminated.
As to Ms. Rayner’s valuation of CSI and PSI under the market approach, we
agree that her valuation resulted in fair market values on a noncontrolling interest
basis. Ms. Rayner vaguely supported her reduction of the minority-marketable
multiples to calculate CSI’s and PSI’s values under the market approach as
necessary to reflect differences in “size, business and geographic concentration.”
We find this reasoning unconvincing. See Estate of Jung v. Commissioner, 101
T.C. 412, 443-446 (1993) (rejecting a lack of control discount where the
incremental risk premium used to calculate the discount was derived solely as a
result of a company’s size). Her justification for reducing the multiples also
undermines her analysis as it suggests that her guideline companies were not
- 37 -
[*37] similar enough to CSI and PSI. See Astleford v. Commissioner, T.C. Memo.
2008-128, 2008 WL 2610466, at *8 (holding that when “comparables are
relatively few in number, we look for a greater similarity between comparables”
and the target entity).
Nor does Ms. Rayner’s use of the similar transactions method as part of the
market approach support a minority interest discount. She failed to find
comparable transactions for her selected dollar-per-horsepower multiple and relied
on WEC’s management to provide an estimated average market price per unit of
horsepower. We cannot rely on a similar transactions analysis when it “did not
take into account any actual comparable transactions.” See Estate of Baird v.
Commissioner, 416 F.3d 442, 450 (5th Cir. 2005), rev’g and remanding T.C.
Memo. 2002-299. Therefore we reject her valuation using this method.
c. WREH and Warren Admin
i. Ms. Rayner’s Approach
Ms. Rayner did not determine a fair market value for WREH or Warren
Admin. A third-party appraiser estimated WREH’s fair market value at $48
million, and WEC presented that value to Ms. Rayner for her analysis. Warren
Admin was not included in Ms. Rayner’s analysis.
- 38 -
[*38] She did, however, determine that the fair market value for WREH was on a
controlling interest basis because it owned all of the WEC-related real estate. She
also determined that a discount for lack of control was necessary because WREH
was paid fair market rent, which means a minority shareholder in WREH would
not expect to increase rent to maximize value.
ii. Mr. Mitchell’s Criticisms
Mr. Mitchell did not dispute the third-party appraisal of WREH or Warren
Admin’s exclusion, but he did dispute Ms. Rayner’s contention that the valuation
of WREH resulted in a fair market value on a controlling interest basis. He briefly
examined the valuation of WREH in his report and concluded that the valuation of
WREH was of a noncontrolling interest. He argued that a controlling investor and
a minority investor would receive the same value because WREH’s assets are
imbedded in the going-concern operations of WEC, so no lack of control discount
is necessary.
iii. Analysis
As with CSI, PSI, and NorAm, Ms. Rayner did not analyze elements that
would differentiate a controlling interest from a noncontrolling interest, but her
failure to analyze these factors does not render the values she computed
noncontrolling. As we did above with respect to CSI, PSI, and NorAm, we
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[*39] conclude that WEC’s interests in WREH involve minority shares with
elements of control for which a discount for lack of control should be reduced but
not eliminated.
d. Conclusion Regarding Minority Discount
In sum, we conclude that most of Ms. Rayner’s valuations of WEC
subsidiaries produced values of interests with at least some elements of control.
We therefore conclude that some discount should apply in valuing a minority
interest in WEC common stock. See Estate of Magnin v. Commissioner, 2001 WL
117645, at *14 (citing Estate of Newhouse v. Commissioner, 94 T.C. 249, in
holding that it is “unreasonable to argue that no discount should be considered for
a minority interest in a closely held corporation”).
We now turn to the appropriate amount.
e. Discount for Lack of Control
To identify the appropriate lack of control discount, Ms. Rayner reviewed
information reported by Mergerstat Review regarding the five-year average
premiums paid in construction, mining and oil equipment, and machinery industry
transactions and Universal Compression Holding, Inc.’s acquisition of Hanover
Compressor Co. in 2007. She then used the formula (control premium / [1 +
control premium]) to determine a range of discounts from 20% to 25%, concluded
- 40 -
[*40] that the low end of the range was most appropriate, and determined that a
20% lack of control discount should apply.
We reject Ms. Rayner’s 20% discount for lack of control. First, as noted
above, not all of her methods produced controlling interest valuations. More
importantly, she valued WEC as a holding company but computed her discount
using construction, mining and oil equipment, and machinery industry
transactions. While WEC’s subsidiaries were heavily involved in that industry, we
conclude that Ms. Rayner should have considered comparable holding companies.
Because Mr. Mitchell determined that Ms. Rayner’s valuations all resulted
in values on a noncontrolling interest basis, he argued that a discount should not
apply and did not present an alternative method for computing one. We therefore
look to our previous decisions involving computation of a minority interest
discount for a holding company. See Estate of Litchfield v. Commissioner, T.C.
Memo. 2009-21, 2009 WL 211421, at *16 (applying minority interest discounts of
11.9% and 14.8%); Lappo v. Commissioner, T.C. Memo. 2003-258, 2003 WL
22048909, at *9 (applying a 15% discount); Hess v. Commissioner, T.C. Memo.
2003-251, 2003 WL 21991627, at *17 (applying a 15% discount). We conclude
that a 15% discount reasonably reflects the lack of control that a buyer of WEC
common stock would have. Applying this 15% discount for lack of control and
- 41 -
[*41] 30% discount for lack of marketability that both experts agree are
appropriate results in a fair market value of $912 per share of WEC common
stock.
2. Longspar Limited Partnership Interest
To value a limited partner interest in Longspar, petitioners rely on Mr.
Shrode and respondent relies on Mr. Mitchell. They agree generally on the
methodology for valuing Longspar; they disagree only on the appropriate
discounts for lack of control and lack of marketability. Both value Longspar as a
holding company and rely upon Ms. Rayner’s valuation of WEC common stock as
their starting point, as WEC common stock shares accounted for approximately
99% of the value of Longspar’s assets.
Mr. Shrode used what he believed was the only appropriate approach (asset-
based) and method (net asset value). He started with Ms. Rayner’s fair market
valuation of WEC common stock of $860 per share, added in the value of
Longspar’s other non-WEC assets, and deducted Longspar’s liabilities to
determine the controlling,9 marketable value of Longspar as of December 31,
2008, to be $57,305,837.
9
Mr. Shrode did not determine the value of Longspar’s other non-WEC
assets or liabilities, but rather accepted management’s representations as to those
values. These values are not in issue.
- 42 -
[*42] Mr. Mitchell used a similar methodology, starting with Ms. Rayner’s
valuation, but his adjustment to remove her lack of control discount produced a
controlling, marketable value for Longspar, as of December 31, 2008, of
$71,246,611, instead. Adjusting the experts’ methodology to account for the 15%
lack of control discount that we decided was reasonable for Ms. Rayner’s
valuation above results in a controlling, marketable value for Longspar, as of
December 31, 2008, of $60,729,361.
Mr. Shrode removed the 1% general partner interests and applied a 15%
discount for lack of control and a 30% discount for lack of marketability to
determine the fair market value of Longspar’s limited partner interests as of the
valuation date to be $33.8 million. He used this value to compute 1%, 6.14%, and
58.65% limited partner interests in Longspar to have fair market values of
$341,000, $2,096,000, and $20 million, respectively.
By contrast, Mr. Mitchell opined that discounts of 5% for lack of control
and 25% for lack of marketability are appropriate. Applying those discounts to his
higher starting valuation of Longspar’s assets, Mr. Mitchell determined the fair
market value of Longspar’s limited partner interests as of the valuation date to be
$50.8 million. He used this value to compute 6.14% and 58.65% limited partner
interests in Longspar to have fair market values of $3,116,861 and $29,772,623,
- 43 -
[*43] respectively. To resolve this dispute between the experts we focus our
analysis on their methodology for deriving their discounts.
a. Lack of Control Discount
i. Mr. Shrode
Mr. Shrode determined that a discount for lack of control was necessary to
determine a limited partner minority interest in Longspar because a hypothetical
buyer of a limited partner’s minority interest in Longspar would not have any
control over the company’s operations or decisions and 100% of Longspar
interests, operations, and decisions were controlled by one family rather than
independent investors. To determine the discount, Mr. Shrode looked to the
public market valuations of closed-end funds that own nonmarketable securities.
Consulting a 2008 report containing the trading values for 43 closed-end funds,
Mr. Shrode ultimately identified three nondiversified closed-end equity funds that
were comparable to Longspar in that the funds owned assets that were held for
long-term appreciation and were not publicly traded. These three funds traded
over the previous five years up to the valuation date at an average lack of control
discount of 11.2%.
Mr. Shrode did observe several differences between Longspar and the 43
closed-end funds in his analysis. Longspar had a shorter history than most of the
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[*44] closed-end funds, and investment decisions were left to Longspar’s general
partners’ discretion (they did not have clear and stated investment objectives).
Longspar was significantly smaller than the three comparable nondiversified
closed-end equity funds. One of the funds, Engex, Inc., was focused on
biotechnology and could only invest up to 15% of its assets in nonmarketable
securities, while the remaining two funds were investment management companies
that managed a wide range of securities with no particular focus on family-owned
assets. Mr. Shrode considered excluding Engex from his analysis, but he decided
that would create too narrow a comparison. He instead adjusted for the additional
risk characteristics that set Longspar apart from the rest of the closed-end funds to
determine a discount of 15%.
ii. Mr. Mitchell
Respondent contends that Mr. Mitchell’s discount computation analysis is
more thorough than Mr. Shrode’s. To calculate a discount, Mr. Mitchell
considered 30 closed-end funds that were classified as general equity funds. He
found that the average control discount for those funds was 14.4%, the median
discount was 17%, and the standard deviation between the funds’ discounts was
7.4%. He observed that the standard deviation indicated a relatively wide discount
range for his fund sample.
- 45 -
[*45] After completing his calculations, Mr. Mitchell noted that closed-end fund
discounts “remain something of an anomaly, with no definitive conclusion based
on empirical support as to the causes of such discounts” before noting some of the
factors and company characteristics that may contribute to the variability in
discounts. He then examined these factors and company characteristics in his fund
sample and determined that Longspar was not comparable to any of the other
closed-end funds. He determined that there would be almost no possibility of a
lack of control disadvantage for a minority owner of Longspar except “under
certain circumstances, the precise nature of which cannot be exactly determined
with reference to empirical/market data.” Mr. Mitchell concluded that he should
apply a discount to account for that remote possibility, so he calculated a 5%
discount by reducing the average discount for his sample funds by one standard
deviation “to account for the differences in control characteristics of the funds in
comparison to * * * [Longspar]” and then reducing that figure further by 2% to
account for “the probability that * * * [Longspar] would undertake any significant
change in its operating profile, while non-zero, is not necessarily significant as of
the Valuation dates.”10
10
There is no evidence in the record telling us why Mr. Mitchell selected
the standard deviation for his first reduction and 2% for his second reduction.
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[*46] iii. Analysis
Both experts’ analyses suffer from a lack of suitable comparables to
Longspar. Where the comparables are relatively few in number, we look for a
greater similarity between comparables and the subject company. See Astleford v.
Commissioner, 2008 WL 2610466, at *8. We do not find any of the funds
identified by Mr. Shrode and Mr. Mitchell to be suitable comparables for
Longspar. We therefore reject both experts’ analyses and proposed discounts. See
Chapman Glen, Ltd. v. Commissioner, 140 T.C. 294, 343 (2013) (rejecting an
expert’s comparables in part because they “were for the most part not comparable”
to the subject properties).
We agree with both experts, however, that a discount should be applied to
reflect the possibility of a lack of control disadvantage for a minority owner of
Longspar. To decide that discount, we will not endorse either expert’s
calculations, but we will consider and draw selectively from their testimony. See
Parker v. Commissioner, 86 T.C. 562. Because valuation involves an
approximation, “the figure at which we arrive need not be directly traceable to
specific testimony if it is within the range of values that may be properly derived
from consideration of all the evidence.” Estate of Heck v. Commissioner, T.C.
Memo. 2002-34, 2002 WL 180879, at *6. While we found Mr. Mitchell’s
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[*47] explanation of how he derived his discount unconvincing, we do agree with
him that the possibility of a lack of control disadvantage for a minority owner is
remote. We therefore adopt a 5% lack of control discount for a hypothetical buyer
of a Longspar limited partnership interest.
b. Lack of Marketability Discount
i. Mr. Shrode
Mr. Shrode determined that a discount for lack of marketability also was
necessary because nonmarketable assets like WEC common stock are less liquid
than their marketable counterparts. To determine the discount Mr. Shrode looked
to several studies on the sales of restricted stock with a two-year holding period
and private, pre-initial-public-offering (IPO) stock.
Mr. Shrode found an average discount in the range of 30% to 40% in the
studies involving sales of restricted stock, and 40% to 45% in the studies
involving sales of private, pre-IPO stock. On the basis of this analysis, Mr.
Shrode selected a discount of 30%.
ii. Mr. Mitchell
Mr. Mitchell compiled a range of discounts from 22% to 34% by using
quantitative models that looked at the role of liquidity premiums in calculating the
value of a forgone put option on the basis of the Black-Scholes model and
- 48 -
[*48] considering hypothetical rates of return on Longspar’s assets. Like Mr.
Shrode, he also examined several studies on the sales of restricted stock and pre-
IPO stock, but these studies involved more recent data. On the basis of these
studies, Mr. Mitchell concluded that the approximate range of discounts was 20%
to 35%. Mr. Mitchell reconciled these two ranges of discounts and determined
that a 25% discount should apply because 25% was approximately equal to the
mid-point of these two ranges and there should be an incremental discount from
the 30% discount applied to the WEC common stock.
iii. Analysis
The two experts are only 5% apart. Mr. Shrode’s analysis depends on
several studies on the sale of restricted stock and private, pre-IPO stock that have
been brought to the attention of this Court before. See Estate of Gallagher v.
Commissioner, T.C. Memo. 2011-148, 2011 WL 2559847, at *20; Estate of Bailey
v. Commissioner, T.C. Memo. 2002-152, 2002 WL 1315805, at *10; Furman v.
Commissioner, T.C. Memo. 1998-157, 1998 WL 209265, at *17 (listing examples
of cases from 1978 through 1995 involving these studies). And in those cases we
have repeatedly disregarded experts’ conclusions as to discounts for long-term
stock holdings when based on these studies. See Estate of Bailey v.
Commissioner, 2002 WL 1315805, at *10; Furman v. Commissioner, 1998 WL
- 49 -
[*49] 209265, at *17. Accordingly, we will disregard Mr. Shrode’s conclusions as
to a discount for Longspar which was based on these studies. See Estate of Bailey
v. Commissioner, 2002 WL 1315805, at *10.
We conclude that Mr. Mitchell’s analysis was more thorough than Mr.
Shrode’s analysis in that Mr. Mitchell considered a larger range of data
(quantitative models and studies with more recent data) to compile two ranges of
discounts and calculate a reasonable discount for lack of marketability for
Longspar. However, we do not think Mr. Mitchell justified his selection of a 25%
discount instead of a 30% discount. As part of his analysis, Mr. Mitchell found
that the comparable guideline company discounts ranged from 22% to 34% using
the income approach and 20% to 35% using the market approach. Mr. Mitchell
contends that Longspar’s discount should be incrementally lower than WEC’s
discount because the marketability of WEC shares was considered in computing
the WEC discount. While his contention is reasonable, he provides no support for
his conclusion that 25% is appropriate other than his claim that 25% was equal to
the median of the ranges (we note that 28% is the median) and his professional
opinion. We therefore will adopt the median in Mr. Mitchell’s analysis--28%--
which reflects his more thorough analysis and stated rationale.
- 50 -
[*50] V. Conclusion
We summarize our conclusions as follows. First, Mrs. Nelson transferred
6.14% and 58.65% Longspar limited partner interests to the Trust. Next,
discounts of 15% for lack of control and 30% for lack of marketability should
apply to the valuation of WEC common stock, resulting in a fair market value of
$912 per share. Therefore, the controlling, marketable value of Longspar is
$60,729,361. Discounts of 5% for lack of control and 28% for lack of
marketability should apply to calculate the fair market value of a Longspar limited
partnership interest. As a result, a 1% Longspar limited partner interest has a fair
market value of $411,235 and the 6.14% and 58.65% Longspar limited partner
interests Mrs. Nelson transferred to the Trust have fair market values of
$2,524,983 and $24,118,933, respectively.
Any contentions we have not addressed we deem irrelevant, moot, or
meritless.
To reflect the foregoing,
An appropriate order will be issued,
and decisions will be entered under Rule
155.