ESTATE OF HARRIETT R. MELLINGER, DECEASED, HUGH V. HUNTER AND WELLS FARGO BANK, CO-EXECUTORS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 6663-97
UNITED STATES TAX COURT
Filed January 26, 1999
112 T.C. No. 4
Robert B. Martin, Jr., for petitioner.
Donna F. Herbert and Mark A. Weiner, for respondent.
- (1) Whether
section 2044 requires aggregation, for valuation purposes, of the stock held in a trust established by decedent‘s predeceased spouse undersection 2056(b)(7) with stock held in decedent‘s revocable trust and with stock held outright by decedent; and - (2) if
section 2044 does not require aggregation, the fair market value of the stock at decedent‘s death.
Unless otherwise indicated, all section references are to the Internal Revenue Code in effect as of the date of decedent‘s death, and all Rule references are to the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the facts set forth in the stipulation are incorporated in our findings by this reference. Decedent died testate on April 18, 1993 (the valuation date), a resident of Los Angeles, California. Decedent was the widow of Frederick N. Mellinger (Mr. Mellinger), founder of Frederick‘s of Hollywood, Inc. (FOH).
Prior to Mr. Mellinger‘s death, decedent and Mr. Mellinger were husband and wife and owned as community property 4,921,160 shares of the common stock of FOH. Such shares were held under the terms of a revocable inter vivos trust known as the Frederick N. Mellinger Family Trust (the family trust).
On the death of Mr. Mellinger, under the terms of the family trust, Mr. Mellinger left his community property interest of 2,460,580 shares of FOH stock in an irrevocable marital trust (the QTIP trust) for the benefit of decedent during her lifetime. Property in the QTIP trust was treated in Mr. Mellinger‘s estate as “qualified terminable interest property” (QTIP property) for which a marital deduction was claimed pursuant to
After Mr. Mellinger‘s death, decedent removed her share of the community property, 2,460,580 common shares of FOH, from the family trust and contributed it to the revocable trust that she established to be known as the Harriett R. Mellinger Revocable Trust (the Harriett trust). The stock that was held by the Harriett trust also constituted 27.8671 percent of the issued and outstanding stock of FOH. Hunter and Wells Fargo Bank were designated as cotrustees. Under the terms of the Harriett trust, upon the death of decedent, the cotrustees were directed to make certain specific gifts and to sell decedent‘s personal residence and distribute the sales proceeds to decedent‘s children. The balance of the Harriett trust was to be held for distribution with certain annual and periodic cash amounts to be made to the children and specified grandchildren. Upon the death of such children and grandchildren, the remaining trust estate was to be distributed equally to certain charitable organizations. At the valuation date, decedent also owned 50 shares of FOH outright.
Hunter and Wells Fargo Bank (coexecutors) filed a United States Estate (and Generation-Skipping Transfer) Tax Return, Form 706, for decedent‘s estate on January 18, 1994. On the return,
In October 1993, FOH filed an Amendment to its Certificate of Incorporation (amendment) resulting in a redesignation of the existing capital stock as class A capital stock and the creation of a new class of nonvoting capital stock designated as class B capital stock. In connection with the amendment, the existing
Subsequently, the coexecutors undertook efforts to sell the FOH stock that was held by the trusts in order to raise funds for the payment of Federal estate tax and to provide funds for the required distributions. Accordingly, pursuant to a stock purchase agreement dated January 12, 1994, the FOH Employee Stock Ownership Plan (FOH ESOP) purchased 357,143 shares of FOH class A capital stock from the Harriett trust for $4.20 per share, a 30-percent discount from the closing price of such stock on the New York Stock Exchange (NYSE) on January 10, 1994. In
On June 14, 1996, FOH, the Harriett trust, and the QTIP trust jointly announced their employment of JMS to sell the FOH stock owned by the trusts and possibly to sell all of the shares of FOH. After holding discussions with numerous prospective purchasers, Knightsbridge Capital Corporation (Knightsbridge) submitted a formal offer to purchase all of the outstanding shares of FOH for not less than $6.00 and not more than $6.25 per share and to merge with FOH. The offer was dated April 9, 1997. The board of directors of FOH determined that this merger was in the best interest of FOH and the stockholders and approved the transaction. Thereafter, the board of directors mailed consent agreements to all shareholders requesting approval for the proposed merger. Approximately 88 percent of FOH stockholders, including the trusts, voted in favor of the merger. After negotiating the price, Knightsbridge and FOH entered into an
On examination, respondent determined that the FOH shares that were held by the Harriett trust and the QTIP trust should be merged for valuation purposes, and, in the January 15, 1997, notice of deficiency, respondent indicated that the FOH shares in each trust should be valued at $20,820,159.39 or $8.46 per share.
Overview of FOH
Founded in 1946 by Mr. Mellinger and incorporated in Delaware in 1962, FOH began as a small mail-order operation selling an assortment of intimate women‘s apparel. In 1947, the business was moved to Hollywood, California, opening its first retail store there in 1952. In its beginning, FOH‘s name was synonymous with risque lingerie. The company‘s original market was American GI‘s who, after spending time abroad, were eager to get for their wives or girlfriends the lingerie that was fashionable in Europe. FOH pioneered many trends in the industry including the extensive use of black, the pointy snow-cone bras of the 1950‘s, and the revival of garter belts in the 1980‘s.
By the early 1980‘s, however, the risque look of FOH‘s products began losing appeal. These trends caught FOH off guard, and the company‘s operations began to falter. At the same time, Mr. Mellinger developed Alzheimer‘s disease. He retired in 1984 with FOH‘s profits dwindling. Under new management, FOH enacted a plan to turn the company around. The company‘s catalogs were purged of nudity, and the black and white pictures were replaced with color photographs of models. On the retail store side, a major overhaul was also enacted. The company spent heavily to upgrade store ambience and to improve the merchandise mix.
All of these steps successfully repositioned FOH as a specialty retailer of intimate apparel. The company operates 206 specialty boutiques in 39 States with the highest concentration of stores in California. FOH developed a mail-order subsidiary to engage in extensive operations in all 50 States, with catalogs published 11 times a year.
For convenience, the following chart shows the net sales, net earnings, earnings per share, total assets, and equity of FOH for the fiscal years ended September 1, 1990; August 31, 1991; August 29, 1992; and August 28, 1993.
| Year End | Net Sales Retail | Net Sales Catalog | Net Earnings | Earnings Per Share | Total Assets | Equity |
|---|---|---|---|---|---|---|
| 1990 | $98,573,000* | $4,242,000 | $.50 | $35,031,000 | $21,855,000 | |
| 1991 | 70,938,000 | $43,196,000 | 5,197,000 | .58 | 39,935,000 | 26,992,000 |
| 1992 | 71,320,000 | 45,710,000 | 5,073,000 | .57 | 45,790,000 | 32,304,000 |
| 1993 | 73,202,000 | 55,314,000 | 4,737,000 | .53 | 50,838,000 | 36,615,000 |
*Total Net Sales for 1990
At the valuation date, FOH had one class of stock outstanding that traded on the NYSE, and those shares were unregistered with the SEC. Additionally, on the valuation date, the average price of FOH stock on the NYSE was $6.9375 per share.
Economic Conditions at the Valuation Date
At the valuation date, the American economy was experiencing a transition from recession to a recovery. The United States gross domestic product (GDP) grew 2.1 percent in 1992 following the 1991 recession. Economic improvements had generally been fueled by low interest rates, increasing corporate profits and strong productivity growth. Despite these positive factors, structural problems, including excessive debt, corporate restructuring and related uncertainties regarding job growth, overvalued real estate, weak banks, defense spending reductions, and consumer confidence continued to hamper the strength and speed of the recovery.
A survey of economists by the Wall Street Journal in early 1993 revealed a consensus estimate of 3-percent GDP growth rate for 1993, with 2.8-percent growth rate expected in the first
The California marketplace did not experience the rebound seen in the majority of the nation in 1992. Its economy continued to be impacted negatively by defense industry layoffs and a declining housing market. The Wall Street Journal reported that the California economy was expected to continue to trail far behind the rest of the United States in 1993.
ULTIMATE FINDINGS OF FACT
The fair market value of FOH shares includable in decedent‘s gross estate should reflect a 25-percent discount for lack of marketability. On the valuation date, the fair market value of each of the two 27.8671-percent interests in FOH that were held by the trusts was $12,802,705, or $5.2031 per share.
OPINION
Issue 1
Property includable in the gross estate is generally included at its fair market value on the date of a decedent‘s death.
The Court of Appeals for the Ninth Circuit addressed respondent‘s aggregation theory in Propstra v. United States, supra. In Propstra, the decedent died with an undivided one-half interest in several parcels of real estate owned by him and his wife as community property. These parcels of community property had an undisputed fair market value of $4,002,000, but, in valuing the property for estate tax purposes, the executrix discounted the fair market value of the decedent‘s one-half interest by 15 percent to account for the relative unmarketability of the decedent‘s undivided fractional interest. The Commissioner disallowed the 15-percent discount, arguing that the decedent‘s interest in the property should be valued together with the interest owned by the surviving spouse. “[O]ne can reasonably assume that the interest held by the estate will ultimately be sold with the other undivided interest and that interest‘s proportionate share of the market value of the whole will thereby by realized.” Id. at 1251.
By no means is * * * [the language of
section 20.2031-1(b) ] an explicit directive from Congress to apply unity of ownership principles to estate valuations. In comparison, Congress has made explicit its desire to have unity of ownership or family attribution principles apply in other areas of the federal tax law. See, e.g., I.R.C. secs. 267, 318, and 544. In the absence of similarly explicit directives in the estate tax area, we shall not apply these principles when computing the value of assets in the decedent‘s estate. [Id. at 1251.]
The court concluded that the decedent‘s fractional interest in the subject property should be valued separately from the accompanying fractional interest held by the surviving spouse, upholding the 15-percent discount. Id. at 1253.
Respondent argues that decedent‘s situation is distinguishable from Propstra because all of the property to be aggregated in this case is included in decedent‘s estate. The FOH shares in the Harriett trust are included pursuant to
The purpose of
Respondent argues that decedent should be treated as the owner of QTIP property for valuation purposes. Respondent has identified nothing in the statute that indicates that Congress intended that result or that QTIP assets should be aggregated with other property in the estate for valuation purposes. Cf.
In Estate of Bonner v. United States, 84 F.3d at 198, the decedent died owning fractional shares in several pieces of real property with the remaining ownership interests being held in a QTIP trust established by his wife at her death. As provided in
The Court of Appeals, relying on its prior holding in Estate of Bright v. United States, 658 F.2d at 1001, concluded that the
The estate of each decedent should be required to pay taxes on those assets whose disposition that decedent directs and controls, in spite of the labyrinth of federal tax fictions. * * * Mrs. Bonner controlled the disposition of her assets, first into a trust with a life interest for Bonner and later to the objects of her largesse. The assets, although taxed as if they passed through Bonner‘s estate, in fact were controlled at every step by Mrs. Bonner, which a tax valuation with a fractional interest discount would reflect. At the time of Bonner‘s death, his estate did not have control over Mrs. Bonner‘s interests in the assets such that it could act as a hypothetical seller negotiating with willing buyers free of the handicaps associated with fractional undivided interests. The valuation of the assets should reflect that reality. [Id. at 199.]
Respondent also argues that, in enacting sections 2056(b)(7) and 2044, Congress did not intend to alter the estate tax consequences that would otherwise arise if a decedent had transferred property to his or her surviving spouse outright. See H. Rept. 97-201, at 160 (1981), 1981-2 C.B. 352, 378 (“tax laws should be neutral and * * * tax consequences should not control an individual‘s disposition of property“). Prior to the enactment of sections 2056(b)(7) and 2044, for the first spouse
Finally, respondent argues that
Issue 2
Based on our conclusion that the two blocks of FOH shares should not be aggregated, we must determine the fair market value of the FOH stock at decedent‘s death.
Valuation is a question of fact, so we must weigh all relevant evidence to draw the appropriate inferences. Ahmanson Found. v. United States, 674 F.2d 761, 769 (9th Cir. 1981); Estate of Andrews v. Commissioner, 79 T.C. at 940. The fair market value of stock listed on an established securities market
Petitioner has the burden of proof as to the correctness and amount of the discount. Rule 142(a); Estate of Van Horne v. Commissioner, 720 F.2d 1114, 1117 (9th Cir. 1983), affg. 78 T.C. 728 (1982). This burden is a burden of persuasion, requiring petitioner to prove the merits of its claim by at least a preponderance of the evidence. Rockwell v. Commissioner, 512 F.2d 882, 885 (9th Cir. 1975), affg. T.C. Memo. 1972-133; Brumley-Donaldson Co. v. Commissioner, 443 F.2d 501, 504 n.4 (9th Cir. 1971), affg. T.C. Memo. 1969-183.
Both parties rely extensively on expert testimony to establish the amount of the discount. Expert opinions are admissible if they will assist the trier of fact to understand evidence that will determine a fact in issue. Fed. R. Evid. 702. We evaluate the opinions of experts in light of the demonstrated qualifications of each expert and all other evidence in the record. Parker v. Commissioner, 86 T.C. 547, 561 (1986).
The parties in this case agree that the undiscounted fair market value of the FOH shares on the valuation date is $6.9375 per share. The parties also agree that a marketability discount is necessary if the shares are not to be aggregated. They disagree, however, as to the appropriate marketability discount to be applied. Respondent contends that the minority blocks of FOH should be valued at $5.8969 per share, a 15-percent discount. Petitioner argues that the shares of FOH have a value of $4.786 per share, a 31-percent discount. Petitioner supports its conclusion with the testimony of Curtis R. Kimball (Kimball) and Ira M. Cotler (Cotler).
Kimball admitted at trial that his synthetic put option analysis was flawed. In his report, he concluded that the price of FOH shares should be valued in a range of $3.545 to $5.166 per share. However, cross-examination of Kimball indicated several mathematical errors in his calculations of the Black-Scholes and Noreen-Wolfson models that are intended to estimate the expense necessary to enter into put options. Respondent also pointed out that there was an alternative calculation of the Shelton model. After the adjustments, the new range in price for FOH shares using the put option methodology was between $5.689 and $5.9372, indicating a discount range of between 14.4 and 18 percent.
Second, Kimball analyzed the secondary offering approach to valuation. As part of his research, Kimball reviewed various studies that were performed to analyze the costs of a secondary offering and similar transactions. Using this approach, Kimball concluded that the fair market value for the subject FOH shares was between $5.286 and $5.037 per share. He noted that the risks of an unsuccessful secondary offering factored into his determination of where, within this range, FOH shares would be priced. He selected a fair market value of $5.10 per share, a discount of about 26.5 percent, as the appropriate value under this approach.
Kimball used the primary body of empirical evidence concerning private placement data, as found in studies of restricted stocks, to analyze the private placement market. Kimball concluded that various surveys reviewed by him indicated a cumulative average discount of 35 percent for restricted stock in a publicly traded company. He ultimately concluded that a 32-percent discount was appropriate considering the combined influences of all of the relevant factors under this approach. Applying the 32-percent discount to the market price on the valuation date results in a fair market value of $4.72 per share.
Petitioner also offered the expert testimony of Cotler to establish the applicable discount. Cotler testified that he analyzed numerous studies to determine the appropriate discount for lack of marketability. From these studies, Cotler observed that there was a mean discount of 34.73 percent for lack of
Cotler expressed an opinion that, at the valuation date, FOH was experiencing an accelerating negative financial performance. Cotler also noted that a large factor influencing the negative results of FOH could be related to the U.S. economy and the recession in California at the valuation date. Cotler also testified that consumer confidence was dropping in the fourth quarter of 1992 and that the retail sector was anticipating a difficult year with continued discounting of merchandise likely in order for retailers to maintain sales levels.
Cotler opined that the declining interest in FOH common stock was likely attributable to a number of factors, the most significant being the continuing decline in FOH‘s operating performance and the low expectations of a near-term turnaround. From an analysis of the common stock trading patterns, he concluded that there was a relatively low level of investor interest in FOH, and selling a large block of FOH common stock would be very difficult. Cotler further observed that the FOH
Cotler pointed out to the size of the block, FOH‘s recent and expected financial performance, and the overall trading characteristics of the FOH common stock as reasons why it would be difficult to sell the FOH stock at a price equal to the publicly traded common stock. Based upon this analysis, his experience as an investment banker, and other information available to him, Cotler concluded that the fair market value of the FOH stock at the valuation date should be $4.79, a 31-percent discount.
Respondent determined that the value of the blocks of FOH shares that were held in the trusts must be discounted between 10 and 17 percent to reflect the lack of marketability. Respondent supports this determination with the expert testimony of David N. Fuller (Fuller).
Fuller agreed with petitioner‘s experts that a discount for lack of marketability was appropriate when disposing of the separate minority interests in FOH. He testified that there were three viable options for selling the separate blocks of FOH stock: (1) A registered secondary offering, (2) a private
Instead, he concluded that a private placement was the likely means of disposition. In calculating the discount for a private placement of FOH stock, Fuller indicated that holding period restrictions were the primary reason for the discount. To ascertain the applicable discount, Fuller reviewed several restricted stock studies on private placement transactions. Fuller recognized that the combined results of these studies indicated a 35-percent marketability discount. He, however, concluded that the studies suffer because they review only restricted share transactions and do not include a sample of
Fuller also used a study being conducted by Business Valuation Services, Inc. (BVS), his firm, as a “sanity check“. The study analyzed private placement transactions and revealed, after an analysis of 51 transactions, a mean discount of 16.2 percent. Fuller pointed out that, for private placements of companies with market capitalizations greater than $50 million, BVS observed an average discount of 11.1 percent, and, as of the valuation date, the market capitalization of FOH was $61.3 million. For companies with annual sales greater than $100 million, BVS observed an average discount of 7.2 percent, and, for the 12-month period ended February 27, 1993, FOH had sales of $125.5 million.
Fuller relied almost exclusively on the private placement analysis that hinged on a single study. In so doing, he rejected an entire body of restricted stock studies covering an extensive time span. Fuller applied a 13.5-percent discount to the market price of freely tradeable stock sold on the public market. The study on which he relied, however, found that the discount for restricted stock, when compared with freely tradeable stock sold in a public market, averaged 42 percent of the market price.
Petitioner points to the subsequent sales of FOH shares by the trusts, arguing that, although fair market value is determined as of the date of death, consideration is given to comparable sales occurring subsequent to the valuation date for purposes of determining fair market value. Estate of Jung v. Commissioner, 101 T.C. 412, 431 (1993). Petitioner concludes that, because the sales by the trusts were consistent with the valuations by Kimball and Cotler, the sales corroborate the value claimed by petitioner and are substantial evidence of the fair market value of the FOH stock on the valuation date.
The market transaction in which the Harriett trust sold 29,500 shares of FOH stock at $4.875 per share on February 18, 1994, does not support petitioner‘s contentions, because those shares sold for the undiscounted price at which the stock was trading on the NYSE on that day.
On the record before us, we are satisfied that the respective discounts as determined by the experts set the appropriate range from which we may determine the marketability discount. We also conclude, however, that each expert excluded information that contradicted his result. Only Cotler addressed the specifics of FOH‘s financial situation in detail, but he relied on mean discounts without relating them to those details.
We conclude that the discount claimed by petitioner is necessarily overstated, but the discount asserted by respondent is inadequate. Weighing the expert opinions and the evidence on which they rely, we have more confidence in the methods of petitioner‘s experts but must adjust their conclusions to reflect their weaknesses. We bear in mind that valuation is necessarily an approximation and a matter of judgment rather than mathematics. Estate of Davis v. Commissioner, 110 T.C. 530, 554 (1998). Based on our examination of the entire record in this case, we conclude that the marketability discount should be 25 percent. We thus have found that, on the valuation date, the fair market value of each of the two 27.8671-percent interests in FOH that were held by the trusts was $12,802,705, or $5.2031 per share.
Decision will be entered under Rule 155.