Lead Opinion
In his notice of deficiency, the Commissioner determined a deficiency in the Federal estate tax of the Estate of John L. Huntsman in the amount of $97,991.40. In his second amendment to the answer, he determined such deficiency to be $107,470.13. The primary issue involves determining the fair market value of the decedent’s stock in Asheville Steel Co. and Asheville Industrial Supply Co., including determining how certain life insurance proceeds payable to such corporations by reason of the death of the decedent, are to be taken into consideration. We must also decide whether the Commissioner properly raised a new issue in his second amendment to the answer.
FINDINGS OF FACT
Some of the facts have been stipulated, and those facts are so found.
John L. Huntsman (the decedent) died testate, a resident of North Carolina, on February 5, 1971. His will was probated in Buncombe County, N.C. Anthony Redmond and Wachovia Bank & Trust Co., N.A., the executors, had their legal address in Asheville, N.C., at the time of filing the petition herein. A Federal estate tax return for the estate was filed with the District Director of Internal Revenue, Greensboro, N.C.
Asheville Steel Co. (Steel), which is located in Asheville, N.C., was chartered as a North Carolina corporation in 1944 and was originally named Asheville Steel & Salvage Co., Inc. (Salvage), but its name was changed to Steel on March 1, 1965. The decedent was originally one of the four equal shareholders in Steel, but by 1959, he had become its sole shareholder. From its creation, the decedent was the dominating force that operated the company.
Asheville Industrial Supply Co. (Supply) was originally organized as a division of Salvage in 1949. It was chartered as a North Carolina corporation on March 1,1965, and pursuant to a plan of reorganization, it acquired all the assets and liabilities of Steel allocable to the Supply division. The decedent then acquired all the outstanding stock of Supply, and at the time of his death, he owned all the outstanding stock, 25,000 shares, of each of the corporations, Steel and Supply.
Steel was engaged in the business of fabricating and erecting structural steel for industrial and commercial buildings, with about 70 percent of its business consisting of fabrication and 30 percent consis-ing of erection and millwright work. To perform a typical job, steel, which had been received by rail, normally in 60-foot lengths, was cut to the desired length and brought into the shop. Using blueprints made in *he drafting room, holes were "'d in úie steel and clip angles ided to allow the steel beam to be attached to a column or another steel beam. Any other changes necessary to make the steel beam fit into the building to be consta ted were also made. The stael beams were then c eaned, painted, and shipped to the construction site, where they were erected by the use of a mobile crane. The steel was then bolted together to make the skeletal framework of the building. Because of its limited crane capacity, Steel did not handle heavy jobs for large buildings or highway bridges; nor did it engage appreciably in operating a warehouse or service center for its customers.
Steel’s customers were primarily general contractors in the construction business. At the time of the decedent’s death, Steel’s principal sales area was western North Carolina, extending to a radius of about 100 miles from Asheville. Although occasionally a project was secured outside this area, it was usually not feasible to do so because of the transportation costs involved. Approximately 70 percent of Steel’s business was obtained by negotiations, rather than competitive bidding. The
Steel’s plant and office facilities were located on an 11-acre tract of land. The facilities included a main shop building, 120 feet by 300 feet; an office building, 54 feet by 90 feet; a warehouse, 100 feet by 70 feet; and a garage. It had about 50,000 square feet of production area. At the time of the decedent’s death, the company had 67 production employees and 27 office employees. Among the larger pieces of production equipment were 6 overhead cranes in the shop having a capacity of 3 tons each. Some of the equipment was purchased used and was getting quite old, requiring considerable maintenance. Steel’s production capacity was about 20 tons per week, or 1,000 tons per year.
Prior to the decedent’s death, Steel began to modernize and renovate its equipment. In the fiscal year ending January 31, 1971, it purchased a 45-ton mobile crane for $105,000 and spent approximately $35,000 improving existing equipment. It borrowed $100,000 to purchase the crane. At a board of directors meeting shortly after the decedent’s death, a preliminary schedule of capital needs, with estimated costs of $333,000, was presented for acquisition over a 5-year period. Of this amount, equipment costing about $262,000 had been purchased by November 1975, and other equipment costing over $280,000 had been purchased between February 1,1971, and January 31,1975. By November 1975, Steel’s production capacity had been increased to almost 80 tons per week.
Supply was a wholesale business which sold supplies such as bolts, nuts, fasteners, tools, ladders, and paint to industrial and manufacturing plants. It did not deal in heavy equipment or high-priced items, and not more than 10 percent of its business related to the construction business. It had several competitors in the Asheville area. Its customers were located in generally the same area as Steel, but the two companies did not have the same customers and did not feed each other business. Before the
Supply was located about 1 mile from Steel’s plant on 1 acre of land. It had a building, 120 feet by 180 feet, and had about 25 employees at the time of the decedent’s death.
Machine & Foundry operated a custom machine shop, doing small, miscellaneous job work, utilizing equipment such as lathes and grinders, but it did no foundry work. Its shop was a building, 100 feet by 200 feet, located on a 2-acre lot about 1 mile from Steel’s plant. At the time of the decedent’s death, it had about 20 employees. Its business was negotiated, and it had no sales force.
The decedent was the president and treasurer of Steei, Supply, and Machine & Foundry and was on the payroll of each corporation. He was closely identified by the public with these three corporations and was the one person that came to mind when one of the companies was mentioned. He was in complete control of all three corporations and made all decisions of any importance, keeping in close contact with each business. He negotiated practically all of the important contracts and sales of the companies up to the time of his death. During the fiscal year ended January 31,1971, Steel obtained some unusually large onetime contracts involving sales of more than $500,000, which were negotiated in large part by the decedent.
The decedent worked 5 days per week, from 7 a.m. to at least 5 p.m. For many years, he took a vacation in Florida during January and February, which was a slack period for the companies. While in Florida, he was in daily contact with the companies and received sales and cash flow reports. He returned from Florida if he was needed in Asheville. The decedent always attended the meetings of the boards of directors. He had very good relations with the employees of the three companies and was friendly with them.
The decedent’s general health up to the time of his death was very good. He died unexpectedly of a heart attack at the age of 62
Steel and Supply owned several life insurance policies (or interests therein) issued on the life of the decedent. Upon the decedent’s death, Steel received $250,371.03, and Supply received $153,174.81. Most of such insurance policies were “keyman” insurance policies while two were “split-dollar” policies. The parties have stipulated that the decedent had no interest in, ownership of, or control of such insurance policies (other than the split-dollar policies) except and to the extent, if any, he is considered to have had such interest, ownership, or control by virtue of his ownership of all the outstanding stock of Steel and Supply.
The keyman life insurance policies were acquired “to tide the company over in case that anything did happen” to the decedent. The last policy obtained was in the face amount of $200,000; $130,000 was payable to Steel, and $70,000 was payable to Supply. The board of directors of each company ratified the purchase of the policy at meetings on May 27, 1969. At such meetings, the decedent presented a letter to the boards which requested each company to redeem enough of his stock to pay his estate’s administration costs and death taxes. The letters provided that the price to be paid for the stock so redeemed was to be 11 times the 5-year average earnings of each company. The board of directors of each company adopted a resolution agreeing to the request in the decedent’s letters. Each resolution stated that the corporation would be bound to carry out the redemption when the corporation’s executive vice president drafted and signed a reply to the decedent’s letter. A copy of the corporation’s acceptance was to be annexed to the corporate minutes, but there was no acceptance in the corporate records of either Steel or Supply.
Prior to the decedent’s death, Steel and Supply paid the premiums on the keyman insurance in the proportions that the proceeds were payable to them. Neither corporation claimed an income tax deduction for such premiums. Prior to the decedent’s death, the cash surrender value of each policy was carried as an
Steel paid the annual premium on the two split-dollar policies to the extent of the increase in the cash surrender value of each policy and was the beneficiary of each policy to the extent of the cash surrender value at the decedent’s death. The balance of the proceeds was paid to the decedent’s estate, which reported them on its Federal estate tax return. The cash surrender values of these policies were carried as an asset on Steel’s balance sheets.
Except for the policies on the life of the decedent, the only corporate life insurance owned by Steel from January 1,1965, to October 29,1975, were two policies totaling $31,000 on the lives of two former officers and one policy for $200,000 on the life of its executive vice president. Neither Supply nor Machine & Foundry maintained any such policies during this period. On January 31, 1971, the total cash surrender value of all the life insurance policies on the decedent’s life owned by Steel and Supply was $95,903 and $42,127, respectively. The cash surrender value of Steel’s policies included $15,080, which represented the cash surrender value of the two split-dollar policies.
On November 22, 1971, the boards of directors of Steel and Supply each agreed to redeem 7,300 shares of its stock held by the decedent’s estate pursuant to section 303 of the Internal Revenue Code of 1954.
Of the approximately $403,000 in insurance proceeds received by Steel and Supply, approximately $175,000 was used to redeem stock from the decedent’s estate, $128,000 was taken into working capital, and $100,000 was held in reserve for possible additional redemptions from the decedent’s estate. Of the amounts added to the working capital of Steel, $100,000 was paid toward the cost of capital additions made from February 1,1971, to January 31,1975.
Due to the close relationship between the general construction business and the steel fabrication industry, both businesses generally experience the same business cycles. Such industries do not operate on a constant basis, and their business cycles involve sharp rises and declines. Therefore, in order to evaluate a business in the steel fabrication industry, an investor should view the business over a 5- to 10-year period.
The net sales and the earnings per share (based upon 25,000 shares outstanding) of Steel and Supply were as follows:
Steel1 Supply
FYE Sales Earnings Earnings per share Sales per share
1/31/67_ $1,533,517 $4.12 $1,284,660 $.95
1/31/68_ 1,641,280 3.60 1,310,101 1.28
1/31/69_ 1,782,279 3.19 1,539,769 1.09
1/31/70_ 1,870,121 1.13 1,633,690 .29
1/31/71_ 2,340,947 4.65 1,531,478 1.21
1/31/72_ 2,302,9792 2.78 1,654,0632 2.33
Neither company paid a dividend for the fiscal years 1967 through 1971. Steel’s earnings for the fiscal year 1971 were unusually high due to some extraordinary contracts acquired that year, the use of first-in-first-out inventory accounting during a period of substantially rising costs, and a change in inventory auditing procedures. The net result was to make the earnings for the fiscal year 1971 unusually high, while making the earnings for 1970 unusually low.
The book values per share of Steel and Supply were as follows:
FYE Steel Supply
1/31/67_ $23.72 $15.74
1/31/68_ 27.33 17.02
1/31/69_ 30.55 18.12
1/31/70_ 31.04 17.72
1/31/71_1 39.06 18.93
If the life insurance proceeds received by the two companies were taken into account at the end of the fiscal year 1971, the book value per share of Steel and Supply would be $45.24 and $23.37, respectively. Steel’s current assets less current liabilities would be $762,945, and it would have $562,043 cash on hand. Supply’s current assets less current liabilities would be $492,967, and it would have $214,805 cash on hand.
The net sales and profits of Machine & Foundry were as follows:
EYE Net sales1 Profits
6/30/67 - $302,000 Unknown
6/30/68 - 354,000 Unknown
6/30/69 _ 352,000 Unknown
6/30/70 - 310,000 Unknown
1/31/712 _ 162,137 $11,182
1/31/72_ 333,964 22,836
1/31/73_ 382,087 34,758
If Steel had acquired Machine & Foundry prior to February 1, 1969, its earnings per share would have been increased by 93 cents in fiscal 1970 and by 66 cents in fiscal 1971. Since Machine & Foundry was actually acquired on October 1,1970, its earnings actually increased Steel’s earnings per share by 26 cents for the fiscal year ending January 31,1971.
On the Federal estate tax return for the Estate of John L. Hunstman, the decedent’s stock in Steel and Supply was valued at $18.40 per share and $5.58 per share, respectively, at the date of the decedent’s death. In his notice of deficiency, the Commissioner determined that the proceeds of the life insurance received by Steel and Supply were includable in the decedent’s gross estate since the decedent possessed the incidents of ownership over the insurance policies at his death within the meaning of section 2042. He further determined that the fair
At the trial of this case, the petitioner and the Commissioner each presented expert testimony as to the fair market value of the stock. The petitioner’s expert stated that in his opinion, on February 5, 1971, the fair market value of the Steel stock was $23.83 per share and the fair market value of the Supply stock was $8.50 per share. The Commissioner’s expert stated that the fair market value of the Steel stock was $30 per share without the insurance proceeds and $40 per share with such proceeds. He also stated that the fair market value of the Supply stock was $6.60 without the insurance proceeds and $12.72 with such proceeds. At the close of the trial, the Commissioner’s counsel orally advised the Court that he would move to amend the answer to conform the allegations concerning the value of the stock in the two corporations to the opinion of his expert. Thereafter, the Commissioner moved to file a second amendment to the answer, and such motion was granted. In his second amendment to-the answer, the Commissioner alleged that the evidence at the trial showed that, although the life insurance proceeds were paid to the corporations in the first instance, most of them were eventually used for the benefit of the decedent’s estate and therefore are includable as a separate asset in such estate under sections 2033 and 2042. In a reply to the second amendment to the answer, the petitioner stated that the Commissioner’s new allegations were contrary to the stipulated facts and were not established during the trial of this case.
OPINION
The first matter to be decided is whether the issue set forth in the Commissioner’s second amendment to the answer is properly before us. Rule 41(b)(1) of the Tax Court Rules of Practice and Procedure provides:
(1) Issues Tried by Consent: When issues not raised by the pleadings are tried by express or implied consent of the parties, they shall be treated in all respects as if they had been raised in the pleadings. The Court, upon motion of any party at any time, may allow such amendment of the pleadings as may be necessary to cause them to conform to the evidence and to raise these issues; but failure to amend does not affect the result of the trial of these issues.
The Commissioner asserts that the issue set forth in his second amendment to the answer was tried with the consent of the petitioner. The petitioner, on the other hand, argues that in no way was such issue raised by the evidence admitted at the trial and that, in fact, it was unaware of the Commissioner’s new theory until the second amendment to the answer was received, long after the trial of this case. We agree with the petitioner.
In his first amended answer and his counsel’s opening statement at trial, the Commissioner unequivocally stated that the only issue in this case was the proper valuation of the stock owned by the decedent in Steel and Supply. Now, the Commissioner asserts that the petitioner was put on notice of the new issue by the cross-examination of one of its witnesses concerning the stock redemption, without objection from the petitioner. However, such testimony appeared to be offered merely to explain a corporate resolution which was included in the records of the corporations to which the parties had stipulated, and the admission of such testimony was not sufficient to indicate that the Commissioner was shifting his position or presenting the alternative position that the life insurance proceeds were in fact used for the benefit of the estate. Indeed, when at the close of the trial, the Commissioner’s counsel orally requested leave to amend his answer to conform to the evidence, he did not, even then, express any intention to present such new position. The only reason given by him for the amendment to his answer was to reflect the higher valuations testified to by his expert.
Under these circumstances, we find that the position set forth in the Commissioner’s second amendment to his answer was not raised by the evidence admitted at the trial and that such issue was not tried by the implied consent of the parties. Edwin E. Markwardt,
The principal issue to be decided in valuing the stock of Steel and Supply is the effect of the life insurance proceeds received by them. The petitioner argues that such proceeds are simply another corporate asset which must be considered in valuing the stock. Whereas, the Commissioner argues that the value of the stock is ascertained by first finding the value of such stock without the life insurance proceeds and by then adding such proceeds to such value. The resolution of this issue turns upon the proper interpretation of two recently amended regulations: sections 20.2042-l(c) and 20.2031-2(f) of the Estate Tax Regulations.
The estate tax regulations concerning the treatment of corporate-owned life insurance, when the insured is the sole or controlling shareholder, have recently undergone substantial change. From 1943 until April 1974, the regulations provided that the sole shareholder of a corporation was considered to possess all of the incidents of ownership retained by the corporation in corporate-owned life insurance on his life. Sec. 20.2042-l(c)(2), Estate Tax Regs. (1958); sec. 81.27, Regs. 105 (1943). Thus, under such regulations, the sole shareholder’s estate was required to include the full amount of any life insurance proceeds paid to the corporation, if the corporation had any incidents of ownership in the insurance policies. Sec. 2042(2). The regulations were apparently based upon an example contained in the legislative history of the predecessor of section 2042. See H. Rept. No. 2333, 77th Cong., 1st Sess. (1942), 1942-
In Rev. Rui. 71-463, 1971-
• In April 1974, new regulations concerning the estate tax treatment of corporate-owned life insurance where the decedent was a shareholder were adopted. T.D. 7312, 1974-
The new regulations deleted the statement concerning a sole shareholder in section 20.2042-l(c)(2), Estate Tax Regs., and substituted a cross-reference to a new paragraph (c)(6) of such section, which provides in pertinent part:
(6) In the case of economic benefits of a life insurance policy on the decedent’s life that are reserved to a corporation of which the decedent is the sole or controlling stockholder, the corporation’s incidents of ownership will not be attributed to the decedent through his stock ownership to the extent the proceeds of the policy are payable to the corporation. * * * See § 20.2031-2(f) for a rule providing that the proceeds of certain life insurance policies shall be considered in determining the value of the decedent’s stock. * * *
The Commissioner maintains the position that since the former regulations carried out the legislative purpose, and since those regulations had been approved by the courts, no change was intended in the treatment of life insurance proceeds when a sole shareholder is involved, and that therefore the life insurance proceeds should be added to the value of the stock otherwise determined under section 20.2031-2(f), Estate Tax Regs. He argues that the only effect of the change is to prorate
Prior to the adoption of the new regulations, the entire proceeds of corporate-owned life insurance were includable in the gross estate of the sole shareholder pursuant to section 2042 because the shareholder was considered to retain the incidents of ownership of the policy. However, the new regulations provide that the mere ownership of stock in a corporation is not sufficient to attribute the incidents of ownership of corporate-owned insurance policies to the sole or controlling shareholder, but such policies shall be considered in valuing the decedent’s interest in the stock. Consequently, section 2042 does not apply to any of the life insurance proceeds received by the two corporations on account of the decedent’s death.
Section 20.2031-2(f), Estate Tax Regs., as amended by the new regulations, merely provides that in addition to the normal factors considered in determining the value of stock in a closely held corporation, life insurance policies payable to or for the benefit of the corporation shall be considered in the same manner as other nonoperating assets. The purpose of the rules contained in such section is to determine the fair market value of stock, which is defined as:
the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. * * * [Sec. 20.20314(b), Estate Tax Regs.]
In determining the price a willing buyer would pay, it is obvious that life insurance proceeds must be given “consideration,” but it is equally obvious that the price paid by a willing buyer would not necessarily be increased by the amount of the life insurance proceeds. A buyer would take into consideration such proceeds in the same manner as he would consider other liquid assets of the
Moreover, section 20.2031-2(f), Estate Tax Regs., calls for life insurance proceeds to be treated in the same manner as other nonoperating assets of the corporation in determining the value of the stock, and our proposed treatment of the life insurance proceeds accomplishes that result. However, the interpretation urged by the Commissioner would treat the life insurance proceeds differently than other nonoperating assets. For example, at the time of the decedent’s death, Steel had on hand over $300,000 of cash, some or all of which may be considered a nonoperating asset; yet, the Commissioner does not propose that such $300,000, or any part of it, be added to the value of the stock of Steel otherwise determined.
The Commissioner argues that our interpretation of section 20.2031-2(f), Estate Tax Regs., frustrates the clear intent of Congress to include corporate-owned life insurance in the estate of its sole shareholder. See H. Rept. No. 2333, 77th Cong., 1st Sess. (1942), 1942-
Where there is an ongoing business, such as Steel or Supply, and where there are no sales near the valuation date, neither the asset value nor the earning power is generally used as the sole criteria in determining stock value. See Hamm v. Commissioner,
The petitioner’s expert witness was a bank vice president in charge of the bank’s closely held business service, a valuation service offered to clients throughout the Southeast United States. In preparing his valuation of the stock of Steel and Supply, he interviewed the principal management of the companies, toured the production facilities, reviewed the books and records of the companies, and made a general review of the economic data of the industry. After acquiring such information, he consulted various financial publications in order to compare Steel and Supply with publicly traded companies in comparable businesses. The Commissioner’s expert witness, a financial analyst for the Internal Revenue Service, used only information supplied by the IRS, did not interview the corporate officers, and made no independent investigation of the two companies. As a result, his valuation report contained several material factual errors.
The petitioner’s expert determined that Steel was comparable to two publicly traded companies. Using the 5-year average earnings, he found that the price-earnings ratios of the two comparable companies were 6.1 and 5.9 at the date of the decedent’s death. He also found that a much larger and more diversified company, partially engaged in the same business as
The Commissioner’s expert treated the two companies as if they were one business. Due to the factual errors in his report, he mistakenly found that Steel and Supply were comparable to businesses which were in fact significantly different. Furthermore, the Commissioner’s expert used only a 3-year weighted average of earnings, even though at trial, he admitted that a 5-year average was preferable in this case. Consequently, we find that his determination of a price-earnings ratio of 10 for each company to be erroneous.
The Commissioner also relies upon the stock acquisition of Hickory Steel & Iron Co. (Hickory) by Carolina Steel Corp. (Carolina) in November 1968 to support his expert’s determination. Hickory was also in the steel fabrication business but did not do steel erection work. He argues that the value of the Carolina stock exchanged for the Hickory stock indicates that the price-earnings ratio of the Hickory stock was in excess of 15. However, the evidence does not support the Commissioner’s argument. The earnings which the Commissioner used to calculate his price-earnings ratio were but part of 1 year’s earnings. Obviously, to be meaningful, a price-earnings ratio must be based upon an entire year’s earnings. Furthermore, due to the cyclical nature of the steel fabrication business, even 1 year’s earnings do not give a true indication of a corporation’s earning potential. In addition, the petitioner’s expert testified that there were substantial economic differences between the time of the acquisition of the Hickory stock in 1968 and the time of the decedent’s death in 1971 which were not fully considered by the Commissioner’s expert. Finally, there were apparently some restrictions on the marketability of the Carolina stock received in exchange for the Hickory stock that may have reduced its value. Consequently, when the necessary adjustments are made to reflect these differences, the price paid for the Hickory stock
In valuing the stock of the two companies based upon earnings, the petitioner’s expert determined the 5-year average earnings and multiplied that amount times the appropriate price-earnings ratio. We believe that the price-earnings ratios used by him were generally reasonable, but in computing the earnings of Steel, he neglected to account for the acquisition of Machine & Foundry in 1970. To reflect the amount a purchaser would have paid for the Steel stock, the average earnings of Machine & Foundry must be taken into account. Although there is only evidence of Machine & Foundry’s earnings for 2 of the 5 years prior to the decedent’s death, the petitioner’s expert should have made an adjustment to the 5-year average earnings of Steel to reflect the average earnings of Machine & Foundry over such period. Using our best judgment, we find that based solely upon earnings, the value of the stock in Steel and Supply at the date of the decedent’s death was $29 and $5 per share, respectively.
The petitioner’s expert determined that valuing the stock of the two corporations solely on their earnings would be unwarranted in view of the high book value
One final adjustment is necessary to determine the actual price a willing buyer would pay for the stock of these two companies.
Decision will be entered under Rule 155.
Notes
All statutory references are to the Internal Revenue Code of 1954 as in effect for the year in issue.
The table does not include the net sales and earnings of Machine & Foundry, which was acquired on Oct. 1,1970.
The extraordinary credit for the life insurance proceeds is not included.
The book value of the assets of Machine & Foundry, acquired Oct. 1,1970, is included.
For the fiscal years 1967 through 1970, only the approximate sales are known.
Machine & Foundry changed its fiscal year to correspond to that of its parent, Steel, when it was acquired on Oct. 1,1970.
Since the Commissioner did not timely raise the issue, we have not considered whether the use of the insurance proceeds by the two corporations to redeem some of the petitioner’s stock pursuant to sec. 303 would result in the proceeds not being paid for the benefit of the corporations so that the incidents of ownership would be attributable to the decedent. See sec. 20.20424(c)(6), Estate Tax Regs. The Commissioner does not contend that the proceeds of the split-dollar insurance received by Steel are to be treated differently from the proceeds of the keyman insurance. See Rev. Rul. 76-274,1976-291.R.B. 13.
Both experts used book value rather than net asset value. Since neither party has raised the issue, we will treat the book value as if it were the net asset value.