Lead Opinion
Respondent determined a deficiency of $10,574,983 in the Federal estate tax of the estate of Harriett R. Mellinger (decedent). After concessions by the parties, the issues remaining for decision are:
(1) Whether section 2044 requires aggregation, for valuation purposes, of the stock held in a trust established by decedent’s predeceased spouse under section 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.
Stock Ownership and Valuations
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 section 2056(b)(7). Hugh V. Hunter (Hunter) and Wells Fargo Bank (referred to collectively as cotrustees and coexecutors herein) were the cotrustees of the QTIP trust after decedent’s death. Under the terms of the QTIP trust, decedent received a qualified income interest for her lifetime. Upon decedent’s death, the QTIP trust provided for the payment of certain periodic and lump sums to the adult children of Mr. Mellinger and decedent, until they attained the age of 65, in addition to certain periodic lump-sum payments to the grandchildren of Mr. Mellinger and decedent, until they attained the age of 30. Upon the final payment to the children and grandchildren, the QTIP trust property was to be distributed equally to certain tax-exempt charitable organizations. On the valuation date, the QTIP trust held 2,460,580 shares of FOH stock, which then constituted 27.8671 percent of the issued and outstanding stock of FOH.
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
Hunter and Wells Fargo Bank (coexecutors) filed a U.S. Estate (and Generation-Skipping Transfer) Tax Return, Form 706, for decedent’s estate on January 18, 1994. On the return, the FOH shares in the Harriett trust were reported at a value of $11,786,178 or $4.79 per share, and the FOH shares in the QTIP trust, includable in decedent’s estate pursuant to section 2044, were reported at a value of $11,786,178 or $4.79 per share. In valuing the shares of FOH, the coexecutors consulted legal counsel and obtained two appraisals. The appraisers that were employed by the co-executors were the investment firm of Janney Montgomery Scott, Inc. (jms), and the appraisal firm of Willamette Management Associates (wma). Each appraisal valued the shares as separate 27.8671-percent interests in foh. The appraisals concluded that, because of the size of the blocks under consideration in relation to the trading volume, petitioner would not be able to sell the holdings in the public market without incurring a blockage discount. The wma appraisal valued the shares at $4.85 per share, after applying a 30-percent discount, and the JMS appraisal valued the shares at $4.79, after applying a 31-percent discount. Based on the appraisals, the estate valued the shares on its U.S. Estate Tax Return at $4.79 per share.
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 FOH capital stock was split at the rate of 1 share for every 3 shares outstanding. At the same time, foh'declared a distribution in the form of a dividend of 2 shares of class B capital stock for every 1 share of class A capital stock
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 establishing the value of these shares, the FOH ESOP relied on an appraisal by JMS that expressed an opinion that the appropriate discount for the transaction was between 29 and 31 percent. Thereafter, on February 18, 1994, the Harriett trust sold, in a market transaction on the NYSE, in conformity with Securities and Exchange Commission (sec) rule 144, 29,500 shares of FOH class B capital stock at a price of $4,875 per share. The aggregate gross proceeds of the sale received by the Harriett trust were $147,492.71.
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 Corp. (Knightsbridge) submitted a formal offer to purchase all of the outstanding shares of FOH for not less than $6 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
On examination, respondent determined that the FOH shares that were held by the Harriett trust and the QTIP trust would 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 women’s intimate 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. The company’s products had the reputation of being “slightly naughty” but not offensive, and this style proved to be highly successful in the 1960’s and 1970’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
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
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
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 U.S. 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 a 3-percent GDP growth rate for 1993, with a 2.8-percent growth rate expected
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 that of the rest of the United States in 1993.
ULTIMATE FINDINGS OP 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
Section 2031 generally provides that the value of a decedent’s gross estate includes the value of property described in sections 2033 through 2044. See sec. 20.2031-1(a), Estate Tax Regs. Under section 2033, the value of a decedent’s gross estate includes the value of all property beneficially owned by the decedent at the time of death. See sec. 20.2033-l(a), Estate Tax Regs. Section 2044(a) includes in the gross estate the value of property in which the decedent had a qualified income interest for life and for which a marital deduction was allowed to the estate of a predeceased spouse under section 2056(b)(7) (QTIP property). Accordingly, at the death of the second spouse, QTIP property is taxed as part of the surviving spouse’s estate. Sec. 2044(c).
Property includable in the gross estate is generally included at its fair market value on the date of a decedent’s death. Sec. 2031(a); sec. 20.203l-l(b), Estate Tax Regs. Fair market value is defined as the price that a willing buyer would pay a willing seller, both persons having reasonable
Historically, undivided fractional interests in property included in an estate have been valued at a discount to reflect lack of marketability and minority interest holdings. See Estate of Andrews v. Commissioner,
The Court of Appeals for the Ninth Circuit addressed the Commissioner’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. “[0]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 be realized.” Id. at 1251.
The Court of Appeals for the Ninth Circuit considered the language of sections 2031 and 2033, along with the accompanying regulations, and decided that Congress did not intend to have “unity of ownership” principles apply to property valuation for estate tax purposes. Id. The court stated:
By no means is * * * [the language of section 20.2031-l(b), Estate Tax Regs.] 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. §§ 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
Section 2044 was added to the Code in conjunction with section 2056(b)(7) in 1981. Economic Recovery Tax Act of 1981, Pub. L. 97-34, sec. 403(d), 95 Stat. 172, 302. Under section 2056(b)(7), the decedent is entitled to a marital deduction for transfers of QTIP property to the surviving spouse at the decedent’s death. The surviving spouse has a lifetime interest in the QTIP property, and, upon the death of the surviving spouse, the property passes to beneficiaries designated by the decedent. Accordingly, the first spouse to die can postpone Federal estate tax that would otherwise be due on the QTIP property while also retaining control over the ultimate disposition of it. Sec. 2056(b)(7). Inclusion in the estate of the second spouse to die, however, is the quid pro quo for allowing the marital deduction for the estate of the first spouse to die.
The purpose of section 2044 is to provide for the taxation of QTIP property upon the death of the second spouse. That section provides, in pertinent part, that “The value of the [surviving spouse’s] gross estate shall include the value of property * * * [for which a deduction was allowed with respect to the transfer of such property to the surviving spouse under section 2056(b)(7) and in] which the * * * [surviving spouse] had a qualifying income interest for life.” Sec. 2044(a). This property is “treated as property passing from the” surviving spouse, sec. 2044(c), and is taxed as part of the surviving spouse’s estate at death, but QTIP property does not actually pass to or from the surviving spouse.
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. secs. 267, 318, 544 (indicating aggregation of
Section 2044 was amended by the Technical Corrections Act of 1982, Pub. L. 97-448, sec. 104(a)(1)(B), 96 Stat. 2365, 2380. The legislative history accompanying that amendment provides no additional guidance on whether the interests involved in this case should be aggregated. Rather, “The bill clarifies that QTIP property included in. a deceased donee spouse’s estate is treated as passing from that spouse, for purposes of the estate tax, including the charitable and marital deductions.” S. Rept. 97-592, at 20 (1982), 1983-
In Estate of Bonner v. United States,
The Court of Appeals, relying on its prior holding in Estate of Bright v. United States,
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-
Section 2044 was designed to prevent QTIP property from escaping taxation by including it in the estate of the second spouse to die. There is, however, no indication that section 2044 mandated identical tax consequences as an outright transfer to the surviving spouse.
Finally, respondent argues that section 2044(c) is a valuation section, rather than just an inclusion section. See Estate of Young v. Commissioner,
Section 2040(b) explicitly sets forth a special rule of valuation for joint tenancy property, but this special rule only applies to section 2040; section 2044 contains no such directive. The absence of such language in section 2044, which was enacted in the same tax act as section 2040(b), belies respondent’s argument that Congress mandated or intended a special rule of valuation to apply to property included in a decedent’s estate pursuant to section 2044(a).
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,
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,
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. Cotier (Cotier).
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
Kimball made no effort to compare the subject transaction to transactions within the secondary offering studies that have similar characteristics, such as where the stock is traded, revenues, sales, and similar factors indicating analogous transactions. Instead, he relied primarily on the mean and median discounts of each study. Petitioner admits on brief that Kimball relied very little on the secondary offering approach and concedes that Kimball relied most heavily on the private placement analysis in coming to his conclusion.
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 Cotier to establish the applicable discount. Cotier testified that he analyzed numerous studies to determine the appropriate discount for lack of marketability. From these studies, Cotier observed that there was a mean discount of 34.73 percent for lack of marketability. Cotier indicated that the discount is most sensitive to block size. For example, a block of stock that represented 39 percent of the outstanding shares averaged a 38.7-percent discount. Cotier further testified that, in order to value properly the FOH stock, there must be a thorough analysis of foh’s operations, the markets it serves, and the characteristics of the FOH stock held by the trusts.
Cotier expressed an opinion that, at the valuation date, FOH was experiencing an accelerating negative financial
Cotier 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. Cotier further observed that the FOH stock in issue represented a significant percentage of the then-outstanding shares, 27.8 percent. With the average volume during the first 6 months of 1993 at 5,197, Cotier concluded that it was improbable that the FOH stock could have been sold in the public market within a reasonable timeframe.
Cotier pointed 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, Cotier 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 placement of the stock, or (3) a periodic sale subject to volume
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 similar private placement block sales of registered shares. In contrast, Fuller relied on a study that analyzed 106 private placement transactions of both restricted and registered shares. This study concluded that discounts were required by private placement investors because of information costs that they bore in investigating the value of shares in the issuing firms as well as from anticipating “monitoring costs” associated with the investment (i.e., assistance in the formulation of management policy and oversight of existing management). He noted that the sale of restricted shares rather than registered shares in private placements resulted in a discount of 13.5 percent.
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,
Fuller concluded that a prudent investor would select the private placement alternative and that, under that analysis, the FOH shares should be valued at $5.8969 per share, a blockage discount of 15 percent. Accordingly, each block of 2,460,580 shares of FOH would be valued at $14,509,794.
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 tradable 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,
The sale of FOH stock by the Harriett trust to the FOH ESOP for a price of $4.20 per share, which represented a discount of 30 percent from its then closing price on the NYSE, occurred 9 months after the valuation date. Respondent argues that this was not a sale to a third party, so it should not be taken into consideration in valuing the stock. In any event, this sale was of class A capital stock after the amendment to the articles of incorporation that altered the capital structure of FOH. After the amendment, there were two classes of stock, one with voting rights and the other without. Neither party addressed how this fact affects the valuation.
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 Cotier addressed the specifics of FOH’s financial situation in detail, but he relied on mean discounts without relating them to those details. Fuller relied on a single method, and we are not persuaded that his method is the only one that would be considered by hypothetical buyers and sellers. Kimball provided several logical methods but failed to implement them correctly. On cross-examination, he made several concessions about his use of survey data as well as his errors in application of the formulas he used.
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,
To reflect the foregoing,
Decision will be entered under Rule 155.
Notes
Total net sales for 1990.