MAUDE G. FURMAN, DONOR, DECEASED, AND ESTATE OF MAUDE G. FURMAN, DECEASED, ROBERT G. FURMAN, EXECUTOR, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent ROYAL G. FURMAN, DONOR, DECEASED, AND ESTATE OF ROYAL G. FURMAN, DECEASED, ROBERT G. FURMAN, EXECUTOR Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 11568-96, 11569-96
United States Tax Court
Filed April 30, 1998
T.C. Memo. 1998-157
BEGHE, Judge
James F. Kearney, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge: Respondent determined deficiencies in petitioners’ Federal gift taxes and Federal estate tax and additions to tax as follows:
| Deficiency | Additions to Tax | ||
|---|---|---|---|
| Sec. 6651(a) | Sec. 6653(a) | ||
| Gift tax--1981 | $75,460 | $18,865 | $3,773 |
| Estate Tax | 115,649 | -- | -- |
Estate of Royal G. Furman
| Deficiency | Additions to Tax | ||
|---|---|---|---|
| Sec. 6651(a) | Sec. 6653(a) | ||
| Gift tax--1981 | $75,460 | $18,865 | $3,773 |
After concessions regarding the estate tax deficiency, the issues for decision are:
- Whether for purposes of computing the taxable gifts of Royal G. Furman (Royal) and the taxable gifts and taxable estate of Maude G. Furman (Maude), the fair market value of 24 shares of Furman‘s, Inc. (FIC) common stock exchanged by each of Royal and Maude in 1981 for preferred stock of FIC was $300,000 ($12,500 per share) as petitioners contend, $540,540 ($22,522 per share) as respondent contends, or some other amount. We hold that the fair market value was $424,552 ($17,690 per share).
- Whether for purposes of computing Maude‘s taxable estate, the fair market value of six shares of FIC common stock that she transferred to Robert G. Furman (Robert) in 1980 was $62,016 ($10,336 per share), as petitioners contend, $147,600 ($24,600 per share), as respondent contends, or some other amount. We hold that the fair market value was $82,859 ($13,810 per share).
Whether Royal and Maude had reasonable cause for failing to file gift tax returns for the period ending September 30, 1981, and whether their failures to pay gift taxes for that period were due to negligence or intentional disregard of rules and regulations. We hold that Royal and Maude had reasonable cause for failing to file gift tax returns and were not negligent in failing to pay gift taxes.
FINDINGS OF FACT
Some of the facts have been stipulated and are incorporated herein by this reference. Unless otherwise noted, all section references are to the Internal Revenue Code in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice & Procedure. All amounts have been rounded to the nearest dollar.
A. Decedents
Royal died testate on June 29, 1990. His wife Maude died testate on June 12, 1992 (collectively decedents). Royal and Maude were residents of Florida at the times of their deaths. Robert, the personal representative of decedents’ estates, resided in Florida at the time of filing the petitions.1 Decedents were survived by five children, including Robert, their son.
FIC is a Florida corporation that was organized in 1959. The principal place of business of FIC is Florida. Throughout its existence FIC has been a C corporation, and the stock of FIC has never been publicly traded. FIC was founded by Maude, Royal, and Robert for the purpose of acquiring and operating a Burger King2 restaurant franchise after Royal had retired from a 35-year career as a mail carrier. Until the founding of FIC, Maude, Royal, and Robert resided in Chicago, Illinois.
From its organization in 1959 until February 1980, FIC was capitalized with 100 shares of no-par common stock issued and outstanding, held as follows:
Maude 30 shares
Royal 30 shares
Robert 40 shares
Although Royal and Maude had five children, Robert is their only child who has ever had a common stock ownership interest in FIC or been active in its management.
Burger King Corp. (BKC), a Florida corporation headquartered in Miami, Florida, is the franchisor of the second largest restaurant chain in the world, after McDonald‘s. Since 1967, BKC has been a wholly owned subsidiary of Pillsbury, Inc. Pillsbury was acquired by Grand Metropolitan PLC in 1989.
FIC entered the fast-food business in May 1959 by opening Burger King Store No. 12 (Store No. 12) in North Miami Beach, Florida, one of the original restaurants in the Burger King chain. Royal and Maude relocated to Florida to operate the new restaurant, while Robert had intended to stay in Chicago, where he was employed as a special agent for an insurance company.
Just 2 weeks after the opening of Store No. 12, Robert received a call from James McLamore, one of the cofounders of BKC, informing him that Royal had been hospitalized. Robert traveled to Florida and immediately went to work in Store No. 12. After Royal‘s recuperation, Robert decided to stay in Florida and help manage FIC. Robert has remained in the fast-food business ever since.
In 1961, FIC purchased a 20-percent interest at a cost of $15,000 in three corporations that were opening Burger King restaurants in the greater Chicago area (the Chicago Operation). In 1962, at the request of Mr. McLamore, Robert moved back to Chicago to participate in the management and operation of the Chicago Operation of which he ultimately became executive vice president and a member of the board of directors. Robert‘s
In 1970, after a corporate reorganization of the Chicago Operation, FIC sold its interest in the Chicago Operation to Self-Service Restaurants (Self-Service), a publicly traded Burger King franchisee. In exchange for all of FIC‘s shares in the Chicago Operation, FIC received shares of Self-Service common stock that FIC later sold for approximately $222,000, as well as Self-Service‘s promissory note in the principal amount of $868,500. Following the sale, Robert was employed by Self-Service to assist during the period of transition to Self-Service management.
In 1971, Robert terminated his employment with Self-Service. Robert remained in Chicago, where he managed five Burger King restaurants that he owned directly, and participated in the management of six Burger King restaurants in Milwaukee, Wisconsin, in whose corporate franchisee he had acquired a 27-percent stock interest.
In 1973, FIC purchased an existing Burger King restaurant in Fort Myers, Florida. Thereafter, in 1976, after Robert returned to Florida, FIC acquired three existing Burger King restaurants,
The Territorial Agreement granted FIC, for a period of 5 years, an exclusive territorial right to build, own, and operate Burger King restaurants in Manatee, Sarasota, and Charlotte Counties in Florida (the Exclusive Territories) and a right of first refusal to build, own, and operate Burger King restaurants in Lee County, Florida (collectively, the Protected Territories). The Territorial Agreement also provided that if FIC had six Burger King restaurants open and in operation on or before August 26, 1981, it would be entitled to a right of first refusal on all Burger King restaurants to be subsequently franchised in the Exclusive Territories through August 1986.
After his return to Florida, Robert moved to Sarasota, Florida, and worked full time for FIC selecting and developing real estate sites, securing financing, and supervising the construction of new restaurants, while continuing to supervise the operations of existing FIC-owned restaurants.
As of February 2, 1980, FIC had seven Burger King restaurants in operation in the Exclusive Territories. As of August 24, 1981, FIC had a total of nine Burger King restaurants.
C. FIC‘s Advisers
1. Hugh B. Shillington
After opening Store No. 12 in 1959, FIC retained Hugh B. Shillington, C.P.A. (Mr. Shillington), as its outside accountant, to assist in tax and financial accounting matters. Mr. Shillington was a principal of Shillington & Fay (S&F), a Coral Gables, Florida, accounting firm. Mr. Shillington served as outside accountant to other Burger King franchisees and had been recommended to FIC by BKC. S&F reviewed3 FIC‘s annual financial statements, including financial statements for FIC‘s fiscal years ending September 30, 1979, 1980, and 1981 (FY 1979, FY 1980, and FY 1981). Mr. Shillington, who advised FIC to retain its financial records for 7 years, died in 1995.
2. Louis B. Tishler, Jr.
Louis B. Tishler, Jr. (Mr. Tishler), is an attorney who has been practicing law in the Chicago area since his graduation from
D. 1980 Gift
By 1976, when the Territorial Agreement was executed, BKC had adopted a new policy requiring that corporate franchisees be operated by a shareholder with voting control of the corporation (the Control Requirement). FIC did not then satisfy the Control Requirement, but Robert made an oral promise to BKC to acquire a controlling interest in FIC. Despite Robert‘s promise, no such action was taken until 1980, when BKC demanded that Robert acquire voting control of FIC. To satisfy BKC‘s demand, on February 2, 1980, decedents each transferred by gift 6 shares of FIC‘s common stock to Robert (the 1980 Gifts). By the time of the 1980 Gifts, neither of decedents was actively participating in the day-to-day management or operations of FIC.
Following the 1980 Gifts, the outstanding common stock of FIC was owned as follows:
Royal 24 shares
Maude 24 shares
Robert 52 shares
Following the 1980 Gifts, decedents executed codicils to their wills providing that their remaining shares of FIC‘s common stock would be distributed equally among all their children, to the exclusion of Robert.
E. 1981 Recapitalization
In 1980 or 1981, BKC requested that all shareholders of FIC personally guarantee the debt of FIC to BKC. Neither decedent was willing to accede to BKC‘s request, while Robert was willing to become liable as the sole guarantor only if decedents agreed to relinquish their voting rights in FIC. Robert‘s reluctance to be the sole guarantor emanated, in part, from the terms of decedents’ wills, under which Robert‘s siblings would eventually
In order to provide Robert with all the voting stock of FIC and satisfy decedents’ conditions, Robert and decedents agreed to a recapitalization of FIC whereby decedents would exchange their common stock for preferred stock. Before the recapitalization, with the assistance of Mr. Tishler, FIC requested and received a private letter ruling from the Internal Revenue Service that the proposed exchange of common stock for preferred stock would qualify as a reorganization for income tax purposes within the meaning of
On August 24, 1981, FIC‘s articles of incorporation were amended to authorize 5,000 shares of no-par voting common stock and 6,000 shares of par value $100, nonvoting, 10-percent cumulative preferred stock (the Preferred Stock). The Preferred Stock contained no participation, conversion or redemption rights. On August 24, 1981, each of decedents exchanged 24
While the Recapitalization indirectly addressed BKC‘s requirement that each common shareholder personally guarantee the debt of FIC, the Recapitalization had not been required by any condition imposed by BKC.
As of September 30, 1981, the book value of FIC‘s common stock was $1,109,400. Decedents did not file any 1981 gift tax returns reporting any donative transfers that they may have made by reason of their participation in the Recapitalization.
After the Recapitalization, decedents executed new wills devising their shares of Preferred Stock to their children other than Robert.4 As of the date of trial, all the Preferred Stock has remained outstanding, all dividends on the Preferred Stock have been timely declared and paid, and Robert has been the only shareholder to personally guarantee the debts of FIC.
F. Estate Tax Returns
Royal died on June 29, 1990, and Maude died on June 12, 1992. Robert, as personal representative, executed and timely filed the required estate tax returns. The adjusted taxable gifts reported on line 4 of the estate tax returns for Royal‘s
G. Notices of Deficiency
On March 11, 1996, respondent issued three deficiency notices: (i) For gift tax for the period ending September 30, 1981, to Maude G. Furman, donor, deceased, Estate of Maude G. Furman, deceased, and Robert G. Furman, Executor (the Maude Gift Tax Notice); (ii) for estate tax to the Estate of Maude G. Furman, deceased, and Robert G. Furman, Executor (the Estate Tax Notice); and (iii) for gift tax for the period ending September 30, 1981, to Royal G. Furman, donor, deceased, Estate of Royal G. Furman, deceased, Robert G. Furman, Executor (the Royal Gift Tax Notice).
The Estate Tax Notice determined that the fair market value of the shares transferred by each decedent in the 1980 Gifts was $147,600 ($24,600 per share), rather than the $62,016 ($10,336 per share) that they had reported on their 1980 gift tax returns. Both the Maude Gift Tax Notice and Royal Gift Tax Notice determined that the fair market value of the 24 shares of FIC common stock exchanged by each decedent in the Recapitalization was $540,540 ($22,522 per share), while the 3,000 shares of preferred stock received by each decedent in the Recapitalization
After concessions by Maude‘s estate, the remaining items at issue in the Estate Tax Notice are respondent‘s determinations that for purposes of the estate tax: (i) The fair market value on February 2, 1980, of the donative transfer of 6 shares of FIC‘s common stock from Maude to Robert was $147,600, rather than
H. Discounts and Premiums
1. Minority Interests
On both February 2, 1980, and August 24, 1981, each decedent was a minority shareholder.
Neither decedent had the power to compel FIC to purchase key person insurance.
2. Absence of Swing Vote
On February 2, 1980, no FIC shareholder could obtain voting
On August 24, 1981, voting control of FIC could not be affected by the transfer of Maude and Royal‘s respective holdings of FIC common stock, singularly or collectively.
3. Lack of Marketability
On both February 2, 1980, and August 24, 1981: (1) BKC had not established a buy-back program or policy for acquiring Burger King franchises; (2) high interest rates contributed to a depressed market for the sale of Burger King franchises; and (3) there was no readily available market for the stock of FIC. Each of the foregoing factors contributed to a lack of marketability of FIC stock.
4. Combined Minority and Lack of Marketability Discount
On February 2, 1980, the fair market value of each decedent‘s gratuitous transfer of 6 shares of FIC‘s common stock was subject to a combined minority and marketability discount of 40 percent. On August 24, 1981, the fair market value of the 24 shares of FIC‘s common stock transferred by each decedent in the
5. Robert Furman a Key Person
At the times of the 1980 Gifts and the Recapitalization, Robert actively managed FIC, and no succession plan was in effect. FIC employed no individual who was qualified to succeed Robert in the management of FIC. Robert‘s active participation, experience, business contacts,8 and reputation as a Burger King franchisee contributed to the value of FIC. Specifically, it was Robert whose contacts had made possible the 1976 Purchase, and whose expertise in selecting sites for new restaurants and supervising their construction and startup were of critical importance in enabling FIC to avail itself of the expansion opportunities created by the Territorial Agreement. The possibility of Robert‘s untimely death, disability, or resignation contributed to uncertainty in the value of FIC‘s operations and future cash-flows. Although a professional manager could have been hired to replace Robert, the following risks would still have been present: (i) Lack of management until a replacement was hired; (ii) the risk that a professional manager would require higher compensation than Robert had received; and (iii) the risk that a professional manager would not perform as well as Robert.
ULTIMATE FINDINGS OF FACT
On February 2, 1980, the fair market value of the gratuitous transfer of 6 shares of FIC‘s common stock by each of Maude and Royal to Robert was $82,859 ($13,810 per share).
On August 24, 1981, when Maude and Royal each exchanged 24 shares of FIC common stock for 3,000 shares of FIC‘s preferred stock, the fair market value of the common stock transferred by each of them was $424,552 ($17,690 per share).
OPINION
A. Fair Market Value of FIC Stock
The principal issues we must decide in this case are the value of the shares of common stock in FIC that decedents gratuitously transferred to Robert on February 2, 1980, and the
Valuation is a question of fact, and the trier of fact must weigh all relevant evidence to draw the appropriate inferences. Commissioner v. Scottish Am. Inv. Co., 323 U.S. 119, 123-125 (1944); Helvering v. National Grocery Co., 304 U.S. 282, 294-295 (1938); Anderson v. Commissioner, 250 F.2d 242, 249 (5th Cir. 1957), affg. in part and remanding in part T.C. Memo. 1956-178; Estate of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990); Skripak v. Commissioner, 84 T.C. 285, 320 (1985).
Fair market value is defined for Federal estate and gift tax purposes as the price that a willing buyer would pay a willing seller, both having reasonable knowledge of all the relevant facts and neither being under compulsion to buy or to sell. United States v. Cartwright, 411 U.S. 546, 551 (1973) (citing
For Federal gift tax purposes, the fair market value of the subject property is determined as of the date of the gift; ordinarily, no consideration is given to any unforeseeable future event that may have affected the value of the subject property on some later date.
Special rules apply to the valuation of the stock of a
- (a) The nature of the business and the history of the enterprise from its inception.
- (b) The economic outlook in general and the condition and outlook of the specific industry in particular.
- (c) The book value of the stock and the financial condition of the business.
(d) The earning capacity of the company. - (e) The dividend-paying capacity.
- (f) Whether or not the enterprise has goodwill or other intangible value.
- (g) Sales of the stock and the size of the block of stock to be valued.
- (h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
[Rev. Rul. 59-60, 1959-1 C.B. at 238-239.]
Because valuation may not be reduced to the rote application of formulas, and because of the imprecision inherent in determining fair market value of stock that lacks a public market (and the Solomon-like pronouncements that often follow), we again remind the parties that these matters are better resolved by agreement rather than trial by ordeal in which conflicting opinions of the experts are pitted against each other. See Estate of Hall v. Commissioner, supra; Messing v. Commissioner, 48 T.C. 502, 512 (1967); see also Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441 (1980).
As is customary in valuation cases, the parties rely primarily on expert opinion evidence to support their contrary valuation positions. We evaluate the opinions of experts in light of the demonstrated qualifications of each expert and all other evidence in the record. Anderson v. Commissioner, supra; Parker v. Commissioner, 86 T.C. 547, 561 (1986). We have broad discretion to evaluate “`the overall cogency of each expert‘s analysis.’ ” Sammons v. Commissioner, 838 F.2d 330, 334 (9th Cir. 1988) (quoting Ebben v. Commissioner, 783 F.2d 906, 909 (9th Cir. 1986), affg. in part and revg. in part T.C. Memo. 1983-200),
1. Respondent‘s Expert
Respondent relies on the expert report of Hugh Jackson Shelton (Mr. Shelton). Mr. Shelton has been employed by respondent as a valuation engineer since 1987, in which time he has completed approximately 10 business valuations. Mr. Shelton holds a bachelor of science degree in industrial engineering from the University of Tennessee and a master of arts degree in business management from Webster University.
In the expert report submitted by respondent, Mr. Shelton represents that he has certain qualifications and credentials to perform business valuations that he does not in fact have, including courses on valuation that he has not successfully completed. Mr. Shelton‘s report also suggests that he is a
Mr. Shelton used a capitalized earnings method to value the FIC stock at the time of the 1980 Gifts. Using the capital asset pricing model (CAPM), Mr. Shelton calculated a cost of equity and then computed FIC‘s weighted average cost of capital (WACC). Earnings before interest, depreciation, and taxes (EBIDT), a variant of EBITDA (earnings before interest, taxes, depreciation, and amortization), were then capitalized using the WACC to arrive at a total enterprise value. In valuing the 1980 Gifts, Mr. Shelton projected 12-month earnings from FIC‘s 10-month income statement for FY 1979, which he then capitalized to arrive at a February 1980 enterprise value. Mr. Shelton determined August 1981 enterprise value by capitalizing FY 1980 EBIDT and then adding 5 percent to reflect FIC‘s value in August 1981.
After determining that FIC had a beta of 1.0., Mr. Shelton used the standard CAPM formula to arrive at a cost of equity of 18.44 percent. See description and discussion of beta infra pp. 28-30. Finding that Burger King was the number two fast food chain, Mr. Shelton reasoned that Burger King would be no more or less volatile than the fast food industry as a whole, justifying a beta of 1.0 for FIC‘s common stock. In his report, Mr. Shelton
After determining a cost of equity using CAPM, Mr. Shelton purported to compute the WACC of FIC in order to arrive at a capitalization rate. Without providing any explanation, Mr. Shelton computed WACC in a manner that did not conform to the accepted method. See Brealey & Myers, Principles of Corporate Finance 465-469 (4th ed. 1991); Pratt et al., Valuing a Business 180, 184, 189-190 (3d ed. 1996). First, Mr. Shelton modified the WACC formula by weighting FIC‘s debt and equity based on book value, rather than market value, to arrive at a WACC of 11.0 percent. Considering that the parties have stipulated risk-free rates of 11.86 percent and 14.4 percent in 1980 and 1981, respectively, it is obvious that Mr. Shelton‘s result is incorrect.
The calculation of WACC provides an after-tax figure, because it is computed using an estimate of the firm‘s marginal corporate income tax rate. After finding that FIC had a WACC of 11.0 percent, Mr. Shelton tried to convert WACC to a pretax figure. Mr. Shelton calculated what he referred to as a pretax
After capitalizing the FY 1979 and FY 1980 EBIDT‘s of FIC, Mr. Shelton arrived at total enterprise values of $2,764,114, $3,481,369, and $3,655,427 on February 2, 1980, September 30, 1980, and August 24, 1981, respectively. Mr. Shelton then discounted the 1980 and 1981 enterprise values by 17 percent to reflect a combined minority, lack of marketability, and “control premium discount [sic]“, to arrive at a fair market value of $22,942 per share as of February 1980 and $30,340 as of August 1981. Applying the annual exclusion to the 1981 gifts only, acceptance of respondent‘s position would result in taxable gifts by each decedent of $137,652 and $425,160 in 1980 and 1981, respectively. Understatements of taxable gifts by each decedent would then amount to $75,636 and $425,160 for 1980 and 1981, respectively.
With the exception of his assessment of the prospects for economic growth on the west coast of Florida, we reject, in toto,
We do not believe that CAPM and WACC are the proper analytical tools to value a small, closely held corporation with little possibility of going public. CAPM is a financial model intended to explain the behavior of publicly traded securities that has been subjected to empirical validation using only historical data of the two largest U.S. stock markets. Raabe & Whittenburg, “Is the Capital Asset Pricing Model Appropriate in Tax Litigation?“, Valuation Strategies 12-15, 36 (Jan./Feb. 1998); see Brealey & Myers, supra at 166 (citing Fama & MacBeth, “Risk, Return and Equilibrium: Empirical Tests,” 81 Journal of Political Economy 607-636 (1973)). Contrary to the assumptions of CAPM, the market for stock in a closely held corporation like FIC is not efficient, is subject to substantial transaction costs, and does not offer liquidity. Mr. Shelton did not increase our confidence in his choice of method when he computed the cost of equity using an unsubstantiated risk-free rate and risk premium that were not in conformance with the amounts stipulated, and when he arbitrarily assigned a beta to FIC‘s common stock. Beta, a measure of systematic risk,10 is a
Mr. Shelton‘s use and application of the WACC fares no better under our scrutiny. WACC is generally used to calculate a discount rate that reflects the weighted average cost of each of the components of a firm‘s capital structure. To compute WACC, it is necessary to know the market value of the firm‘s debt and equity, which if known, would go far toward negating the need to perform a valuation. In computing WACC, Mr. Shelton used FIC‘s book value weighting of debt and equity, rather than market value, without justifying his departure.
We also find fault with Mr. Shelton‘s computation of EBIDT and the manner in which he arrives at an enterprise value as of August 24, 1981. Since the parties have stipulated the proper EBIDTA amounts for the periods in question, we abstain from further comment on Mr. Shelton‘s computation of EBIDT. We do,
Mr. Shelton‘s report also contains detailed calculations from which he attempts to determine the replacement cost of building 10 Burger King restaurants. We are unsure what relevance such a calculation has to the valuation of a business where value is determined by the prospect of future earnings rather than net asset value. Moreover, Mr. Shelton‘s use of 1992 data in computing replacement cost is of no relevance to the valuation of stock in 1980 and 1981.
Our final criticism of Mr. Shelton‘s report has little if any bearing on his valuation conclusion but has again caused us to doubt his expertise. In his report, Mr. Shelton attempted to analyze the FY 1979 and FY 1980 balance sheets of FIC. Using the FY 1979 balance sheet data of FIC, Mr. Shelton “projected” a 12-month balance sheet for 1979 by substantially increasing the amounts of some of the balance sheet items, without indicating what items on the income statement would lead to such growth in the amounts reported on the projected balance sheet.
Petitioners rely on the expert report of Francis X. Burns (Mr. Burns) and Brian R. Oliver (Mr. Oliver) of IPC Group, LLC (IPC). Messrs. Burns and Oliver are both experienced in business valuation and, in addition to their undergraduate degrees, hold master‘s degrees in finance from Northwestern University‘s Kellogg School of Management. Although Messrs. Burns and Oliver are not formally accredited as appraisers, we are satisfied that they are qualified to perform a business valuation. Fed. R. Evid. 702; see Martin Ice Cream Co. v. Commissioner, 110 T.C. ___, ___ (1998) (slip op. at 52).
IPC valued the FIC shares using two approaches: A capitalized income method (income method) and a multiple of EBITDA method (EBITDA multiple method).
Applying the income method, IPC determined per-share values for the stock transferred in the 1980 Gifts and the 1981 Recapitalization of $7,388 and $4,273, respectively. Value was determined under the income method by capitalizing a measure of normalized earnings, adding the fair market value of nonoperating assets, and then applying a marketability discount to the per-share value. IPC determined normalized earnings using net operating cash-flow available to equity holders (NCF), adjusted to reflect noncash charges. In valuing the 1980 Gifts, IPC used the NCF for FY 1979, a 10-month fiscal year. A weighted average of the net operating cash-flows for the previous 3 years was used
IPC applied CAPM principles to determine the rate of return an investor would expect in February 1980 and August 1981. IPC used market data from Ibbotson Associates13 and determined that the expected rate of return an investor in FIC stock would demand would be equal to the sum of the applicable risk-free rate, risk premium, and small-stock premium, as well as an additional premium to account for the risk specific to FIC. To reflect the effect of nominal long-term earnings growth, IPC subtracted a growth factor14 from the expected rate of return and determined a capitalization rate of 21.38 percent for valuing the 1980 Gifts and a 25.50 percent capitalization rate for valuing the stock transferred in the Recapitalization.
After capitalizing normalized earnings to determine enterprise value from operations, IPC added the market value of FIC‘s nonoperating assets to determine total equity value. IPC computed a per-share equity value of $11,366 for the 1980 Gifts
In comparison, book value per share after applying a 30-percent minority interest discount and a 35-percent marketability discount was determined to be $4,703 in 1980 and $5,048 in 1981. Applying book value as a floor in the valuation, IPC determined that use of the income method resulted in an undervaluation.
Petitioners have relied upon IPC‘s second method of valuation, the EBITDA multiple method. Under this method, a multiple of net earnings before interest, taxes, depreciation, and amortization (EBITDA) was used to determine total enterprise value. IPC determined the EBITDA of FIC for the FY 1979 through FY 1981. In valuing the 1980 Gifts, IPC used a multiple of FY 1979 EBITDA; a multiple of the weighted average of EBITDA for FY 1979 through FY 1981 was used to value the stock transferred in the Recapitalization. The parties have stipulated FIC‘s EBITDA for FY 1979 through FY 1981, using the figures determined by IPC.
IPC determined that a multiple of 4 to 6 times EBITDA was a
After determining total enterprise value, IPC made various adjustments, such as subtracting the value of outstanding debt, to determine total equity value, which was then converted to equity value per share. Equity value per share was determined to be $20,842 in February 1980 and $26,245 in August 1981. After applying a 30-percent minority discount, a 35-percent marketability discount, and a 10-percent key-person discount, or a total of 59.05 percent in discounts, IPC determined a fair market value per share of $8,535 in February 1980 and $10,747 in August 1981; following these conclusions would result in an overstatement of $10,806 for Royal and Maude‘s 1980 taxable gifts, and zero taxable gifts for their transfers in 1981.
We found Messrs. Burns and Oliver to be qualified, experienced, and credible expert witnesses. We agree with them that valuing FIC using the income method would not be appropriate inasmuch as the income method produces a value less than book
Our major criticism of IPC‘s application of the income method was their construction of the capitalization rate. In deducting a long-term growth factor from the expected rate of return, IPC deducted 8 percent for the 1980 capitalization rate and 7 percent for the 1981 rate. Since these figures are identical to the inflation estimates of the Value Line Investment Survey that were cited by IPC in its report, the growth factors used represented only the expectation of nominal earnings growth: the growth in earnings caused by price inflation. FIC was a growing business; real sales and earnings growth could be expected, both from increased volume at existing restaurants and from the construction of new stores in the Exclusive Territory,
We accept IPC‘s valuation under the EBITDA multiple approach as the most accurate measurement of value available, but we do not accept the percentages of minority interest and marketability discounts that were applied. We also reject IPC‘s use of a multiple rate of 5.0 as unreasonable in light of FIC‘s growth potential and the prevailing economic conditions.
At time of the Recapitalization, FIC had only nine Burger King restaurants open but held a right of first refusal that provided FIC with a protected territory in four southwest Florida counties that were experiencing rapid population growth. Because many of the FIC restaurants were new at the time of the Recapitalization, we think that a prospective purchaser of stock in FIC would expect earnings from existing restaurants to increase as an area presence was established and store sales were increased; the fact that FIC had the ability to block potential Burger King franchisees from entering its market would only strengthen such an expectation. Since the exercise of the right of first refusal would enable FIC to open additional restaurants in the Protected Territories, we think that a prospective purchaser would be bullish regarding FIC‘s potential for earnings growth from expansion.
Because we think that IPC has not properly taken into account FIC‘s potential for growth, we find 6.0 times EBITDA to be the proper multiple to be employed in the valuation of the FIC
3. Discounts
a. Minority Interest Discount
A minority interest discount reflects the minority shareholder‘s inability to compel either the payment of dividends or liquidation in order to realize a pro rata share of the corporation‘s net earnings or net asset value. Discounts for a minority interest and for lack of marketability are conceptually distinct, and the appropriate percentage rate of each of them is a question of fact. Estate of Newhouse v. Commissioner, 94 T.C. at 249.
Because the blocks of stock transferred in the 1980 Gifts and in the 1981 Recapitalization were minority interests, it is appropriate to apply a minority interest discount in their valuation. Since the willing buyer-willing seller test is an objective test, requiring that potential transactions be analyzed
Both parties agree that a minority discount should be applied in valuing both the 1980 Gifts and 1981 transfers by decedents in the Recapitalization, although we do not understand how respondent‘s expert determined that both a minority discount and a control premium should be applied, since the two are essentially opposites. We recognize that a hypothetical investor would not be willing to purchase a minority interest in FIC without a significant discount; no matter how successful the corporation, a minority interest in a corporation that does not pay dividends and whose stock does not have a ready market is of limited value.
Petitioners’ expert cited three articles on minority discounts. The first, Bolten, “Discounts for Stocks of Closely Held Corporations“, 129 Tr. & Est. 47 (Dec. 1990), summarized nine studies regarding discounts for minority interests that indicated a mean discount of 29.63 percent. The second article, “Survey Shows Trend Towards Larger Minority Discounts“, 10 Est. Planning 281 (Sept. 1983), summarized the results of a study
We do not believe that any control premium is warranted. We reject respondent‘s argument that a swing vote potential existed, since we have found that the transferred shares did not have swing vote potential. We are required to value the shares as if they were transferred to a hypothetical buyer and are not permitted to take into account the circumstances of the actual transferee in valuing the shares.
b. Marketability Discount
Both petitioners and respondent acknowledge the necessity of applying a marketability discount in the valuation but disagree as to the proper percentage. A lack of marketability discount
The factors limiting the marketability of stock in FIC in February 1980 and August 1981 included the following: (1) FIC had never paid dividends on its common stock; (2) the corporation was managed and controlled by one individual; (3) the blocks of stock to be transferred were minority interests; (4) a long holding period was required to realize a return; (5) FIC had no
In concluding that a 35-percent marketability discount should be applied, petitioners’ expert cited four articles, including three studies on the sale of restricted stock17 that have been frequently brought to the attention of this Court. See, e.g., Estate of Jung v. Commissioner, 101 T.C. 412, 435-436 (1993); Mandelbaum v. Commissioner, T.C. Memo. 1995-255 (1995), affd. without published opinion 91 F.3d 124 (3d Cir. 1996); Estate of Lauder v. Commissioner, T.C. Memo. 1992-736; Estate of Friedberg v. Commissioner, T.C. Memo. 1992-310; Estate of Berg v. Commissioner, T.C. Memo. 1991-279, affd. in part and revd. and remanded in part 976 F.2d 1163 (8th Cir. 1992); Estate of O‘Connell v. Commissioner, T.C. Memo. 1978-191, affd. in part and revd. in part 640 F.2d 249 (9th Cir. 1981). The first restricted stock study, Gelman, “An Economist-Financial Analyst‘s Approach to Valuing Stock of a Closely-Held Company“, 36 J. Taxn. 353 (June 1972), studied the transactions of four large, closed-end
c. Combined Minority and Lack of Marketability Discount
Respondent has chosen to apply a combined minority and lack of marketability discount of 17 percent, while petitioners seek a minority discount of 30 percent and a marketability discount of 35 percent, which would result in a combined discount of approximately 54.5 percent. While we take into account the articles cited by petitioners, we are by no means bound by the report of petitioners’ expert. We also recognize that while the minority and marketability discounts may be conceptually distinct, Estate of Newhouse v. Commissioner, 94 T.C. at 249 (1990), the boundaries are often less clear in practice, and the empirical studies cited by petitioners may in fact reflect the
d. Key-Person Discount
Where a corporation is substantially dependent upon the services of one person, and where that person would no longer be able to perform services for the corporation by reason of death or incapacity, an investor would expect some form of discount below fair market value when purchasing stock in the corporation to compensate for the loss of that key employee. See Estate of Huntsman v. Commissioner, 66 T.C. 861 (1976); Estate of Mitchell v. Commissioner, supra; Estate of Feldmar v. Commissioner, T.C. Memo. 1988-429; Estate of Yeager v. Commissioner, T.C. Memo. 1986-448. Although FIC could have purchased key-person life insurance on Robert‘s life, a minority shareholder could not compel FIC to purchase such insurance, and FIC had no such
We have found as facts that Robert was a key person in the management of FIC, that FIC had no second layer of management, and that Robert‘s contacts, experience, and managerial expertise were critically important to the success of FIC. While the operation of a franchised Burger King restaurant might appear to be formulaic, FIC was a growing organization, and Robert‘s responsibilities extended well beyond the operation of existing restaurants. Moreover, since BKC had considerable control over FIC‘s costs, expansion opportunities, competition, and ultimately profits, Robert‘s personal relationships with the founders of BKC were very helpful to the success of FIC. We therefore agree with petitioners and find that a key-person discount of 10 percent was appropriate in determining the value of FIC stock as of February 1980 and August 1981.
Accordingly, we allow a total discount of 46 percent in valuing the FIC common stock transferred by decedents in 1980 and 1981, reflecting a combined minority and marketability discount of 40 percent and a key-person discount of 10 percent.
4. Valuation Conclusions
On the basis of the foregoing, we find that for purposes of computing the taxable gifts of Royal and the taxable gifts and taxable estate of Maude: (1) The fair market value of 24 shares of FIC common stock exchanged by each decedent in 1981 for preferred stock of FIC was $424,552; (2) the fair market value of
B. Additions to Tax
1. Failures To File 1981 Gift Tax Returns
For the 1981 taxable year, individuals who were required to file a timely gift tax return but did not do so are subject to an addition to tax equal to 5 percent of the amount of tax that should have been shown on the return, for every month in which the failure to file continues, subject to a maximum of 25 percent.
The addition to tax for failure to timely file a gift tax return may be avoided if the taxpayer can show that his failure to file was due to reasonable cause and not due to willful neglect.
“Courts have frequently held that `reasonable cause’ is established when a taxpayer shows that he reasonably relied on the advice of an accountant or attorney that it was unnecessary to file a return, even when such advice turned out to have been mistaken.” United States v. Boyle, supra at 250 (citing United States v. Kroll, 547 F.2d 393, 395-396 (7th Cir. 1977)); Commissioner v. American Association of Engg. Employment, Inc., 204 F.2d 19, 21 (7th Cir. 1953); Burton Swartz Land Corp. v.Commissioner, 198 F.2d 558, 560 (5th Cir. 1952); Haywood Lumber & Mining Co. v. Commissioner, supra at 771; Orient Inv. & Fin. Co. v. Commissioner, 166 F.2d 601, 602-603 (D.C. Cir. 1948); Hatfried, Inc. v. Commissioner, 162 F.2d 628, 634 (3d Cir. 1947); Girard Inv. Co. v. Commissioner, 122 F.2d 843, 848 (3d Cir. 1941); Dayton Bronze Bearing Co. v. Gilligan, 281 F. 709, 712 (6th Cir. 1922). Thus in some cases, reliance on the opinion of a tax adviser may constitute reasonable cause for failure to file a return. United States v. Boyle, supra at 250-251; Commissioner v. Lane-Wells Co., 321 U.S. 219 (1944).
Reasonable cause based upon reliance on the opinion of a competent adviser has been found where the reliance concerned a question of law, such as whether the filing of a return was required; a taxpayer‘s reliance on an adviser ordinarily cannot supplant his personal duty to ensure the timely filing of any required return.
When an accountant or attorney advises a taxpayer on a matter of tax law * * * it is reasonable for the taxpayer to rely on that advice * * *
By contrast, one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. [United States v. Boyle, supra at 251.]
Compare Haywood Lumber & Mining Co., supra at 770-771 (reasonable cause for failure to file personal holding company surtax returns where corporation had relied on competent certified public accountant to prepare income tax returns) and Hollingsworth v. Commissioner, supra at 108-109 (reasonable cause for failure to
Decedents were advised not to file a gift tax return by Messrs. Tishler and Shillington in connection with the transfers made in the Recapitalization. Messrs. Tishler and Shillington concluded that the fair market values of the common stock exchanged and the preferred stock received in the recapitalization were equal, so that no taxable gift had been made.
Respondent argues that the addition to tax is nonetheless applicable because decedents did not rely on a formal appraisal of FIC to determine whether they had made taxable gifts. Respondent‘s argument is unwarranted on the facts of this case. As we have discussed in our findings of fact, supra, Mr. Tishler is highly experienced in restaurant franchising, and at the time of the Recapitalization, had served as FIC‘s attorney for approximately 15 years. Mr. Tishler‘s representation of FIC included tax matters; for instance: (1) In connection with the 1980 Gifts, he had advised decedents to file gift tax returns,
That decedents received advice that ultimately proved erroneous does not alter our conclusion; valuation is an area of inherent uncertainty. See United States v. Boyle, 469 U.S. at 250. Consequently, we conclude that decedents’ failure to file was due to reasonable cause and do not sustain any portion of respondent‘s additions to gift tax under
2. Negligence
For the same reasons that we have found that decedents had reasonable cause for their failures to file gift tax returns, we do not find them to have been negligent by reason of having underpaid their gift taxes. In light of the qualifications and expertise of Mr. Tishler, FIC‘s attorney, and Mr. Shillington, FIC‘s accountant, we think that decedents acted reasonably in relying on their opinions. Finally, although the advice rendered to decedents by Messrs. Tishler and Shillington has proven to be erroneous, we do not think, in light of the uncertainty associated with valuation, that their determination of fair
To reflect the foregoing,
Decisions will be entered
under Rule 155.