T.C. Memo. 1999-254



                      UNITED STATES TAX COURT



     WALTER L. GROSS, JR., AND BARBARA H. GROSS, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent

    CALVIN C. LINNEMANN AND PATRICIA G. LINNEMANN, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 4460-97, 4469-97.             Filed July 29, 1999.
‚


           Ps made gifts to their children of shares in
      S corporation, which, annually, distributed
      substantially all of its income. R determined gift tax
      deficiencies based on adjustments increasing the fair
      market value of the shares. Principal differences
      between the parties are (1) whether to “tax affect”
      corporation’s earnings in determining discounted cash-
      flow, (2) the discount for lack of marketability, and
      (3) the cost of equity.
           Held: Value of shares determined; marketability
      discount and cost of equity determined; tax affecting
      inappropriate under facts presented.



      James J. Ryan and Gerald J. Rapien, for petitioners.

      Robin Herrell and Matthew Fritz, for respondent.
                                   - 2 -


               MEMORANDUM FINDINGS OF FACT AND OPINION


     HALPERN, Judge:     These cases have been consolidated for

trial, briefing, and opinion.      By notices of deficiency dated

December 16, 1996, respondent determined deficiencies in Federal

gift taxes as follows:

     Docket
     Number           Petitioner            Year      Deficiency

     1460-97    Walter L. Gross, Jr.        1992       $584,139
     1460-97    Barbara H. Gross            1992        584,140
     1469-97    Calvin C. Linnemann         1992        581,605
     1469-97    Patricia G. Linnemann       1992        582,807

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     The common question presented by these consolidated cases is

the July 31, 1992, fair market value of certain shares of

corporate stock transferred by gift by petitioners Walter L.

Gross, Jr. (Walter Gross), and Patricia G. Linnemann (Patricia

Linnemann) to their respective children.      Petitioners Barbara H.

Gross (Barbara Gross) and Calvin C. Linnemann (Calvin Linnemann),

the wife and husband of Walter Gross and Patricia Linnemann,

respectively, are petitioners because they and their respective

spouses consented to having the gifts made by each spouse

considered for Federal gift tax purposes as having been made
                                - 3 -


one-half by each spouse.    Respondent initially determined that

each share of stock in question had a value of $11,738, but now

concedes that each such share has a value of no more than

$10,910.   Petitioners based their gift tax liabilities on a value

of $5,680, which they maintain is the correct value.

                           FINDINGS OF FACT

Introduction

     Some of the facts have been stipulated and are so found.

The stipulation of facts, with accompanying exhibits, is

incorporated herein by this reference.    At the time of the filing

of the petitions, all of the petitioners resided in Cincinnati,

Ohio.

G&J Pepsi-Cola Bottlers, Inc.

     The shares of stock in question are shares of G&J Pepsi-Cola

Bottlers, Inc. (G&J), an Ohio corporation formed in 1969.    The

business operations of G&J can be traced to a business conducted

by a partnership formed in the 1920s between two married couples,

Isaac N. and Esther M. Jarson and Walter L. and Nell R. Gross

(the founders).   By 1992 (the year of the gifts here in

question), the founders had died, and ownership of G&J had

devolved to certain relatives of the founders, viz, the Gross

family group (which included members of the Linnemann family) and

the Jarson family group.    In 1992, directly and through voting
                               - 4 -


trusts, each family group owned 50 percent of the outstanding

shares of stock of G&J.

     In 1982, G&J elected to be taxed as a “small business

corporation” (an S corporation), within the meaning of section

1371 of the Internal Revenue Code of 1954.    By agreement dated

November 1, 1982 (the S corporation agreement), the shareholders

of G&J agreed to maintain G&J’s status as an S corporation for at

least 10 years.   G&J, in fact, maintained its S corporation

status through July 31, 1992, at which time there were no plans

to change its S corporation status.    Further, an agreement

restricting the transfer of the G&J shares by and among the

members of the Gross family group (the Gross family restrictive

transfer agreement), dated October 29, 1982, also remained in

effect as of July 31, 1992.1   The Gross family restrictive

transfer agreement contained express provisions to prevent

termination of G&J's S corporation status.    As of July 31, 1992,

G&J had issued an outstanding 19,680 shares of common stock

without par value.

     In 1992, G&J's top management positions and voting control

were largely in the hands of the senior members of the Gross and

Jarson family groups.   The shareholders of G&J got along well,


1
     There was a similar restrictive transfer agreement by and
among the members of the Jarson family group holding shares of
G&J dated Apr. 1, 1983, which also remained in effect as of
July 31, 1992.
                                - 5 -


and they did not allow differences in their business philosophies

to interfere with the successful operation of the corporation.

None of G&J's shareholders was interested in selling his or her

shares.

     In 1992, G&J bottled and distributed various soft drinks,

including Seven-Up, Dr. Pepper, and five variations of Pepsi-

Cola.   Through franchise agreements with PepsiCo, Dr. Pepper, and

Seven-Up, G&J had the exclusive right to bottle and distribute

the various soft drinks it produced within several geographic

territories.    G&J was a well-managed company in 1992.   It was the

third-largest independent Pepsi-Cola bottler.    G&J owned most of

the real estate associated with its plants and warehouses.     It

owned in excess of 800 vehicles, including tractors, trucks, and

trailers.    Additionally, G&J owned about 11,400 soft drink

vending machines.    G&J sold the soft drinks it produced to

supermarkets, convenience stores, mass merchandisers, gas mini-

marts, drugstores, vending companies, restaurants, bars, lunch

counters, and concessions.    In 1992, it had approximately 24,000

customers.

     From 1988 through 1992 there were steady increases in G&J's

operating income, total income, and distributions to

shareholders.    During that period, distributions to shareholders

nearly equaled the company's entire income, as shown below:
                                - 6 -


Fiscal
Year          Operating      Other        Total        Shareholder
Ended          Income        Income       Income      Distributions

1988        $15,680,903    $2,050,232   $17,731,135    $17,778,483
1989         18,150,034     1,329,796    19,479,830     19,458,148
1990         21,623,537     2,323,068    23,946,605     24,032,651
1991         23,796,119       542,321    24,338,440     24,126,041
1992         23,258,506     4,327,367    27,585,873     28,188,889

Petitioners' Gifts

       On July 31, 1992, Walter Gross made a gift of 124.5 shares

of common stock in G&J to each of his three children (together,

the Walter Gross gifts).    Each of the Walter Gross gifts

represented 0.63 percent of the issued and outstanding shares of

G&J.    Walter and Barbara Gross (the Grosses) each reported one-

half of the amount they determined to be the value of the Walter

Gross gifts on a timely filed Form 709, United States Gift (and

Generation Skipping Transfer) Tax Return (Form 709).    In

determining (and reporting) the value of the Walter Gross gifts,

the Grosses relied on an appraisal report prepared by Business

Valuations, Inc. (the Business Valuations report and Business

Valuations, respectively), dated July 22, 1992, valuing shares of

G&J's common stock as of May 31, 1992, at $5,680 a share.    Since

the Grosses used a value of $5,680 a share, the total reported

value of the Walter Gross gifts was $2,121,480.

       On July 31, 1992, Patricia Linnemann made a gift of 187.5

shares of common stock in G&J to each of her two children (the

Patricia Linnemann gifts).    Each of the Patricia Linnemann gifts
                                 - 7 -


represented 0.95 percent of the issued and outstanding shares in

G&J.    Patricia and Calvin Linnemann (the Linnemanns) each

reported one-half of the amount they determined to be the value

of the Linnemann gifts on a timely filed Form 709.    In

determining (and reporting) the values of the Patricia Linnemann

gifts, the Linnemanns also relied on the Business Valuations

report.    The total reported value of the Patricia Linnemann gifts

was $2,130,000.

                      ULTIMATE FINDING OF FACT

       On July 31, 1992, the fair market value of a share of stock

of G&J representative of the shares constituting both the Walter

Gross and Patricia Linnemann gifts was $10,910.

                                OPINION

I.   Introduction

       On July 31, 1992, Walter Gross and Patricia Linnemann made

gifts to their respective children of shares of stock in a

corporation, G&J Pepsi-Cola Bottlers, Inc. (G&J).    Walter Gross

and Patricia Linnemann are members of a family group (the Gross

family group) that, in 1992, owned 50 percent of the outstanding

shares of stock of G&J.    Each child received a number of shares

of stock in G&J constituting less than a 1-percent interest in

the corporation.    The parties disagree as to the fair market

value (value) of those gifts.    The parties have assumed that each

of the shares of stock in question (a G&J share) had the same
                                - 8 -


value, but have expressed their disagreement over that value.

Petitioners argue that, on July 31, 1992 (the gift date), the

value of a G&J share was $5,680; respondent argues that it was

$10,910.

II.   Code and Regulations

      Section 2501 imposes a tax for each calendar year on the

transfer of property by gift during such calendar year by

individuals.    Section 2512 provides that "[i]f the gift is made

in property, the value thereof at the date of the gift shall be

considered the amount of the gift."     The standard for determining

the value of a gift for purposes of the gift tax is fair market

value, i.e., the price at which the property would change hands

between a willing buyer and seller, neither being under any

compulsion to buy or sell, and both having knowledge of relevant

facts.    See United States v. Cartwright, 

, 551

(1973); sec. 25.2512-1, Gift Tax Regs.    Valuation is an issue of

fact, see, e.g., Estate of Newhouse v. Commissioner, 

,

217 (1990), and petitioners bear the burden of proof, Rule

142(a).    We have found that the fair market value of a G&J share

was $10,910 on the gift date.   We shall explain our reasons for

that finding.
                                   - 9 -


III.    Arguments of the Parties

       A.   Reliance on Expert Testimony

       Both parties rely on expert testimony to establish the value

of a G&J share.     Petitioners rely on the expert testimony of

David O. McCoy, a business appraiser, who prepared a report

valuing the common shares of G&J.      Mr. McCoy was accepted as an

expert appraisal witness by the Court, and his report was

accepted into evidence as his direct testimony.     Mr. McCoy also

prepared a report in rebuttal to respondent’s expert witness,

which report was accepted into evidence as additional direct

testimony.     Petitioners also called Charles A. Wilhoite, an

appraiser and valuation expert, who prepared a second report in

rebuttal to respondent’s expert witness.     Mr. Wilhoite was

accepted as an expert on appraisal and valuation methodology by

the Court, and his report was accepted into evidence as his

direct testimony.     Respondent called Mukesh Bajaj, Ph.D., an

appraisal expert, who prepared two reports, one valuing minority

interests in G&J as of the gift date, and one in rebuttal to

Mr. McCoy’s first report.     Dr. Bajaj was accepted as an expert

appraisal witness by the Court, and his reports were accepted

into evidence as his direct testimony.

       The principal disagreements among the parties’ expert

witnesses are: (1) whether it is appropriate to “tax affect”

G&J’s earnings in determining the value of a G&J share, (2) the
                                - 10 -


lack of marketability discount to be applied in valuing a G&J

share, and (3) G&J’s cost of equity.

     We shall describe their testimony with respect to their

areas of disagreement.

     B.    Mr. McCoy’s Testimony

            1.   Introduction

     Mr. McCoy stated that his assignment was “to determine the

fair market value of small minority interests in the common stock

of G&J”.    Mr. McCoy used three separate methods to determine that

value:    market price comparison method, discounted future free

cash-flow method, and valuation by capitalization of earnings.

Mr. McCoy gave equal weight to the results reached under the

second and third methods, but only one-third of that weight to

the result reached under the first method.      Mr. McCoy determined

a weighted average value for a G&J share and, then, applied a

discount for lack of marketability to arrive at the

aforementioned value for a G&J share of $5,680.

            2.   Tax Affecting G&J’s Earnings

     Under the discounted future free cash-flow method, Mr. McCoy

considered G&J to be an asset capable of producing cash-flows to

its owners for an infinite number of periods.     He determined the

present value of G&J by, first, hypothesizing the available cash

for each such period, second, discounting each such amount to
                              - 11 -


reflect both the delay in payment and the risk of nonpayment, and

third, summing the results.

     Mr. McCoy testified that, in 1992, various professional

associations published standards governing the conduct of

professional business appraisers and that professional appraisers

were ethically bound to follow those standards.   Specifically,

Mr. McCoy specified an appraisal foundation publication entitled

the Uniform Standards of Professional Appraisal Practice (USPAP),

which required business appraisers to be aware of, to understand,

and correctly to employ recognized methods and techniques

necessary to produce a credible result (the standards rule).

Mr. McCoy further testified that, in order to comply with the

standards rule, it was necessary for professional appraisers to

"tax affect" the earnings of an S corporation in order to produce

a credible business appraisal.   To accomplish such tax affecting,

Mr. McCoy introduced a fictitious tax burden, equal to an assumed

corporate tax rate of 40 percent, which he applied to reduce each

future period’s earnings, before such earnings were discounted to

their present value.2


2
     Sec. 11 imposes a tax on the income of every corporation.
Additionally, the shareholders of a C corporation, defined in
sec. 1361(a)(2) as any corporation which is not an S corporation,
must include in gross income any dividends received from the
C corporation, sec. 301(c)(1), thus giving rise to the claim that
the income of a C corporation is subject to a double tax.
Conversely, an S corporation (as defined in sec. 1361(a)(1)),
                                                   (continued...)
                                 - 12 -


          3.   Lack of Marketability Discount

     Mr. McCoy examined several studies that considered the lack

of marketability of closely held and restricted securities.

Mr. McCoy testified that, based on his examination, an average

lack of marketability discount for shares that would eventually

become freely tradable was "30%+".        Mr. McCoy then concluded that

a greater discount was required for the G&J shares because they

were illiquid and not marketable.3        Mr. McCoy testified that a

discount rate of at least 35 percent was required to compensate

an owner for the lack of marketability of those shares.

          4.   Cost of Capital

     Mr. McCoy testified that G&J's cost of equity capital was

19 percent.4   He explained that G&J compared in size to very


2
 (...continued)
generally is not subject to the sec. 11 tax. See sec. 1363(a).
Instead, the items of income, loss, deduction, or credit, of the
S corporation are passed through to the shareholders of the S
corporation and are taken into account directly in computing
their tax liabilities. See sec. 1366(a). Additionally, in Ohio,
S corporations (such as G&J) are not subject to State income tax.
See Ohio Rev. Code Ann. sec. 5733.09(B) (Banks-Baldwin 1995).
3
     Specifically, Mr. McCoy noted that, in addition to being
closely held, the G&J shares were restricted as to
transferability and were subject to a right of first refusal.
4
     In his oral testimony, Mr. McCoy distinguished between
“nominal” and “real” numbers. Mr. McCoy testified that the
difference was that the effects of inflation, which he opined to
be 4 percent, were eliminated from “nominal” numbers to produce
“real” numbers. Mr. McCoy explained that we must add his opined
4-percent inflation rate to his reported cost of equity
                                                   (continued...)
                               - 13 -


small capitalization public companies, which necessitated such a

required rate of return.   In addition to his market-derived

required rate of return, Mr. McCoy further buttressed his opinion

by summing the following component risk factors of G&J's cost of

equity capital:   (1) 2.1 percent as the risk-free rate of return,

(2) 7 percent as an equity risk premium, (3) 1 percent as an

adjustment for company specific risk, and finally (4) 4.8 percent

as a small capitalization risk premium.5

     C.   Dr. Bajaj’s Testimony

           1.   Introduction

     Dr. Bajaj also stated that his assignment was to determine

the fair market value of certain minority blocks of stock in G&J.

Dr. Bajaj relied principally on a discounted cash-flow approach

to determine that value.   To test the validity of his

conclusions, he considered the values of companies he thought

comparable to G&J.   He also applied a discount for lack of

marketability, and he arrived at the aforementioned value for a

G&J share of $10,910.


4
 (...continued)
(15 percent) in order to convert it back to a nominal number for
comparative purposes. He, therefore, agreed that using “nominal”
numbers, his calculated cost of equity was 19 percent compared to
Dr. Bajaj's calculation of 15.5 percent.
5
     Although the sum of Mr. McCoy's risk factors is 15 percent,
Mr. McCoy added 4 percent to his result in order to convert it
to a nominal rate of return for comparison purposes. See supra
note 4.
                               - 14 -


          2.    Assumption of a Zero-Percent Corporate Tax Rate

     Dr. Bajaj knew that G&J was an S corporation on the

valuation date, and, based on information that he had received

from G&J's management, he assumed that it would remain an

S corporation indefinitely.   He further assumed that virtually

all of G&J's earnings would continue to be distributed to its

shareholders.   Dr. Bajaj determined that a zero-percent corporate

tax rate was an appropriate assumption to make in determining the

earnings of G&J available for distribution.      Dr. Bajaj also

ignored shareholder level taxes in arriving at his discount rate.

          3.    Lack of Marketability Discount

     Dr. Bajaj testified that an appropriate discount for lack of

marketability applicable to G&J's shares on the valuation date

was 25 percent.   In arriving at his conclusion, Dr. Bajaj first

reviewed various commonly cited published studies that examined

marketability discounts.   He divided the studies into two

categories:    (1) studies that analyzed sales of restricted stock

by firms that also had publicly traded shares, and (2) studies

that compared share prices observed in successful initial public

offerings (IPOs).   With regard to the first category, Dr. Bajaj

concluded that, due to variations in characteristics of the

observed firms and transactions, only about 10 to 15 percent of
                                   - 15 -


the observed discounts6 could be attributed to a lack of

marketability.    With regard to the second category, Dr. Bajaj

concluded that the published results were not useful in

evaluating discount levels for two reasons.      First, Dr. Bajaj

testified that many of the pre-IPO private market transactions

probably did not occur at fair market value.      Second, Dr. Bajaj

testified that examining only a selection of firms that carried

out successful IPOs was a biased statistical sample, and that

such bias would tend to increase the apparent "discount".

Relying more on his own empirical analysis of lack of

marketability discounts, and considering such factors as G&J's

generous dividend policy and its greater marketability

restrictions (i.e., the restrictive transfer agreements),

Dr. Bajaj concluded that a conservative estimate of the lack of

marketability discount for G&J's shares on the valuation date was

25 percent.

          4.     Cost of Capital

     Dr. Bajaj used a 15.5-percent cost of equity and a

8.25-percent cost of debt to derive a 14.4-percent weighted cost

of capital for G&J.    He used the capital asset pricing model to

derive his opined cost of equity.       Dr. Bajaj used 7.46 percent as


6
     According to Dr. Bajaj, the studies that analyzed sales of
restricted stock by firms that also had publicly traded shares
demonstrated that the median discounts ranged from 10 to 40
percent.
                                - 16 -


the risk-free rate of return,7 7.4-percent as the long-term

market risk premium,8 and 1.09 percent as G&J's beta

coefficient.9 Dr. Bajaj's cost of equity calculation was as

follows:   7.46 + (1.09 * 7.4) = 15.5 percent.

     Dr. Bajaj determined G&J's cost of debt capital by looking

at G&J's real borrowing costs.    In April 1991, G&J took on debt

in part to fund an expansion.    It borrowed the needed funds at

8.25 percent, which was three-quarters of a percent below the

then prime rate of 9 percent.

     D.    Petitioners' Motion in Limine

     Petitioners have moved to exclude Dr. Bajaj's testimony (the

motion).    First, petitioners argue that Dr. Bajaj's opinion as to

the fair market value of a minority stock ownership interest in

G&J is inadmissible because it was derived from the application

of scientifically unreliable methodologies.    See Daubert v.

Merrell Dow Pharm. Inc., 

, 589 (1993)(under the


7
     Dr. Bajaj explained that the yield to maturity on 30-year
Treasury securities was an appropriate measure of a risk-free
rate, which, according to information published by the Federal
Reserve was 7.46 percent as of July 31, 1992.
8
     Dr. Bajaj explained that the 7.4-percent long-term market
risk premium was derived from historical data published by
Ibbotson Associates, Inc.
9
     Dr. Bajaj defined beta as a measure of the tendency of a
security's return to move with the overall market's return. He
estimated G&J's beta from the betas for public firms operating in
the soft drink industry for which published figures were
available.
                              - 17 -


Federal Rules of Evidence, the trial judge must ensure that any

and all scientific testimony or evidence admitted is not only

relevant, but is also reliable).   Petitioners further argue that

neither Dr. Bajaj's underlying data nor his empirical analysis

has been published or otherwise submitted for peer review by the

appraisal profession.   Finally, petitioners argue that, in part,

the data Dr. Bajaj relied upon was not available in 1992, and,

therefore, a willing and knowledgeable buyer and seller could

not, at that time, be expected to have relied on Dr. Bajaj's

marketability discount analysis in arriving at a fair market

value determination of G&J's stock.    Petitioners cite Estate of

Newhouse v. Commissioner, 

 (1990), and Estate of

Mueller v. Commissioner, T.C. Memo. 1992-284, as authority for

the proposition that we must reject Dr. Bajaj's new data and

empirical analysis as a matter of law.   We disagree.

     In Daubert v. Merrell Dow Pharm. Inc., supra at 585-587, the

Supreme Court held that the "general acceptance" test, the

dominant standard for determining the admissibility of novel

scientific evidence at trial, was superseded by the adoption of

the Federal Rules of Evidence.   Fed. R. of Evid. 702 reads:

          If scientific, technical, or other specialized
     knowledge will assist the trier of fact to understand
     the evidence or to determine a fact in issue, a witness
     qualified as an expert by knowledge, skill, experience,
                               - 18 -


     training, or education, may testify thereto in the form
     of an opinion or otherwise.

Pursuant to Fed. R. of Evid. 702, the Court must assure that

scientific evidence is not only relevant, but also reliable.

Daubert v. Merrell Dow Pharm., Inc., supra at 589.    Daubert,

however, is not limited to evidence that is scientific only in

the laboratory sense.    Recently, in Kumho Tire Co. v. Carmichael,

___, ___, 

, 1171 (1999), the Supreme

Court made clear:   “Daubert’s general holding--setting forth the

trial judge’s general ‘gatekeeping’ obligation--applies not only

to testimony based on ‘scientific’ knowledge, but also to

testimony based on ‘technical’ and ‘other specialized’

knowledge.”   Dr. Bajaj's testimony (as well as Mr. McCoy's) was

of a technical nature.    Therefore, Daubert is applicable here,

and we have a gatekeeping role to perform.

     As we have said, value is a question of fact.    See supra

sec. II.   Dr. Bajaj has an opinion as to that fact, arrived by

applying certain tools of financial analysis, primarily a

discounted cash-flow analysis, which is a method of analysis also

employed by Mr. McCoy.    Petitioners do not claim that a

discounted cash-flow analysis is an unreliable tool for

determining the present value of one or more future cash-flows

(e.g., the distributions of cash Dr. Bajaj assumed G&J would

continue indefinitely).    We have for many years relied on a
                             - 19 -


discounted cash-flow analysis to determine the present value of

one or more future cash-flows.   See, e.g., Plumb v. Commissioner,

, 297 (1927); Willamette Indus., Inc. v.

Commissioner, T.C. Memo. 1990-339 (setting forth the algebraic

formula to determine the present value of a future payment).

When properly applied, a discounted cash-flow analysis is a

reliable tool for financial analysis.   The difference in opinions

as to value reached by the two expert witnesses, at least to the

extent it is attributable to the discounted cash-flow approach,

is exclusively the result of differences between them as to the

values of certain variables, not a difference as to methodology.

Therefore, since we find the discounted cash-flow analysis to be

a reliable tool to determine the present value of one or more

future cash-flows, we believe that petitioners’ argument, to wit,

that Dr. Bajaj’s opinion is based on unreliable methodologies, is

nonsensical.

     Because we find that both parties' experts relied on the

same acceptable valuation methodology, and that the areas of

disagreement between the experts are merely factual disagreements

over various factors and assumptions, we need not address further

petitioners' second concern, that Dr. Bajaj's "method" has not

been subjected to peer review.

     Finally, we address petitioners' last contention, that the

data Dr. Bajaj relied upon was not available in 1992 and,
                                - 20 -


therefore, in calculating a discount for lack of marketability a

willing buyer and seller could not have relied upon it.

Dr. Bajaj's sample consisted of 157 observed transactions from

January 1, 1980, to October 31, 1996.      Seventy-eight of the

transactions preceded the gift date, and 79 were announced

subsequent to the gift date.    Petitioners' reliance on Estate of

Newhouse v. Commissioner, supra, and Estate of Mueller v.

Commissioner, supra, is misplaced.       In Estate of Newhouse we

held: "[t]he focus of a valuation inquiry * * * is on the

existing facts, circumstances, and factors at the valuation date

that influence a hypothetical willing buyer and willing seller in

determining a selling price."     Estate of Newhouse v.

Commissioner, 94 T.C. at 231.     It is not improper, however, to

consider later events to the extent that such events may shed

light upon a fact, circumstance, or factor as it existed on the

valuation date.   See, e.g., Estate of Gilford v. Commissioner,

, 52-53 (1987).     We do not interpret Dr. Bajaj to have

opined that a willing buyer and a willing seller would or could

have relied upon the data he used on the gift date.       Instead,

Dr. Bajaj testified that, based on a survey and examination of

similar transactions, including transactions that occurred after

the gift date, we can determine with reasonable accuracy what

willing buyers and willing sellers were doing on the valuation

date.   Dr. Bajaj testified
                                 - 21 -


      it is methodologically appropriate to use the
      comprehensive sample I collected to estimate
      marketability discounts even though approximately half
      the sample consists of post-valuation date
      announcements because there is no reason to believe
      that the underlying economics of private placement
      would have changed after the valuation date.

      We agree.    Further, petitioners have not alleged that the

observed lack of marketability discounts in similar private

placement transactions would have changed after the valuation

date.

      Additionally, after performing an identical statistical

analysis on only the prevaluation portion of his data sample,

Dr. Bajaj reported a predicted discount similar to the discount

he predicted using his complete data.10    For the foregoing

reasons, petitioners' motion will be denied, and an appropriate

order will be issued.

IV.   Valuation of the Gift

      1.   Tax Affecting G&J's Earnings

           A.     Introduction

      The decision whether to tax affect G&J’s projected earnings

under the discounted cash-flow approach accounts for the most

significant differences between the parties' expert witnesses.

In fact, Dr. Bajaj repeated his analysis, substituting a




10
     In fact, the predicted discount associated with the
prevaluation data was slightly lower than with the full sample.
                               - 22 -


40-percent corporate income tax rate for the zero-percent

corporate rate he first assumed.   Offsetting for interest payment

deductions, Dr. Bajaj calculated that the resulting market

capitalization dropped from $286 million to $188 million, a

34-percent reduction, which amount was within 10 percent of the

weighted average value ($171,993,000) computed by Mr. McCoy.

      Petitioners argue for tax affecting not only on the basis of

the testimony of their expert witnesses, but also on the basis

that respondent has advocated that adjustment and must be held to

it.

      B.   Petitioners' Position

      Petitioners introduced into evidence two internal documents

of the Internal Revenue Service:   (1) a valuation guide for

income, estate, and gift taxes (the guide), and (2) an

examination technique handbook for estate tax examiners (the

handbook).

      We read those excerpts as neither requiring tax affecting

nor laying the basis for a claim of detrimental reliance.    The

guide, in relevant part, reads:

      * * * [S] corporations are treated similarly to
      partnerships for tax purposes. S Corporations lend
      themselves readily to valuation approaches comparable
      to those used in valuing closely held corporations.
      You need only to adjust the earnings from the business
      to reflect estimated corporate income taxes that would
      have been payable had the Subchapter S election not
      been made.
                                - 23 -


The handbook, in relevant part, reads:

     If you are comparing a Subchapter S Corporation to the
     stock of similar firms that are publicly traded, the
     net income of the former must be adjusted for income
     taxes using the corporate tax rates applicable for each
     year in question, and certain other items, such as
     salaries. These adjustments will avoid distortions
     when applying industry ratios such as price to
     earnings.

     Both statements lack analytical support, and we refuse to

interpret them as establishing respondent’s advocacy of tax-

affecting as a necessary adjustment to be made in applying the

discounted cash-flow analysis to establish the value of an

S corporation.

     Even if we were to interpret the excerpts as petitioners do,

petitioners do not claim that the excerpts have the force of a

regulation or ruling, nor have they shown the type of detrimental

reliance that might work an equitable estoppel against

respondent.   “Equitable estoppel is a judicial doctrine that

precludes a party from denying his own acts or representations

which induced another to act to his detriment.      Estoppel is

applied against the Commissioner with utmost caution and

restraint.”   Hofstetter v. Commissioner, 

, 700 (1992)

(internal citations and quotation marks omitted).      In any event:

“Detrimental reliance on the part of the party seeking to invoke

estoppel is a key condition.”    Id.     Petitioners have failed to

prove that they relied on either the guide or the handbook in any
                                - 24 -


way.    Accordingly, respondent is not estopped from disregarding a

fictitious corporate tax when valuing an S corporation.

       C.   Mr. McCoy’s Testimony

       Mr. McCoy lists eight costs or tradeoffs shareholders incur

as a result of electing to be taxed as an S corporation.      The

enumerated costs or tradeoffs highlight three areas of concern,

which "tax-affecting" is directed to address.      First, Mr. McCoy

addresses the possibility that, if an S corporation distributes

less than all of its income, the actual distributions might be

insufficient to cover the shareholders' tax obligations.      As a

theoretical matter, we do not believe that "tax-affecting" an

S corporation's projected earnings is an appropriate measure to

offset that potential burden associated with S corporations.        In

any event, we do not think it is a reasonable assumption that G&J

would not make sufficient distributions to cover its

shareholders' tax liabilities.      G&J had a strong growth record

and a history of making cash distributions to shareholders that

nearly equaled its entire income.      Petitioners have not convinced

us that it would be reasonable to assume G&J would not continue

this practice.

       Second, Mr. McCoy addresses the risk that an S corporation

might lose its favorable S corporation status.      We might consider

an approach that sought to determine the probability of such an

occurrence, and which utilized a tax rate equal to the product of
                                - 25 -


such probability and the corporate tax rate in an effort to

quantify that potential loss.    We do not, however, think it is

reasonable to tax affect an S corporation's projected earnings

with an undiscounted corporate tax rate without facts or

circumstances sufficient to establish the likelihood that the

election would be lost.

     Finally, Mr. McCoy argues that S corporations have a great

disadvantage in raising capital due to the restrictions of

ownership necessary to qualify for the S corporation election.

This concern is more appropriately addressed in determining an

appropriate cost of capital.    In any event, it is not a

justification for tax affecting an S corporation's projected

earnings under a discounted cash-flow approach.    Mr. McCoy has

failed to put forward any cognizable argument justifying the

merits of tax affecting G&J's projected earnings under a

discounted cash-flow approach.

     D.   Mr. Wilhoite’s Testimony

     Mr. Wilhoite was asked to address whether, as of the

valuation date, it was reasonable for Dr. Bajaj to value a G&J

share, using the discounted cash-flow method, while assuming a

zero-percent corporate tax rate.     Mr. Wilhoite faults Dr. Bajaj

for not taking into account the “known payment” of taxes in

arriving at a value for the G&J shares.    It is unclear, however,

whether the “known payment” that Mr. Wilhoite has in mind is the
                              - 26 -


avoided corporate level tax paid by a C corporation, or the

shareholder level tax that results from the flowthrough of tax

items to the shareholders of an S corporation.

      The clearest argument Mr. Wilhoite put forward explaining

why it is appropriate to "tax-affect" an S corporation's earnings

is:

      In effect, an S corporation is committed to making
      distributions to shareholders sufficient to cover
      individual tax liabilities on allocated S corporation
      earnings in the same fashion that a C corporation is
      committed to making tax payments to the Service to
      cover corporate tax liabilities on reported taxable
      earnings. * * * Whether the outflow is a cash
      distribution made by an S corporation to satisfy
      shareholders' tax liabilities, or the direct payment of
      a tax liability by a C corporation, the decrease in
      cash experienced by either entity represents a known
      payment which reduces the availability of cash which
      could otherwise be used to maintain or expand existing
      operations. Such a decrease must be taken into
      consideration when valuing an entity, whether it is
      structured as a C corporation or an S Corporation.

Mr. Wilhoite’s testimony is not persuasive.   On redirect

examination, Mr. Wilhoite stated:   “[Y]ou deduct the taxes that

would be paid if the company were structured as a C corporation;

and that leaves you with a distributable amount of earnings”.

Further, Mr. Wilhoite had the following discussion with the

Court:

           Mr. Wilhoite: We’re dealing with a stock of a
      corporation, G&J. And G&J is an S corporation. And
      G&J has generated significant earnings up until the
      date of the valuation * * * and all of those earnings
      have been distributed to the shareholders.
                                 - 27 -


          The Court:   Um-hmm.

          Mr. Wilhoite: But every dollar of earnings for
     G&J, in any particular year, has to go to the IRS.
     Whether it goes through the shareholders or directly,
     it has to go to the IRS.

          So, what’s left above the tax that they’re paying
     to the IRS is the true distribution to the shareholder,
     and also represents the true available cash that the
     company can distribute.

     It is possible that Mr. Wilhoite is arguing that, in valuing

an S corporation, the avoided C corporation tax must be taken

into account as a hypothetical expense, in addition to the

shareholder level taxes actually imposed on the S corporation’s

shareholders.   Indeed, that is the position taken by Mr. McCoy.

Mr. Wilhoite has failed to convince us, however, that Dr. Bajaj

should have applied a hypothetical corporate tax rate in excess

of the zero-percent actual corporate tax rate he did apply.     He

has not convinced us that such an adjustment is appropriate as a

matter of economic theory or that an adjustment equal to a

hypothetical corporate tax is an appropriate substitute for

certain difficult to quantify disadvantages that he sees

attaching to an S corporation election.   We believe that the

principal benefit that shareholders expect from an S corporation

election is a reduction in the total tax burden imposed on the

enterprise.   The owners expect to save money, and we see no

reason why that savings ought to be ignored as a matter of course

in valuing the S corporation.
                               - 28 -


     Although perhaps less likely, Mr. Wilhoite may believe that,

as a matter of proper application of a present value analysis,

Dr. Bajaj was required to tax affect G&J’s expected distributions

on account of the expected tax burden to be borne by its

shareholders.   Dr. Bajaj assumed that G&J would continue to

distribute all of its earnings annually.   He made no explicit

adjustment for any shareholder level taxes, although,

undoubtedly, he knew such taxes would be due.   Dr. Bajaj did not,

however, ignore shareholder level taxes.   He simply disregarded

them both in projecting G&J’s available cash and in determining

the appropriate discount rate.   The present value of any future

(deferred) cash-flow is a function of three variables:   (1) the

amount of the cash-flow, (2) the discount rate, and (3) the

period of deferral.11   The discount rate reflects the return,

over time, to the investor on the amount invested (commonly

expressed as a rate of interest).   If, in determining the present

value of any future payment, the discount rate is assumed to be

an after-shareholder-tax rate of return, then the cash-flow

should be reduced (“tax affected”) to an after-shareholder-tax

amount.   If, on the other hand, a preshareholder-tax discount

rate is applied, no adjustment for taxes should be made to the



11
     PV = C/(1+r)n, where PV equals the present value, r equals
the discount rate, C equals the cash-flow, and n equals the
number of periods of deferral.
                                 - 29 -


cash-flow.12     Since, in applying his discounted cash-flow

approach, Dr. Bajaj assumed a preshareholder-tax discount rate,

he made no error in failing to tax affect the expected cash-flow.

If Mr. Wilhoite’s criticism is based on his assumption that

Dr. Bajaj wrongly disregarded shareholder level taxes, then he is

in error.

            2.   Lack of Marketability Discount

     We have considered the expert testimony on the lack of

marketability issue, and we weigh that testimony in light of the

experts' qualifications and other credible evidence.     See Estate

of Newhouse v. Commissioner, 94 T.C. at 217.      While we recognize

the severity of the restrictions imposed both by law and by and

among the existing shareholders, which limited the marketability

of G&J's shares in 1992, we find Dr. Bajaj's testimony to be

thorough and more persuasive than Mr. McCoy's.     Taking account of

the inherently subjective and imprecise nature of the




12
     Thus, assume that, in consideration for today investing
$100, an investor is to receive $110 in 1 year. The interest
rate implicit in this example is 10 percent. Assume that the
investor’s return will be subject to a 40-percent tax. If the
investor considers that his after-tax return will be $106 and
assumes an after-tax discount rate of 6 percent, then the present
value of the after-tax cash flow of $106 would be $100. If, on
the other hand, the investor considers that his pretax return
will be 10 percent, then the present value of the pretax cash
flow of $110 would also be $100. Hence, there is no difference
in result.
                                   - 30 -


investigation,13 we find that an appropriate lack of

marketability discount for the gifted shares on the gift date was

25 percent.

          3.     Cost of Capital

     The final significant area of contention between the parties

is the appropriate cost of equity capital to be used for purposes

of valuing the G&J shares.    Based on the opinions of their

respective experts, petitioners and respondent assert G&J’s

appropriate cost of equity capital was 19 percent and

15.5 percent, respectively.

     It is unclear how Mr. McCoy arrived at 19 percent.

Mr. McCoy begins by stating:       “The required rate of return is

determined by comparison to rates of return on investments of

similar risk.”    He then ranks various investments by quality, as

of December 1991, beginning with long-term Government bonds and

ending with the category “extreme risk”.       One ranking consists of

“CC Bond” and “Very Small Cap. Companies”, which shows “Yield to



13
     Both parties criticize the opposing opinion evidence
testimony as being arbitrary and unsupported. Petitioners note
that, at first, Dr. Bajaj, in his report, carefully estimated a
"conservative" lack of marketability discount of 13 percent.
Then, arbitrarily, based on "several additional facts", and with
less than half a page of discussion, he "virtually doubles" his
estimate and concludes that an appropriate discount is
25 percent. Respondent, in turn, notes that the Business
Valuations report relies on studies which examined biased
statistical data, and studies which misinterpret observed
results.
                              - 31 -


Maturity” of “18+”.   The next higher ranking, “CCC Bond” and

“Small Cap. Companies” shows a “Yield to Maturity” of “21+”.

Mr. McCoy testified that he chose 19 percent because it fell

within the range of yields to maturity for very small

capitalization companies.   He also testified that he checked his

conclusion by building up the required rate of return from

various factors, including an “Expected Small Stock Risk Premium”

of 4.8 percent, the source of which, allegedly, was Stocks,

Bonds, Bills and Inflation:   1992 Yearbook, Ibbotson Associates

Inc. (1992).   It is not clear how Mr. McCoy defines "Very Small

Cap. Companies".   At trial, Mr. McCoy in fact admitted that G&J

did not fall into the Ibbotson definition of a small company.

We, therefore, have no confidence in the foundation of

Mr. McCoy's analysis on this issue.    We are not bound by the

opinion of any expert witness and will accept or reject expert

testimony in the exercise of sound judgment.    See Helvering v.

National Grocery Co., 

, 295 (1938); Estate of Hall v.

Commissioner, 

, 338 (1989).    Petitioners have not met

their burden of demonstrating that an appropriate cost of equity

capital for G&J on the gift date was 19 percent.

     We find Dr. Bajaj's testimony to be thorough and convincing.

Dr. Bajaj opined a 14.4-percent weighted average cost of capital

for G&J as of the valuation date.   He used the capital asset

pricing model to derive an appropriate cost of equity capital,
                                - 32 -


and he used G&J's real borrowing costs to derive an appropriate

cost of debt capital for G&J as of the valuation date.   Indeed,

G&J's 8.25-percent borrowing rate in 1991 was three-quarters of a

percent below the prime rate.    By the valuation date, the prime

rate had dropped to 6 percent; therefore we believe that

Dr. Bajaj's opinion errs on the generous side, if at all.    We

accord significant weight to Bajaj's opinion.

      Further, the category immediately above "Very Small Cap.

Companies" in Mr. McCoy's rankings is entitled "Small Cap.

Companies", which, according to McCoy, has a reported required

rate of return of 15 percent.    That figure is associated with a

nominal category that is not inconsistent with petitioners'

assertions (that G&J was a "small company"), and it is in harmony

with respondent's asserted value.    Therefore, we conclude that an

appropriate cost of equity capital for G&J on the gift date was

15.5 percent.

V.   Conclusion

      For the foregoing reasons, we conclude that the value of the

gifted shares on the gift date was $10,910 per share.


                                          Decisions will be entered

                                     under Rule 155.