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Estate of Harriet R. Mellinger, Hugh v. Hunter and Wells Fargo Bank, Co-Executors v. Commissioner, 6663-97 (1999)

Court: United States Tax Court Number: 6663-97 Visitors: 15
Filed: Jan. 26, 1999
Latest Update: Mar. 03, 2020
Summary: 112 T.C. No. 4 UNITED STATES TAX COURT ESTATE OF HARRIETT R. MELLINGER, DECEASED, HUGH V. HUNTER AND WELLS FARGO BANK, CO-EXECUTORS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 6663-97. Filed January 26, 1999. P died owning 2,460,580 shares of stock that were held in her revocable trust. The stock was included in her estate pursuant to sec. 2033, I.R.C. Also included in her estate, pursuant to sec. 2044, I.R.C., were 2,460,580 shares of the same stock held in a QTIP tru
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112 T.C. No. 4


                    UNITED STATES TAX COURT



           ESTATE OF HARRIETT R. MELLINGER, DECEASED,
HUGH V. HUNTER AND WELLS FARGO BANK, CO-EXECUTORS, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket No. 6663-97.                    Filed January 26, 1999.



         P died owning 2,460,580 shares of stock that were
    held in her revocable trust. The stock was included in
    her estate pursuant to sec. 2033, I.R.C. Also included
    in her estate, pursuant to sec. 2044, I.R.C., were
    2,460,580 shares of the same stock held in a QTIP trust
    established by decedent's predeceased spouse. Held:
    The shares of stock should not merge or be aggregated
    for Federal estate tax valuation purposes.



    Robert B. Martin, Jr., for petitioner.

    Donna F. Herbert and Mark A. Weiner, for respondent.
                                - 2 -


     COHEN, Chief Judge:    Respondent determined a deficiency of

$10,574,983 in the Federal estate tax of the estate of

Harriett R. Mellinger (decedent).    After concessions by the

parties, the issues remaining for decision are:

     (1) Whether section 2044 requires aggregation, for valuation

purposes, of the stock held in a trust established by decedent's

predeceased spouse under section 2056(b)(7) with stock held in

decedent's revocable trust and with stock held outright by

decedent; and

     (2) if section 2044 does not require aggregation, the fair

market value of the stock at decedent's death.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect as of the date of decedent's

death, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

                           FINDINGS OF FACT

     Some of the facts have been stipulated, and the facts set

forth in the stipulation are incorporated in our findings by this

reference.   Decedent died testate on April 18, 1993 (the

valuation date), a resident of Los Angeles, California.     Decedent

was the widow of Frederick N. Mellinger (Mr. Mellinger), founder

of Frederick's of Hollywood, Inc. (FOH).
                                 - 3 -


Stock Ownership and Valuations

     Prior to Mr. Mellinger's death, decedent and Mr. Mellinger

were husband and wife and owned as community property 4,921,160

shares of the common stock of FOH.       Such shares were held under

the terms of a revocable inter vivos trust known as the

Frederick N. Mellinger Family Trust (the family trust).

     On the death of Mr. Mellinger, under the terms of the family

trust, Mr. Mellinger left his community property interest of

2,460,580 shares of FOH stock in an irrevocable marital trust

(the QTIP trust) for the benefit of decedent during her lifetime.

Property in the QTIP trust was treated in Mr. Mellinger's estate

as "qualified terminable interest property" (QTIP property) for

which a marital deduction was claimed pursuant to section

2056(b)(7).   Hugh V. Hunter (Hunter) and Wells Fargo Bank

(referred to collectively as cotrustees and coexecutors herein)

were the cotrustees of the QTIP trust after decedent's death.

Under the terms of the QTIP trust, decedent received a qualified

income interest for her lifetime.    Upon decedent's death, the

QTIP trust provided for the payment of certain periodic and lump

sums to the adult children of Mr. Mellinger and decedent, until

they attained the age of 65, in addition to certain periodic

lump-sum payments to the grandchildren of Mr. Mellinger and

decedent, until they attained the age of 30.      Upon the final

payment to the children and grandchildren, the QTIP trust
                               - 4 -


property was to be distributed equally to certain tax-exempt

charitable organizations.   On the valuation date, the QTIP trust

held 2,460,580 shares of FOH stock, which then constituted

27.8671 percent of the issued and outstanding stock of FOH.

     After Mr. Mellinger's death, decedent removed her share of

the community property, 2,460,580 common shares of FOH, from the

family trust and contributed it to the revocable trust that she

established to be known as the Harriett R. Mellinger Revocable

Trust (the Harriett trust).   The stock that was held by the

Harriett trust also constituted 27.8671 percent of the issued and

outstanding stock of FOH.   Hunter and Wells Fargo Bank were

designated as cotrustees.   Under the terms of the Harriett trust,

upon the death of decedent, the cotrustees were directed to make

certain specific gifts and to sell decedent's personal residence

and distribute the sales proceeds to decedent's children.    The

balance of the Harriett trust was to be held for distribution

with certain annual and periodic cash amounts to be made to the

children and specified grandchildren.   Upon the death of such

children and grandchildren, the remaining trust estate was to be

distributed equally to certain charitable organizations.    At the

valuation date, decedent also owned 50 shares of FOH outright.

     Hunter and Wells Fargo Bank (coexecutors) filed a United

States Estate (and Generation-Skipping Transfer) Tax Return, Form

706, for decedent's estate on January 18, 1994.   On the return,
                               - 5 -


the FOH shares in the Harriett trust were reported at a value of

$11,786,178 or $4.79 per share, and the FOH shares in the QTIP

trust, includable in decedent's estate pursuant to section 2044,

were reported at a value of $11,786,178 or $4.79 per share.    In

valuing the shares of FOH, the coexecutors consulted legal

counsel and obtained two appraisals.   The appraisers that were

employed by the coexecutors were the investment firm of Janney

Montgomery Scott, Inc. (JMS), and the appraisal firm of

Willamette Management Associates (WMA).   Each appraisal valued

the shares as separate 27.8671-percent interests in FOH.   The

appraisals concluded that, because of the size of the blocks

under consideration in relation to the trading volume, petitioner

would not be able to sell the holdings in the public market

without incurring a blockage discount.    The WMA appraisal valued

the shares at $4.85 per share, after applying a 30-percent

discount, and the JMS appraisal valued the shares at $4.79, after

applying a 31-percent discount.   Based on the appraisals, the

estate valued the shares on its United States Estate Tax Return

at $4.79 per share.

     In October 1993, FOH filed an Amendment to its Certificate

of Incorporation (amendment) resulting in a redesignation of the

existing capital stock as class A capital stock and the creation

of a new class of nonvoting capital stock designated as class B

capital stock.   In connection with the amendment, the existing
                               - 6 -


FOH capital stock was split at the rate of one share for every

three shares outstanding.   At the same time, FOH declared a

distribution in the form of a dividend of two shares of class B

capital stock for every one share of class A capital stock

outstanding on October 15, 1993.   The effect of the amendment,

split, and dividend was to convert each three existing shares of

FOH capital stock into one share of class A capital stock and two

shares of class B capital stock.   As a consequence of the

recapitalization of FOH, except as set forth below, all rights to

vote were exclusively vested in the class A capital stock.     The

holders of class B capital stock were entitled to vote separately

as a class only with respect to designated issues.    In addition,

the trusts were prohibited from selling any of the class B

capital stock for a 2-year period at a price of less than $7.00

per share.

     Subsequently, the coexecutors undertook efforts to sell the

FOH stock that was held by the trusts in order to raise funds for

the payment of Federal estate tax and to provide funds for the

required distributions.   Accordingly, pursuant to a stock

purchase agreement dated January 12, 1994, the FOH Employee Stock

Ownership Plan (FOH ESOP) purchased 357,143 shares of FOH class A

capital stock from the Harriett trust for $4.20 per share, a

30-percent discount from the closing price of such stock on the

New York Stock Exchange (NYSE) on January 10, 1994.   In
                               - 7 -


establishing the value of these shares, the FOH ESOP relied on an

appraisal by JMS that expressed an opinion that the appropriate

discount for the transaction was between 29 and 31 percent.

Thereafter, on February 18, 1994, the Harriett trust sold, in a

market transaction on the NYSE, in conformity with Securities and

Exchange Commission (SEC) Rule 144, 29,500 shares of FOH class B

capital stock at a price of $4.875 per share.   The aggregate

gross proceeds of the sale received by the Harriett trust were

$147,492.71.

     On June 14, 1996, FOH, the Harriett trust, and the QTIP

trust jointly announced their employment of JMS to sell the FOH

stock owned by the trusts and possibly to sell all of the shares

of FOH.   After holding discussions with numerous prospective

purchasers, Knightsbridge Capital Corporation (Knightsbridge)

submitted a formal offer to purchase all of the outstanding

shares of FOH for not less than $6.00 and not more than $6.25 per

share and to merge with FOH.   The offer was dated April 9, 1997.

The board of directors of FOH determined that this merger was in

the best interest of FOH and the stockholders and approved the

transaction.   Thereafter, the board of directors mailed consent

agreements to all shareholders requesting approval for the

proposed merger.   Approximately 88 percent of FOH stockholders,

including the trusts, voted in favor of the merger.   After

negotiating the price, Knightsbridge and FOH entered into an
                               - 8 -


agreement dated September 25, 1997.    Pursuant to this agreement,

Knightsbridge purchased from the Harriett trust and the QTIP

trust, all of the FOH shares that were held by the trusts for

$6.90 per share.   Immediately thereafter, pursuant to the merger

agreement, Knightsbridge acquired the remaining outstanding

shares of FOH from the remaining shareholders for $7.75 per

share.

     On examination, respondent determined that the FOH shares

that were held by the Harriett trust and the QTIP trust should be

merged for valuation purposes, and, in the January 15, 1997,

notice of deficiency, respondent indicated that the FOH shares in

each trust should be valued at $20,820,159.39 or $8.46 per share.

Overview of FOH

     Founded in 1946 by Mr. Mellinger and incorporated in

Delaware in 1962, FOH began as a small mail-order operation

selling an assortment of intimate women's apparel.   In 1947, the

business was moved to Hollywood, California, opening its first

retail store there in 1952.   In its beginning, FOH's name was

synonymous with risque lingerie.   The company's original market

was American GI's who, after spending time abroad, were eager to

get for their wives or girlfriends the lingerie that was

fashionable in Europe.   FOH pioneered many trends in the industry

including the extensive use of black, the pointy snow-cone bras

of the 1950's, and the revival of garter belts in the 1980's.
                                - 9 -


The company's products had the reputation of being "slightly

naughty" but not offensive, and this style proved to be highly

successful in the 1960's and 1970's.

     By the early 1980's, however, the risque look of FOH's

products began losing appeal.   These trends caught FOH off guard,

and the company's operations began to falter.     At the same time,

Mr. Mellinger developed Alzheimer's disease.     He retired in 1984

with FOH's profits dwindling.   Under new management, FOH enacted

a plan to turn the company around.      The company's catalogs were

purged of nudity, and the black and white pictures were replaced

with color photographs of models.    On the retail store side, a

major overhaul was also enacted.    The company spent heavily to

upgrade store ambience and to improve the merchandise mix.

     All of these steps successfully repositioned FOH as a

specialty retailer of intimate apparel.     The company operates 206

specialty boutiques in 39 States with the highest concentration

of stores in California.   FOH developed a mail-order subsidiary

to engage in extensive operations in all 50 States, with catalogs

published 11 times a year.

     For convenience, the following chart shows the net sales,

net earnings, earnings per share, total assets, and equity of FOH

for the fiscal years ended September 1, 1990; August 31, 1991;

August 29, 1992; and August 28, 1993.
                                      - 10 -


Year    Net Sales      Net Sales        Net       Earnings      Total
 End     Retail         Catalog      Earnings    Per Share     Assets        Equity
1990   $98,573,000*                 $4,242,000     $.50      $35,031,000   $21,855,000
1991    70,938,000    $43,196,000   5,197,000       .58      39,935,000    26,992,000
1992    71,320,000    45,710,000    5,073,000       .57      45,790,000    32,304,000
1993    73,202,000   55,314,000     4,737,000       .53      50,838,000    36,615,000
*Total Net Sales for 1990

       At the valuation date, FOH had one class of stock

outstanding that traded on the NYSE, and those shares were

unregistered with the SEC.          Additionally, on the valuation date,

the average price of FOH stock on the NYSE was $6.9375 per share.

Economic Conditions at the Valuation Date

       At the valuation date, the American economy was experiencing

a transition from recession to a recovery.                The United States

gross domestic product (GDP) grew 2.1 percent in 1992 following

the 1991 recession.       Economic improvements had generally been

fueled by low interest rates, increasing corporate profits and

strong productivity growth.          Despite these positive factors,

structural problems, including excessive debt, corporate

restructuring and related uncertainties regarding job growth,

overvalued real estate, weak banks, defense spending reductions,

and consumer confidence continued to hamper the strength and

speed of the recovery.

       A survey of economists by the Wall Street Journal in early

1993 revealed a consensus estimate of 3-percent GDP growth rate

for 1993, with 2.8-percent growth rate expected in the first
                                - 11 -


half.     This rate represents continued moderate growth but is

below that normally experienced in postrecessionary years.

Nondurable goods expenditures advanced 5.9 percent in 1992 after

falling 5.6 percent in 1991.

     The California marketplace did not experience the rebound

seen in the majority of the nation in 1992.     Its economy

continued to be impacted negatively by defense industry layoffs

and a declining housing market.     The Wall Street Journal reported

that the California economy was expected to continue to trail far

behind the rest of the United States in 1993.

                       ULTIMATE FINDINGS OF FACT

     The fair market value of FOH shares includable in decedent's

gross estate should reflect a 25-percent discount for lack of

marketability.     On the valuation date, the fair market value of

each of the two 27.8671-percent interests in FOH that were held

by the trusts was $12,802,705, or $5.2031 per share.

                                OPINION

Issue 1

        Section 2031 generally provides that the value of a

decedent's gross estate includes the value of property described

in sections 2033 through 2044.     See sec. 20.2031-1(a), Estate Tax

Regs.     Under section 2033, the value of a decedent's gross estate

includes the value of all property beneficially owned by the

decedent at the time of death.     See sec. 20.2033-1(a), Estate Tax
                               - 12 -


Regs.    Section 2044(a) includes in the gross estate the value of

property in which the decedent had a qualified income interest

for life and for which a marital deduction was allowed to the

estate of a predeceased spouse under section 2056(b)(7) (QTIP

property).    Accordingly, at the death of the second spouse, QTIP

property is taxed as part of the surviving spouse's estate.

Sec. 2044(c).

     Property includable in the gross estate is generally

included at its fair market value on the date of a decedent's

death.    Sec. 2031(a); sec. 20.2031-1(b), Estate Tax Regs.   Fair

market value is defined as the price that a willing buyer would

pay a willing seller, both persons having reasonable knowledge of

all of the relevant facts and neither person being under a

compulsion to buy or sell.    United States v. Cartwright, 
411 U.S. 546
, 551 (1973); sec. 20.2031-1(b), Estate Tax Regs.    The willing

buyer and the willing seller are hypothetical persons, rather

than specific individuals or entities, and the individual

characteristics of these hypothetical persons are not necessarily

the same as the individual characteristics of the actual seller

or the actual buyer.    Propstra v. United States, 
680 F.2d 1248
,

1252 (9th Cir. 1982).    The issue in this case is whether FOH

shares in the Harriett trust should be aggregated with FOH shares

in the QTIP trust for purposes of ascertaining the fair market

value of property passing from decedent.
                              - 13 -


     Historically, undivided fractional interests in property

included in an estate have been valued at a discount to reflect

lack of marketability and minority interest holdings.   See Estate

of Andrews v. Commissioner, 
79 T.C. 938
, 952-953 (1982) (minority

interests); Estate of Piper v. Commissioner, 
72 T.C. 1062
, 1084-

1086 (1979) (marketability discount).   Respondent, however, has

long opposed such discounts and has argued for unity of ownership

principles in estate tax cases.   See, e.g., Estate of Bonner v.

United States, 
84 F.3d 196
, 198 (5th Cir. 1996); Propstra v.

United 
States, supra
at 1251; Estate of Bright v. United States,

658 F.2d 999
, 1001 (5th Cir. 1981); Estate of Andrews v.

Commissioner, supra
at 952-956.   Specifically, respondent has

argued that a decedent's fractional interest in property should

be aggregated with fractional interests owned by family members

in the same property for purposes of valuing the property in the

estate.   Propstra v. United 
States, supra
at 1251; Estate of

Bright v. United 
States, supra
at 1001; Estate of Andrews v.

Commissioner, supra
at 952.   Respondent's basis for this position

was that such undivided fractional interests should be valued by

taking into consideration family cooperation and the likelihood

that fractional interests will be sold together rather than

separately.   See Propstra v. United 
States, supra
at 1251; Estate

of Andrews v. 
Commissioner, supra
at 952.   Respondent relied on

this argument despite section 20.2031-1(b), Estate Tax Regs.,
                               - 14 -


which ignores subjective factors of ownership in valuing estate

assets.   Estate of Bonner v. United 
States, supra
at 198.

Ultimately, respondent reviewed this position and conceded that,

for estate tax purposes, respondent would follow Estate of Bright

v. United 
States, supra
, and Propstra v. United 
States, supra
,

where family attribution had been rejected.   See Rev. Rul. 93-12,

1993-1 C.B. 202.

     The Court of Appeals for the Ninth Circuit addressed

respondent's aggregation theory in Propstra v. United 
States, supra
.    In Propstra, the decedent died with an undivided one-half

interest in several parcels of real estate owned by him and his

wife as community property.   These parcels of community property

had an undisputed fair market value of $4,002,000, but, in

valuing the property for estate tax purposes, the executrix

discounted the fair market value of the decedent's one-half

interest by 15 percent to account for the relative

unmarketability of the decedent's undivided fractional interest.

The Commissioner disallowed the 15-percent discount, arguing that

the decedent's interest in the property should be valued together

with the interest owned by the surviving spouse.   "[O]ne can

reasonably assume that the interest held by the estate will

ultimately be sold with the other undivided interest and that

interest's proportionate share of the market value of the whole

will thereby by realized."    
Id. at 1251.
                               - 15 -


     The Court of Appeals for the Ninth Circuit considered the

language of sections 2031 and 2033, along with the accompanying

regulations, and decided that Congress did not intend to have

"unity of ownership" principles apply to property valuation for

estate tax purposes.   
Id. The court
stated:

     By no means is * * * [the language of section 20.2031-
     1(b)] an explicit directive from Congress to apply
     unity of ownership principles to estate valuations. In
     comparison, Congress has made explicit its desire to
     have unity of ownership or family attribution
     principles apply in other areas of the federal tax law.
     See, e.g., I.R.C. secs. 267, 318, and 544. In the
     absence of similarly explicit directives in the estate
     tax area, we shall not apply these principles when
     computing the value of assets in the decedent's estate.
     [
Id. at 1251.
]

The court concluded that the decedent's fractional interest in

the subject property should be valued separately from the

accompanying fractional interest held by the surviving spouse,

upholding the 15-percent discount.      
Id. at 1253.
     Respondent argues that decedent's situation is

distinguishable from Propstra because all of the property to be

aggregated in this case is included in decedent's estate.    The

FOH shares in the Harriett trust are included pursuant to section

2033, and FOH shares in the QTIP trust are included pursuant to

section 2044.   Thus, respondent contends that decedent is

considered to be the owner of all of these shares outright for

purposes of valuation, in which case the shares should be valued

as one 55.7-percent ownership block.     Respondent concludes that,
                               - 16 -


because the aggregate ownership in decedent's estate represents a

controlling interest in FOH, the shares should be valued at a

premium rather than at a discount.

     Section 2044 was added to the Code in conjunction with

section 2056(b)(7) in 1981.    Economic Recovery Tax Act of 1981,

Pub. L. 97-34, sec. 403(d), 95 Stat. 172, 302.   Under section

2056(b)(7), the decedent is entitled to a marital deduction for

transfers of QTIP property to the surviving spouse at the

decedent's death.    The surviving spouse has a lifetime interest

in the QTIP property, and, upon the death of the surviving

spouse, the property passes to beneficiaries designated by the

decedent.   Accordingly, the first spouse to die can postpone

Federal estate tax that would otherwise be due on the QTIP

property while also retaining control over the ultimate

disposition of it.   Sec. 2056(b)(7).   Inclusion in the estate of

the second spouse to die, however, is the quid pro quo for

allowing the marital deduction for the estate of the first spouse

to die.

     The purpose of section 2044 is to provide for the taxation

of QTIP property upon the death of the second spouse.   That

section provides, in pertinent part, that "The value of the

[surviving spouse's] gross estate shall include the value of

property * * * [for which a deduction was allowed with respect to

the transfer of such property to the surviving spouse under
                               - 17 -


section 2056(b)(7) and in] which the * * * [surviving spouse] had

a qualifying income interest for life."    Sec. 2044(a).   This

property is "treated as property passing from the" surviving

spouse, sec. 2044(c), and is taxed as part of the surviving

spouse's estate at death, but QTIP property does not actually

pass to or from the surviving spouse.

     Respondent argues that decedent should be treated as the

owner of QTIP property for valuation purposes.    Respondent has

identified nothing in the statute that indicates that Congress

intended that result or that QTIP assets should be aggregated

with other property in the estate for valuation purposes.     Cf.

secs. 267, 318, 544 (indicating aggregation of interests in terms

of ownership).    Furthermore, at no time did decedent possess,

control, or have any power of disposition over the FOH shares in

the QTIP trust.    Cf. secs. 2035, 2036, 2041 (requiring inclusion

in the gross estate where a decedent had control over the assets

at some time during her life).

     Section 2044 was amended by the Technical Corrections Act of

1982, Pub. L. 97-448, sec. 104(a)(1)(B), 96 Stat. 2365, 2380.

The legislative history accompanying that amendment provides no

additional guidance on whether the interests involved in this

case should be aggregated.    Rather, "The bill clarifies that QTIP

property included in a deceased donee spouse's estate is treated

as passing from that spouse, for purposes of the estate tax,
                              - 18 -


including the charitable and marital deductions."      S. Rept.

97-592, at 20 (1982), 1983-1 C.B. 475, 483.     In addition, the

legislative history to the amendment does not suggest that

Congress intended that section 2044 property be treated as being

owned by the second spouse to die for purposes of aggregation and

does not provide for aggregation with other fractional interests

in the same property included in the decedent's estate under

section 2033.   Neither section 2044 nor the legislative history

indicates that decedent should be treated as the owner of QTIP

property for this purpose.

     In Estate of Bonner v. United 
States, 84 F.3d at 198
, the

decedent died owning fractional shares in several pieces of real

property with the remaining ownership interests being held in a

QTIP trust established by his wife at her death.     As provided in

section 2044, the interest that was held by the QTIP trust was

included in the decedent's estate.     The fractional shares that

were owned outright by the decedent were also included in the

decedent's estate pursuant to section 2033.     The executor of the

decedent's estate, however, valued each interest separately with

a 45-percent discount.   The Government argued that the fractional

interests in the real property should be aggregated for valuation

purposes.

     The Court of Appeals, relying on its prior holding in Estate

of Bright v. United 
States, 658 F.2d at 1001
, concluded that the
                               - 19 -


fractional interests in the assets should not merge into a

100-percent fee ownership by the estate.   The court stated that

"the statute does not require, nor logically contemplate that in

so passing, the QTIP assets would merge with other assets."

Estate of Bonner v. United 
States, supra
at 198.     The court also

relied on the decedent's lack of control over the disposition of

property.   
Id. at 198-199.
  The court stated:

     The estate of each decedent should be required to pay
     taxes on those assets whose disposition that decedent
     directs and controls, in spite of the labyrinth of
     federal tax fictions. * * * Mrs. Bonner controlled
     the disposition of her assets, first into a trust with
     a life interest for Bonner and later to the objects of
     her largesse. The assets, although taxed as if they
     passed through Bonner's estate, in fact were controlled
     at every step by Mrs. Bonner, which a tax valuation
     with a fractional interest discount would reflect. At
     the time of Bonner's death, his estate did not have
     control over Mrs. Bonner's interests in the assets such
     that it could act as a hypothetical seller negotiating
     with willing buyers free of the handicaps associated
     with fractional undivided interests. The valuation of
     the assets should reflect that reality. [Id. at 199.]

     Respondent also argues that, in enacting sections 2056(b)(7)

and 2044, Congress did not intend to alter the estate tax

consequences that would otherwise arise if a decedent had

transferred property to his or her surviving spouse outright.

See H. Rept. 97-201, at 160 (1981), 1981-2 C.B. 352, 378 ("tax

laws should be neutral and * * * tax consequences should not

control an individual's disposition of property").    Prior to the

enactment of sections 2056(b)(7) and 2044, for the first spouse
                              - 20 -


to get the full marital deduction, the decedent had to leave

property to the surviving spouse outright or had to leave

property to the surviving spouse in trust with a general power of

appointment.   In either situation, the decedent's property was

aggregated with the property of the surviving spouse for

valuation purposes when the surviving spouse died.   Accordingly,

respondent concludes that property in the QTIP trust should be

aggregated with the FOH shares in the Harriett trust for purposes

of determining the fair market value of the FOH stock.

     Section 2044 was designed to prevent QTIP property from

escaping taxation by including it in the estate of the second

spouse to die.   There is, however, no indication that section

2044 mandated identical tax consequences as an outright transfer

to the surviving spouse.

     Finally, respondent argues that section 2044(c) is a

valuation section, rather than just an inclusion section.    See

Estate of Young v. Commissioner, 
110 T.C. 297
, 308-309 (1998).

In Estate of Young, we held that section 2040 provides an

"artificial inclusion" of joint tenancy property, the entire

value less any contribution by the surviving joint tenant.     
Id. at 315.
  We rejected the taxpayer's contention that section 2040

was merely an includability section because Congress had provided

an explicit approach to valuing joint tenancy property to be

included in the decedent's gross estate.   
Id. at 315-316.
  Thus,
                               - 21 -


the entire value of the joint tenancy was included in the estate

except for that portion attributable to the consideration

supplied by the surviving joint tenant.   Respondent argues that

section 2044 provides a similar "artificial inclusion" for the

assets held in the QTIP trust, concluding that the analysis in

Estate of Young compels a valuation of the FOH shares as if

decedent owned the whole block.

     Section 2040(b) explicitly sets forth a special rule of

valuation for joint tenancy property, but this special rule only

applies to section 2040; section 2044 contains no such directive.

The absence of such language in section 2044, which was enacted

in the same tax act as section 2040(b), belies respondent's

argument that Congress mandated or intended a special rule of

valuation to apply to property included in a decedent's estate

pursuant to section 2044(a).

Issue 2

     Based on our conclusion that the two blocks of FOH shares

should not be aggregated, we must determine the fair market value

of the FOH stock at decedent's death.

     Valuation is a question of fact, so we must weigh all

relevant evidence to draw the appropriate inferences.   Ahmanson

Found. v. United States, 
674 F.2d 761
, 769 (9th Cir. 1981);

Estate of Andrews v. Commissioner, 
79 T.C. 940
.   The fair

market value of stock listed on an established securities market
                               - 22 -


is the mean between the highest and lowest selling prices on the

valuation date.   Sec. 20.2031-2(b)(1), Estate Tax Regs.   A

blockage discount may, however, be applied when the block of

stock to be valued is so large that it cannot be liquidated in a

reasonable time without depressing the market.    Sec. 20.2031-

2(e), Estate Tax Regs.    The concept of blockage is essentially

one of timing.    See Estate of Smith v. Commissioner, 
57 T.C. 650
,

657-658 (1972), affd. 
510 F.2d 479
(2d Cir. 1975).

     Petitioner has the burden of proof as to the correctness and

amount of the discount.    Rule 142(a); Estate of Van Horne v.

Commissioner, 
720 F.2d 1114
, 1117 (9th Cir. 1983), affg. 
78 T.C. 728
(1982).   This burden is a burden of persuasion, requiring

petitioner to prove the merits of its claim by at least a

preponderance of the evidence.    Rockwell v. Commissioner, 
512 F.2d 882
, 885 (9th Cir. 1975), affg. T.C. Memo. 1972-133;

Brumley-Donaldson Co. v. Commissioner, 
443 F.2d 501
, 504 n.4 (9th

Cir. 1971), affg. T.C. Memo. 1969-183.

     Both parties rely extensively on expert testimony to

establish the amount of the discount.    Expert opinions are

admissible if they will assist the trier of fact to understand

evidence that will determine a fact in issue.    Fed. R. Evid. 702.

We evaluate the opinions of experts in light of the demonstrated

qualifications of each expert and all other evidence in the

record.   Parker v. Commissioner, 
86 T.C. 547
, 561 (1986).
                              - 23 -


However, we are not bound by the opinion of an expert witness,

especially when such opinions are contrary to our judgment.    IT&S

of Iowa, Inc. v. Commissioner, 
97 T.C. 496
, 508 (1991).    Where

experts offer divergent estimates of fair market value, we decide

what weight to give those estimates by examining the factors used

by those experts to arrive at their conclusions.   Casey v.

Commissioner, 
38 T.C. 357
, 381 (1962).   While we may accept the

opinion of an expert in its entirety, Buffalo Tool & Die

Manufacturing Co. v. Commissioner, 
74 T.C. 441
, 452 (1980), we

may be selective and use only part of such an opinion.     Parker v.

Commissioner, supra
.   We may also reach a determination of value

based on our own examination of the evidence in the record.

Estate of Davis v. Commissioner, 
110 T.C. 530
, 538 (1998).

     The parties in this case agree that the undiscounted fair

market value of the FOH shares on the valuation date is $6.9375

per share.   The parties also agree that a marketability discount

is necessary if the shares are not to be aggregated.   They

disagree, however, as to the appropriate marketability discount

to be applied.   Respondent contends that the minority blocks of

FOH should be valued at $5.8969 per share, a 15-percent discount.

Petitioner argues that the shares of FOH have a value of $4.786

per share, a 31-percent discount.   Petitioner supports its

conclusion with the testimony of Curtis R. Kimball (Kimball) and

Ira M. Cotler (Cotler).
                              - 24 -


     Kimball focused on the following methods of disposition to

determine the fair market value of the minority blocks of FOH

stock:   (1) "Synthetic" put option analysis, (2) public secondary

offering, and (3) private placement analysis.   Kimball explained

that the holder of a significant block of shares, such as the FOH

block, would be exposed to significant risks when attempting to

dispose of the shares in the public market.   According to

Kimball, the blocks may represent several weeks or months of

trading volume, exposing the seller to fluctuations in the market

stock price.   He explained that a method of eliminating such risk

is to buy put option contracts granting the seller the right to

sell the shares at a fixed price over a predetermined period.

Hence, for a price, the seller would eliminate the risk of

downward stock price movement over the disposition period.   This

approach is called a synthetic option analysis because FOH stock

had no actual public market for any options or warrants in

existence on the valuation date.   Kimball estimated the expense

necessary to enter into such options for blocks of FOH stock

using several econometrics and theoretic option pricing models,

including the Black-Scholes model, the Noreen-Wolfson model, and

the Shelton model.   He settled on $4.50 per share, a discount of

roughly 35 percent, as the most appropriate value.   In coming to

his conclusion, Kimball indicated that he placed more weight on

the Shelton model because of his greater confidence in the
                               - 25 -


ability of that model to deal with longer holding period option

values.

     Kimball admitted at trial that his synthetic put option

analysis was flawed.   In his report, he concluded that the price

of FOH shares should be valued in a range of $3.545 to $5.166 per

share.    However, cross-examination of Kimball indicated several

mathematical errors in his calculations of the Black-Scholes and

Noreen-Wolfson models that are intended to estimate the expense

necessary to enter into put options.     Respondent also pointed out

that there was an alternative calculation of the Shelton model.

After the adjustments, the new range in price for FOH shares

using the put option methodology was between $5.689 and $5.9372,

indicating a discount range of between 14.4 and 18 percent.

     Second, Kimball analyzed the secondary offering approach to

valuation.    As part of his research, Kimball reviewed various

studies that were performed to analyze the costs of a secondary

offering and similar transactions.      Using this approach, Kimball

concluded that the fair market value for the subject FOH shares

was between $5.286 and $5.037 per share.     He noted that the risks

of an unsuccessful secondary offering factored into his

determination of where, within this range, FOH shares would be

priced.    He selected a fair market value of $5.10 per share, a

discount of about 26.5 percent, as the appropriate value under

this approach.
                                - 26 -


     Kimball made no effort to compare the subject transaction to

transactions within the secondary offering studies that have

similar characteristics, such as where the stock is traded,

revenues, sales, and similar factors indicating analogous

transactions.   Instead, he relied primarily on the mean and

median discounts of each study.    Petitioner admits on brief that

Kimball relied very little on the secondary offering approach and

concedes that Kimball relied most heavily on the private

placement analysis in coming to his conclusion.

     Kimball used the primary body of empirical evidence

concerning private placement data, as found in studies of

restricted stocks, to analyze the private placement market.

Kimball concluded that various surveys reviewed by him indicated

a cumulative average discount of 35 percent for restricted stock

in a publicly traded company.    He ultimately concluded that a

32-percent discount was appropriate considering the combined

influences of all of the relevant factors under this approach.

Applying the 32-percent discount to the market price on the

valuation date results in a fair market value of $4.72 per share.

     Petitioner also offered the expert testimony of Cotler to

establish the applicable discount.       Cotler testified that he

analyzed numerous studies to determine the appropriate discount

for lack of marketability.   From these studies, Cotler observed

that there was a mean discount of 34.73 percent for lack of
                              - 27 -


marketability.   Cotler indicated that the discount is most

sensitive to block size.   For example, a block of stock that

represented 39 percent of the outstanding shares averaged a

38.7-percent discount.   Cotler further testified that, in order

to value properly the FOH stock, there must be a thorough

analysis of FOH's operations, the markets it serves, and the

characteristics of the FOH stock held by the trusts.

     Cotler expressed an opinion that, at the valuation date, FOH

was experiencing an accelerating negative financial performance.

Cotler also noted that a large factor influencing the negative

results of FOH could be related to the U.S. economy and the

recession in California at the valuation date.   Cotler also

testified that consumer confidence was dropping in the fourth

quarter of 1992 and that the retail sector was anticipating a

difficult year with continued discounting of merchandise likely

in order for retailers to maintain sales levels.

     Cotler opined that the declining interest in FOH common

stock was likely attributable to a number of factors, the most

significant being the continuing decline in FOH's operating

performance and the low expectations of a near-term turnaround.

From an analysis of the common stock trading patterns, he

concluded that there was a relatively low level of investor

interest in FOH, and selling a large block of FOH common stock

would be very difficult.   Cotler further observed that the FOH
                                - 28 -


stock in issue represented a significant percentage of the

then-outstanding shares, 27.8 percent.     With the average volume

during the first 6 months of 1993 at 5,197, Cotler concluded that

it was improbable that the FOH stock could have been sold in the

public market within a reasonable time frame.

     Cotler pointed to the size of the block, FOH's recent and

expected financial performance, and the overall trading

characteristics of the FOH common stock as reasons why it would

be difficult to sell the FOH stock at a price equal to the

publicly traded common stock.    Based upon this analysis, his

experience as an investment banker, and other information

available to him, Cotler concluded that the fair market value of

the FOH stock at the valuation date should be $4.79, a 31-percent

discount.

     Respondent determined that the value of the blocks of FOH

shares that were held in the trusts must be discounted between

10 and 17 percent to reflect the lack of marketability.

Respondent supports this determination with the expert testimony

of David N. Fuller (Fuller).

     Fuller agreed with petitioner's experts that a discount for

lack of marketability was appropriate when disposing of the

separate minority interests in FOH.      He testified that there were

three viable options for selling the separate blocks of FOH

stock:   (1) A registered secondary offering, (2) a private
                               - 29 -


placement of the stock, or (3) a periodic sale subject to volume

restrictions under SEC rule 144.   With respect to the registered

secondary offering, Fuller testified that a discount between

10 and 13 percent was warranted.   He also testified that, under a

periodic sale subject to SEC rule 144, the minority interests in

FOH should be discounted between 13 and 17 percent.   However,

Fuller ultimately dismissed these options concluding that none

were viable and that the private placement analysis was the

exclusive means by which to value the blocks of FOH stock.

Specifically, Fuller testified that a secondary offering was not

feasible because it would require the consent of FOH management.

Likewise, he concluded that it would take 7 years to liquidate

the stock under the periodic sales method, rendering that means

of disposition inadequate.

     Instead, he concluded that a private placement was the

likely means of disposition.   In calculating the discount for a

private placement of FOH stock, Fuller indicated that holding

period restrictions were the primary reason for the discount.    To

ascertain the applicable discount, Fuller reviewed several

restricted stock studies on private placement transactions.

Fuller recognized that the combined results of these studies

indicated a 35-percent marketability discount.   He, however,

concluded that the studies suffer because they review only

restricted share transactions and do not include a sample of
                               - 30 -


similar private placement block sales of registered shares.     In

contrast, Fuller relied on a study that analyzed 106 private

placement transactions of both restricted and registered shares.

This study concluded that discounts were required by private

placement investors because of information costs that they bore

in investigating the value of shares in the issuing firms as well

as from anticipating "monitoring costs" associated with the

investment (i.e., assistance in the formulation of management

policy and oversight of existing management).   He noted that the

sale of restricted shares rather than registered shares in

private placements resulted in a discount of 13.5 percent.

     Fuller also used a study being conducted by Business

Valuation Services, Inc. (BVS), his firm, as a "sanity check".

The study analyzed private placement transactions and revealed,

after an analysis of 51 transactions, a mean discount of

16.2 percent.    Fuller pointed out that, for private placements of

companies with market capitalizations greater than $50 million,

BVS observed an average discount of 11.1 percent, and, as of the

valuation date, the market capitalization of FOH was

$61.3 million.   For companies with annual sales greater than

$100 million, BVS observed an average discount of 7.2 percent,

and, for the 12-month period ended February 27, 1993, FOH had

sales of $125.5 million.
                              - 31 -


     Fuller concluded that a prudent investor would select the

private placement alternative and that, under that analysis, the

FOH shares should be valued at $5.8969 per share, a blockage

discount of 15 percent.   Accordingly, each block of 2,460,580

shares of FOH would be valued at $14,509,794.

     Fuller relied almost exclusively on the private placement

analysis that hinged on a single study.   In so doing, he rejected

an entire body of restricted stock studies covering an extensive

time span.   Fuller applied a 13.5-percent discount to the market

price of freely tradeable stock sold on the public market.   The

study on which he relied, however, found that the discount for

restricted stock, when compared with freely tradeable stock sold

in a public market, averaged 42 percent of the market price.

     Petitioner points to the subsequent sales of FOH shares by

the trusts, arguing that, although fair market value is

determined as of the date of death, consideration is given to

comparable sales occurring subsequent to the valuation date for

purposes of determining fair market value.   Estate of Jung v.

Commissioner, 
101 T.C. 412
, 431 (1993).   Petitioner concludes

that, because the sales by the trusts were consistent with the

valuations by Kimball and Cotler, the sales corroborate the value

claimed by petitioner and are substantial evidence of the fair

market value of the FOH stock on the valuation date.
                                - 32 -


     The sale of FOH stock by the Harriett trust to the FOH ESOP

for a price of $4.20 per share, which represented a discount of

30 percent from its then-closing price on the NYSE, occurred

9 months after the valuation date.       Respondent argues that this

was not a sale to a third party, so it should not be taken into

consideration in valuing the stock.      In any event, this sale was

of class A capital stock after the amendment to the articles of

incorporation that altered the capital structure of FOH.      After

the amendment, there were two classes of stock, one with voting

rights and the other without.    Neither party addressed how this

fact affects the valuation.   Thus, we are cautious in assigning

weight to this transaction.

     The market transaction in which the Harriett trust sold

29,500 shares of FOH stock at $4.875 per share on February 18,

1994, does not support petitioner's contentions, because those

shares sold for the undiscounted price at which the stock was

trading on the NYSE on that day.

     On the record before us, we are satisfied that the

respective discounts as determined by the experts set the

appropriate range from which we may determine the marketability

discount.   We also conclude, however, that each expert excluded

information that contradicted his result.      Only Cotler addressed

the specifics of FOH's financial situation in detail, but he

relied on mean discounts without relating them to those details.
                                - 33 -


Fuller relied on a single method, and we are not persuaded that

his method is the only one that would be considered by

hypothetical buyers and sellers.    Kimball provided several

logical methods but failed to implement them correctly.    On

cross-examination, he made several concessions about his use of

survey data as well as his errors in application of the formulas

he used.

     We conclude that the discount claimed by petitioner is

necessarily overstated, but the discount asserted by respondent

is inadequate.    Weighing the expert opinions and the evidence on

which they rely, we have more confidence in the methods of

petitioner's experts but must adjust their conclusions to reflect

their weaknesses.    We bear in mind that valuation is necessarily

an approximation and a matter of judgment rather than

mathematics.     Estate of Davis v. Commissioner, 
110 T.C. 530
, 554

(1998).    Based on our examination of the entire record in this

case, we conclude that the marketability discount should be

25 percent.    We thus have found that, on the valuation date, the

fair market value of each of the two 27.8671-percent interests in

FOH that were held by the trusts was $12,802,705, or $5.2031 per

share.
                        - 34 -


To reflect the foregoing,

                                  Decision will be entered

                             under Rule 155.

Source:  CourtListener

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