Valuing a decedent's closely held stock.

A contentious issue in estate taxation is the valuation of stock in a closely held corporation. The fair value of such stock at the valuation date may be difficult to determine since no market quotations are available. Treasury regulations section 20.2031-2(f) and revenue ruling 59-60 (1959-1 CB 237) lists factors CPAs can consider in determining the value for estate tax purposes. Generally, the value would be what a willing buyer would pay to receive the economic benefits attached to that amount of stock.

J.R. Simplot Co. is a family-owned corporation that processes and sells frozen food, fertilizer and cattle. The company also owns stock in Micron Technology, Inc. Simplot has two classes of common stock, A and B, which are held by family members, family trusts and an employee-stock-ownership plan. Although only class A stock has voting rights, both classes have the dividend rights (none has ever been declared), and class B stock has a slight liquidation advantage. Class A stock has a transfer restriction of 180 days during which the company may buy the stock and another 180 days in which other class A stockholders may purchase the stock before a shareholder can sell it to an outsider.

At the time of his death in 1993, Richard R. Simplot owned 23.55% of the 76.445 shares of class A stock and 2.79% of the 141,288.584 shares of class B stock. His estate hired Morgan Stanley & Co. to ascertain the stock's value for estate tax purposes. Morgan Stanley determined a value of $2,650 per share. Because the decedent held only a minority interest in class A stock, it was assigned the same per-share value as the class B stock. The IRS determined a value of $801,994 per share of class A stock and $3,585 per share of class B stock and assessed a tax deficiency of $17,662,886 and penalties of $7,057,554. The estate petitioned the Tax Court for review.

After hearing from valuation experts for both the IRS commissioner and the estate, the Tax Court reached its own value determination, adding a premium to the class A stock equal to 3% of the equity value ($830 million) of the company. The court based its decision on the presumption that class A stock, as voting stock, had the potential to influence and control the company. The court then allocated the total premium equally to all class A shares, resulting in a per-share value of $331,595.70, subject to a 35% discount for lack of marketability. The court created several specific scenarios to support the idea that a willing buyer might pay such a premium to obtain the decedent's 18 shares of class A stock. The Tax Court waived penalties, but assessed a deficiency of $2,162,052. The estate appealed to the Ninth Circuit Court of Appeals.

Result. For the taxpayer. According to the Ninth Circuit, the Tax Court committed three errors in reaching its decision.

* The Tax Court correctly stated the property valuation law: "The standard is objective, using a purely hypothetical willing buyer and willing seller.... The hypothetical persons are not specific individuals or entities." However, the Tax Court violated that law by creating scenarios involving particular purchasers, their likely combinations with other family members and their probable patience in waiting for a return on their investment.

* After determining the class A stock should receive a premium of 3% of equity value based on the above scenarios, the Tax Court allocated that premium equally to each class A share. The court erred in valuing all class A stock as a controlling block. The asset to be valued was the'18 shares of class A stock (not a controlling interest) Simplot owned at his death. According to Treasury regulations section 20.2031-1(b), the value of each unit of property is to be determined; in the case of stock, a unit is a share of stock.

* The Tax Court's third error was attributing any premium to the class A stock. Stock should not be valued at a premium for estate tax purposes unless the commissioner can prove a purchaser would be able to use the stock to obtain an economic benefit sufficient to justify such a premium.

The Ninth Circuit concluded that a minority interest in class A stock was worth the same as class B stock. Justice Fletcher wrote a lengthy dissent stating that the Tax Court was correct in its application of the law and the resulting decision.

This case reaffirms the idea that fair value should be based on the amount a buyer is willing to pay for the economic benefits attached to the property as of the valuation date. In this decision, the Ninth Circuit brought the Tax Court back to reality.

* Estate of Richard R. Simplot, 87 AFTR2d 2001-2165, 5/14/01.

Prepared by Karyn Bybee Friske, CPA, PhD, assistant professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.