Tax Court bases premium for minority interest on percentage of company value.
Sec. 2031(a) requires a gross estate to include all property of the decedent valued at the date of death. Fair market value (FMV) is used, defined as the price a willing buyer would pay a willing seller, both with reasonable knowledge of all relevant facts and neither under compulsion to buy or sell. The willing buyer and willing seller are hypothetical persons; therefore, they do not necessarily have the same characteristics as actual buyers and sellers, including the decedent's relatives.
It is difficult to determine the FMV of stock of a closely held corporation with infrequent stock trades. Rev. Rul. 59-60 listed various factors, including the nature of the business, its earning capacity, the amount of stock at issue, the market price of similar publicly traded companies, etc. Normally, a court has broad discretion in assigning weight to the factors and in evaluating expert testimony. Ultimately, the court applies "judgment, experience and reason."
Typically, experts value closely held corporations using market capitalization, a discounted cashflow approach or both. Discounts for lack of marketability or minority interest or both may apply, as may premiums for controlling interests. Although there have not been many cases on the issue, premiums for voting or discounts for nonvoting stock may apply as well. In Barnes, TC Memo 1998-413, the Tax Court allowed a 3.66% discount for nonvoting stock calculated by simply reducing its per-share price. The court cited without analysis a study of public corporations.
In Est. of Winkler, TC Memo 1989-231, a decedent owned 10% (8,000 shares) of voting common and 1% (7,600 shares) of nonvoting common stock. The Tax Court applied a 10% premium to the voting common, emphasizing that the swing-vote characteristics of a 10% block could determine control, because the Winkler family owned 40% of the stock and another family owned the other 50%. (Under the willing buyer-willing seller rule, one can consider who owns the other shares, but not the family relationships of the hypothetical buyer of the decedent's shares.) Using the simple method, the court added 10% to the $45.89 per-share price of the voting common stock otherwise calculated.
Wallace, 566 F Supp 904 (DC Mass. 1981), is the only case prior to Est. of Simplot to base a voting premium on a percentage of the company's value. The premium (5% in Wallace) multiplied by the company's value would be divided by the shares of voting common stock and then added to the voting common stock's share price otherwise determined. (The issue in Wallace was the price of nonvoting common stock.) The district court stated, without elaborating, that the percentage of total equity method was superior to the simple method. However, the court warned that the percentage of the company's value method "could produce absurdly disproportionate value as between voting and nonvoting shares in extreme circumstances."
The J.R. Simplot Company, an agricultural products company with 1993 sales of $1.8 billion and net income of $38 million, had 76.445 shares of voting common stock and 141,288.584 shares of nonvoting common stock outstanding on June 24,1993, when Richard Simplot died. The company had never paid a dividend. At his death, Mr. Simplot owned 18 shares (23.55%) of voting common stock and 3,942.048 (2.81%) of nonvoting common stock. Two of Mr. Simplot's siblings also owned 18 shares of voting common stock; another sibling owned 22.445 shares. Over 96% of the nonvoting common stock was owned by retirees and descendants of J.R. Simplot, including trusts for his siblings' children. There was a 360-day restriction on selling voting common stock to new shareholders. Between 1983-1993, as the company's competitors became larger and better financed, several inquired as to whether part or all of the Simplot company might be available for acquisition.
The decedent left his voting common stock, plus the amount of nonvoting common stock that, when added to the voting common stock, would equal the estate tax unified credit amount ($600,000 in 1993), in trust for his children; he left the rest of the nonvoting common stock to his surviving spouse. The estate valued the voting and nonvoting common stock at $2,650 per share, resulting in $47,700 for the voting common stock and $10,446,427 for the nonvoting common stock. The IRS valued the voting common stock at $801,995 per share, and the nonvoting common stock at $3,586 per share.
The estate's experts argued that no premium should apply, because the decedent did not have voting control and the remaining voting common stock was owned by his three siblings. Therefore, a hypothetical buyer of the decedent's voting common stock would obtain no extra economic benefits. The estate's experts also cited studies of public companies with two classes of stock.
The Service's experts argued that nonmajority voting blocks of sufficient size should be valued at a premium, as they represented a potential swing block in determining control. They strongly advocated the "percentage of the company's value" method and applied premiums of 6%-10%. One expert argued that the simple method made no sense, because voting stock should be valued as a class followed by the application of a minority discount. Also, the IRS's experts argued that public company comparisons were irrelevant, because public markets understated the value of blocks of shares with the potential for control, and publicly traded stock did not possess the extreme ratio of voting to nonvoting shares present in Est. of Simplot.
Ruling that common sense dictated that the voting shares' "inherent potential for influence and control of the [Simplot] company" made them "far more valuable" than the nonvoting shares, the Tax Court adopted the percentage of the company's value method. The court pointed out that the hypothetical buyer (who could be an investor, supplier, major customer or one of the Simplots) would be put on the board of directors. Also, over time, closely held companies eventually sell, merge or go public, and the Simplot company was experiencing increased competition. However, because the three Simplot siblings would all want to maximize their children's interests in the company, they would probably require the proceeds of a sale or merger to be distributed on an equal pershare basis to the voting and nonvoting common stock. Therefore, the court applied only a 3% premium, multiplying it by the Simplot company's $830 million value, for a premium of $24 million. This amount was allocated to the 76.445 voting shares with the remainder of the overall value divided equally by all 141,365.029 common shares. The court then subtracted a 35% lack of marketability discount, resulting in a $215,539 per-voting share value. Finally, the court noted that the premium for control would be "substantially greater"
Est. of Simplot is the first Tax Court case to use a percentage of the company's value to calculate the premium for voting common stock. Once the premium percentage is determined, this method produces higher voting premiums per share than the simple method. Although swing-vote characteristics appear to increase the probability the Tax Court will use the percentage of the company's value method, the court was not clear on the criteria it will use to determine which method should apply. The arguments in Est. of Simplot for applying the percentage of the company's value method would be equally persuasive if a larger number of voting shares were outstanding while the decedent's ownership percentage remained unchanged or in the case of a general partnership interest. CPAs should be familiar with this new method and the effect its application will have in specific situations.
FROM PETER BARTON, MBA, CPA, J.D., PROFESSOR OF ACCOUNTING, AND ROY C. WEATHERWAX, PH.D., CPA, PROFESSOR OF ACCOUNTING, UNIVERSITY OF WISCONSIN-WHITEWATER, WHITEWATER, WI (NOT ASSOCIATED WITH SUMMIT INTERNATIONAL ASSOCIATES, INC.)
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|Author:||Weatherwax, Roy C.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1999|
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