T.C. Memo. 1996-372

UNITED STATES TAX COURT

ESTATE OF ROSS H. FREEMAN, DECEASED, 

DENNIS HERSEY, EXECUTOR, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 22427-93. Filed August 13, 1996.

R determined a deficiency in estate tax. The sole

issue for decision is the fair market value on the date

of decedent's death of certain shares of common stock

and an option to acquire additional shares of common

stock that were properly includable in decedent's gross

estate.

Held: R's valuation of such shares and the option

is sustained, except that allowance will be made for

the exercise price of the option shares.

Leroy J. Neider, for petitioner.

Kimberley J. Peterson, for respondent.
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1 In part, Rule 151 provides as follows:

RULE 151. BRIEFS

 

* * * * * * *

(e) Form and Content: * * *

 * * * * * * *

(3) * * * In an answering or reply brief, the party

(continued...)

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: Respondent determined a deficiency in

Federal estate tax of $1,489,660. The adjustment giving rise to

the deficiency is on account of respondent’s increase in the

value of certain shares of stock (and an option to acquire

additional shares of stock) included in the gross estate. 

Petitioner has assigned error to that adjustment, and we must

decide the value of those shares.

Unless otherwise noted, all section references are to the

Internal Revenue Code as in effect at the time of decedent’s

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

Practice and Procedure.

FINDINGS OF FACT

Some facts have been stipulated and are so found. The

stipulation of facts filed by the parties and the accompanying

exhibits are incorporated herein by this reference. Some of

respondent's proposed findings of fact have been conceded by

petitioner and, accordingly, are so found.1
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1(...continued)

shall set forth any objections, together with the

reasons therefor, to any proposed findings of any other

party, showing the numbers of the statements to which

the objections are directed; in addition, the party may

set forth alternative proposed findings of fact.

Petitioner has filed an answering brief, but petitioner has

failed therein to set forth objections to the proposed findings

of fact made by respondent. Petitioner has simply set forth

therein the proposed findings made in its opening brief and again

asked the Court to make those findings. Accordingly, we must

conclude that petitioner has conceded respondent's proposed

findings of fact as correct except to the extent that

petitioner's proposed findings are clearly inconsistent

therewith. See Fein v. Commissioner, T.C. Memo. 1994-370; Estate

of Stimson v. Commissioner, T.C. Memo. 1992-242; Cunningham v.

Commissioner, T.C. Memo. 1989-260. 

2 In the stipulation of facts and in their briefs, the parties

have generally referred to the 702,000 shares of common stock and

the 13,333 option shares as the “shares” of the corporation. 

Each party has argued for a particular value to be applied to

each of the shares; i.e., the same value to be applied both to

each of the shares already acquired by decedent and to each of

the option shares. Indeed, in the estate tax return, petitioner

states a “unit value” for each of the option shares ($1.05) that

is the same as the per-share value of each of the acquired

shares. The parties, however, have entered into a subsequent

stipulation that the value of the option shares is equal to the

value of the shares of common stock, reduced by 35 cents, which

(continued...)

Introduction

Decedent died on October 22, 1989. Among the assets

includable in decedent’s gross estate are: (1) 702,000 shares of

common stock in Xilinx, Inc. (the corporation), and (2) an option

to acquire from the corporation an additional 13,333 of its

common shares (hereafter, both (1) such already owned shares and

(2) such option shares being referred to, without distinction, as

either “the shares” or “the shares of the corporation”).2
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2(...continued)

amount represents the exercise price of those option shares. For

purposes of this opinion, we will adopt the convention of the

parties and, without distinction, generally refer to both the

shares already acquired by decedent and to the option shares as

the “shares” of the corporation.

Petitioner timely made an estate tax return on Form 706,

United States Estate (and Generation-Skipping Transfer) Tax

Return (the Estate tax return). Petitioner did not elect

alternate valuation. In the estate tax return, petitioner valued

the shares at $1.05 per share.

Respondent determined a deficiency in estate tax by a letter

dated July 21, 1993. In a statement attached to that letter,

respondent explained her determination by stating that she had

increased the value of the shares to $4.94 per share.

Organization of the Corporation

The corporation is a California corporation, organized in

1985. Decedent was one of the founders of the corporation. The

corporation’s Standard Industrial Code is 3674, Semiconductors

and Related Devices. The corporation is a leader in the field of

programmable logic devices. The annual accounting period of the

corporation is a fiscal year ending on March 31. (Hereafter,

when referring to financial data of the corporation for a

particular year, we will be referring to financial data for the

fiscal year ending on March 31 of that year.)
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Capital Structure

At the time of decedent’s death, there were outstanding one

series of common stock of the corporation and eight series of

preferred stock. With the exception of the Series F preferred

stock, all series of preferred stock were convertible to common

stock at the ratio of 1 to 1. The Series F preferred stock was

convertible at the ratio of 1.05 shares of common stock to

1 share of preferred. 

Financial Performance

From 1986 through 1989, the corporation’s revenues and net

income were as follows:

FYE Revenues Net Income

1986 $435,000 ($4,928,000)

1987 4,375,000 (5,080,000)

1988 13,755,000 (1,689,000)

1989 30,445,000 4,382,000

 

Private Sales of Stock

From its inception through June 1990, the corporation sold

13,331,060 shares of preferred stock at prices ranging from $1 to

$4. 

On August 24, 1989, common stock of the corporation was

authorized to be sold to certain outside sales representatives of

the corporation for $1.25 a share. On December 8, 1989, common

stock of the corporation was authorized to be sold to certain

outside sales representatives of the corporation for $2.25 a

share. The purpose of those sales was to give those sales
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representatives a direct financial interest in the success of the

corporation. 

On July 7, December 8, and December 31, 1989, incentive

stock options were granted to certain employees for $1.25, $2.25,

and $2.25 a share, respectively. All such options were to vest

over 5 years. 

Public Offering

The corporation had an initial public offering of stock in

June 1990, at a price of $10 per share. The possibility of an

initial public offering was discussed at a meeting of the board

of directors of the corporation on August 24, 1989. 

Technology Sharing Agreement

On June 9, 1986, the corporation entered into a 3-year

technology sharing agreement (the agreement) with Monolithic

Memories, Inc. (MMI). Among other things, the agreement accorded

MMI rights in certain present and future technology of the

corporation. In April 1987, Advanced Micro Devices (AMD)

acquired MMI and succeeded to MMI’s rights under the agreement. 

In 1990, the agreement was terminated.

Respondent’s Expert

Respondent presented as her expert witness Herbert T. Spiro

(Spiro), who was accepted by petitioner as an expert and whose

written report was received in evidence as his direct testimony.

Spiro reached the conclusion, supported by his report, that the

aggregate fair market value of the shares, as of October 22,
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1989, on an illiquid minority basis, was $3,530,575, or $4.94 a 

share. Subsequently, respondent came to realize that Spiro had

made a computational error, and offered a correction to Spiro’s

conclusion; viz, that the value of the shares was $3,004,399, or

$4.20 a share.

In reaching his conclusion, Spiro relied on numerous

factors, including, specifically, the following: (1) An analysis

of the corporation’s operating results and financial condition;

(2) an analysis of the U.S. economy and the semiconductor

industry; (3) a forecast of operations after the date of

valuation; and (4) an investigation of the prices that investors

were paying for the stock of comparable publicly traded

companies. 

Spiro’s analysis of the corporation’s financial condition

was based primarily on his review of the corporation’s annual

reports and Forms 10-K and 10-Q for 1985 through 1989, an income

statement of the corporation for the 6-month period ending

September 30, 1989, and a Form S-1, filed on April 27, 1990, in

connection with the corporation’s initial public offering. 

For the first half of 1990, revenue was $21,771,000, which,

if annualized, would be $43,542,000 for 1990, a 43-percent

increase over 1989. Spiro concluded, however, that, given the

corporation’s growth in sales, it was unlikely that there would

be no growth in sales during the second half of 1990. Therefore,

he expected that the corporation’s growth in sales for 1990 would
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exceed 43 percent. Spiro thought that the company’s growth rate

was “meteoric” when compared to a 25-percent growth rate in 1989

for the semiconductor industry. Spiro concluded that the

corporation’s growth rate was higher than any publicly traded

comparable company that he examined other than one. 

For the first 6 months of 1990, operating income was

$3,606,000, which, if annualized, would be $7,212,000. Spiro

concluded, however, that, if sales for the first 6 months of 1990

continued to grow, and expenses continued to decline as a

percentage of sales, then operating income would be even greater. 

The corporation’s actual operating income for 1990 was

$8,846,000. 

Spiro’s analysis of the corporation’s financial position

also included an examination of the corporation’s gross profit

margins, research and development expenses, marketing, general

and administrative expenses, interest income and expenses, tax

position, profitability, assets, liabilities, and book equity

value. 

Spiro determined the value of the shares using both an

income and a market approach. 

Under the income approach, Spiro projected the cash-flow

available for distribution for 5 years. He made assumptions

about future levels of sales, expenses, and taxes to estimate

annual available cash-flow. After making certain adjustments, he

calculated the present value of that income stream and added to
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it an amount to reflect the future value of the corporation at

the end of 5 years. He then divided that result by the number of

shares that were outstanding on the appropriate valuation date to

derive a value for each such share. The value he so derived was

$5.65. Because shares of the corporation were not readily

marketable on that date, he then applied a liquidity discount to

yield a final estimate of value. Although he recognized that a

35-percent liquidity discount had come to be regarded as an

average discount, he applied a discount of only 10 percent. He

did so because he thought that an initial public offering of

shares of the corporation was likely, based on (1) the ownership

of a substantial portion of the corporation by venture

capitalists, (2) the recent history of public offerings by

similar companies, and (3) his assumption that decedent would

have been aware of (and would have communicated to any potential

buyer) steps towards a public offering that already had been

taken by the corporation. Spiro thus computed a per-share fair

market value for the shares of $5.09 using the income approach. 

Under the market approach, Spiro first made a list of public

companies that he considered comparable to the corporation. He

then identified those on the list that resembled the corporation

sufficiently closely in terms of both earnings per share and

growth in earnings per share. For those three companies, he used

certain market value indicators (e.g., the ratio of price to

recent earnings) to derive a range of market values for shares of
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the corporation. He then averaged the appropriate market values

to derive a value for a share of the corporation of $5.41. As

with the income approach, Spiro applied a liquidity discount of

10 percent to arrive at a per-share value of $4.87 under the

market approach. 

Spiro then reconciled the values he had reached under the

income and market approaches by assigning weights to the results

reached under each. Because of the difficulty associated with

forecasting the financial performance of startup, high growth

companies, Spiro accorded greater weight to the result reached

under the market value approach. He gave the market value

approach a 70-percent weight and gave the income approach a 

30-percent weight. Using that approach, he concluded that the

aggregate fair market value of the shares was $3,530,575, or

$4.94 a share. 

Spiro erred in calculating the value of the shares under the

income approach. He erred in calculating the future value of the

corporation after 5 years. Correcting that error results in a

value per share under the income method of $2.63 and a weighted

average fair market value of $4.20 per share, or $3,004,399 for

all the shares. 

Petitioner’s Expert

Petitioner presented as its expert witness David L. Klemm

(Klemm), who was accepted by respondent as an expert and whose

written report was received in evidence as his direct testimony. 
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3 Klemm calculates a value for the shares of $729,700 by

multiplying the number of shares (715,333) by $1.02. The number

715,333 multiplied by $1.02 is $729,640, rounded to the nearest

dollar.

Klemm reached the conclusion, supported by his report, that the

fair market value of the shares, as of October 22, 1989, on a

minority interest basis, was $729,700, or $1.02 a share.3

In reaching his conclusion, Klemm relied on numerous sources

of information, including, specifically, the following:

1. Financial statements for the corporation for 1986 

 through 1989;

2. An equipment list and a depreciation schedule as of the 

 end of 1989;

3. Industry information gathered from various sources;

4. Information on the U.S. economy gathered from 

 various sources;

5. Information on comparative publicly traded companies 

 gathered from various sources; and

6. An interview with Bernard V. Vonderschmitt, president of

 the corporation. 

Klemm did not analyze financial statements for the

corporation for the first 6 months of 1990. He did consider

financial results for the first quarter of 1990, and he concluded

that revenue and pretax earning levels were “generally in line”

with such levels for the prior two quarters. Klemm did not make

any forecasts of future growth or sales. 
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Klemm determined the value of the shares based on (1) a

capitalization of the corporation’s 1989 earnings, (2) a

capitalization of the corporation’s 1989 revenues, and (3) a

return-on-equity analysis using the book value per share as of

the end of 1989. 

To capitalize the corporation’s 1989 earnings Klemm utilized

a capitalization rate that, in his report, he did not relate to

any specific publicly traded companies but merely stated was

“appropriate” after discussing the “price/earnings ratio of the

Dow Jones Industrial Average” at October 20, 1989, and the range

of that average for 5 years. In his report, Klemm did not

explain the capitalization rate that he used to capitalize the

corporation’s revenues. To perform his return-to-equity

analysis, Klemm again referred to Dow Jones Industrial Averages

but failed to specify any companies comparable to the

corporation. Klemm had prepared an earlier report valuing the

shares, which was appended to the estate tax return filed by

petitioner. In that earlier report, Klemm listed eight publicly

traded companies that he considered comparable to the

corporation. Seven of those eight companies were omitted from

the report received as Klemm’s testimony. One company (Altera

Corp.) is mentioned, but no analysis of that company to support

Klemm’s valuation methods is provided. 

Using his three approaches, Klemm arrived at the following

three indications of value for each of the shares:
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 Approach Indicated Value

Capitalization of 1989 earnings $1.87

Capitalization of revenues 1.75

Price/book value 1.48

Without explaining the weight to be given to each approach, other

than stating that the most weight should be given to 1989

earnings, less weight should be given to price/book value, and

the least value should be given to revenues, Klemm opined that

the publicly traded equivalent value of the shares on a per-share

basis, as of October 22, 1989, was $1.70 

Klemm then applied two discounts to the $1.70 per-share

value. He first applied a 20-percent discount to reflect the

minority position that an owner of the shares would have. He

then applied a 25-percent discount to reflect the lack of an

established market for the shares. 

Taking into account the two discounts that he had applied,

Klemm concluded that the fair market value of the shares, on a

minority interest basis, was $729,000, or $1.02 per share. 

In his interview with Bernard V. Vonderschmitt, president of

the corporation, Klemm did not inquire as to whether, on

October 22, 1989, the corporation had any plans for a public

offering of stock. He did not consider the potential for a

public offering in valuing the shares.

Value of the Shares

The fair market value of the shares, on a per-share basis,

was $4.20 on October 22, 1989.
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OPINION

I. Introduction

We must determine the fair market value of the shares of the

corporation on October 22, 1989, the date of decedent’s death. 

The shares were included by petitioner in the gross estate and

reported on the estate tax return at a value of $1.05 per share. 

In determining a deficiency in estate tax, respondent valued the

shares at $4.94. Respondent now argues that the value of the

shares is no less than $4.20 per share. We interpret

respondent’s change in position as a concession of a portion of

the deficiency, and we accept that concession. Petitioner now

argues that the value of the shares is $1.02 per share. A

decision for petitioner on that basis would necessarily mean that

petitioner had overpaid the estate tax. Petitioner failed to

raise the issue of an overpayment in the petition. Because we

find no overpayment, we need not deal with the consequences of

that failure.

II. Law

Section 2001(a) imposes a tax on “the transfer of the

taxable estate of every decedent who is a citizen or resident of

the United States.” Section 2031(a) provides: “The value of the

gross estate of the decedent shall be determined by including to

the extent provided for in this part, the value at the time of

his death of all property, real or personal, tangible or

intangible, wherever situated.”
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The standard of valuation is fair market value. Section

20.2031-1(b), Estate Tax Regs., defines fair market value as:

“the price at which the property would change hands between a

willing buyer and a willing seller, neither being under any

compulsion to buy or sell and both having reasonable knowledge of

the relevant facts.” Future events that were reasonably

foreseeable at the valuation date may be taken into account in

determining fair market value. Gray v. Commissioner, 2 B.T.A.

672, 682 (1925); Estate of Livermore v. Commissioner, T.C. Memo.

1988-503. In determining the value of unlisted stock and

securities, we take into consideration, among other factors, the

value of publicly traded stock or securities of corporations in

the same or a similar line of business. Sec. 2031(b).

Petitioner bears the burden of proof. Rule 142(a).

III. Testimony

Both petitioner and respondent rely heavily, if not

exclusively, on expert testimony to establish the value of the

shares on the date of decedent’s death. Indeed, respondent’s

only witness was respondent’s expert witness, Spiro. Petitioner

also called one expert witness, Klemm. Petitioner called two lay

witnesses, Bernard V. Vonderschmitt and Frank Quattrone, neither

of whom had an opinion as to the value of the shares.

We found both of petitioner’s lay witnesses to be

straightforward and believable. We have taken their testimony

into account. Like the parties, however, we rely heavily on
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expert testimony in making our finding as to the value of the

shares. We found Spiro to be convincing, and we agree with his

valuation, as corrected by respondent, as to the value of the

shares. We had difficulty with Klemm’s valuation, and we will

set forth some of our more significant concerns. We accorded

Klemm’s valuation no weight.

IV. Klemm’s Testimony

A. Approaches to Valuation

Klemm followed three approaches in valuing the shares:

Capitalization of earnings, capitalization of revenues, and

return on equity. His aim was to find the price that the market

would set for a share of the common stock of the corporation on

October 22, 1989. Under each approach, such a market price was

the unknown to be discovered. Under each approach, that unknown

was a function of two variables, one particular to the

corporation (e.g., earnings) and one reflective of the market

(i.e., a variable characteristic of publicly traded companies

comparable to the corporation). Our first major concern is with

Klemm’s identification of variables characteristic of publicly

traded companies comparable to the corporation. Simply put,

petitioner has failed to persuade us that Klemm identified

companies comparable to the corporation and used data with

respect to those companies to derive the appropriate marketreflective variables. In our findings of fact, we pointed out

the discrepancy between Klemm’s earlier report and his expert
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testimony with respect to the identification of comparable

companies. Except perhaps for one company, no comparable

companies are identified in his expert testimony. During his

oral testimony, Klemm tried to explain that discrepancy; he also

asked that his expert testimony be amended to make his earlier

identification of comparable companies part of that testimony. 

We cannot reconcile his explanation of why he took the

comparables out (which we do not fully comprehend) with his

request to amend his expert testimony and add them back in. We

have little confidence in his quantification of appropriate

variables reflective of the market (e.g., capitalization rates). 

Klemm’s oral testimony has raised for us serious doubts as to his

understanding of the approaches to valuation that he selected. 

That, alone, is sufficient reason for us to reject the

conclusions resulting from those approaches.

We are also concerned that in relying on his three

approaches Klemm ignored the dynamic state of the corporation,

which had experienced exceptional growth in both revenues and

earnings since its inception. We can find in neither Klemm’s

identification of (1) market variables or (2) variables

particular to the corporation (e.g., earnings) nor in his

manipulation of those variables any recognition that future

earnings and revenues might be any different than they were in

1989 (i.e., that earnings and revenues would continue to grow). 

Although, in the body of his report, Klemm takes note of the
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growth since inception of both the corporation’s earnings and

revenues, and although an income statement for the first 6 months

of 1990 was reasonably available to him, which showed continued

growth in both earnings and revenues, Klemm does not specifically

acknowledge such growth (or any future growth) in any of the

approaches that he adopted. He seems to contradict his own

statement, in introducing his valuation approaches, that “Value

measures generally take into account the trends in growth,

performance, and stability of * * * [earnings, revenue, and book

value].” We are unpersuaded that his static view of the

corporation’s future was either necessary or correct.

We are unconvinced that, either individually, or in

conjunction, Klemm’s approaches to valuation of the shares

produce a reliable result.

B. Public Offering

The corporation had an initial public offering of stock in

June 1990, at a price of $10 per share. The possibility of an

initial public offering was discussed at a meeting of the board

of directors of the corporation on August 24, 1989. In his

report, Klemm states specifically that (1) during his interview

with Bernard V. Vonderschmitt, president of the corporation, he

did not inquire as to whether, on October 22, 1989, the

corporation had any plans for a public offering of stock, and

(2) he did not consider the potential for a public offering in

carrying out his valuation assignment. 
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Petitioner has cited to us no authority prohibiting an

inquiry into plans for a public offering. We assume that a

potential purchaser would be interested in such plans and might

pay a premium depending on her judgment of the likelihood of such

an offering. Indeed, in his report, Klemm tells us that

(1) professional investment firms had purchased the preferred

stock in the corporation, and (2) it is typical for a high

technology startup company to sell convertible preferred shares

to venture capital investors. We assume that venture capital

investors invest with the hope, if not the expectation, that a

public offering will not be too far off. 

Klemm’s failure to take any account of a public offering,

which actually occurred within 8 months of decedent’s death, and

the possibility of which was discussed before his death, seems to

us unwarranted. It seems to us that Klemm turned his back on a

datum that he should have considered. Klemm’s decision to ignore

the possibility of a public offering adds to our dissatisfaction

with his report. Cf. Messing v. Commissioner, 48 T.C. 502, 509

(1967) (public offering price is a factor to be taken into

account in valuing shares of stock in a company that was

privately held on the valuation date; due regard must be give "to

the time span involved between the critical dates and the dates

of sale to the public, as well as to the contingencies inherent

in the successful culmination of a contemplated public

offering."). 
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C. Minority Discount

Klemm applied a 20-percent discount to reflect what he

believed would be the minority position that a purchaser of the

shares would have. We think that that is inappropriate. Klemm

did not arrive at a value for the corporation and then try to

determine the value of minority interest. He arrived at a market

equivalent value for a share of the corporation and then

multiplied to arrive at the value of the shares. We assume that,

in valuing a single share of stock, the market would recognize

the minority position of that share, and that no further minority

discount would (or could) be demanded.

V. Spiro’s Testimony

A. Analysis

We will summarize our reasons for agreeing with respondent’s

valuation of the shares.

We found Spiro’s use of the income and market approaches to

be straightforward and reasonable. With respect to his use of

the income approach, we agree with his adjustments to income and

his use of a 5-year projection. We do not think that he

overestimated either base revenues, expected revenue growth, or

the other factors and adjustments going into the calculations of

expected cash-flows. We are satisfied with his choice of a

discount rate of 23.3 percent as appropriate for the corporation. 

We agree with his calculation of the present value of the 5-year

expected cash-flows. We agree with the necessity to add to that
- 21 -

sum the present value of cash-flows expected after year 5 (the

reversion). We agree with respondent’s corrected computation of

the present value of the reversion.

Also, we are satisfied with his use of the market approach. 

Indeed, three of the companies selected by Spiro as comparable

were selected by Klemm in his initial report, which accompanied

the estate tax return.

We agree with Spiro’s application of a liquidity discount of

10 percent. We also agree with the weight he gave the results

reached under the two approaches.

B. Petitioner’s Criticism

Petitioner has criticized Spiro’s testimony on numerous

grounds. Implicitly, we have dealt with most of that criticism

in our analysis of Spiro’s report. We have not, however, dealt

with petitioner’s claim that Spiro failed to recognize the effect

on the value of the shares of the June 9, 1986, technology

sharing agreement (agreement) entered into with Monolithic

Memories, Inc. (MMI). The agreement was terminated in 1990. The

agreement, argues petitioner, decreased the corporation’s

earnings potential (and therefore decreased the value of the

corporation) because MMI (and later its successor, AMD) could

produce and sell, at lower prices, products using the

corporation’s technology.

We do not think that Spiro failed to take the agreement into

account. The pace of change for technology in the computer
- 22 -

industry is rapid. If the agreement had had any effect on

earnings, it is likely that that effect would have made itself

felt during 1989 and the first half of 1990. Spiro relied

heavily on the financial figures for those periods. Implicitly,

he took the agreement into account. The agreement was canceled

in 1990. 

Petitioner’s expert, Klemm, testified that he did not assign

a particular value or a particular discount to the shares due to

the agreement.

We conclude that the agreement was of little consequence to

the value of the shares.

VI. Conclusion

We have found that the fair market value of the shares, on a

per-share basis, was $4.20 on October 22, 1989. The value of the

715,333 shares in issue is, thus, $3,004,399. Petitioner

understated the value of the gross estate, and we sustain 

respondent’s determination of a deficiency to the extent

necessary to reflect the values that we have found and the

stipulation of the parties as to the option shares.

Decision will be entered

under Rule 155.