T.C. Memo. 2011-148

UNITED STATES TAX COURT

ESTATE OF LOUISE PAXTON GALLAGHER, DECEASED, F. GORDON SPOOR,

PERSONAL REPRESENTATIVE, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 16853-08. Filed June 28, 2011.

Decedent owned 3,970 units of Paxton Media Group, LLC,

representing a 15-percent ownership interest in the limited

liability company.

Held: Fair market value of the units determined. 

Sec. 2031, I.R.C.

James R. Spoor and Jon M. Wilson, for petitioner.

Stephen R. Takeuchi, for respondent.
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MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: By notice of deficiency (the notice),

respondent determined a deficiency of $6,990,720 in Federal

estate tax due from the estate of Louise Paxton Gallagher

(decedent). The only issue for decision is the fair market value

of 3,970 membership interests (units) in Paxton Media Group, LLC

(PMG), a Kentucky limited liability company (L.L.C.), included in

decedent’s gross estate.

Unless otherwise stated, section references are to the

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

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

and Procedure. We round all amounts to the nearest dollar.

FINDINGS OF FACT

Some facts are stipulated and are so found. The stipulation

of facts, with accompanying exhibits, is incorporated herein by

this reference. The parties agree that venue for appeal of a

decision in this case would lie in the U.S. Court of Appeals for

the Eleventh Circuit.1

Background

Decedent died on July 5, 2004 (the valuation date). Among

the assets includable in her gross estate are 3,970 units of PMG

1The parties to a Tax Court decision may by stipulation in

writing designate the U.S. Court of Appeals in which an appeal of

the decision would lie. See sec. 7482(b)(2).
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(decedent’s units or the units). As of the valuation date,

decedent’s estate was PMG’s largest single unit holder, holding

15 percent of the company’s 26,439 outstanding units. 

On September 30, 2005, the co-personal representatives of

decedent’s estate, Frederick Gordon Spoor (petitioner) and J.

Frederick Paxton, filed a Form 706, United States Estate (and

Generation-Skipping Transfer) Tax Return (the return) on behalf

of decedent’s estate. The return stated that the fair market

value of decedent’s units as of the valuation date was

$34,936,000, or $8,800 per unit, based upon a July 12, 2004,

appraisal of the company’s units by David Michael Paxton (Mr.

Paxton), PMG’s president and chief executive officer.2 They did

not elect alternative valuation under section 2032. Upon J.

Frederick Paxton’s death, petitioner became the sole personal

representative of decedent’s estate.

Respondent selected the return for examination, and, on June

13, 2007, petitioner received respondent’s notice of proposed

adjustment, which proposed $49,500,000 as the fair market value

of decedent’s units as of the valuation date. After unsuccessful

settlement negotiations with respondent3 and an appeal request to

2The personal representatives also made a sec. 6166 election

on the return, choosing to defer payment of the qualifying estate

tax.

3After the negotiations failed, respondent sent petitioner

an amended notice of proposed adjustment, dated Oct. 4, 2007. 

(continued...)
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respondent’s Appeals Office, petitioner obtained an independent

appraisal from Sheldrick, McGehee & Kohler, LLC (SMK), appraising

the units at $26,606,940 as of the valuation date. On June 6,

2008, respondent issued the notice, confirming the notice of

proposed adjustment and valuing the units at $49,500,000 as of

the valuation date. On July 8, 2008, petitioner filed a petition

with this Court for redetermination of the deficiency, relying on

the SMK appraisal’s fair market value determination. 

Before the start of trial, petitioner hired another

appraiser, Richard C. May, who valued decedent’s units at

$28,200,000 as of the valuation date. On November 19, 2009,

petitioner filed an amendment to the petition to reflect this new

appraisal. Before trial, respondent hired Klaris, Thomson &

Schroeder, Inc. (KTS), to value decedent’s units as of the

valuation date; KTS determined a fair market value of

$40,863,000, less than the amount used to determine the tax

liability on the notice.

Organization and Operation of PMG

W.F. Paxton formed PMG in 1896 in Paducah, Kentucky. The

privately held and family-owned newspaper publishing company

initially operated one newspaper. PMG grew by acquiring

3(...continued)

Although the amended notice of proposed adjustment corrected

certain errors in the original notice of proposed adjustment, the

proposed fair market value of decedent’s units remained

unchanged.
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underperforming companies and improving their financial

performance. Due, in part, to that strategy, by July 2004, PMG

published 28 daily newspapers, 13 paid weekly publications, and a

few specialty publications, and owned and operated a television

station. PMG was carrying out that acquisition strategy as of

the valuation date. 

PMG serves primarily small and mid-sized communities in the

southeastern and midwestern United States. PMG dominates the

print media in those communities by reporting mostly local news,

unlike its competitors. That dominance generates higher and more

consistent revenue streams for PMG than are received by other

companies in the industry.

On December 26, 1996, PMG elected to become an S corporation

(within the meaning of section 1361(a)(1)). On the same day, PMG

executed a shareholder agreement to protect its “S” election by

restricting the sale of its stock. PMG later amended the

agreement to ensure continued election protection upon its

conversion to an L.L.C. in 2001. The election and shareholder

agreement restrictions were in place as of the valuation date and

there was no plan to discontinue the “S” election at that time. 

On February 1, 1999, PMG acquired a 50-percent interest in

High Point Enterprises, Inc. (High Point), with an option to

purchase the remaining 50 percent at fair market value upon the

death of High Point’s publisher. High Point’s publisher died on
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May 4, 2004. PMG exercised its option to purchase the remaining

50-percent interest in High Point on October 22, 2004.

PMG adopted two stock option programs, one in 1996 and one

in 2000, providing key executives of PMG with options to purchase

units. As of July 2004, PMG had a total of 2,800 options

outstanding under both programs, of which 2,298 were vested. The

average strike price of the options outstanding was $2,786.

In February 2004, Wachovia Capital Markets, LLC, which PMG

had hired to arrange and syndicate a $350,000,000 senior secured

credit facility (the facility), distributed a confidential

information memorandum (CIM) to potential lenders in connection

with the proposed facility. PMG intended to use the financing to

secure additional capital for future acquisitions and to

refinance its existing debt. PMG later increased the amount of

the facility to $400,000,000, intending to use the additional

$50,000,000 as capital for acquisitions. The CIM’s terms and

conditions required PMG to adhere to scheduled principal

repayments and reductions in the “aggregate commitment of the

Lenders”. The CIM matured and final payment was due 7 years from

the facility’s closing date. 

Financial Information

From 1998 through 2004, PMG’s total operating revenue and

net income were as follows:
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Fiscal Year Ended Revenues Net Income

1998 $100,286,174 $3,742,337

1999 115,574,813 8,763,173

2000 131,435,923 17,215,339

2001 158,478,905 1,572,124

2002 161,352,375 35,821,086

2003 162,225,998 42,374,244

2004 169,094,523 48,199,873

As of December 28, 2003, PMG’s audited balance sheet showed total

assets valued at $357,480,762, liabilities of $283,682,159

(current liabilities of $56,707,407 and long-term obligations of

$226,974,752), and members’ equity of $73,798,603. 

Respondent’s Expert

At trial, respondent offered John A. Thomson (Mr. Thomson)

as an expert in business valuation. He is vice president and

managing director of KTS’s Long Beach, California, office. He is

also an accredited senior appraiser of the American Society of

Appraisers, is a member of the Appraisal Institute, and has

directed and conducted several valuation appraisals of various

business enterprises. The Court accepted Mr. Thomson as a

business valuation expert and received his written report into

evidence as his direct testimony. Mr. Thomson valued the units

using both a market approach and an income approach. He applied

a 17-percent minority discount to the result under the income

approach, and then applied a 31-percent marketability discount to

the results under both approaches. After according both

approaches equal weight, Mr. Thomson derived a unit value for PMG
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of $10,293, concluding that decedent’s units had a fair market

value of $40,863,000. 

Petitioner’s Expert

Petitioner offered his appraiser, Richard C. May (Mr. May),

as an expert in valuation. Mr. May has previously performed

several appraisals of publishing companies, including those

holding radio and TV broadcast assets. The Court accepted him as

an expert in business valuation and received his written report

into evidence as his direct testimony. Mr. May relied primarily

on the income approach in valuing decedent’s units, using the

market approach only to establish a reasonable estimate of fair

market value. After certain adjustments and applying a 30-

percent lack of marketability discount to his result, he

concluded that the fair market value of decedent’s units was

$28,200,000, or $7,100 per unit.

OPINION

I. Introduction

We must determine the fair market value of decedent’s units

on the valuation date. The units were included in her gross

estate and valued on the estate tax return at $8,800 per unit. 

Relying on Mr. May’s expert testimony, petitioner now argues that

the correct fair market value is $7,100 per unit. In Estate of

Hinz v. Commissioner, T.C. Memo. 2000-6, we stated:

It is well settled that the valuation of an asset

in a tax return is an admission by the taxpayer when
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that valuation is inconsistent with a later position

taken by the taxpayer. See Waring v. Commissioner, 412

F.2d 800, 801 (3d Cir. 1969), affg. T.C. Memo.

1968-126; McShain v. Commissioner, 71 T.C. at 1010. It

is equally well settled that such an admission is not

conclusive and that the trier of fact is entitled to

determine, based on all the evidence, what weight, if

any, should be given to the admission. McShain v.

Commissioner, supra. That is, “admission” is not here

used in the binding sense of Rule 37(c), 90(f), or

91(e), but rather in the evidentiary sense of rule

801(d)(2) of the Federal Rules of Evidence. * * * 

In Estate of Hall v. Commissioner, 92 T.C. 312, 337-338 (1989),

we required “cogent proof” that the value of stock reported on an

estate tax return was erroneous. In Rabenhorst v. Commissioner,

T.C. Memo. 1996-92, a gift tax case, we stated “this cogent proof

principle is essentially synonymous with the general burden of

proof set forth in Rule 142(a).” We thus assume that petitioner

may overcome the estate tax valuation of the units by a

preponderance of the evidence. See Merkel v. Commissioner, 109

T.C. 463, 476 (1997) (“The usual measure of persuasion required

to prove a fact in this Court is ‘preponderance of the evidence’,

which means that the proponent must prove that the fact is more

probable than not”. (citations omitted)), affd. 192 F.3d 844 (9th

Cir. 1999).

In his notice of deficiency, respondent valued decedent’s

units at $12,469 a unit. Relying on Mr. Thomson’s expert

testimony, respondent now argues that the fair market value was

at least $10,293 per unit, which we regard as a concession. See

Estate of Hinz v. Commissioner, supra (finding that the
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Commissioner conceded his valuation position as set forth in the

notice of deficiency by arguing for a lower fair market value on

brief).

II. Burden of Proof

In general, a taxpayer bears the burden of proof. Rule

142(a)(1). However, section 7491(a) shifts the burden of proof

to the Commissioner in certain situations if the taxpayer raises

the issue, introduces credible evidence with respect to any

factual issue relevant to ascertaining the proper tax liability,

and demonstrates compliance with the applicable requirements of

section 7491(a)(2).

Petitioner raised the issue of section 7491(a) in his

posttrial brief. We need not address whether section 7491(a)

applies because the parties have provided sufficient evidence for

us to find that the value of decedent’s units as of the valuation

date was $32,601,640. See Estate of Black v. Commissioner, 133

T.C. 340, 359 (2009).

III. Law

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

decedent’s taxable estate, the value of which includes the fair

market value “at the time of his death of all property, real or

personal, tangible or intangible, wherever situated.” Sec.

2031(a); United States v. Cartwright, 411 U.S. 546, 550-551

(1973). Fair market value is defined as “the price at which the
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property would change hands between a willing buyer and a willing

seller, neither being under any compulsion to buy or to sell and

both having reasonable knowledge of relevant facts.” Sec.

20.2031-1(b), Estate Tax Regs. The willing buyer is a

hypothetical person; therefore, an actual buyer’s personal

characteristics are disregarded. Estate of Newhouse v.

Commissioner, 94 T.C. 193, 218 (1990).

If the property to be valued is stock of a closely held

corporation, its fair market value is best determined through

“arm’s-length sales near the valuation date of reasonable amounts

of that stock”. Estate of Noble v. Commissioner, T.C. Memo.

2005-2; accord Estate of Andrews v. Commissioner, 79 T.C. 938,

940 (1982). If it is not possible to so value the stock,

however, fair market value is calculated by “analyzing the value

of publicly traded stock in comparable corporations engaged in

the same or a similar line of business, as well as” by

considering certain factors that an informed buyer and seller

would consider.4 Estate of Noble v. Commissioner, supra.

4The factors include the company’s net worth, prospective

earning and dividend-paying capacity, and other relevant factors,

including the economic outlook for the particular industry, the

company’s position in the industry, the company’s management, the

degree of corporate control represented by the block of stock to

be valued, and the value of publicly traded stock or securities

of corporations engaged in the same or similar lines of business. 

See sec. 20.2031-2(f), Estate Tax Regs.; Rev. Rul. 59-60, 1959-1

C.B. 237, modified by Rev. Rul. 65-193, 1965-2 C.B. 370.
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IV. Expert Opinions

The parties rely principally on expert testimony to

establish the fair market value of decedent’s units as of the

valuation date. In addition to the expert testimony of Mr.

Thomson, respondent also called as a witness Mr. Paxton, PMG’s

former chief financial officer and current president and chief

executive officer. Beginning in 1991, Mr. Paxton, as chief

financial officer, authored PMG’s annual valuation reports, which

reported the fair market value of its stock or units as of that

year. Although Mr. Paxton testified as to his July 12, 2004,

valuation report, which formed the basis for the value reported

in the return, petitioner requests that we adopt Mr. May’s

appraised value.

Valuation is a question of fact. Estate of Newhouse v.

Commissioner, supra at 217. Courts often consider expert

witnesses’ opinions in deciding such cases; however, we are not

bound by the opinion of any expert witness and may accept or

reject such testimony in the exercise of our sound judgment. 

Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938); Estate

of Newhouse v. Commissioner, supra at 217. Although we may

accept an expert’s opinion in its entirety, we may instead select

what portions of the opinion, if any, to accept. Parker v.

Commissioner, 86 T.C. 547, 562 (1986); see Buffalo Tool & Die

Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980). 
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Because valuation involves an approximation, “the figure at which

we arrive need not be directly traceable to specific testimony if

it is within the range of values that may be properly derived

from consideration of all the evidence.” Estate of Heck v.

Commissioner, T.C. Memo. 2002-34.

The parties disagree over: (1) The date of financial

information relevant to a date-of-death valuation of decedent’s

units, (2) the appropriate adjustments to PMG’s historical

financial statements, (3) the propriety of relying on a marketbased valuation approach (specifically the guideline company

method) in valuing the units, and, if appropriate, the proper

manner of applying that method, (4) the application of the income

approach (specifically the discounted cashflow valuation method),

(5) the appropriate adjustments to PMG’s enterprise value, and

(6) the proper type and size of applicable discounts.5

5The parties also disagree as to whether Mr. Paxton’s July

12, 2004, valuation report identifies the highest possible fair

market value for decedent’s units. Petitioner argues that, as of

the valuation date, the only available market for PMG units was

PMG’s discretionary redemption policy, under which only 25

percent of decedent’s units could have been redeemed annually,

assuming no other unitholder elected to have his units redeemed

that same year. Petitioner thus concludes that only 25 percent

of decedent’s units were worth the amount determined in Mr.

Paxton’s report “because that is the most that could have been

sold to PMG at that time”; the remaining 75 percent of the units

would be worth less than the value per unit shown in Mr. Paxton’s

report. Petitioner’s argument fails on three accounts. First,

and most fundamentally, petitioner has failed to support his

factual claim that “there was no market for the Paxton Units

other than PMG as of the Valuation Date”. Mr. Spoor’s testimony

(continued...)
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V. Date of Financial Information

Property includable in a decedent’s gross estate is valued

as of the valuation date “on the basis of market conditions and

facts available on that date without regard to hindsight.”

Bergquist v. Commissioner, 131 T.C. 8, 17 (2008) (citing Estate

of Gilford v. Commissioner, 88 T.C. 38, 52 (1987)). Subsequent

events may be considered, however, “to the extent that such

events may shed light upon a fact, circumstance, or factor as it

existed on the valuation date.” Gross v. Commissioner, T.C.

Memo. 1999-254, affd. 272 F.3d 333 (6th Cir. 2001).

Mr. Thomson bases his valuation analysis on data gathered

from PMG’s internally prepared financial statements ending June

27, 2004, and financial information for comparable public

companies as of the quarter ending June 30, 2004. He considered

that information to be more accurate than earlier data, despite

the quarterly report’s publication 1 or 2 months after the

valuation date. In contrast, Mr. May’s report relies upon

5(...continued)

concerning his attempts to sell units is vague and unsupported by

specific facts or corroborating data. Second, petitioner did not

offer Mr. Paxton as an expert witness, and even if he had, we are

not bound by the opinion of any expert witness. See Estate of

Newhouse v. Commissioner, 94 T.C. 193, 218 (1990). Third,

petitioner erroneously bases his argument on the particular

characteristics of the buyer of decedent’s units. See Estate of

Hall v. Commissioner, 92 T.C. 312, 336-337 (1989) (“Under the

hypothetical willing buyer/willing seller standard, decedent’s

stock cannot be valued by assuming that sales would be made to

any particular person.”).
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financial information for comparable public companies ending

March 28, 2004, the latest quarterly data available before the

valuation date, and PMG’s internally prepared financial

statements ending May 30, 2004, the latest statements published

before the valuation date. Mr. May declined to use the June 2004

financial statements, stating that a willing buyer and willing

seller would be unaware of the information as of the valuation

date, since the statements likely would not have been closed and

published by such date. 

We agree with Mr. Thomson that the June 2004 financial

information should be used in valuing decedent’s units. 

Petitioner argues that the June information was not publicly

available as of the valuation date, preventing a willing buyer

and seller from relying upon it in determining fair market value. 

That is not to say, however, that our hypothetical actors could

not make inquiries of PMG or of the guideline companies (or of

financial analysts), which would have elicited non-publicly

available information as to end-of-June conditions. Moreover, we

understand Mr. Thomson’s testimony to be that the June 2004

financial information accurately depicts the market conditions on

the valuation date, not that a willing buyer and seller would

have relied upon the data. Importantly, petitioner has not

alleged an intervening event between the valuation date and the

publication of the June financial statements that would cause
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them to be incorrect. See Gross v. Commissioner, supra. 

Therefore, we shall rely on the June 30 and 27, 2004, financial

information for comparable public companies and PMG,

respectively.

VI. Adjustments to PMG’s Historical Financial Statements

Before commencing their valuation analyses, both Mr. Thomson

and Mr. May subtracted items not expected to recur in the future

(nonrecurring items) from PMG’s historical financial statements

to better represent the company’s normal operations. The experts

disagree only as to the appropriate number of adjustments.

Mr. Thomson made one adjustment to PMG’s income statements,

subtracting a $7,895,016 gain on divested newspapers in 2000. 

Mr. May made, among other adjustments, the following three

adjustments to PMG’s earnings: (1) Reduced PMG’s 2000 earnings

before interest, taxes, depreciation, and amortization (EBITDA)

by a $7,900,000 gain on divested newspapers, (2) subtracted from

both EBITDA and earnings before interest and taxes (EBIT) a 2003

$700,000 gain from a life insurance policy PMG inherited through

an acquisition, and (3) subtracted from both EBITDA and EBIT a

2003 $1,100,000 positive claim experience from PMG’s self-insured

health insurance.

Respondent objects to those three adjustments. We are

unclear as to why respondent objects to the 2000 newspaper

divestiture adjustment since his own expert, on whose appraisal
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he relies, made the same adjustment. We thus consider respondent

to have acquiesced to the adjustment. However, we disregard Mr.

May’s self-insured health insurance and life insurance policy

adjustments because he provides no explanation as to why the

gains were nonrecurring. See Estate of Jung v. Commissioner, 101

T.C. 412, 450 (1993) (granting little weight to an expert’s

valuation report because it was “deficient in providing data and

support for its conclusions”).

Mr. May also made adjustments for the following: Net

pension income (or expense), and other income (or expense). In

his report, Mr. May stated that PMG had an overfunded defined

benefit plan, which, for most years, increased the company’s

reported net income. He eliminated the pension amounts from

PMG’s historical financial statements in showing its EBITDA,

adding back the “full amount of the overfunding”, $11,664,000, to

PMG’s enterprise value. Mr. May has failed adequately to explain

both his $11,664,000 calculation and the reason for assuming the

overfunded plan provided no annual benefit under the discounted

cashflow method, thus prompting its exclusion from PMG’s

financial statements. Because we fail to understand his

adjustments, we shall disregard them. See Estate of Jung v.

Commissioner, supra at 450; Parker v. Commissioner, 86 T.C. at

562. Mr. May also failed to explain his other income (expense)

adjustments, which we similarly disregard.
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VII. The Guideline Company Methodology

We must next decide whether the guideline company method is

an appropriate method to use in valuing decedent’s units of PMG,

and if appropriate, the size and nature of applicable discounts

and adjustments.

A generally accepted method for valuing stock of a closely

held company, the guideline company method is “a market-based

valuation approach that estimates the value of the subject

company by comparing it to similar public companies.” Estate of

True v. Commissioner, T.C. Memo. 2001-167, affd. 390 F.3d 1210

(10th Cir. 2004). Since the method determines fair market value

using market data from similar public companies (guideline

companies), “the selection of appropriate comparable companies is

of paramount importance.” Estate of Hendrickson v. Commissioner,

T.C. Memo. 1999-278. Both parties’ experts used that method in

their analyses but only respondent’s expert, Mr. Thomson, relied

upon its results in valuing decedent’s units. Petitioner argues

that such reliance is improper because no companies sufficiently

similar to PMG exist to support the method’s application. We

discuss and evaluate Mr. Thomson’s guideline company analysis

below.

A. Mr. Thomson’s Guideline Companies and Analysis

To identify PMG’s guideline companies, Mr. Thomson compiled

a list of publicly held companies from 10K Wizard,
- 19 -

StockSelector.com, and Yahoo.com, screening out those not

operated primarily as newspaper publishing companies. He

identified 13 potential companies from the list, ultimately

selecting the four most similar in size to PMG: Journal Register

Co., Lee Enterprises, Inc., the McClatchy Co., and Pulitzer,

Inc., and subsidiaries (Pulitzer, Inc.). He believed those

companies to be the most comparable to PMG because their

underlying price multiples “generally reflect an investor’s

assessment of both current and future earnings prospects as well

as the business and financial risks, inherent in the Company’s

business as of the valuation date.”

Mr. Thomson analyzed the four chosen guideline companies

based on a MVIC-to-EBITDA6 price multiple value indication. He

first determined that the MVIC-to-EBITDA price multiples for

Journal Register Co., Lee Enterprises, Inc., the McClatchy Co.,

and Pulitzer, Inc., as of June 30, 2004, were 11.1, 12.4, 10.9,

and 12.6, respectively, with a median multiple of 11.8. He then

calculated PMG’s price multiple by adjusting the guideline

companies’ median multiple downward to 10.6 because PMG’s “EBITDA

growth rates slowed while those same growth rates reported by the

guideline companies improved, * * * [PMG] was at a size

6MVIC/EBITDA represents the market value of invested capital

in relation to earnings before interest, taxes, depreciation, and

amortization.
- 20 -

disadvantage and, all else equal, private companies tend to sell

for less than public companies.”

Mr. Thomson applied PMG’s price multiple to PMG’s adjusted

EBITDA and subtracted the company’s interest-bearing debt as of

June 27, 2004, concluding that PMG’s marketable minority interest

value was $435,000,000 (rounded) at the valuation date. Upon

applying a 31-percent marketability discount “to account for the

lack of marketability inherent in a minority interest of a

closely held company”, he determined that the fair market value

of the members’ equity in PMG on an aggregate minority interest

basis as of the valuation date was $300,000,000 (rounded) under

that method.

B. Guideline Companies Not Sufficiently Comparable to PMG

Mr. Thomson failed to analyze sufficiently comparable

publicly held companies to warrant application of the guideline

company method herein. Publicly held companies involved in

similar, rather than the same, lines of business may act as

guideline companies. Sec. 2031(b). However, “As similarity to

the company to be valued decreases, the number of required

comparables increases in order to minimize the risk that the

results will be distorted by attributes unique to each of the

guideline companies.” Estate of Heck v. Commissioner, T.C. Memo.

2002-34. While the small number of guideline companies chosen by
- 21 -

Mr. Thomson are engaged in business ventures similar to PMG’s,

their differences from PMG prevent a reliable comparison.

Size: As of June 2004, PMG was smaller than any of the four

guideline companies in terms of both total assets and revenue. 

PMG had approximately one-third of the revenue and approximately

one-fourth of the total assets of the guideline companies’

respective medians ($163,600,000 versus $557,300,000 and

$353,000,000 versus $1,368,200,000, respectively).

Products: While PMG primarily published daily and weekly

newspapers, it also published a few specialty publications. In

contrast, Lee Enterprises and Pulitzer, Inc., complemented their

daily and weekly newspapers with a wide variety of classified,

specialty, shoppers, and niche publications. Further, three of

the guideline companies heavily integrated Internet news into

their business models. The Journal Register Co. operated 152

news websites, intending to expand its business through Internet

initiatives, while both Lee Enterprises and Pulitzer, Inc.,

published their newspapers with associated and integrated online

services. PMG’s business plan did not include an Internet

component.

Other Differences: PMG experienced greater EBITDA and

revenue growth than the median growth of the guideline companies

during the 5 years before June 2004. As of June 2004, however,

PMG shared a similar liquidity ratio with, but was more highly
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leveraged (as measured by long-term debt in relation to net

worth) than, the guideline companies’ median liquidity and

leverage ratios. 

C. Conclusion

We find that Mr. Thomson improperly relied on the guideline

company method because the four guideline companies alone were

not similar enough to PMG to warrant its application. See, e.g.,

Estate of Hall v. Commissioner, 92 T.C. at 325, 341 (finding that

the taxpayer’s experts “acted reasonably in selecting” six

comparable companies where those companies were involved in

similar businesses as, and occupied similar positions within

those industries as, the subject company); Estate of Zaiger v.

Commissioner, 64 T.C. 927, 935, 945 (1975) (finding that the

comparable companies the Commissioner’s expert used were not

sufficiently comparable because of differences in product mix and

size operations). Although the McClatchy Co. is arguably of

sufficient similarity to PMG, a single comparable company is

insufficient on which to base the valuation method. See Estate

of Hall v. Commissioner, supra at 339. Because Mr. Thomson

improperly relied on the market-based approach in valuing

decedent’s units of PMG, it is unnecessary to address the other

two areas of disagreement concerning the approach’s application: 

Appropriate adjustments and discounts.
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VIII. Discounted Cashflow Method

A. Introduction

We next consider the proper application of the discounted

cashflow (DCF) method in valuing decedent’s units. Given the

lack of public companies comparable to PMG, we agree that the DCF

method is the most appropriate method under which to value the

units. See Estate of Heck v. Commissioner, supra. The DCF

method is an income-based approach whereby a company’s value is

measured by the “present value of future economic income it

expects to realize for the benefit of its owners.” Estate of

True v. Commissioner, T.C. Memo. 2001-167. After analyzing the

company’s revenue growth, expenses, capital structure, and the

industry in which it operates, the company’s future cashflows are

estimated and their present values are calculated based on “an

appropriate risk-adjusted rate of return.” Id.

Both Mr. May and Mr. Thomson rely on the method in their

appraisals but disagree as to: (1) PMG’s projections, (2)

whether to tax affect PMG’s earnings in calculating the company’s

value, (3) cashflow adjustments, (4) the amounts to be included

in the rate of return, (5) earnings adjustments to PMG’s

enterprise value, and (6) the nature and amount of applicable

discounts. We discuss both experts’ computations in arriving at

the PMG units’ fair market value.
- 24 -

B. Discounting PMG’s Net Free Cashflow

Both Mr. Thomson and Mr. May valued PMG’s units under the

DCF method; however, they discounted different economic benefits

of the company. Specifically, Mr. Thomson discounted PMG’s net

EBITDA, beginning his calculations with PMG’s revenue for the

last 12 months ended June 27, 2004. Mr. May, in contrast,

derived the present value of PMG’s net free cashflow7 and began

his analysis with PMG’s operating income during the 5 months

ended May 30, 2004. The parties have not distinguished between

these two economic benefits against which to apply the DCF

method. We shall derive the present value of PMG’s net free

cashflow (net cashflow). However, the financial statements on

which the experts’ revenue and operating income numbers are based

are not in evidence. Petitioner failed to object to and disprove

the amount of PMG’s revenue as of June 27, 2004, relied upon by

Mr. Thomson; therefore, we deem it to be accurate. Because we

determine the appropriate revenue growth rate below, and the

experts calculated PMG’s projected operating income as a

percentage of PMG’s projected revenue, we shall construct our own

operating income projections in discounting PMG’s net cashflow.

7“The term ‘free cash flow’ is used because this cash is

free to be paid back to the suppliers of capital.” Quick MBA,

http://www.quickmba.com/finance/free-cash-flow/ (last visited

Mar. 30, 2011).
- 25 -

C. Projections

1. Confidential Information Memorandum

Since the DCF method calculates the present value of a

company’s future economic income, it is imperative to use a

reliable economic forecast in applying the method. Both parties’

experts prepared their own economic projections rather than use

the February 2004 multiyear forecast Wachovia Bank prepared in

conjunction with its CIM. 

On brief, respondent argues that Mr. May erred in not using

the CIM forecast, which respondent argues best projects PMG’s

future income and expenses. Respondent does not disavow his own

expert’s appraisal, however, which does not rely on the CIM

forecast. We regard respondent’s continued reliance on his own

expert’s appraisal as a retreat from respondent’s position

regarding the use of the CIM forecast. We, therefore, need not

consider the need to use it herein.

2. Projected Revenue Growth Rate

a. The Experts’ Computations

In projecting PMG’s future revenue, Mr. Thomson estimated

that the company’s revenue would grow by 5.45 percent in year 1,8

1.5 percent in year 2, and 1 percent annually during years 3, 4,

and 5. He arrived at those projections by assuming an annual 1-

8Mr. Thomson used fiscal years ended June 27 in his

projection.
- 26 -

percent baseline growth rate based on PMG management’s statements

that, absent acquisitions, the company grew approximately 1

percent each year from 1999 to 2004 and was expected to continue

to do so.

He then made two adjustments to this annual rate. For year

1, Mr. Thomson assumed a starting revenue of $85,828,303 (half of

the revenue estimated in PMG’s 2004 budget), to account for the

second half of 2004, adding to that 1 percent of growth for that

same amount, to account for the first 6 months of 2005.9 This

resulted in 5.45 percent of growth from PMG’s revenue for the

last 12 months ended June 27, 2004. For year 2, he added 0.5

percent of growth to the presumed 1-percent revenue growth to

reflect PMG’s acquisition of the remaining 50-percent interest in

High Point, resulting in 1.5 percent total growth for the year. 

Mr. Thomson calculated this percentage increase after determining

that PMG grew 0.8 percent in 2002 as a result of a 100 percent

acquisition that year. 

In his report, Mr. May projected total revenue growth for

PMG of 4.6 percent for its year ending December 31, 2004, and of

2.9 percent, 4.9 percent, 3 percent, 4.9 percent, 3 percent, and

4.8 percent for years 2005, 2006, 2007, 2008, 2009, and 2010,

9At trial, Mr. Thomson testified that the additional 1-

percent growth accounted for the revenue expected from the

October 2004 High Point acquisition. We reject Mr. Thomson’s

contradictory testimony and rely on his written report.
- 27 -

respectively. The total revenue growth rates were composed of: 

(1) An annual newspaper revenue growth rate of 4 percent, and (2)

a vacillating annual television revenue growth rate. Mr. May

chose a constant 4-percent newspaper revenue rate based on his

assumption that PMG “is going to grow at the same rate as the

comparable companies long term”, thus aligning the newspaper

revenue rate with the guideline companies’ 3.9-percent average

implied long-term growth rate. He did not include PMG’s option

to acquire the remaining 50-percent interest in High Point in the

company’s future expected cashflow because “it would be neither

accretive nor dilutive to shareholder value because the price to

be paid was to be fair market value.”

b. Analysis

We find Mr. Thomson’s revenue growth projections to be more

persuasive. Mr. May chose a growth rate that he himself

acknowledged was “significantly” higher than the company’s actual

2002 and 2003 newspaper growth (0.6 percent and 1.1 percent,

respectively).

In contrast, Mr. Thomson’s baseline projection derives from

PMG’s historical growth absent acquisitions, a reasonable

benchmark given that PMG did not specifically identify to either

party’s expert future acquisitions as of the valuation date. We

also agree with Mr. Thomson that revenue expected from the

October 22, 2004, completion of the High Point acquisition should
- 28 -

be included in the projections, since the completion of that

acquisition was foreseeable as of the valuation date.10 See,

e.g., Bergquist v. Commissioner, 131 T.C. at 17 (“Subsequent

events are not considered to fix fair market value, except to the

extent that they were reasonably foreseeable at the date of

valuation.” (internal quotation marks omitted)). Contrary to Mr.

May’s position, although PMG acquired the remaining 50-percent

interest at fair market value, thus not affecting the company’s

balance sheet, the expected future revenue affects the company’s

economic projections, thereby demanding its consideration under

the DCF method. Finally, Mr. Thomson based adjustments to the

baseline projection on actual past performance and resulting

effects to the company. We shall rely on Mr. Thomson’s revenue

projections in valuing decedent’s units of PMG.

3. Newsprint Adjustment

Respondent next disputes Mr. May’s adjustment to his

economic projections to account for higher industry newsprint

costs. Because of the “industry-expected rise of newsprint costs

for 2004 and 2005”, Mr. May estimated a 0.7-percent cost increase

in 2004 and an annual 1.3-percent cost increase in years 2005

through 2010. He fails, however, to explain how he arrived at

those projected costs. Petitioner provides no further support

10The death of High Point’s president was publicly known as

of the valuation date.
- 29 -

for the annual adjustment, other than referring to Mr. Paxton’s

testimony that such an adjustment may be necessary if future

cashflows will differ from past cashflows. Because neither

petitioner nor his expert, Mr. May, has convinced us as to the

propriety of the adjustment, we shall disregard it.

4. Operating Income

a. Operating Margin

Mr. Thomson projected PMG’s operating margin (operating

income) as a percentage of revenue for year 1 through year 5 at

39.5 percent of revenue. He computed operating income by

subtracting operating costs (excluding depreciation and

amortization of syndicated programming contracts), which he

estimated at a constant 60.5 percent of revenue, from revenue. 

He derived that estimate from PMG’s 2004 budget, which estimated

total operating costs at 60.8 percent of revenue, and PMG’s 2003

total operating costs, which were 60.4 percent of revenue.

Mr. May projected an operating income profit margin of 34.7

percent for 2004 and 34.1 percent for all subsequent years. He

based his projection, which shows a decrease in operating income

margins, on two assumptions: (1) Projected annual corporate

overhead expenses of 2.9 percent of revenue, which he arrived at

by averaging PMG’s historical corporate overhead expenses between

2000 and 2003, after adjusting for nonrecurring items (namely, a

2003 positive claim experience for self-insured life insurance
- 30 -

and a 2003 gain on life insurance from acquired companies), and

(2) an increase in newspaper cost of goods sold margins for

expected increases in newsprint costs in 2004 and 2005. Absent

these two assumptions, Mr. May stated that “our projected

operating income margins would have been higher than any of

Paxton’s historical operating margins.” In projecting operating

costs, he also factored in a projected depreciation cost of 3.1

percent of revenue.

We do not have confidence in Mr. May’s projection as it is

based on improper earnings and newsprint cost adjustments. See

supra parts VI. and VIII.C.3. We determine Mr. Thomson’s

analysis to be reasonable. Therefore, we find that PMG’s

projected total operating costs (excluding depreciation and

amortization of syndicated programming contracts) are 60.5

percent of revenue. Because we are discounting PMG’s cashflow,

we modify Mr. Thomson’s forecasted operating margin to include

Mr. May’s projected depreciation deduction of 3.1 percent of

revenue, which we find to be a reasonable projection. After

examining all of the evidence, we conclude that PMG’s projected

operating margin is 36.4 percent of total revenue.

b. Other Income (Expense)

Both Mr. Thomson and Mr. May adjusted PMG’s operating income

to reflect other income (expense) from affiliate company

management fees and equity in net income of affiliate company. 
- 31 -

However, they disagree over whether to also add other net income

and net pension income (expense). As stated earlier, supra part

VI., we disregard Mr. May’s exclusion of these items from PMG’s

historical financial statements. We adopt Mr. Thomson’s

projection of other income (expense) at 0.1 percent of revenue,

which we consider to be reasonable.

D. Tax Affecting PMG’s Earnings

The parties next dispute the propriety of tax affecting

PMG’s earnings under the DCF method. Tax affecting “is the

discounting of estimated future corporate earnings on the basis

of assumed future tax burdens imposed on those earnings”. Dallas

v. Commissioner, T.C. Memo. 2006-212. Since most data on which

stock valuation is based is derived from publicly traded C

corporations, appraisers may tax affect an S corporation’s

earnings to reflect its S status in its stock value.11 See

Bogdanski, Federal Tax Valuation, par. 6.03[6][e] (2009 & Supp.

2011).

Mr. May tax affected PMG’s earnings by assuming a 39-percent

income tax rate in calculating the company’s future cashflows,

before discounting PMG’s future earnings to their present value. 

He also assumed a 40-percent marginal tax rate in calculating the

11A C corporation’s income is subject to income tax at the

corporate level and its shareholders must also include any

received dividends in their gross income. See secs. 11,

301(c)(1). In contrast, an S corporation’s income is taxed only

at the shareholder level. Sec. 1366(a).
- 32 -

applicable discount rate. In contrast, Mr. Thomson disregarded

shareholder-level taxes in projecting both the company’s

cashflows and computing the appropriate discount rate.

Mr. May failed to explain his reasons for tax affecting

PMG’s earnings and discount rate and for employing two different

tax rates (39 percent and 40 percent)12 in doing so. Absent an

argument for tax affecting PMG’s projected earnings and discount

rate, we decline to do so. As we stated in Gross v.

Commissioner, T.C. Memo. 1999-254, the principal benefit enjoyed

by S corporation shareholders is the reduction in their total tax

burden, a benefit that should be considered when valuing an S

corporation. Mr. May has advanced no reason for ignoring such a

benefit, and we will not impose an unjustified fictitious

corporate tax rate burden on PMG’s future earnings.

E. Cashflow Adjustments

Mr. May defines net cashflow generally as net operating

income after taxes plus depreciation and amortization expenses

and minus working capital and capital expenditures. We have

accepted similar definitions, see, e.g., N. Trust Co. v.

Commissioner, 87 T.C. 349, 365 n.17 (1986), and accept that

definition, but, for the reasons stated supra part VIII.D.,

12Indeed, we are also unclear as to the source of those

income tax rates. In the year in issue, 2004, the highest

marginal corporate tax rate was 35 percent, with the highest

individual tax rate set at 39.6 percent. Secs. 1(c),

11(b)(1)(D).
- 33 -

without regard to a hypothetical corporate tax. The experts

disagree only as to the latter two adjustments, and we discuss

these modifications below.

1. Capital Expenditures

Mr. Thomson estimated PMG’s annual capital expenditures at

2.77 percent of revenue for years 1 through 5. He based his

projection on PMG’s operating history and historical amounts,

discussions with PMG’s management, and “additions necessary to

support the projected future revenue volumes”. Mr. May, in

contrast, projected that the company’s capital expenditures would

steadily increase from $4,190,000, or 2.3 percent of revenue, in

2005 to $7,807,000, or 3.1 percent of revenue, in 2014. Mr. May

did not justify his projection.

PMG’s historical financial statements show capital

expenditures (“purchase of property and equipment”), as a

percentage of revenue, fluctuating between 1999 and 2003: 4.6

percent in 1999, 14.2 percent in 2000, 0.9 percent in 2001, 3.6

percent in 2002, and 2.9 percent in 2003. The dramatic increase

in capital expenditures in 2000 resulted from a major acquisition

that year. The average annual capital expenditures for the 1999-

2003 period, excluding 2000, was 2.4 percent of revenue. Thus,

we consider Mr. Thomson’s projection of 2.77 percent of revenue

(2.8 percent, rounded) to be reasonable, and we adopt it. 

Conversely, not only does Mr. May fail to support his projection,
- 34 -

but PMG’s financial statements do not justify his estimated

increase in capital expenditures.

2. Working Capital

Mr. Thomson estimated that PMG’s debt-free working capital

(current assets less current liabilities (excluding current

maturities of long-term debt and line of credit)) would remain at

-2.5 percent of revenue throughout his projection, on the basis

of PMG’s historical data. Mr. May projected that PMG’s future

investment in working capital would fluctuate; however, he failed

to explain how he arrived at those estimates. Mr. May’s only

explanation consisted of an appendix to his report containing his

projected income statement, balance sheet, and cashflow statement

for PMG. We shall ignore Mr. May’s working capital projections

because of their complete lack of support. After analyzing the

record, we are persuaded that PMG’s historical performance

justifies Mr. Thomson’s projection of working capital levels, and

we find in accordance.

F. Rate of Return

Both parties’ experts used PMG’s weighted average cost of

capital (WACC)13 as the appropriate rate of return with which to

13In his report, Mr. May expressed the WACC formula as:

WACC = ((Ke)*(%E) + ((Kd*(%D)*(1-t))

(continued...)
- 35 -

discount PMG’s expected future cashflow under the DCF method. We

have previously held that WACC is an improper analytical tool to

value a “small, closely held corporation with little possibility

of going public.” Estate of Hendrickson v. Commissioner, T.C.

Memo. 1999-278; cf. Gross v. Commissioner, supra (allowing the

use of WACC when the expert used the subject corporation’s actual

borrowing costs to calculate the cost of debt capital component

of the WACC formula). Neither party has indicated the likelihood

of PMG’s becoming a publicly held company; however, because both

experts used WACC as the rate of return in their analyses, and

neither party otherwise raised the issue, we shall adopt it,

although we do not set a general rule in doing so.

Mr. Thomson computed a 10-percent WACC, assuming a zeropercent marginal tax rate, whereas Mr. May calculated a WACC of

12.3 percent, assuming a 40-percent corporate tax rate. As

stated earlier, supra part VIII.D., we shall not tax affect PMG’s

expected cashflows or the discount rate; we assume a zero-percent

tax rate in discounting the company’s earnings. The remaining

disagreements between the parties center around two components of

13(...continued)

Where: 

WACC = weighted average cost of capital,

Ke = leveraged cost of equity,

%E = percent equity in capital structure,

Kd = average cost of debt,

%D = percent debt in capital structure,

t = marginal tax rate.
- 36 -

the WACC formula: (1) The method for computing PMG’s cost of

equity capital, and (2) the percentages of PMG’s total capital

composed of debt and equity. Although the parties have not

raised as an issue the size of PMG’s cost of debt capital, the

experts have taken different positions, and we must, therefore,

decide the issue. 

1. Cost of Equity Capital

Mr. May used the capital asset pricing model formula (CAPM)14

to derive a 13.5-percent cost of equity capital for PMG; Mr.

Thomson, in contrast, calculated a 20-percent cost of equity

capital under the buildup method.15 We agree with Mr. Thomson

that the buildup method is the appropriate method by which to

compute PMG’s cost of equity capital. The special

characteristics associated generally with closely held corporate

stock make CAPM an inappropriate formula to use in this case. 

See, e.g., Hoffman v. Commissioner, T.C. Memo. 2001-109 (“The use

14We have stated that CAPM “is used to estimate a discount

rate by adding the risk-free rate, an adjusted equity risk

premium, and a specific risk or unsystematic risk premium. The

company’s debt-free cash-flow is then multiplied by the discount

rate to estimate the total return an investor would demand

compared to other investments.” Estate of Klauss v.

Commissioner, T.C. Memo. 2000-191 n.10.

15“Under the build-up method, an appraiser selects an

interest rate based on the interest rate paid on governmental

obligations and increases that rate to compensate the investor

for the disadvantages of the proposed investment.” Id. n.11.
- 37 -

of CAPM is questionable when valuing small, closely held

companies.”).

Although we accept Mr. Thomson’s use of the buildup method,

we are not convinced as to the accuracy of his analysis. To

compute a cost of equity capital of 20 percent, Mr. Thomson first

identified from Ibbotson Associates an equity risk premium of

11.7 percent,16 to which he added a risk-free rate of 5.22

percent. Ibbotson Associates, Stocks, Bonds, Bills, and

Inflation, 2004 Yearbook 32 (Ibbotson 2004). He then subtracted

PMG’s projected 1-percent long-term growth rate to arrive at a

minority capitalization rate. After converting this result to a

minority market multiple, he added a 20-percent premium for

control, ultimately arriving at a majority discount rate for PMG

of 14 percent. To this number, he added a 4-percent firm

specific risk premium and a 2-percent premium to account for

PMG’s “S” corporate status.

We do not understand why Mr. Thomson included PMG’s firm

specific risk premium at the final step of his analysis rather

than considering it along with the risk-free rate and equity risk

premium. We find this to be in error. See Trugman,

Understanding Business Valuation: A Practical Guide to Valuing

Small to Medium-Sized Businesses 250 (1998). In addition, we

16The premium size represents an equity risk premium plus a

small company risk premium. See Ibbotson Associates, Stocks,

Bonds, Bills, and Inflation, 2004 Yearbook 32 (Ibbotson 2004).
- 38 -

modify Mr. Thomson’s control premium of 20 percent to 30 percent,

as discussed below. After taking into consideration these

modifications, we find that PMG’s cost of equity capital is 18

percent.

2. Cost of Debt Capital

Mr. Thomson estimated PMG’s pretax cost of debt at 6.6

percent on the basis of his review of PMG’s weighted pretax cost

of debt as of December 28, 2003, and December 26, 2004 (2.9

percent and 3.5 percent, respectively), and of the average of Baa

corporate bonds as of July 2, 2004 (6.6 percent). He also

considered PMG’s leverage, its industry, and the low debt

financing rates in 2003 and early 2004, which were expected to

rise.

In his expert report, Mr. May calculated a 5-percent average

cost of debt. The entirety of his reasoning lies in a footnote:

“Based on Company’s existing costs of debt and estimated costs of

debt, given the companies [sic] financial condition and the

current interest rate environment.”

Neither expert convinced us as to the accuracy of his

analysis. We accept the assumptions upon which Mr. Thomson’s

calculation is based, which cannot be objectionable to

petitioner, since Mr. Thomson’s proposed higher cost of debt

results in a lower present value of expected cashflow. See
- 39 -

Estate of Heck v. Commissioner, T.C. Memo. 2002-34. We find that

6.6 percent is a reasonable cost of debt capital for PMG.

3. Percentages of Total Capital Composed of Debt and

 Equity

As part of his WACC analysis, Mr. Thomson selected 75

percent and 25 percent as PMG’s total capital composed of debt

and equity, respectively. He derived those percentages after

considering both PMG’s capital structure, (composed of 73-percent

audited book debt and 27-percent audited book equity) and the

guideline companies’ median capital structure (16-percent debt

and 84-percent equity, based on market values). He relied upon

PMG’s own capital structure rather than on the guideline

companies’ median because: (1) A minority shareholder cannot

change the capital structure of the company, and (2) Mr. Paxton’s

statement that PMG would continue to be more leveraged than those

companies because of future acquisitions financed with debt. 

Additionally, Mr. Thomson observed that PMG’s total capital

composed of debt and equity percentages for 2003, the year

immediately preceding the valuation date, were 77.5 percent and

22.5 percent, respectively.

Mr. May determined that percentages of debt and equity in

PMG’s capital structure were 15 percent and 85 percent,

respectively. He provided no analysis as to how he arrived at

those percentages, other than to state that the 15 percent is

“based on analysis guideline companies’ capital structure”.
- 40 -

Petitioner argues that Mr. Thomson erroneously used book,

rather than market, values in determining the equity and debt

ratios. We agree that market values of a company’s debt and

equity are to be used in estimating its weighted average cost of

capital. See Furman v. Commissioner, T.C. Memo. 1998-157

(finding that “To compute WACC, it is necessary to know the

market value of the firm’s debt and equity”); Brealey & Myers,

Principles of Corporate Finance 525 (7th ed. 2003). However,

because both experts rely on the WACC formula and PMG’s own

market values are unknown because of its closely held company

status, we must determine the appropriate debt and equity ratios

on the basis of the persuasiveness of the experts’ analyses.

Mr. Thomson testified that he used the company’s own capital

structure because decedent could not affect PMG’s capital

structure as a minority interest unitholder. He explained that

that decision required that he use the company’s book values as

its market values were unknown. In contrast, despite Mr. May’s

conclusion that the guideline companies were not comparable under

the guideline company method, he declared that the same companies

were sufficiently comparable under the DCF method to justify

using their capital structures to calculate PMG’s WACC. We lend

no weight to Mr. May’s wavering stance and therefore use PMG’s

own capital structure at book value for purposes of this case. 
- 41 -

We find that 75-percent total capital composed of debt and 25-

percent total capital composed of equity is appropriate.

Petitioner also argues that Mr. Thomson erroneously

maintained the 75-percent debt and 25-percent equity ratio

throughout his analysis, a ratio that violates the requirement

under the CIM that PMG reduce its debt over time. We agree that

WACC is an improper discount rate tool for a company planning to

pay down its debt, thereby changing its capital structure. See

Brealey & Myers, supra at 536. However, given the parties’

reliance on their own experts, both of whom use the WACC formula

in their respective analyses, we must adopt the approach. 

Therefore, we will use Mr. Thomson’s constant WACC rate in this

case, although we do not intend to establish a general rule in

doing so.

4. Conclusion

We agree with Mr. Thomson that the weighted average cost of

capital for PMG is 10 percent (rounded), as our modification to

Mr. Thomson’s cost of equity capital determination does not

materially alter this result.

G. Adjustments to PMG’s Enterprise Value

1. Long-Term Debt

Both experts agree that, under the DCF method, PMG’s longterm debt must be subtracted from the present value of its future

economic income stream in order to arrive at the fair market
- 42 -

value of PMG’s units as of the valuation date. They disagree,

however, as to the amount of PMG’s debt as of the valuation date. 

Mr. Thomson determined that PMG had $243,602,413 of interestbearing debt as of June 27, 2004, on the basis of PMG’s

comparative balance sheet for interim period ended June 27, 2004. 

Mr. May, meanwhile, concluded that PMG had $243,300,000 (rounded)

of net debt as of May 30, 2004, relying on PMG’s internally

prepared financial statements for the 5 months ended May 30,

2004.

Mr. Thomson and Mr. May both arrive at their debt numbers on

the basis of balance sheets for interim periods that are not in

evidence. Because neither party objects to the other’s debt

number, we deem the parties to have conceded the numbers as

accurate. Therefore, we must determine which expert provided a

more reliable long-term debt calculation.

Neither expert supports his conclusion with an explanation. 

After examining the record, we find that the experts generally

included the same categories of obligations in their PMG debt

calculations, and the difference apparently is because of the

dates of the financial data used. Because we have already

concluded that PMG’s June 27, 2004, unaudited financial statement

provides the most relevant information, we shall adopt Mr.

Thomson’s long-term debt conclusion of $243,602,413. Moreover,

Mr. May identified differing debt amounts throughout his report. 
- 43 -

We will not rely on a consistently changing number, especially

one that Mr. May fails to justify.

2. Working Capital Deficit

Mr. May adjusted PMG’s marketable minority enterprise value

by $900,000 (rounded) to reflect PMG’s working capital excess (or

deficit). He determined that, as of the valuation date, PMG’s

working capital was underfunded by $900,000 (rounded) after

comparing PMG’s working capital level with the guideline

companies’ median ratio of working capital-to-sales. He applied

this adjustment to his results under both the guideline company

method and the DCF method, justifying its need only under the

former. Mr. Thomson did not make a similar adjustment under

either valuation method.

We do not find Mr. May’s analysis to be persuasive. Mr. May

once again failed to explain why the public companies that he

deemed to be not comparable to PMG under the guideline company

method provide a sufficient comparison upon which to base a

working capital adjustment. We lend little weight to his

seemingly contradictory positions. In addition, although

explaining the need for a working capital adjustment under the

guideline companies methodology, he failed to do so under the DCF

method despite applying the adjustment to the results under both

methods. For these reasons, we disregard his working capital

deficit adjustment.
- 44 -

3. S Corporation Benefits

Mr. May made the following three adjustments to his result

under the DCF method to account for certain shareholder benefits

associated with PMG’s S corporation election: (1) Adding

$12,847,000 to account for “S shareholder tax savings on all

future projected distributions in excess of tax distributions”,

(2) adding $44,262,000 to reflect the future value of the

company’s deductible goodwill, discounted back to the valuation

date, and (3) adding $6,693,000 to account for the company’s

extra marginal debt tax shield. Petitioner argues that such

adjustments are proper under Gross v. Commissioner, T.C. Memo.

1999-254, in which we stated that “the principal benefit that

shareholders expect from an S corporation election is a reduction

in the total tax burden imposed on the enterprise” and that such

savings ought not be ignored in valuing an S corporation. 

Petitioner argues that with the aforementioned three adjustments,

Mr. May’s valuation of PMG’s units reflects the full economic

value of PMG’s S corporation tax status, thus satisfying our

directive in Gross. Mr. Thomson made no similar adjustments.

Although correctly cited by petitioner, Mr. May erred in

implementing our directive in the case. In Gross, one of the

taxpayer’s experts criticized the Commissioner’s expert for not

accounting for the “known payment” of taxes in valuing the

subject S corporation’s earnings under the DCF method because he
- 45 -

assumed a zero-percent corporate tax rate. Interpreting the

taxpayer’s expert as arguing that “the avoided C corporation tax

must be taken into account as a hypothetical expense, in addition

to the shareholder level taxes actually imposed on the S

corporation’s shareholders” when valuing an S corporation, we

concluded that

[The taxpayer’s expert] has not convinced us that such an

adjustment is appropriate as a matter of economic theory or

that an adjustment equal to a hypothetical corporate tax is

an appropriate substitute for certain difficult to quantify

disadvantages that he sees attaching to an S corporation

election. We believe that the principal benefit that

shareholders expect from an S corporation election is a

reduction in the total tax burden imposed on the enterprise. 

The owners expect to save money, and we see no reason why

that savings ought to be ignored as a matter of course in

valuing the S corporation.

Id. Thus, we found such savings properly reflected through the

imposition of a zero-percent corporate tax rate in valuing S

corporations under the DCF method. Our conclusion did not

address the propriety of imposing other adjustments, such as

those made by Mr. May to PMG’s enterprise value, to similarly

reflect such tax savings. Petitioner fails to convince us of the

accuracy of Mr. May’s adjustments and, therefore, we disregard

them.

4. Stock Options Outstanding as of the Valuation Date

Both experts acknowledged PMG’s stock option program, which

was in effect as of the valuation date, in their respective

valuation analyses. They disagreed, however, as how to best
- 46 -

measure its impact on the fair market value of the company’s

units. To determine the units’ fair market value before

discounting for lack of marketability, Mr. May assumed that all

of the outstanding options would vest and subtracted the expected

proceeds from the option exercise, an in-the-money value of

$12,100,000 (rounded), from PMG’s enterprise value.

In contrast, Mr. Thomson did not account for the outstanding

options’ strike price. Rather, and without explanation, he

calculated PMG’s per unit fair market value by dividing the fair

market value of PMG’s members’ equity by the total number of

issued and outstanding fully diluted units as of the valuation

date. After reviewing the evidence, it seems that his

calculation rests upon the same “treasury stock method”

assumption used in Mr. Paxton’s July 12, 2004, valuation report;

namely, that an option exercise causes a company to use the

resulting proceeds to repurchase shares at the prevailing market

price and issue a mix of new and repurchased shares to meet its

obligation. Relying on this assumption, Mr. Thomson appears to

have concluded that money received from the option exercise would

not increase PMG’s cashflows; the exercise would result solely in

an increased number of outstanding units. Mr. Thomson has not

convinced us that the above assumption reflects how PMG operates

its stock option program, and Mr. Paxton’s report does not

provide an answer. Therefore, we shall adopt Mr. May’s approach
- 47 -

(but not his numbers) in estimating the dilutive impact of the

options outstanding.

H. Discounts

The parties do not dispute that, in valuing the units, it is

appropriate to take account of both a minority discount and a

lack of marketability discount. Indeed, we have accepted both

discounts when valuing stock of closely held corporations. See

Estate of Newhouse v. Commissioner, 94 T.C. at 249. The parties

differ, however, on the size of and, with respect to the minority

discount, the method of application of the discounts.

As a preliminary matter, we note that, although similar,

there is a discernible difference between the two discounts, as

articulated in Estate of Andrews v. Commissioner, 79 T.C. at 953:

The minority shareholder discount is designed to reflect the

decreased value of shares that do not convey control of a

closely held corporation. The lack of marketability

discount, on the other hand, is designed to reflect the fact

that there is no ready market for shares in a closely held

corporation. * * *

Those discounts should not be combined when applied to the result

under a valuation approach. Estate of Magnin v. Commissioner,

T.C. Memo. 2001-31. Rather, to avoid distorting the valuation

analysis, the minority discount should be applied first, followed

by the lack of marketability discount. Id.

Mr. Thomson applied a 17-percent minority discount to his

result under the DCF method on the basis of studies of control

premiums, since, he believes, the inverse of a control premium
- 48 -

“equates to a minority interest discount.” He then applied a 31-

percent marketability discount to reach an aggregate minority

interest value in PMG of $267,000,000 as of the valuation date. 

In contrast, Mr. May applied only one discount under his DCF

analysis: a 30-percent lack of marketability discount. He found

a specific minority discount unnecessary because: “The DCF

Methodology is derived based on cashflows that we assume would

accrue pro rata to all equity holders, therefore, the resulting

firm value is on a minority interest basis and needs no further

adjustment to reflect a minority interest value.” We discuss

each discount below.

1. Minority Interest Discount

Mr. Thomson applied a 17-percent minority interest discount

to the fair market value of PMG’s members equity on a controlling

interest basis that he calculated under the DCF methodology. He

applied the discount so as to reflect the decline in value of

decedent’s units given the lack of control inherent in her

minority interest. To calculate the discount size, and

concluding that a minority interest discount is the mathematical

inverse of a control premium,17 he reviewed statistics, compiled

17Assuming that a minority discount is the inverse of a

control premium, a minority discount can be represented

mathematically as: 1 - [(1 ÷ (1 + control premium)]. See 

(continued...)
- 49 -

in Mergerstat Review 2004, on control premiums paid in mergers

and acquisitions between 2002 and 2003. He found the following: 

(1) The median percent premium paid for all industries in 2002

(based on 326 transactions) and 2003 (based on 371 transactions)

was 34.4 percent and 31.6 percent, respectively, (2) the overall

median percent premium paid for transactions in 2002 (based on 86

transactions) and 2003 (based on 100 transactions) where the

purchase price was between $100,000,000 and $499,900,000 was 30.3

percent and 27.4 percent, respectively, and (3) within the

printing and publishing services industry during 2002 and 2003,

one transaction had a premium of 45.2 percent, and the average

premium of the five additional transactions was 67.5 percent. On

the basis of those statistics and general factors that affect a

control premium’s size, he concluded that a 20-percent control

premium was reasonable for a majority investment in PMG, which

equated to a 17-percent minority interest discount. Mr. May did

not apply a specific minority interest discount under his DCF

analysis.

Because we generally follow Mr. Thomson’s DCF approach,

which derives PMG’s members’ equity on a controlling basis, we

agree that a minority discount is appropriate in valuing

decedent’s 15-percent minority interest in PMG. Cf. Estate of

17(...continued)

Trugman, Understanding Business Valuation: A Practical Guide to

Valuing Small to Medium-Sized Businesses 265 (1998).
- 50 -

Jung v. Commissioner, 101 T.C. at 439 (if an expert’s DCF

calculations are on a minority basis, no minority discount should

be applied to the resulting values). We disagree, however, with

Mr. Thomson’s analysis. Mr. Thomson only vaguely supported his

chosen control premium with the above-referenced statistics. Mr.

Thomson determined a control premium for PMG that is 10

percentage points below the median control premium paid for

transactions in all industries and 20 percentage points below

control premiums paid in PMG’s own industry. He provided no

explanation as to why he chose such a comparatively low control

premium, besides listing general factors that affect a control

premium’s size. We cannot justify Mr. Thomson’s control premium

and resulting minority interest discount without a more

comprehensive explanation. Since the parties are in general

agreement that a minority discount is appropriate, we determine a

23-percent minority discount to the equity value of PMG computed

on a 30-percent controlling interest basis under the DCF method.18

2. Lack of Marketability Discount

Mr. Thomson determined a 31-percent lack of marketability

discount after reviewing seven independent restricted stock 

18Thirty percent is near the lower end of the range of

medians and means he found.
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studies,19 which report average and median lack of marketability

discounts in restricted stock transactions. Those studies show

an average discount of 32.1 percent. Mr. Thomson chose a 31-

percent discount based on, among other things, PMG’s established

name and reputation, its upward trend in distributions, and its

trend of redeeming shares.

Mr. May computed a 30-percent lack of marketability discount

based on the same seven studies, plus four20 additional restricted

stock studies and two pre-IPO studies.21 In selecting a discount

size, he observed that the restricted stock studies report a

smaller average discount than do the pre-IPO studies. He also

noted that PMG’s stock was significantly more restricted and more

likely to be held for a longer period of time than the studied

restricted stock, characteristics leading to a higher lack of

marketability discount for PMG’s units. He, therefore, chose a

30-percent discount, which fell within the range of average

discounts (13 percent - 35.6 percent) found by the restricted

stock studies. 

19The seven studies are: (1) SEC Institutional Investor

Study, (2) Gelman Study, (3) Trout Study, (4) Moroney Study, (5)

Maher Study, (6) Silber Study, and (7) Management Planning Study.

20The additional restricted stock studies are: (1) Standard

Research Consultants, (2) Willamette Management Associates, (3)

FMV Opinions, and (4) Columbia Financial Advisors.

21The pre-IPO studies are: (1) Emory and (2) Valuation

Advisors.
- 52 -

We have previously disregarded experts’ conclusions as to

marketability discounts for stock with holding periods of more

than 2 years when based upon the above-referenced studies. See

Furman v. Commissioner, T.C. Memo. 1998-157 (finding the

taxpayer’s reliance on the restricted stock studies in

calculating a lack of marketability discount to be misplaced

since owners of closely held stock held long term do not share

the same marketability concerns as restricted stock owners with a

holding period of 2 years). Given both experts’ reliance on the

studies, however, we shall accept them as setting the benchmark

discount size for decedent’s units. We find a 31-percent lack of

marketability discount to be appropriate.

IX. Conclusion

We shall redetermine a deficiency in Federal estate tax

commensurate with our finding that the value of the shares as of

the valuation date was $32,601,640. See appendix.

Decision will be entered

under Rule 155.
- 53 -

APPENDIX

Valuation of 3,970 Units of Paxton Media Group, LLC as of July 5, 2004

Projected Items LTM* ended June 27, 2004 Year 1 Year 2 Year 3 Year 4 Year 5

Revenue $163,602,288 $172,514,890 $175,102,613 $176,853,640 $178,622,176 $180,408,398

Operating income

 (@ 36.4% op. margin)

62,795,420 63,737,351 64,374,725 65,018,472 65,668,657

Other income (expense)

 (@ 0.1% of revenue)

172,515 175,103 176,854 178,622 180,408

Adjusted operating income 62,967,935 63,912,454 64,551,579 65,197,094 65,849,065

Cashflow adjustments

+ Depreciation

 (3.1% of revenue)

5,347,962 5,428,181 5,482,463 5,537,288 5,592,660

(-) Working capital additions 

 (-2.5% of revenue)

222,815 64,693 43,776 44,213 44,656

(-) Capital expenditures

 (2.8% of revenue)

(4,830,417) (4,902,873) (4,951,902) (5,001,421) (5,051,435)

Yearend cashflow 63,708,295 64,502,455 65,125,916 65,777,174 66,434,946

Discount rate (WACC) 10% 10% 10% 10% 10%

Present value interest factor (1 / (1.1)n) 0.9091 0.8265 0.7513 0.6830 0.6209

Present value of cashflows 57,917,211 53,311,279 48,929,101 44,925,810 41,249,458

Total present value of cashflows (year 1 - year 5) $246,332,859

Present value of reversion:

 66,434,946 ((1.01 / (0.1 - 0.01)) / ((1 + 0.1)6)

421,129,997

Total present value of all future cashflows 667,462,856

Long-term debt (243,602,413)

Enterprise value of PMG (w/o discount) 423,860,443

Value less in-the-money value of options1 408,667,643

Value with 23% minority discount 314,674,085

Value with 31% lack of marketability discount 217,125,119

Value of each unit 8,212

Value of 3,970 units 32,601,640

* Last 12 months

1($8,212-$2,786) x $2,800