T.C. Memo. 2000-264

UNITED STATES TAX COURT

ESTATE OF CHARLES A. BORGATELLO, DECEASED, C. NORMAN BORGATELLO 

AND JOSEPHINE E. DONNELLY, CO-EXECUTORS, AND C. NORMAN BORGATELLO,

SUCCESSOR TRUSTEE TO THE CHARLES A. BORGATELLO LIVING TRUST,

Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 24756-97. Filed August 18, 2000.

John W. Ambrecht and Gregory Arnold, for petitioners.

Donna F. Herbert, for respondent.

MEMORANDUM OPINION

WELLS, Chief Judge: Respondent determined a deficiency of

$3,424,504 in the Federal estate tax of the estate of Charles A.

Borgatello (the estate). After concessions, the issues we must

decide involve the fair market value of stock representing an
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1 Valley Improvement Co. is a California C corporation.

2 The value of the other assets is as follows:

Real Property Fair Market Value

550 Santa Angela Lane $425,000

Monterey county Ranch (remainder interest) 325,000

15.8 acres of vacant land outside Solvang (50% interest) 170,000

(continued...)

82.76-percent interest in Valley Improvement Co., Inc. (VIC)1 as

of January 12, 1994. To value the 82.76-percent shareholder's

interest in VIC, we must first decide the fair market value of

two shopping centers owned by VIC, Montecito Village North (MVN)

and Montecito Village South (MVS), as of January 12, 1994. The

parties agreed on the value of VIC's other assets. Some of the

facts have been stipulated and are incorporated herein by this

reference. Unless otherwise noted, all section references are to

the Internal Revenue Code, and all Rule references are to the Tax

Court Rules of Practice and Procedure. Charles Borgatello died a

resident of California. Mr. Borgatello died on July 12, 1993.

Background

For the purpose of valuing Mr. Borgatello's assets, the

estate's executors elected the alternate valuation date of

January 12, 1994. On the alternate valuation date, VIC owned 100

percent of MVN and MVS. VIC also owned other assets with a total

value (pursuant to the parties' stipulations) of $3,188,000

(rounded).2 Per the parties' stipulations, on the alternate
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(...continued)

1562 Alamo Pintado outside of Solvang 475,000

Seven Properties zoned M-1 in Santa Barbara

130 Nopalitos 140,000

126 Nopalitos 61,595

710 Kimball Street 87,785

712 Kimball Street 101,850

718 Kimball Street 101,850

713 Carpinteria Street 101,850

119 Powers Avenue 91,180

 Total $2,081,110

Tangible Personalty

Equipment & cattle $195,000

 Total $195,000

Investments Fair Market Value

Chevron Corp. stock $25,974

Pepsico, Inc. stock 154,319

Transamerica Corp. stock 79,463

General Motors stock 14,457

General Motors E stock 1,808

General Motors H stock 709 

Western art 66,450

 Total $343,180

Other Assets Fair Market Value

Cash $72,000

Accounts and notes receivable 293,000

Other current assets 151,000

Other assets 52,000

 Total $568,000*

 

*The parties made a computational error in their stipulation. This amount

was reported as $516,000 in the stipulation, not $568,000. 

3 According to the parties, net asset value is generally the

difference between assets and liabilities, where assets have been

adjusted to reflect fair market values and liabilities have been

adjusted to reflect the reality of their ultimate payment.

valuation date, VIC had total liabilities of $2,543,000. The net

value of VIC's assets3 on the alternate valuation date equaled

the values of MVN and MVS, plus $645,000 (assets of $3,188,000

minus liabilities of $2,543,000).
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Discussion

The estate contends that the combined value of MVN and MVS

is $13,375,000 (MVN, $8,375,000 and MVS, $5,000,000). On the

basis of those values and the stipulated value of VIC's other

assets, the estate contends that Mr. Borgatello's 1,037 shares of

VIC stock are worth $7,542,101. Respondent contends that the

combined value of MVN and MVS is $15,799,000 (MVN, $9,925,000 and

MVS, $5,874,000). On the basis of those values and the

stipulated value of VIC's other assets, respondent contends that

Mr. Borgatello's interest in VIC is worth $9,930,000.

Procedural Issue

Before we tackle the issues of the fair market values of MVN

and MVS and Mr. Borgatello's interest in VIC, we must first

address an evidentiary issue concerning certain appraisal reports

prepared by the experts in this case. The estate commissioned

several appraisals of MVN and MVS. One of the real estate

appraisers, Wayne Holden, was asked to value MVN and MVS as of

the date of Mr. Borgatello's death. For this purpose, Mr. Holden

produced a set of appraisals that he completed on January 14,

1994 (Holden I reports). Subsequently, the estate asked Mr.

Holden to appraise MVN and MVS as of the alternate valuation

date. Mr. Holden updated his previous appraisals in two letters

dated February 21, 1994 (Holden II reports). The Holden II
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reports ostensibly adjusted Mr. Holden's conclusions regarding

the shopping center values in the Holden I reports for changes in

the real estate market during the 6 months between the date of

Mr. Borgatello's death and the alternate valuation date. On the

basis of the Holden II reports, the estate decided to elect the

alternate valuation date.

During the audit of the instant case, the estate provided

respondent with the Holden I and II reports. Later, during

discussions with respondent's Appeals Office, the estate provided

the Appeals officer with two reports by Carlos A. Cardenas

(Cardenas reports) valuing MVN and MVS on the alternate valuation

date. The Cardenas reports were not used in the preparation of

the estate's tax return and were not provided to the Internal

Revenue Service during the audit of the estate. At trial, the

estate did not use the Holden I or II reports or the Cardenas

reports. Instead, the estate used two new appraisals by Mr.

Holden (Holden III reports), which valued MVN and MVS on the

alternate valuation date.

Respondent's valuation of MVN and MVS is based upon two

appraisal reports (in a single bound volume) prepared by David

Marx. Mr. Marx prepared a Limited Summary report in which he

reviewed the Holden I, II, and Cardenas reports and adopted some

background data and conclusions from those reports. In
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particular, Mr. Marx adopted background data pertaining to

Montecito-Santa Barbara area vacancy rates and fair rental value.

He also agreed with the estate's experts' analyses pertaining to

highest and best use, zoning, site and improvement, and

neighborhood description. The first two pages of each of Mr.

Marx's reports contain cover letters dated March 7, 1999, from

Mr. Marx to respondent's attorney. Both letters contain the

following disclaimer:

This Limited Summary Report is valid only if another

reviewer or entity is in possession of the [Holden I,

Holden II, and Cardenas appraisals] * * *. The

appraiser agreed on some of the factual data and issues

in these reports, and these items were used in this

Limited Summary Report as part of the analysis of the

subject. The three appraisals being reviewed, will be

relied upon as to facts concerning the site,

improvements, zoning and other descriptions. The

appraiser will not complete a zoning analysis, site &

improvement analysis or Highest and Best Use or

neighborhood descriptions. These items are found in

the appraisals reviewed by David Marx, and are assumed

to be valid. [Emphasis in the original.]

At the trial of the instant case, the estate objected to the

admission of Mr. Marx's reports, the Cardenas reports, and the

Holden I and II reports. The Court admitted, over the estate's

objection, the Holden I and II reports into evidence. The Court

conditionally admitted Mr. Marx's reports, but reserved ruling on

the admissibility of the Cardenas reports. The Court instructed
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the parties to brief the admissibility of Mr. Marx's reports and

the Cardenas reports. 

The estate disputes the admissibility of Mr. Marx's reports

on several grounds. Chiefly, however, the estate argues that the

Cardenas reports are inadmissible hearsay pursuant to rule 802 of

the Federal Rules of Evidence. Additionally, the estate argues

that if the Cardenas reports were excluded, it would cause Mr.

Marx's reports to become invalid in accordance with the abovequoted disclaimer. Respondent contends that the Cardenas reports

are not hearsay because they constitute admissions by the estate. 

Rule 801(d)(2)(B) of the Federal Rules of Evidence expressly

provides that any statement offered against a party where that

party has manifested an adoption or belief in the statement's

truth is admissible. See Fed. R. Evid. 801(d)(2)(B). Statements

admitted pursuant to rule 801(d)(2)(B) of the Federal Rules of

Evidence are admissible only against parties who have adopted

them or who bear a specified relationship to the declarant. See

Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-559. In

the instant case, the Cardenas reports were given to respondent

before trial by the estate's counsel. The reports were not

obtained by respondent directly from the estate's experts. The

estate supplied the reports to respondent as representations of

the values (and the data underlying those values) of MVN and MVS. 
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4 The Cardenas reports are admissible on other grounds as

well. One significant distinction between expert and fact

witnesses is that experts are permitted to rely on evidence

outside the trial record. See H Group Holding, Inc. v.

Commissioner, T.C. Memo. 1999-334. The evidence outside the

record may be hearsay and need not be otherwise admissible, but

it can be used by the expert to formulate an opinion. See Fed.

R. Evid. 703. 

The act of producing the reports to respondent constitutes an

adoption of belief in the truth of their contents pursuant to

rule 801(d)(2)(B) of the Federal Rules of Evidence. 

Consequently, we hold that the requirements of rule 801(d)(2)(B)

of the Federal Rules of Evidence are satisfied and the Cardenas

reports are admissible.4

The estate vaguely suggests that the Cardenas reports were

provided to respondent during settlement negotiations and,

therefore, are inadmissible pursuant to rule 408 of the Federal

Rules of Evidence. Although respondent acknowledged at trial

that there may be some question as to whether the Cardenas

reports were provided to respondent during settlement

negotiations, the estate failed to demonstrate that such was the

case. Consequently, we hold that the estate has not shown that

the Cardenas reports are inadmissible pursuant to rule 408 of the

Federal Rules of Evidence. 

The estate's other main argument against the admission of

Mr. Marx's report is based upon our holding in Diego Investors IV
- 9 -

v. Commissioner, T.C. Memo. 1989-630. In Diego Investors IV, the

Court refused to allow an expert selected and paid for by the

Commissioner to testify as the taxpayers' witness. The taxpayers

in Diego Investors IV sought to call the Commissioner's expert to

enhance their tactical position by using selected portions of a

report pertaining to sales data while refuting the remainder of

the expert's unfavorable conclusions. Although Diego Investors

IV is distinguishable from the instant case in numerous ways, one 

critical distinction is that in the instant case, respondent has

gained no tactical advantage by adopting some of the information

in the estate's expert's reports. 

In the instant case, the estate provided the Holden I, II,

and Cardenas reports to respondent as evidence of the values of

MVN and MVS, as well as to provide the facts and data underlying

those values. The estate now seeks to exclude those reports

because they believe that if they are successful, we shall

conclude that Mr. Marx's reports are invalid based on the

language in Mr. Marx's disclaimer. However, it appears that the

estate failed to appreciate that the use of expert testimony is

within the sound discretion of the trial judge. The test for

admissibility of expert testimony is whether the testimony will

aid the trier of fact to understand the evidence. See Fed. R.

Evid. 702; United States v. Amaral, 488 F.2d 1148, 1152 (9th Cir.
- 10 -

1973). Under Rule 702 of the Federal Rules of Evidence, the

trial judge is given broad discretion in his role as gatekeeper

to decide what evidence is relevant, reliable, and helpful to the

trier of fact. See Desrosiers v. Flight Intl. of Fla., Inc., 156

F.3d 952, 961 (9th Cir. 1998). In the instant case, the estate's

experts' reports are being offered to aid the Court in

understanding Mr. Marx's report. They are not being offered to

refute the unfavorable conclusions of the estate's experts, nor

are they being offered for a matter of out-of-context conjecture

or opinion which supports only one party's position, as was the

case in Diego Investors IV. Respondent gained no real tactical

advantage in the instant case when Mr. Marx adopted information

from the estate's experts' reports. The use of such reports is

tantamount to an informal stipulation which saves the Court time

in deciding a case that could have been settled by the parties. 

Indeed, such information should have been incorporated into a

formal stipulation. We hold that the Marx and Cardenas reports

are admitted into evidence.

Fair Market Value of the MVS and MVN Shopping Centers

As is customary in valuation cases, the parties in the

instant case rely primarily on expert opinion evidence to support

their contrary valuation positions. In such cases, we evaluate

the opinions of experts in light of the demonstrated
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qualifications of each expert and all other evidence in the

record. See Estate of Christ v. Commissioner, 480 F.2d 171, 174

(9th Cir. 1973), affg. 54 T.C. 493 (1970); Parker v.

Commissioner, 86 T.C. 547, 561 (1986). We have broad discretion

to evaluate "'the overall cogency of each expert's analysis.'" 

Sammons v. Commissioner, 838 F.2d 330, 334 (9th Cir. 1988)

(quoting Ebben v. Commissioner, 783 F.2d 906, 909 (9th Cir.

1986), affg. in part and revg. in part T.C. Memo. 1983-200),

affg. in part and revg. in part on another ground T.C. Memo.

1986-318.

Expert testimony sometimes aids the Court in determining

values, and sometimes it does not. See, e.g., Estate of Halas v.

Commissioner, 94 T.C. 570, 577 (1990); Laureys v. Commissioner,

92 T.C. 101, 129 (1989) (stating that expert testimony is not

useful when the expert is merely an advocate for the position

argued by one of the parties). We are not bound by the formulas

and opinions proffered by an expert witness and shall accept or 

reject expert testimony in the exercise of sound judgment. See

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

Estate of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990). 

Where necessary, we may reach a determination of value based on

our own examination of the evidence in the record. See Silverman

v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), affg. T.C.
- 12 -

Memo. 1974-285; Estate of Davis v. Commissioner, 110 T.C. 530,

538 (1998). Where experts offer divergent estimates of fair

market value, we decide what weight to give these estimates by

examining the factors they used in arriving at their conclusions. 

See Casey v. Commissioner, 38 T.C. 357, 381 (1962). 

We have broad discretion in selecting valuation methods, see

Estate of O'Connell v. Commissioner, 640 F.2d 249, 251 (9th Cir.

1981), affg. on this issue and revg. in part T.C. Memo. 1978-191,

and the weight to be given the facts in reaching our conclusion

because "finding market value is, after all, something for

judgment, experience, and reason", Colonial Fabrics, Inc. v.

Commissioner, 202 F.2d 105, 107 (2d Cir. 1953), affg. a

Memorandum Opinion of this Court. Moreover, while we may accept

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

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

may be selective in the use of any part of such opinion, or

reject the opinion in its entirety, see Parker v. Commissioner,

supra at 561. Because valuation necessarily results in an

approximation, the figure at which this Court arrives need not be

one as to which there is specific testimony if it is within the

range of values that may properly be arrived at from

consideration of all the evidence. See Estate of O'Connell v.
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Commissioner, supra at 252; Silverman v. Commissioner, supra at

933.

Real estate valuation is a question of fact resolved on the

basis of the entire record. See Ahmanson Found. v. United States,

674 F.2d 761, 769 (9th Cir. 1981); Estate of Fawcett v.

Commissioner, 64 T.C. 889, 898 (1975). The trier of fact must

weigh all relevant evidence to draw the appropriate inferences. 

See Commissioner v. Scottish Am. Inv. Co., 323 U.S. 119, 123-125

(1944); Helvering v. National Grocery Co., supra at 294-295;

Estate of Newhouse v. Commissioner, supra at 217. The standard

for valuation is fair market value, which is defined as the price

that a willing buyer would pay a willing seller, both persons

having reasonable knowledge of all relevant facts and neither

person being under a compulsion to buy or to sell. See sec.

20.2031- 1(b), Estate Tax Regs.; see also United States v.

Cartwright, 411 U.S. 546, 551 (1973); Estate of Simplot v.

Commissioner, 112 T.C. 130, 151 (1999). The standard is

objective, using a purely hypothetical willing buyer and seller

who are presumed to be dedicated to achieving maximum economic

advantage in any transaction involving the property, see Estate

of Simplot, supra at 152, which must be achieved in the context

of market and economic conditions at the valuation date, see

Estate of Newhouse v. Commissioner, supra at 218.
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There are generally three kinds of valuation methods used to

determine the fair market value of real property: (1) The

comparable sales method, (2) the income method, and (3) the cost

method. See Marine v. Commissioner, 92 T.C. 958, 983 (1989),

affd. without published opinion 921 F.2d 280 (9th Cir. 1991). 

Variously using these methods, the appraisers in the instant case

estimated the property values as follows:

Montecito Village North

Appraisal Method Holden Marx

Income approach $8,375,000 $9,925,000

 (Discounted cash-flow) 

Sales comparison 7,900,000 10,369,000

Cost1 –- --

Montecito Village South

Appraisal Method Holden Marx

Income approach $5,000,000 $5,874,000

 (Discounted cash-flow) 

Sales comparison 4,900,000 5,972,000

Cost 4,600,000 –-

 

1Mr. Holden performed a cost approach analysis for Montecito Village

North, but only for the date of death, not the alternate valuation date. The

date of death value was determined by Mr. Holden to be $10,225,000.

Although the parties used more than one method to value MVN and

MVS, each expert relied most heavily on a version of the income

method called the discounted cash-flow method. The sales

comparison and the cost approach methods played insignificant

roles in their analyses and appear to have little effect on Mr.
- 15 -

5 With respect to the cost approach, the estate's expert said

the following:

The Cost Approach to value is an indicator for new or

proposed improvements, however, older improvements,

such as the subject are more difficult to analyze. The

most important factor in appraising older properties is

the estimate of depreciation. Although great care is

taken in this analysis, it is difficult for the

Appraiser to truly and accurately estimate the value

losses by depreciation. This is mainly due to the lack

of full knowledge of the infrastructure of a building. 

You cannot see into the walls and many areas are

inaccessible. Therefore, it is difficult to determine

the true condition of all building components. This

weakens the support for the depreciation estimate. The

typical purchaser does not generally use this approach

to make an investment decision. * * * Also, there is

a lack of * * * [comparable] land sales. This makes

the analysis for the land value weak. Therefore, this

approach is given least weight in support of the final

estimate of value.

As for the sales comparison approach, we are concerned about the

lack of suitable comparables in the Monecito-Santa Barbara area

upon which to base any meaningful analysis. Mr. Holden echoed

this concern in his report, stating that "Due to the varying

characteristics of the sales data, direct market comparison [as a

method to value MVN and MVS] is weak." Under the circumstances

of the instant case, the sales comparison approach is unreliable. 

This unreliability is reflected in Mr. Holden's report where he

abandons his cost approach and sales comparison analyses and

adopts whole hog his conclusions from his discounted cash-flow

analysis as the fair market value of MVN and MVS.

Holden's and Mr. Marx's bottom line valuations.5 The income

method, on the other hand, is embraced by both Mr. Marx and Mr.

Holden and dominates their analyses. Because the parties' main

focus is on the income method of valuing MVN and MVS, our focus,

too, will be on the income valuation method.
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6 The cash-flow estimates of the experts are as follows:

 MVN

Holden Marx

Year 1 $849,228 $812,778

Year 2 866,213 845,042

Year 3 883,537 876,840

Year 4 901,208 887,042

Year 5 946,268 923,371

Year 6 993,582 941,771

Year 7 1,043,261 948,896

Year 8 1,095,424 1,007,989

Year 9 –- 1,156,425

Year 10 –- 1,171,932

Year 11 –- 1,209,313

 

 MVS

 Holden Marx

Year 1 $560,638 $598,160

Year 2 547,080 472,941

Year 3 561,617 592,840

Year 4 584,522 613,129

Year 5 610,669 628,580

Year 6 634,919 644,039

Year 7 652,406 627,970

(continued...)

 The parties in the instant case rely on a version of the

income valuation method called the discounted cash-flow (DCF)

method. The DCF method is a set of procedures in which an

appraiser specifies the quantity, variability, timing, and

duration of periodic income, as well as the quantity and timing

of reversions, and discounts each to its present value at a

specified yield. In formulating their DCF analyses, each expert

in the instant case uses different input assumptions but their

cash-flow estimates end up being very similar.6 The main reason
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(...continued)

Year 8 685,026 652,898

Year 9 –- 686,984 

Year 10 –- 693,587

Year 11 –- 707,083 

7 The discount rate is a rate of return on capital used to

convert future payments, rental income, or receipts into a

present value.

the parties arrive at different values for MVN and MVS is that

their experts make different assumptions concerning the discount

rate.7

Both Mr. Marx and Mr. Holden arrive at a discount rate by 

abstracting sales of comparable commercial properties in order to

derive a capitalization rate. The capitalization rate is the

property's cash-flow divided by its sales price. The discount

rate is ascertained by making adjustments to the capitalization

rate, primarily for inflation. Mr. Holden's capitalization rate

was derived from a pool of comparable sales more extensive than

Mr. Marx's capitalization rate. Most of Mr. Holden's

comparables, however, are properties located in places outside

the Montecito-Santa Barbara area, such as Oxnard and Los Angeles,

California. Indeed, we find that aspect of Mr. Holden's analysis

troubling. MVN and MVS are located in an area adjacent to the

city of Santa Barbara. MVN and MVS are more than 90 miles away
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from Mr. Holden's comparables in Huntington Beach and Los

Angeles, and more than 30 miles away from Oxnard. 

Mr. Holden acknowledges that MVN and MVS are "situated in

Santa Barbara's most desirable neighborhood". He also notes that

MVN and MVS "make up the majority of the commercial property in

Montecito. They almost set their own rental market." The

Montecito-Santa Barbara community is unique in that there is very

limited vacant land. It is a small community, and there are not

many shopping centers for sale at any given time, in contrast to

Los Angeles and Orange counties where many shopping centers are

for sale at any particular moment in time. Moreover, during

1989, Santa Barbara voters passed "Measure E", which restricts

the building of commercial and industrial properties in the city

limits of Santa Barbara. Mr. Holden states that, although it is

too early to tell how Measure E would affect the real estate

market in Santa Barbara, "more than likely, it will cause a

shortage of commercial rental facilities and create high rents". 

Accordingly, the unique character of the Montecito-Santa Barbara

real estate market will be maintained well after the alternate

valuation date. 

Mr. Holden attempted to demonstrate the rising

capitalization rates of commercial shopping center sales in
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8 In 1991, the average capitalization rate in southern

California was 9.06 percent; in 1992 it was 9.59 percent; in 1993

it was 9.70 percent; in 1994 it was 10.66 percent; and in 1995 it

was 10.26 percent.

southern California.8 However, because of the unique character

of the Montecito-Santa Barbara area, we are primarily concerned

only with how the softness in the real estate market was

affecting capitalization rates in that area. Mr. Holden reported

that sales in the Santa Barbara area during the time in question

commanded capitalization rates of 9.17 percent and 9.4 percent.

Mr. Marx researched three additional sales in Santa Barbara

during 1993 and 1994 and found capitalization rates ranging from

7.83 percent to 9.4 percent. On the basis of such data, Mr. Marx

concludes that an overall capitalization rate of 9.25 percent to

9.5 percent is appropriate in valuing MVN and MVS. He settles on

9.5 percent as the capitalization rate. Mr. Holden, on the other

hand, went outside the Santa Barbara area in order to justify a

higher capitalization rate for MVN and MVS. In his view,

southern California was experiencing a soft real estate market at

the time of the alternate valuation date. Mr. Holden fails to

explain, however, why any market softness is not already

reflected in the capitalization rates of the Montecito-Santa

Barbara area comparables. We are inclined to keep the

capitalization rate in the instant case within the range of
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capitalization rates found in the Montecito-Santa Barbara area at

or near the time of the alternate valuation date. MVN and MVS

are uniquely situated because of the lack of commercial rental

property in the area. Mr. Holden fails to convince the Court

that his use of widespread, southern California comparables is

appropriate in analyzing MVN and MVS. We are persuaded,

therefore, that a capitalization rate of 9.5 percent is in line

with capitalization rates generally in the Montecito-Santa

Barbara area at the alternate valuation date and is a reasonable

estimation of the appropriate capitalization rate to use in

valuing MVN and MVS. 

As stated above, the discount rate is a derivative of the

capitalization rate. Messrs. Holden and Marx agree that a 2-

percent adjustment is needed to account for inflation. Mr. Marx

makes a further adjustment that considers leasing and selling

commissions along with absorption and tenant improvement issues, 

which reduces Mr. Marx's capitalization rate adjustment by

approximately one-half of a percent. Mr. Holden makes no such

adjustment. Given the range of estimated adjustments suggested

by the experts, we find that 1.75 percent is a reasonable

adjustment to the capitalization rate in order to arrive at the

appropriate discount rate.
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Another area of disagreement among the experts is the

appropriate duration of the cash-flow period. Mr. Holden uses a

7-year cash-flow period whereas Mr. Marx uses a 10-year cash-flow

period. Mr. Holden justifies his 7-year period on the basis of,

inter alia, market uncertainties and the fact that as the cashflow period is extended into the future, the analysis becomes

less reliable. Mr. Holden also notes that real estate markets

tend to flow in 7-year cycles. Mr. Marx points out that a 10-

year cash-flow period is supported by information from local

brokers and national real estate publications. Although 7 years

may be a reasonable cash-flow period in some cases, we are

inclined to follow the trends of the Montecito-Santa Barbara real

estate market. We find, therefore, that Mr. Marx's estimate of a

10-year cash-flow period is persuasive because it follows more

closely Santa Barbara's real estate norms. 

On the basis of the foregoing discussion, we find Mr.

Holden's valuation estimates to be too low and find Mr. Marx's

estimates to be too high. We believe that $9,600,000 is a

reasonable estimate of the value of MVN and $5,680,000 is a

reasonable estimate of the value of MVS. With such values in

mind, we now proceed to value Mr. Borgatello's interest in VIC. 
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Value of Mr. Borgatello's Interest in VIC

Knowing the value of MVS and MVN, we are now able to decide

the price at which Mr. Borgatello's 82.76 percent stock interest

in VIC "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 the relevant facts." Sec.

20.2031-1(b), Estate Tax Regs. In the case of unlisted stock,

such as the stock in question, the price at which sales of such

stock are made in arm's-length transactions in an open market is

the best evidence of value. See Estate of Davis v. Commissioner,

110 T.C. 530, 535 (1998). The record in the instant case does

not contain any such sale of stock. Where the value of unlisted

stock cannot be determined from actual sale prices, its value

generally is to be determined by taking into consideration a host

of factors, including, among others, the company's net worth,

prospective earning power, and dividend-paying capacity. See,

e.g., Estate of Davis, supra at 536. 

When valuing a real estate holding company, however, the

main emphasis is on the company's assets. See id. The net asset

value method is the most reasonable one to use in a case such as

the instant case, where the corporation functions as a holding,

rather than an operating, company and earnings are relatively low

in comparison to the fair market value of the underlying assets.
- 23 -

See, e.g., Estate of Davis v. Commissioner, supra; Estate of

Piper v. Commissioner, 72 T.C. 1062, 1069-1070 (1979). The net

asset value method involves arriving at the company's net asset

value (the value of the company's assets less liabilites, where

the assets have been adjusted to reflect their fair market value)

and then discounting that value to account for various factors

that affect its marketability. Principal factors affecting the

discount in the instant case are the tax liability inherent in

the built-in gain assets of VIC and the lack of marketability due

to the difficulty of selling stock in a small closely held

corporation such as VIC. We do not employ a fixed formula in

considering the factors that we use to determine the fair market

value of unlisted stock. See Estate of Davis, supra at 536. The

weight to be given to the various factors in arriving at fair

market value depends upon the facts of each case. See sec.

25.2512-2(f), Gift Tax Regs. We have broad discretion in

assigning weight to the various factors and in selecting the

method of valuation. See Estate of O'Connell v. Commissioner,

640 F.2d 249, 251-252 (9th Cir. 1981), affg. on this issue and

revg. in part T.C. Memo. 1978-191; sec. 25.2512-2(f), Gift Tax

Regs. The determination of the value of closely held stock is a

matter of judgment rather than one of mathematics. See Estate of

Davis, supra at 537. Moreover, because the valuation is
- 24 -

necessarily an approximation, it is not required that the value

that we determine be one as to which there is specific testimony,

provided that it is within the range of figures that properly may

be deduced from the evidence. See id.

As in most valuation cases, the parties in the instant case

rely extensively on the opinions of their respective experts to

support their differing views about the fair market value on the

valuation date. Each expert utilizes the net asset value method

in order to value Mr. Borgatello's interest in VIC. For purposes

of determining the appropriate discount to be applied to VIC's

assets, the estate introduced the report of James Brockardt, who

asserts that the net asset value of VIC should be discounted by

35 percent for lack of marketability. Respondent offered the

report of Roger Wilde, who asserts that VIC's net asset value

should be discounted by 27 percent for lack of marketability. 

Mr. Wilde arrives at his discount using a build-up method. 

Mr. Wilde examines various factors and assigns a percentage value

to each. Some factors increase and some decrease the net asset

value discount. Wilde made the following adjustments to be

included in the discount for lack of marketability:

1. Shareholder dividends and compensation paid - 5% 

2. Local economy and real estate market at 1/12/94 + 5%

3. Management continuity - 2%

4. Potential corporate gain and tax + 19%

5. Restrictions on stock transfer + 3% 

6. Transaction and other costs + 7%
- 25 -

Mr. Brockardt, on the other hand, presents a general discussion

of various factors, but does not assign a percentage value to any

of them. He bases his total discount on his judgment and

consideration of the factors as a whole. Thus, for example, Mr.

Wilde reveals exactly how much of a discount he allows for the

built-in gains in the assets of VIC, whereas with Mr.

Brockhardt's report, we do not know how much of the discount was

attributable to built-in gains. Mr. Wilde's build-up method

presents a useful framework to consider the various factors at

play in the instant case. Below, we consider those factors

within his framework and in light of Mr. Brockardt's report. 

Mr. Wilde reduces the discount by 5 percent because of VIC's

"consistent and strong cash-flow (dividend payment capability)

and low vacancy rate of the [VIC's] shopping centers." Mr. Wilde

further states: "The Company's financial statements and dividend

policy indicate that the company has paid nominal dividends, but

does pay the controlling shareholder significant salary. This

would be a favorable factor for an investor in the shares being

valued."

Messrs. Marx and Holden accounted for the cash-flow provided

by the properties and the economic conditions of the Santa

Barbara area in their valuations of MVN and MVS. The estate

argues that when arriving at a value for the corporation, we
- 26 -

should not consider factors that have already been taken into

account in the valuation of VIC's assets. We agree with the

estate. 

As pertains to cash-flow and dividend paying capacity,

Section 5 of Rev. Rul. 59-60, 1959-1 C.B. 243, provides in

pertinent part:

(b) The value of the stock of a closely held investment

or real estate holding company, whether or not family

owned, is closely related to the value of the assets

underlying the stock. For companies of this type, the

appraiser should determine the fair market values of

the assets of the company. Operating expenses of such

a company and the cost of liquidating it, if any, merit

consideration when appraising the relative values of

the stock and the underlying assets. The market values

of the underlying assets give due weight to potential

earnings and dividends of the particular items of

property underlying the stock, capitalized at rates

deemed proper by the investing public at the date of

appraisal. A current appraisal by the investing public

should be superior to the retrospective opinion of an

individual. For these reasons, adjusted net worth

should be accorded greater weight in valuing the stock

of a closely held investment or real estate holding

company, whether of not family owned, than any of the

customary yardsticks of appraisal, such as earnings and

dividend paying capacity. [Emphasis added.]

The revenue ruling implies that potential earnings are already

accounted for in the market value of MVN and MVS and should not

be considered again in valuing the VIC stock. As pertains to

economic conditions and the softness in the real estate market,

in Estate of Berg v. Commissioner, T.C. Memo. 1991-279, affd. in
- 27 -

part and revd. and remanded in part on another ground 976 F.2d

1163 (8th Cir. 1992), we stated:

The values arrived at by * * * [the expert] were

the basis for the date of death values of the corporate

properties. * * * Because in appraising the

properties * * * [the expert] took into account the

market for such property, as well as general economic

conditions in Grand Forks, the fair market value of

Vaberg's corporate assets, and therefore the fair

market value of 100 percent of the Vaberg stock, has

already been adjusted for such conditions. 

To the extent that the market for residential real

estate and general economic conditions would have a

negative impact on the fair market value of the 26.92

percent of Vaberg stock held by the decedent,

petitioner has already reduced the reported value of

the stock on account of such impact. For this Court to

adjust the discounts for minority interest and lack of

marketability for these factors would be to duplicate

the reduction in reported value due to such factors. 

On the basis of our reasoning in Estate of Berg, supra, Mr.

Wilde's 5-percent increase in the net asset value discount

attributable to the general economic conditions of the Santa

Barbara area is inappropriate. Similarly, the 5-percent decrease

in the net asset value discount attributable to Mr. Wilde's

consideration of VIC's cash-flow and ability to pay dividends is

inappropriate pursuant to the reasoning of Rev. Rul. 59-60, 1959

C.B. 243, which is consistent with our conclusion in the instant

case. The estate additionally contends that Mr. Wilde's

adjustment for "Management Continuity" is already reflected in

the value of MVN and MVS. We do not agree. 
- 28 -

It is not evident that Mr. Wilde's "Management Continuity"

factor is reflected in the value of MVN and MVS or VIC's other

assets. The estate incorrectly equates Mr. Wilde's discussion of

management continuity with the management costs associated with

overseeing MVN and MVS. Such management costs are indeed

reflected in the value of MVN and MVS. What we believe Mr. Wilde

refers to in his brief discussion of management continuity is

that managing VIC's real estate does not require the expertise

needed to oversee a management intensive operating company with

many employees. Because VIC is a real estate holding company

that maintains low vacancy rates in its properties (1 percent of

total square footage vacant in a sluggish market), Mr. Wilde

concludes that "The likelihood of a buyer being able to

successfully manage the real estate holdings is strong." Indeed,

it seems likely that any buyer of VIC will choose not to employ

VIC's current managers to oversee the company's properties. 

Continuity of the current VIC management is unnecessary for the

company to succeed as a going concern. The question then becomes

whether Mr. Wilde's management continuity factor affects the

discount in the manner he suggests. We tend to think it does

not. Mr. Wilde reduces the net asset value discount by 2 percent

for the management continuity factor, but we think the factor is

neutral. Consequently, we do not assign any weight to it. 
- 29 -

We shall assign weight to the consideration of the built-in

capital gain tax inherent in VIC's assets. We may allow the

application of a built-in capital gains tax discount if we

believe that a hypothetical buyer would have taken into account

the tax consequences of the built-in capital gains when arriving

at the amount he would be willing to pay for Mr. Borgatello's VIC

stock. See Estate of Davis v. Commissioner, 110 T.C. at 550-554;

Estate of Jameson v. Commissioner, T.C. Memo. 1999-43. Both

parties agree in the instant case that a willing buyer would

consider those tax consequences, but they disagree on how much to

discount the net asset value to account for this factor.

The largest portion of Mr. Wilde's net asset value discount

is attributable to the built-in gains inherent in VIC's assets. 

In calculating the discount attributable to the tax on the builtin gains, Mr. Wilde utilizes a 10-year holding period for the

assets. Assuming a 2-percent growth rate, Mr. Wilde estimates

the value of VIC's assets to be $22,214,089 for the year 2004. 

On the basis of such estimated value, Mr. Wilde calculates the

built-in gain and applies California's 9.3 percent capital gains

rate and a 34-percent Federal income tax rate to arrive at a

future tax in 2004 in the amount of $7,500,008. Applying a

discount rate of 8.3 percent (Long Term AFR + 2 percent for added

risk), Mr. Wilde determines the present value of the future tax
- 30 -

to be $3,378,914. In order to arrive at the discount

attributable to the future tax, Mr. Wilde divided $3,378,914 (the

present value of the future tax) by $18,223,290 (the total value

of VIC's real estate and investments) to arrive at a 19-percent

(rounded from 18.5 percent) discount. Accordingly, Mr. Wilde's

discount is not calculated as a percentage of net asset value;

rather, it is calculated as a percentage of the value of VIC's

real estate and investment property. Mr. Wilde errs in

calculating the discount attributable to the tax on the built-in

gain this manner. 

Mr. Wilde errs in that the present value of the future tax

should have been stated as a percentage of net asset value, not

as a percentage of only VIC's real estate and investments. The

estate correctly points out that the figure that Mr. Wilde

arrives at "is irrelevant for purposes of calculating the

percentage amount by which the taxes reduce the net asset value,

because it excludes some assets and all liabilities." As a

percentage of net asset value, the discount amount would not be

19 percent. The present value of the future tax, $3,378,914,

divided by Mr. Wilde's net asset value, $16,443,000 produces a

20.5-percent discount. Accordingly, after correcting that error,

the discount attributable to the tax on the built-in gains
- 31 -

9 We arrived at this amount as follows:

Net asset value $15,924,290

Total assets at market value $18,467,290

Less book value (5,649,963)

Unrealized capital gain $12,817,327

Net California gain $12,817,327

Less: California tax at 9.3% (1,192,011)

Net Federal gain $11,625,316

Less: Federal tax at 34% (3,952,607)

Total Tax on capital gain $5,144,618

TOTAL CAPITAL GAIN AS A PERCENTAGE OF NET ASSET VALUE: 32.3%

inherent in VIC's assets would be 20.5 percent, not 18.5 percent

rounded to 19 percent.

Mr. Brockardt does not engage in the kind of explicit

analysis in which Mr. Wilde engages, but Mr. Brockardt does

calculate, on the basis of Mr. Holden's valuations of MVN and

MVS, the impact of an immediate tax on the net asset value of

VIC. According to Mr. Brockardt, an immediate tax on the builtin gains would warrant a 31.2-percent discount in the net asset

value of VIC. On the basis of our valuations of MVN and MVS, an

immediate tax on the built-in gain would warrant a 32.3-percent

discount in the net asset value of VIC.9 Applying that amount 

as a discount to the net asset value is unrealistic because it

does not account for any holding period for the assets. The

estate's expert concedes that there would be some period of tax

deferral although he did not articulate how long the period of

deferral would be. Mr. Wilde assumes a 10-year holding period
- 32 -

10 The current fair market value of the built-in gain assets is 

$17,704,290 ($17,361,110 (real estate) plus (investments in stock

and art) $343,180). Such amount, assuming a 2-percent annual

growth rate for the 10-year holding period, would be worth

$21,581,354 on Jan. 12, 2004. After adjusting for annual

depreciation of $156,000 per year during the 10-year holding

period (adding $1,560,000 to the projected built in gain), the

total projected built-in gain on Jan. 12, 2004, is $18,052,828. 

The California tax on that amount, at 9.3 percent is $1,678,913. 

Total Federal gain is $16,373,915 and, taxed at the 34-percent

corporate Federal rate, produces $5,567,131 in Federal tax. The

total amount of Federal and California taxes on the projected

built-in gain is $7,246,044. Assuming, as Mr. Wilde did, a

discount rate of 8.3 percent (Long term AFR + 2 percent for added

risk), the present value of the future $7,246,044 in taxes is

$3,264,571. This amount, as a percentage of net asset value, is

20.5 percent ($3,264,571 divided by $15,924,290). 

for the assets. Adjusting Mr. Wilde's figures for our lower

valuation of the shopping centers does not yield a different

percentage value.10 

The range of discount values attributable to the tax on the

built-in gain in VIC's assets presented by the experts is 32.3

percent (if the assets are immediately liquidated) to 20.5

percent (if the assets are held for 10 years). Although there is

no evidence that a willing buyer of VIC would immediately

liquidate the assets, there is also not much support for

respondent's contention that a buyer would wait 10 years before

liquidating the assets. In reaching a middle ground, therefore,

we find it reasonable to discount the net asset value by 24
- 33 -

percent to account for the tax liability inherent in VIC's

assets. 

One of petitioner’s main contentions for discounting the VIC

stock is the presence of a stock purchase agreement. Although we

believe that such agreement would have some chilling effect on a

hypothetical sale, we do not agree that it would have the effect

that the estate contends it would have. The agreement provides

that before Mr. Borgatello or his estate sells his VIC shares, he

must first offer his shares to the other VIC shareholders on pro

rata basis at the price offered to the outside buyer. The other

shareholders have 15 days to exercise their right of first

refusal, and they may purchase any amount of the shares offered. 

After that 15-day period expires, VIC has the option of buying as

many shares as it desires. After the consecutive 15-day periods

expire, Mr. Borgatello could then sell the remaining shares to

the third-party buyer.

The estate contends that the stock purchase agreement will

inevitably lead to Mr. Borgatello's 82.76 percent block being

sold in two smaller blocks because the minority shareholders will

purchase just enough of the shares to gain control of VIC,

leaving the third-party buyer with a minority interest. The

estate, however, does not offer any evidence to prove that any of

the VIC minority shareholders possess the means or the
- 34 -

inclination to purchase enough of the stock to force Mr.

Borgatello's 82.76 percent block to be sold in two smaller

blocks. More importantly, our analysis presumes that the

transaction involves a willing buyer and a willing seller under

no particular compulsion to enter into a transaction. We

seriously doubt that a willing seller under no compulsion to sell

would dispose of an 82.76-percent block of stock in the manner

suggested by the estate. What is more likely is that the buyer

and seller would seek assurances from the other shareholders that

they would not interfere in the transaction by exercising their

rights pursuant to the stock purchase agreement. This would add

some uncertainty and a chilling effect to the transaction, but

not to the extent that the estate argues. Consequently, we

accept respondent's assessment of the stock purchase agreement

and discount the net asset value by 3 percent for that factor.

The final adjustment Mr. Wilde makes to the net asset value

accounts for transaction costs associated with the eventual sale

of the assets. Mr. Wilde's estimation of these transaction costs

is 7 percent of the net asset value. In an immediate

liquidation, Mr. Brockardt estimates these costs to be 5.7

percent of the net asset value. Given the narrow range of these

figures, we think a 6-percent discount for transaction costs is a

reasonable estimate. 
- 35 -

In sum, a total discount of 33 percent accounts properly for

the lack of marketability of the VIC stock. Discounting the net

asset value by 33 percent leads to a valuation adjustment of

$5,255,016. On the basis of the foregoing examination of the

record we conclude that the fair market value of Mr. Borgatello's

VIC shares is as follows:

Net asset value $15,924,290

Less: Valuation adjustment 5,255,016

Aggregate fair market value $10,669,274

Fair market value per share $8,515

(1253 shares outstanding)

Fair market value of 1037 shares $8,830,038

To reflect the foregoing,

Decision will be entered

pursuant to Rule 155.