* This Memorandum Opinion supplements our Memorandum

Opinion in Estate of Mitchell v. Commissioner , T.C. Memo. 1997-

461, vacated and remanded 250 F.3d 696 (9th Cir. 2001). T.C. Memo. 2002-98

UNITED STATES TAX COURT

ESTATE OF PAUL MITCHELL, DECEASED, PATRICK T. FUJIEKI, EXECUTOR,

Petitioner v

. COMMISSIONER OF INTERNAL REVENUE, Respondent *

Docket No. 21805-93. Filed April 9, 2002.

David Wing Keong Wong

, Miriam Louise Fisher

, Karen L. Hirsh

,

and Melvin E. Lefkowitz , for petitioner.

Henry E. O’Neill

, Alan Summers , and Paul G. Robeck , for

respondent.- 2 -

1 On remand, in Leonard Pipeline Contractors v.

Commissioner , T.C. Memo. 1998-315, affd. without published

opinion 210 F.3d 384 (9th Cir. 2000), we reentered our decision

. SUPPLEMENTAL MEMORANDUM OPINION

JACOBS, Judge : This case is before us on remand from the

Court of Appeal s for the Ninth Circuit. E state of Mitchell v.

Commissioner

, 250 F.3d 696 (9th Cir. 2001), affg. 103 T.C. 520

(1994) and vacating and remanding T.C. Memo. 1997-461. The Court

of Appeals has directed us to shift the burden of proof to

respondent regarding the determination of additional taxes and to

e xplain our valuation of stock included in decedent’s estate for

purposes of Federal est ate tax consistent with the standards

established in Leonar d Pipeline Contractors v. Commissioner , 142

F.3d 1133 (9th Cir. 1998), revg. and remanding T.C. Memo. 1996-

316. 1

We incorporate herein the findings of fact set forth in Estate

of Mitchell v. Commissioner

, T.C. Memo. 1997-461, by this

reference. For ease of understanding, we herein summarize the

relevant facts from that opinion as well as set forth additional

findings of fact for the purpose of deciding the issue on remand.

The stipulations and exhibits are also incorporated herein by this

reference.

Background- 3 -

Paul Mitchell (Mr. Mitchell or decedent) died on April 21,

1989. Among the assets included in Mr. Mitchell’s taxable estate

were 1,226 shares of John Paul Mitchell Systems common stock held

by the Paul Mitchell Trust (the tr ust), a revocable trust

established by Mr. Mitchell. It is our determination of the value

of those shares (at the moment of Mr. Mitchell’s death) that is the

subject of the remand.

In 1979, Mr. Mitchell and John Paul “Jones” DeJoria joined

together to market Mr. Mitchell’s hair care products (particularly

the sculpting lotion) through pr ofessional-only hair salons. On

March 31, 1980, Messrs. Mitchell and DeJoria formed Paul Mitchell

Systems, Inc. The name of the corporation was subsequently changed

to John Paul Mitchell Systems (JPMS). Messrs. Mitchell and DeJoria

granted JPMS all proprietary and distribution rights to the hair

and skin products that Mr. Mitchell had developed, including the

products’ trademark, service mark, or other intellectual property

rights.

JPMS’s bylaws provided for a board of directors (the board)

consisting of four directors and cumulative voting for the election

of directors. However, from 1984 until April 15, 1989, Mr.

Mitchell, Mr. DeJoria, and Peter Langenberg were the only board

members. On April 15, 1989, Mr. Langenberg resigned, and Jeanne

Braa was elected to replace him.- 4 -

From 1984 until April 1989, Mr. Mitchell served as president

of JPMS; Mr. DeJoria served as chairman of the board, chief

executive officer, chief financial officer, and secretary.

JPMS adopted a fiscal year ending July 31. Beginning with the

fiscal year ended July 31, 1984, the corporation elected subchapter

S status for Federal income tax purposes.

As of April 21, 1989, the stock in JPMS had not been

registered under any securities law; moreover, neither Mr. DeJoria

nor Mr. Mitchell had ever contemplated such a registration or a

public offering of JPMS’s common stock.

JPMS products were sold only through professional salons. Mr.

Mitchell was the heart of JPMS’s connection to hair stylists, who

were the foundation for JPMS’s marketing strategy of promoting and

selling products that Mr. Mitchell develo ped. Mr. Mitchell was

JPMS’s creative trendsetter, a n d his hair sculpting technique

revolutionized hair styling. Mr. Mitchell was the focal point of

JPMS’s advertising. In 1986, JPMS began using photographs of Mr.

Mitchell in its advertising.

Mr. DeJoria ran th e daily operations at JPMS, making all

management decisions and having all managers reporting directly to

him. Mr. Mitchell, however, had the last word on all policy

matters.

JPMS was known for its styling products. Over the years, JPMS

developed into a major force in the hair care industry, with brand- 5 -

recognition by the consuming public, a sophisticated distribution

network, and hun dreds of hair stylists trained in the use of the

company’s products. From 1982 through April 21, 1989, JPMS’s share

of the salon-only market, in comparison with those of its chief

competitors, improved every year. In April 1989, JPMS was among

the top five companies in the salon-only market.

From JPMS’ s inception until Mr. Mitchell’s death in April

1989, neither Mr. Mitchell nor Mr. DeJoria had any formal contract

with JPMS regarding compensation. Instead, they set sales and

profitability goals for JPMS at the beginning of each fiscal year.

Thereafter, in September or October of each year, they divided

equally the company’s available income.

For fiscal years ended July 31, 1984 throu gh 1988, Messrs.

Mitchell and DeJoria each received the following payments from

JPMS:

FYE 7/31 Salary Management Fees Total

1984 ---

--- 1 $1,086,500

1985

--- --- 1 2,305,000

1986 ---

--- 1 4,162,525

1987 $185,125 $8,565,000 8,750,125

1988 1,308,000 10,500,000 11,808,000

1 Pa yments to Messrs. Mitchell and DeJoria for this year

were not broken down into salary or management fees.

J PMS characterized these payments as compensation for services

rendered.

Between August 1, 1988, and April 21, 1989, JPMS paid Mr.

Mitchell $10,758,046 (which JPMS characterized as compensation for- 6 -

services rendered). For fiscal year 1989, Messrs. Mitchell and

DeJoria agreed that each of them would receive a $2 million annual

salary and a $15 million management fee. The JPMS board approved

these compensation amounts on October 21, 1988.

From the inception of JPMS until the moment of Mr. Mitchell’s

death, the only dividend declared by JPMS was for its fiscal year

ended July 31, 1988. The dividend was originally set at $1.4

million, but the dividend was subsequently raised to $2.5 million.

Robert Taylor was presid ent and chief executive officer of

Minnetonka Corp. (Minnetonka), a publicly traded company. As

chairman, Mr. Taylor was responsible f or Minnetonka’s strategic

acquisitions.

Mr. Taylor initiated discussions with Mr. DeJoria in the fall

of 1987 (JPMS’s 1988 fiscal year) when JPMS’s sales were

approximately $50 million. Mr. Taylor informed Mr. DeJoria that

Minnetonka was willing to pa y $100 million to acquire all of the

JPMS stock, assuming officers’ salaries were revised. Mr. Taylor

regarded the level of compensation for Messrs. Mitchell and DeJoria

as too high; he considered a more appropriate level of compensation

to be in the $500,000 to $1 million range, including performance

bonuses. Mr. DeJoria insisted on a $125 million acquisition price.

Mr. Taylor refused to raise Minnetonka’s bid, and the negotiations

were terminated.- 7 -

In the fall of 1988, Mr. Taylor again approached Messrs.

DeJoria and Mitchell. (At the time, JPMS’s sales were in the $65

million range.) Mr. Taylor offered $125 million to acquire all of

the JPMS stock. The proposed acquisition price assumed that: (1)

Mr. DeJoria would continue managing JPMS; (2) Mr. Mitchell would

continue promoting the products for at least 18 months to 2 years;

and (3) both Messrs. Mitchell and DeJoria would be compensated in

salary and s tock at a level paid to officers of other Minnetonka

subsidiaries, such as Calvin Klein.

Mr. DeJoria did not accept Minnetonka’s $125 million offer; he

believed that Minnetonka was “just a little short every time”.

(Mr. DeJoria represented to Mr. Taylor that he had received from

the Gillette Co. (Gillette) a $150 million offer plus a royalty of

2 percent of sales for life. Mr. Taylor informed Mr. DeJoria that

he could not match Gillette’s offer.) Sales discussions with

Minnetonka thus ended.

KPMG Peat Marwick (or one of its predecessors) certified

JPMS’s audited financial statements. JPMS’s net sales and net

income after taxes for fiscal years ended July 31, 1982 through

1988, inclusive, were as follows:- 8 -

FYE 7/31 Net Sales Net Income After Taxes

1982 $1,369,316 $142,375

1983 3,590,641 159,947

1984 5,349,152 4,004

1985 1 11,266,610 207,777

1986 24,131,739 2,265,875

1987 41,371,318 281,777

1988 60,693,857 2,569,297

1 The audited financial statements for the years ended July

31, 1986 and 1985, state this amount as $10,918,252.

Until approximately May 1988, Mr. Mitchell’s health had been

g ood. In July 1988, he was hospitalized and diagnosed as having

pancreatic cancer; thereafter, his pancreas, spleen, gall bladder,

and a portion of his stomach were surgically removed. He remained

in the hospital until Septem ber 30, 1988, undergoing additional

surgeries and medical procedures, including radiation therapy.

Although follow-up te sts revealed no evidence of metastasis, a

November 1988 blood test raised a possibility of a recurrence of

cancer, but the test was inconclusive.

Although Mr. Mitchell continued his roles as the JPMS creative

force, spokesman, and executive, his medical condition prev ented

him from working or performing at hai r shows until approximately

January 1989.

In February 1989, tests revealed a recurrence of cancer.

Physicians encouraged Mr. Mitchell to begin chemotherapy, but he

refused. Mr. DeJoria avoided disclosing the severity of Mr.

Mitchell’s illness to quell any fears about the uncertainty of

JPMS’s future without Mr. Mitchell.- 9 -

2 Ms. Re, an attorney, joined JPMS on Jan. 1, 1989, as

vice president and general counsel, to oversee the correction of

certain operational problems. On Mar. 1, 1989, she became JPMS’s

(continued...) To a degree, the 1989 advertising campaign (which was shot in

November or December 1988) still focused on Mr. Mitchell. However,

Mr. DeJoria and JPMS began shifting emphasis away from Mr. Mitchell

as an individual and towards the products themselves.

During the latter part of Mr. Mitchell’s illness, Messrs.

DeJoria and Mitchell discussed Mr. DeJoria’s future compensation.

Mr. DeJoria promised Mr. Mitchell that in the event of Mr.

Mitchell’s death, he would reduce his management fee from $15

million to $10 million for JPMS’s fiscal year ending July 31, 1990.

However, Mr. DeJoria’s $2 million salary for that year was to

remain intact.

Mr. Mitchell died on April 21, 1989, at the age of 53.

As of Ap ril 21, 1989, the common stock of JPMS was owned as

follows:

Number of Shares Percent

Mr. DeJoria 1,250 50.00

The trust 1,226 49.04

Ms. Braa 1 16 0.64

Angus Mitchell 1 8 0.32

Total 2,500 100.00

1 Ms. Braa and Angus Mitchell, Mr. Mitchell’s son, acquired

their shares by gift from Mr. Mitchell.

On June 29, 1989, Patrick Fujieki, trustee of the trust, and

Michaeline Re 2 we re elected to the JPMS board. (The board thus- 10 -

2 (...continued)

chief operating officer. comprised Mr. DeJoria, Ms. Braa, Mr. Fujieki, and Ms. Re.) At this

time, the trust was the shareholder of record of 49.04 percent of

the outstanding common shares of JPMS, of which 1 percent was to be

transferred to Mr. DeJoria in accordance with the terms of Mr.

Mitchell’s will and trust.

In June 1989, Mr. Fujieki (in his capacities as director of

JPMS, trustee for the trust, and executor of Mr. Mitchell’s estate)

asked to inspect the JPMS corporate records and financial

information. On April 10, 1992, representatives of Mr. Fujieki

were permitted to review JPMS’s financial records but were not

allowed to make copies. Before permitting Mr. Fujieki’s

representatives to review its financial records, JPMS required Mr.

Fujieki and his representatives to execute confidentiality

agreements.

Mr. Fujieki continuall y questioned the actions of the JPMS

board at its meetings and the accuracy of the corporate minutes.

Beginning July 30, 1992, through at least April 20, 1993, James

Ukropina, Esq., outside legal counsel for JPMS, attended the JPMS

board meetings.

Mr. DeJoria assumed many of Mr. Mitchell’s corporate

responsibilities following Mr. Mitchell’s death. Between April 22

and July 31, 1989, JPMS paid Mr. DeJoria $4,901,537 as compensation- 11 -

for services rendered to JPMS. For JPMS’s fiscal year ended July

31, 1990, Mr. DeJoria agreed to reduce his management fee from $15

million to $10 million, as promised to Mr. Mitchell. Mr. DeJoria

also received $2 million in salary for that year. In summary, JPMS

paid Mr. DeJoria the following amounts for fiscal years ended July

31, 1990 through 1994:

FYE 7/31 Amount

1990 $12,000,000

1991 17,025,000

1992 17,025,568

1993 17,000,000

1994 17,000,000

JPMS characterized these payments as compensation for services

rendered.

From August 1, 1989 through 1992, Mr. Fujieki repeatedly

requested that the board retain an independent compensation

consultant to consider the reasonableness of Mr. DeJoria’s

compensation. The board rejected Mr. Fujieki’s requests. At this

time, tension began to mount among members of the board.

In late 1990, Mr. Fujieki retained Coopers & Lybrand to

determine a reasonable level of compensation for Mr. DeJoria.

Coopers & Lybrand preliminarily determined that a reasonable level

of compensation was within the range of $600,000 to $1 million,

with a possible $2 million ceiling. At the January 10, 1992, board

meeting, the b oard approved Mr. DeJoria’s compensation at 13

percent of JPMS’s gross sales, not to exceed $17 million per year,- 12 -

f or JPMS’s fiscal years ended July 31, 1992 through 1996. Mr.

Fujieki objected to this approval by the board.

In June 19 93, Mr. Fujieki brought suit against Mr. DeJoria,

Ms. Re, and JPMS on the trust’s behalf, alleging that Mr. DeJoria’s

compensation was excessive. In April 1995, the litigation between

the trust and JPMS was settled. The JPMS board and shareholders,

as well as the court, approved the settlement agreement.

On its estate tax return, the estate valued the trust’s

interest in the 1,226 shares of JPMS common stock at the moment of

decedent’s death at $28.5 million. In the notice of deficiency,

respondent determined that the fair ma rket value of the trust’s

interest in the 1,226 shares of JPMS common stock at the moment of

death was $105 million. Accordingly, respondent determined that

the value of the gross estate should be increased by $76.5 million.

The estate filed a petition in this Court challenging

respondent’s moment-of-death valuation for the trust’s 1,226 shares

of JPMS common stock.

In this Court’s opinion, T.C. Memo. 1997-461, we held that the

value of decedent’s interest was $41,532,600 as of the moment of

his death. We calculated this amount as follows:- 13 -

Value of JPMS at the moment immediately

prior to Mr. Mitchell’s death $150,000,000

Less: Discount to reflect the loss of

Mr. Mitchell to JPMS (15,000,000 )

Value of JPMS at the moment of Mr.

Mitchell’s death 135,000,000

Percent of trust’s interest in JPMS x 49.04

Value of trust’s interest in JPMS before

discounts 66,204,000

Discount for lack of marketability and

minority interest (35%) (23,171,400 )

43,032,600

Discount for possibility of lawsuit (1,500,000 )

Value of trust’s interest in JPMS after

discounts 41,532,600

On appeal, the Court of Appeals for the Ninth Circuit vacated

our decision and remanded the case for findings to explain our

valuation. More specifically, the Court of Appeals stated that it

is unclear whethe r a 35-percent combined discount for lack of

control and lack of marketability falls within a range that is

supported in the record.

Additionally, the Court of Appeals directed us to shift the

burden of proof to respondent. Pursuant to the mandate of the

Court of Appeals, we shift the burden of proof to respondent.

Consequently, respondent has the burden of proving by a

preponderance of the evidence the existence and the amount of the

deficiency. C ohen v. Commissioner

, 266 F.2d 5, 11 (9th Cir. 1959),

remanding T.C. Memo. 1957-172.

The deficiency in this case is attributable to the valuation

of 1,226 shares of JPMS common stock at the moment of decedent’s

death. On its estate tax return, the estate valued the shares at- 14 -

$28.5 million. Thus, respondent must prove by a preponderance of

the evidence that the value of the s h ares at the moment of

decedent’s death was greater than $28.5 million.

With the discussion that follows, we attempt to provide the

Court of Appeals with a re asoned account of how we reach our

valuation conclusion in this case, mindful that the burden of

persuasion is on respondent.

Discussion

Fair market value for Federal estate and gift tax purposes is

defined as “the price at which the property would change hands

between a willing buyer and a willing seller, neither being under

any compulsion to buy or to sell and both having reasonable

knowledge of relevant facts.” U nited States v. Cartwright

, 4 1 1

U.S. 546, 551 (1973); Snyder v. Commissioner

, 93 T.C. 529, 539

(1989); sec. 20.2031-1(b), Estate Tax Regs.; sec. 25.2512-1, Gift

Tax Regs. The standard is objective; it uses a hypothetical

willing buyer and willing seller. See Propstra v. United States

,

680 F.2d 1248, 1251-1252 (9th Cir. 1982); Estate of Newhouse v.

Commissioner

, 94 T.C. 193, 218 (1990). However, “the hypothetical

sale should not be constructed in a vacuum isolated from the actual

facts that affect the value of the stock”. E s tate of Andrews v.

Commissioner , 79 T.C. 938, 956 (1982).- 15 -

When valuing unlisted stock, it may be appropriate to apply a

discount for lack of marketability, a discount for a mi nority

interest, or a premium for control.

Discounts for lack of marketability and lack of control are

conceptually distinct when valuing stock of cl osely held

corporations. E state of Newhouse v. Commissioner

, supra at 249.

The distinction between the two discounts is succinctly stated in

Estate of Andrews v. Commissioner

, supra 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. Although there may be some

overlap between these two discounts in that lack of

control may reduce marketability, it should be borne in

mind that even controlling shares in a nonpublic

corporation suffer from lack of marketability because of

the absence of a ready private placement market and the

f act that flotation costs would have to be incurred if

the corporation were to publicly offer its stock. * * *

A control premium may be appropriate when valuing a large

block of stock. A control premium represents the additional value

associated with the shar eholder’s ability to control the

corporation by dictating its policies, procedures, or operations.

Estate of Chenoweth v. Commissioner , 88 T.C. 1577, 1581-1582

(1987); Rev. Rul. 59-60, 1959-1 C.B. 237, 242.

Application of a premium for control is based on the principle

that the per-share value of minority interests is less than the

per-share value of a controlling interest. Estate of Salsbury v.- 16 -

Commissioner

, T.C. Mem o. 1975-333. A premium for control is

generally the percentage by which the amount paid for a controlling

block of shares exceeds the amount which would have otherwise been

paid for the shares if sold as minority interests. Id.

Although, generally, the minority discount is the inverse of

the control premium, Rakow v. Commissioner

, T.C. Memo. 1 999-177,

the control premium which is added to the majority block might be

less than the proper minority discount to be attributed to a

minority of the shares, E state of Chenoweth v. Commissioner

, supra

at 1589-1590.

Whether a premium for control, a discount for a minority

interest, or a discount for lack of marketability should be applied

in valuing nonpublicly traded closely held stock depends on the

valuation method employed in reaching the unadjusted value of the

stock.

The approach or approaches used in the valuation each

lead to a value with certain characteristics

(control/minority, marketable/nonmarketable, and so on).

* * * The characteristics of the value produced by the

approach dictate, to a large degree, the premiums and/or

discount(s) appropriate for the standard and premises of

value being sought.* * *

Pratt et al., Valuing A Business: The Analysis and Appraisal of

Closely Held Companies 303 (3d ed. 1996).

The market approach (comparable companies analysis) is based

on comparisons with publicly traded stocks and derives a value

based on publicly traded minority shares. Thus, the method- 17 -

provides a marketable, minority ownership indication of value. I d.

at 304. Under this method, a discount from the listed value is

typically warranted in order to reflect the lack of marketability

of the unlisted stock. M andelbaum v. Commissioner

, T.C. Memo.

1995-255, affd. without published opinion 91 F.3d 124 (3d Cir.

1996). If the stock to be valued by the market approach represents

a minority interest, no discount for the lack of control is applied

because the method reflects a minority interest. If, on the other

hand, the stock represents a control interest, a control premium is

warranted in order to reflect the increased value over the minority

value determined under the market valuation method. E state of

Desmond v. Commissioner , T.C. Memo. 1999-76.

A discounted economic income approach can produce either a

control value or a minority value, depend ing on the assumptions

used in determining the economic income pro jections and the

discount rate. Where the method used values the stock as if it

were a controlling interest, no contro l premium is necessary

because the control aspect has already been acco unted for within

the unadjusted value. Pratt, supra at 303-306. “The most common

example of economic income projections that would lead to a

minority or control value is whether or not owners’ compensation is

adjusted to reflect value of services rendered.” Id. at 304.- 18 -

Generally, if the inputs in the valuation model reflect

changes that only a control owner would (or could) make

(e.g., changed capital structure, reduced owner’s

compensation, and so o n), then the model would be

expected to produce a control value. * * *

If the economic income projections merely reflect

the continuatio n of present policies, then the model

would be expected to produce a minority value. * * *

Id. at 194-195.

Under a discounted cashflow analysis, a discount rate based on

a traditiona l capital asset pricing model relates to marketable,

minority ownership in the investment to be valued. Issues of

control and lack of marketabilit y are usually treated separately

rather than incorporating them in the discount rate. Id. at 162-

163.

If an indication of value is developed on the basis of

acquisition data, applying a minority interest discount is usually

appropriate when valu ing a minority ownership interest. I d. at

305. However, “if the benchmark for the estimated sale price is

valuation multiples observed in acquisitions of public companies,

data indicate that valuation multiples for acquisitions of private

companies tend to be less.” Id. at 354.

In thi s case, the parties relied on expert testimony to

establish the fair market value of the trust’s 1,226 shares of JPMS

as of the moment of decedent’s death. The estate offered the

expert reports and testimony of George B. Weiksner and Kenneth W.

McGraw, and respondent offered the report and testimony of Martin- 19 -

3 Respondent also offered the report and testimony of E.

James Brennan to evaluate the reasonable level of compensation

for services provided by Messrs. Mitchell and DeJoria before Mr.

Mitchell’s death and to make an estimate of the reasonable level

of compensation for Mr. DeJoria for the 5 fiscal years following

Mr. Mitchell’s death. Mr. Brennan opined that the amounts

Messrs. Mitchell and DeJoria paid themselves for the 1984-89

fiscal years were far greater than the maximum amounts paid to

comparable top executives at equivalent enterprises for employee

services. Mr. Brennan concluded that the maximum level of

reasonable compensation for Mr. DeJoria for 1990-94 would range

between $820,300 and $1,159,420, on the basis of projections of

an increase in sales revenue for those years. D. Hanan, to establish the value of the stock. 3 All three experts

created earnings models that generally served as the bases of their

analyses, and all experts used comparable companies, discounted

cashflow, and/or comparable acquisitions analyses. The experts

treated their comparable c ompanies analyses as the estimated

publicly traded value of the minority interest of JPMS stock to

determine an initial value of the company before applying discounts

for lack of marketability.

In deriving their earnings models, all the experts made

adjustments to J PMS’s financial data. Most significant were

adjustments (or lack thereof) to Mr. DeJoria’s compensation. The

estate’s experts, Messrs. Weiksner and McGraw, assumed that Mr.

DeJoria’s compensation would be $12 million in 1990 and $17 million

thereafter. Respondent’s expert, Mr. Hanan, created three models.

The initial model assumed that a 49-percent shareholder could

negotiate a reduction in Mr. DeJoria’s compensation to $5 million- 20 -

per year. The second assumed compensation of $2.5 million, and the

third assumed compensation of $12 million in 1990 and $17 million

thereafter.

A nother significant difference in the experts’ analyses w a s

the discount rates used by the experts in their discounted cashflow

analyses. Messrs. Hanan and Weiksner determined that JPMS’s

weighted average cost of capital (WACC) was 15 percent. Mr. Hanan

used the 15 percent WACC as his discount rate. Mr. Weiksner used

discount rates between 17 and 21 percent to take into account

JPMS’s smaller size. Mr. McGraw determined JPMS’s WACC at 24.7

percent and used a discount rate of 25 percent. Mr. McGraw

attributed 3 percent to JPMS’s smaller size and 6 percent to

reflect individual risk associated with JPMS. The individual risk

specified by Mr. McGraw was the limited number of prospective

purchasers for the st ock due to the size of the investment, the

minority interest status of the block of stock, and the control

exercised by Mr. DeJoria.

The enterprise values (in millions of dollars) determined by

t he experts under their comparable companies and disco unted

cashflow analyses are shown in the following table:- 21 -

Enterprise Value

DeJoria Comparable Discounted

Expert Compensation Companies Cashflow

Hanan $2.5 $302 $227

Hanan 5.0 272 (267-281) 218

Hanan 12.0-17.0 193 155

Weiksner 12.0-17.0 85-105 115-140

McGraw 12.0-17.0 109 101

Under their comparable companies analyses, Messrs. Weiksner

and McGraw applied a 45-percent discount to reflect lack of

marketability. Mr. McGraw also applied the 45-percent lack of

marketability discount in his discounted cashflow analysis; he did

not apply a minority interest discount or assert that the value

reflected a premium for control. Mr. Weiksner opined that his

discounted cashflow analysis produced a control value that

dem o nstrated a 34-percent control premium over the comparable

compani es value and confirmed his valuation under the comparable

companies analysis. Mr. Hanan applied a 30-percent discount for

lack of marketability from the value determined under both his

comparable companies approach and his discounted cashflow analysis.

Mr. Weiksner applied a 10-percent extraordinary risk discount

to JPMS’s comparable companies value. This discount accounted for:

(1) The approximate cost of replacing Mr. Mitchell’s services that

was estimated in the projections of JPMS’s operating expenses; (2)

operational difficultie s; (3) dependence on Mr. DeJoria; and (4)

difficulty in maintaining future growth.- 22 -

Mr. Weiksner valued the trust’s 49.04-percent interest in JPMS

common stock (1,226 shares) at $20,634,000 to $25,489,000, with a

midpoint value of $23,062,000.

Mr. McGraw’s comparative companies analysis resulted in a

$29.5 million value for the 1,226 shares of JPMS common stock. His

discounted cashflow analysis resulted in a $27.2 million value for

the 1,226 shares of JPMS common stock.

Mr. Hanan determined an $81 million fair market value for the

1,226 shares of JPMS common stock under his comparable companies

analysis. Although Mr. Hanan proposed an $81 million fair market

value for the 1,226 shares of JPMS common stock, he conceded that

because of a likely disagreement between the buyer/seller and Mr.

DeJoria over Mr. DeJoria’s com pensation and the possibility of

litigation, the value of the subject stock could be as high as

$165.3 million and as low as $57.7 million.

Expert witness reports may help the Court understand an area

requiring specialized training, knowledge, or judgment. S nyder v.

Commissioner

, 93 T.C. at 534. We may be selective in deciding what

part of an expert witness’ s report we will accept. H elvering v.

Na tl. Grocery Co. , 304 U.S. 282, 295 (1938); P arker v.

Commissioner

, 86 T.C. 547, 561 (1986). The purpose of expert

testimony is to assist the trier of fact to understand evidence

that will determine the fact in issue. L aureys v. Commissioner

, 92

T.C. 101, 127-129 (1989). An expert has a duty to the Court that- 23 -

exceeds his duty to his client; the expert is obligated to present

data, analysis, and opinion with detached neutrality and without

bias. E state of Halas v. Commissioner

, 94 T.C. 570, 577-578

(1990). In the context of valuation cases, experts lose their

usefulness (and credibility) when they merely become advocates for

the position argued by a party. L aureys v. Commissioner

, supra at

129; Buffalo Tool & Die Manufacturing Co. v. Commissioner

, 74 T.C.

441, 452 (1980). When an expert displays an unyielding allegiance

to the party who is paying his or her bill, we generally will

disregard that testimony as untrustworthy. E state of Halas v.

Commissioner

, supra ; Laureys v. Commissioner

, supra

.

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. C asey v.

Commissioner

, 38 T.C. 357, 381 (1962). We have broad discretion in

selecting valuation methods, 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, C olonial Fabrics, Inc. v. Commissioner

,

202 F.2d 105, 107 (2d Cir. 1953), affg. a Memor andum Opinion of

this Court.

We have considered all of the testimony before us, as well as

the expert witness reports, and have weighed all o ther relevant- 24 -

factors. All of the expert reports in this case are subject to

criticism.

Mr. Weiksner describes his discounted cashflow analysis as an

estimation of the company’s value that “presumes certainty of

outcome and control of the company’s cash flows.” Consequently, he

asserts that the method results in an estimate of value that is

substantially higher than the public enterprise value of the

company determined under his comparable companies analysis.

Similarly, Mr. Weiksner opines that his comparable acquisitions

analysis generat es control values that include a significant

premium to public values. In his discounted cashflow and

comparable acquisitions analyses, however, Mr. Weiksner assumed Mr.

DeJoria’s compensation would be $12 million in 1990 and $17 million

thereaft er. That assumption clearly presupposes lack of control

and shows a minority interest value. Rather than demonstrating a

34-percent control premium, we find that Mr. Weiksner’s discounted

cashflow analysis demonstrates the inaccurac y of the comparable

companies method of valuing the stock in this case.

Mr. McGraw also set Mr. DeJoria’s compensation at $12 million

in 1 990 and $17 million thereafter. Mr. McGraw properly did not

claim that the value he determined under the d iscounted cashflow

analysis demonstrates a control premium. In setting his discount

rate at 25 percent, however, he attributed 6 percent to the

individual risk, described by Mr. McGraw as the limited number of- 25 -

prospective purchasers for the stock due to the size of the

investment, the minority interest status of the block of stock, and

the control exercised by Mr. DeJoria. The individual risk reflects

lack of marketability. We find that increasing the discount rate

to reflect this “individual risk” in addition to applying a large

separate discount for lack of marketability results in an

undervaluation of the stock.

We are of the opinion that here the comparable companies and

discounted cashflow methods (which are theoretical valuation

methods) are not appro priate. We did not use them because (1)

there were real-world acquisition offers by Minnetonka and

Gillette, and (2) the discounted cashflow and comparable companies

analyses, as determ ined by the estate’s experts, produced

theoretical values for JPMS that were substantially less than these

real-world acquisition offers.

While listed market prices are the benchmark in the case of

publicly traded stock, recent arm’s-length transactions generally

are the best evidence of fair market value in the case of unlisted

stock. See E state of Andrews v. Commissioner

, 79 T.C. at 940;

Duncan Indu s., Inc. v. Commissioner , 73 T.C. 266, 276 (1979);

Estate of Branson v. Commissioner , T.C. Memo. 1999-231.

In Estate of Mitchell v. Commissioner

, T.C. Memo. 1997-461, we

began our analysis by placing a $150 million value on JPMS at the

moment immediately prior to Mr. Mitchell’s death. In determining- 26 -

this value, we considered all the evidence but gave the greatest

consideration to Minnetonka’s real-world $125 million offer in the

fall of 1 988 (which Mr. DeJoria found “a little short”) and the

Gillette offer o f $150 million. This value represents the

acquisition value of all the nonpublicly traded stock of JPMS.

In Estate of Mitchell v. Commissioner

, 250 F.3d at 705, the

Court of Appeals stated:

Acquisition value and publicly traded value are different

because acquisition pri ces involve a premium for the

purchase of the entire company in one deal. Such a

lumpsum valuation was not taken into account when the

minority i nterest value of the stock was calculated by

the experts. In general, the acquisition price is

higher, resulting in an inflated tax consequence for the

Estate.

In reaching our valuation determination, we wer e, and are,

mindful that, in general, a publicly traded value (determined under

the comparable companies analysis) represents a minority,

marketable value. Moreover, we were, and are, mindful that

acquisition value , if determined by reference to acquisitions of

publicly traded companies, reflect s a premium over the publicly

traded value. It produces a control, marketable value that is

greater than th e minority, marketable publicly traded value. If

the acquisition price of publicly traded companies is used to value

a minority interest in a closely he ld corporation, discounts for

both lack of marketability and lack of control would apply.

The real-world acquisition value of $150 million we applied in

this case is the acquisition valu e based on an offer to purchase- 27 -

all of the stock of JP MS, which is not publicly traded. The

acquisition value based on that offer reflects the fact that there

is no ready market for shares in JPMS, a closely held corporation.

As we pointed out in Estate of Andrews v. Commissioner

, 79 T.C. at

953, “even controlling shares in a nonpublic corporation suffer

from lack of marketability because of the absence of a ready

private placement market and the f act that flotation costs would

have to be incurred if the corporation were to publicly offer its

stock.” The $150 million acquisition value reflects a control,

nonmarketable value. T h erefore, a discount for lack of

marketability of JPMS stock from the value determined by reference

to the offer to purchase the JPMS stock is not appropriate.

Because we used the real-world acquisition (control,

nonmarketable) value of $150 million for the entire company, we

were n ot convinced that the combined discounts opined by the

experts in their theoretical va lues are appropriate. Those

combined rates would apply an additional separate 30- to 40-percent

discount for lack of marketability to a value that reflects that

lack of marketability, in effect doubling the discount.

We recognize, however, that there may be some overlap between

discounts for a minority interest and for lack of marketability in

that lack of control may red uce marketability. Mr. Weiksner

applies a larg er lack of marketability discount for minority

interests than for a controlling interest. In his report, he- 28 -

opines that a “larger illiquidity and private com pany discount”

always applies to a minority shareholding of stock than to a

control shareholding of that same stock because the minority holder

does not have the same access to information and ability to create

liquidi ty as a control holder has. In this case, because the

acquisition price includes the discount for lack of marketability,

we were, and remain, of the opinion that it is more appropriate to

account for any lack of marketability attributable to the minority

interest in the minority discount we apply, which for lack of a

better term we have referred to as the combined discount.

Mr. McGraw, in setting his discount rate under his discounted

cashflow analysis, attributed 6 percent to the individual risk,

described by him as the limite d number of prospective purchasers

for the stock due to the size of the investmen t, the minority

interest status of the block of stock, and the control exercised by

Mr. DeJoria. Mr. McGraw’s individual risk reflects lack of

marketability specifically related to decedent’s minority interest.

We have increased the minority discount by 6 percentage points to

reflect this additional lack of marketability.

Mr. Hanan’s discounted cashflow analysis setting Mr. DeJoria’s

compensation at $2.5 million, resulting in a value of $227 million,

reflects a control value of the enterprise. His analysis setting

Mr. DeJoria’s compensation at $12 to $17 million, resulting in an

enterprise value of $155 million, reflects lack of co ntrol.- 29 -

Finally, his analysis setting the compensation at $5 million,

resulting in an enterprise va lue of $218 million, reflects some

power but less than control. We think that a comparison of those

values demonstrates most accurately the difference between the

value of contr ol of the company, the value of shares having some

power, and the value of shares lacking any control. A comparison

of these values supports a minority discount of 29 percent for some

power but le ss than control (155/218 = 0.711) and 32 percent for

lack of any control (155/227 = 0.683).

The 49.04-percent interest in JPMS to be valued in this case

had significant power. This interest, through the cumulative

voting provision, could elect at least one of three directors. (If

there were four directors as provided for in the articles of

incorporation, decedent’s stock could elect two directors, giving

decedent’s stock power equal to that of Mr. DeJoria). Mr. Weiksner

acknowledges i n his report that in some cases investors would

consider a 49.04-percent shareholding adequate to influence or even

control a company but cautions that an investor would have had no

assurance of his ability to influence the management or disposition

of the company except through cooperative means.

We find that a 29-percent discount for decedent’s 49.04-

percent shareholding is appropriate to reflect some power but less

than control. We also find that here the minority discount should

be increased by 6 percentage points (a total of 35 percent) to- 30 -

4 This 10-percent discount is consistent with Mr.

Weiksner’s extraordinary risk discount. r eflect the additional lack of marketability attributable to a

minority interest.

On the basis of a thorough review of the entire record before

us, we believe that we correctly arrived at a 35-percent discount

rate that combines the lack of control and any additional lack of

marketability attributable to that lack of control that is not

reflected in the $150 million cont rol, nonmarketable acquisition

value.

The experts generally agreed that the most significant factors

included the impact of Mr. Mitchell’s death on the reputation of

the company, the costs of the DeJoria litigation, cashflow

patterns, the marketability of the estate’s minority (i.e.

noncontrolling) interest of stock in the company, and the overall

competition in the hair care industry. The $150 million

acquisition price reflects the cashflow patterns a nd the overall

competition in the hair care industry. We apply a 10-percent

discount to the $150 million to reflect the impact of Mr.

Mitchell’s death on the value of the corporation. 4 We apply a 35-

percent discount for lack of control and additional lack of

marketability attributable to the minority interest. Finally, we

reduce the value of the 49.04- percent ownership interest by

$1,500,000 to account fo r the possibility of litigation with Mr.- 31 -

DeJoria. Thus, we find that the value of the shares of stock at

the moment of decedent’s death was $41,532,600.

We calculated this amount as follows:

Value of JPMS at the moment immediately

prior to Mr. Mitchell’s death $150,000,000

Less: Discount to reflect the loss of

Mr. Mitchell to JPMS (15,000,000 )

Value of JPMS at the moment of Mr.

Mitchell’s death 135,000,000

Percent of trust’s interest in JPMS x 49.04

Value of trust’s interest in JPMS before

discounts 66,204,000

Discount for lack of marketability and

minority interest (35%) (23,171,400 )

43,032,600

Discount for possibility of lawsuit (1,500,000 )

Value of trust’s interest in JPMS after

discounts 41,532,600

To reflect the foregoing,

Decision will be entered as

previously entered on January 5,

1999.