t c memo united_states tax_court estate of helen p richmond deceased amanda zerbey executrix petitioner v commissioner of internal revenue respondent docket no filed date at the time of her death d owned a interest in a family-owned personal_holding_company phc whose assets consisted primarily of publicly traded stock d’s estate_tax_return reported the fair_market_value of d’s interest in phc as dollar_figure using a capitalization-of-dividends method to value the asset r used instead a net asset value nav method and determined a deficiency in d’s estate_tax as well as an accuracy-related_penalty under sec_6662 held the fair_market_value of d’ sec_23 interest in phc is better determined by an nav method and is dollar_figure held further p is liable for a accuracy-related_penalty under sec_6662 b and g peter samuel gordon and john w porter for petitioner warren p simonsen for respondent contents findings_of_fact pearson holding_company phc’s maximizing of dividends phc’s bicg tax_liability phc stock transactions ms richmond’s ownership and bequest of phc stock financial information the estate_tax_return the notice_of_deficiency and the petition the commissioner’s expert the estate’s expert ultimate findings opinion introduction i ii general principles of estate_tax_valuation iii choice of valuation method the value of the decedent’s interest in phc iv a discount for bicg liability notice_of_deficiency a zero discount the estate’s expert of the bicg tax the commissioner’s expert of the bicg tax our conclusion present_value of the bicg tax_liability b c d discount for lack of control discount for lack of marketability conclusion v accuracy-related_penalty memorandum findings_of_fact and opinion gustafson judge by a statutory_notice_of_deficiency dated date the internal_revenue_service irs determined a deficiency of dollar_figure in federal estate_tax due from the estate of helen p richmond the irs also determined an accuracy-related_penalty of dollar_figure due under sec_6662 the estate commenced this suit by filing its petition to challenge those determinations the issues for decision are whether the interest consisting of shares in pearson holding co phc that was included in the value of the gross_estate for purposes of federal estate_tax had a fair_market_value of dollar_figure as the estate unless otherwise indicated all section references are to the internal_revenue_code u s c in effect at the date of the decedent’s death and all rule references are to the tax_court rules_of_practice and procedure numerical amounts appearing in this opinion are sometimes rounded now asserts or any other amount less than the dollar_figure that the commissioner now asserts we find it had a value of dollar_figure and whether there is an underpayment of estate_tax attributable to a substantial estate_tax_valuation understatement for purposes of the accuracy- related penalty imposed by sec_6662 b and g and if so whether any portion of the underpayment was attributable to reasonable_cause under sec_6664 we find a substantial valuation_understatement for which there was no reasonable_cause findings_of_fact some of the facts have been stipulated and are so found at the time of her death ms richmond resided in pennsylvania at the time the petition was filed the irs’s notice_of_deficiency determined that the asset at issue had a fair_market_value not of dollar_figure as the estate had reported on its return but rather dollar_figure--ie an increase of dollar_figure the commissioner now contends it had a value of dollar_figure ie about less than on the notice_of_deficiency and a concession of about of the original increase the estate_tax_return reported a value of dollar_figure but the estate now contends it had a value of dollar_figure ie about more than on the return in the notice_of_deficiency the irs calculated the amount of the penalty using the rate that generally applies to gross_valuation_misstatements see sec_6662 on brief however the commissioner concedes that the gross_valuation_misstatement penalty does not apply and he asserts instead that the underpayment is attributable to a substantial valuation_understatement under sec_6662 and g thus incurring a penalty the two co-executors of the estate resided in pennsylvania where the will was probated and new jersey pearson holding_company phc was incorporated in delaware in date it originated as and continues to be a family-owned investment holding_company phc is a subchapter_c_corporation its business_purpose as stated in its certificate of incorporation is to guarantee purchase hold sell assign transfer mortgage pledge or otherwise dispose_of shares of capital stock or any bonds securities or other evidence_of_indebtedness created by anyone in the corporation or corporations organized under the law of the state of government phc’s approach as described by its current chairman and president is to preserve under sec_7482 this case would be reviewed on appeal by the united_states court_of_appeals for the circuit in which is located the legal residence of the petitioner to the extent the estate reside s where its co- executors reside or where the will was probated this case would be reviewed on appeal by the court_of_appeals for the third circuit neither party has suggested any reason that appeal might lie in the court_of_appeals for the fifth circuit or the court_of_appeals for the eleventh circuit both of which see 507_f3d_1317 11th cir vacating and remanding tcmemo_2005_131 estate of 301_f3d_339 5th cir rev’g and remanding tcmemo_2000_12 have held that a holding company’s net asset value should be discounted by of the built-in capital_gains_tax for which the holding_company would eventually be liable see part iv a below capital to grow capital where possible and to maximize dividend income for the family shareholders as of date phc had big_number shares of common_stock outstanding those shares were held by members whose interests ranged from to the three largest shareholders which included the decedent owned a total of of the shares phc’s maximizing of dividends through the date of the decedent’s death phc followed its stated philosophy of maximizing dividend income as a holding_company subject_to tax on undistributed_income see sec_541 phc has a strong incentive to pay out most of the dividend income generated by the securities held in its portfolio and the ultimate objective of the company was to provide a steady stream of income to the descendants of frederick pearson while minimizing taxes and preserving capital phc has paid dividends reliably at a rate that in the years from through had grown slightly more than per year in the seven years preceding the decedent’s death phc paid out dividend distributions as follows year dividend distribution decedent’s share dollar_figure big_number big_number big_number big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number big_number the turnover of phc’s securities has been slow--for the period from to per year and for the 10-year period ending date per year at that rate a complete turnover of the securities would take years however in a potential investor would have observed that with the passing decades the ownership of phc stock had become more diffuse--and would continue to become more diffuse--among heirs and legatees with less and less identification with frederick pearson and his philosophy and goals and with less and less knowledge of and affinity for one another the mindset of the shareholders as owning a family company would more and more give way to an attitude that regards the phc shares simply as an investment and the company would be increasingly likely to follow the financial advice of diversifying its holdings we find that as the commissioner’s expert witness testified a potential investor who considered purchasing phc would likely expect that approximately years would pass before a complete turnover of the portfolio or a liquidation of the company would occur phc’s bicg tax_liability when securities or any other assets appreciate in value the owner becomes liable for tax--but only upon the occurrence of an income_tax recognition event such as the sale of the assets a holding_company that owns securities that both produce dividends and appreciate may prefer to hold the securities rather than sell them because it can thereby defer payment of the tax and accrue dividends from a larger portfolio undiminished by payment of tax_liabilities this has been phc’s approach as a result the value of its portfolio has grown to consist more and more of untaxed appreciation as of date of the value of phc’s portfolio consisted of appreciation on which capital_gain tax had not yet been paid but would eventually become due upon sale of the appreciated securities this deferred liability that inheres in appreciated assets is referred to as built-in capital_gain tax bicg tax from time to time wilmington trust co as phc’s financial adviser has suggested that phc sell substantial amounts of its securities in order to diversify its portfolio however phc never acted on this advice because of the large bicg tax attributable to the appreciation of its securities phc has preferred not to incur that tax_liability the payment of which would diminish its total assets and therefore its ability to generate dividends phc stock transactions from through there were nine transactions involving the sale or redemption of phc stock by a shareholder it appears that the value of the stock for those transactions was determined using the dividend model in addition when another shareholder died in the estate used the dividend model to value his interest in phc ms richmond’s ownership and bequest of phc stock as of date helen p richmond owned shares in phc she was phc’s second largest shareholder holding a interest as the owner of less than a majority of phc’s stock ms richmond could not unilaterally change the management or investment philosophy of the company nor could she unilaterally gain access to the corporate books increase distributions from the company or cause the company to redeem its stock she could not force phc to make an s election or to diversify its holdings she had no rights to put her stock to the company ie to force it to buy her shares and the company could not call her stock ie could not demand to buy it on date ms richmond executed a codicil to her will that named john w lyle and amanda zerbey as co-executors of her estate mr lyle graduated in the 1950s from lasalle university in philadelphia and was a certified_public_accountant c p a in the state of delaware mr lyle served as an accountant for phc from until before working at phc mr lyle had been employed as an accountant at haskin sells in their philadelphia office ms zerbey attended business school at the keystone school of business from to ms zerbey has been employed as an internet operations quality control manager at eastwood co in pottstown pennsylvania since before her position at eastwood co ms zerbey was employed from to in malvern pennsylvania as a buyer for cottage craft where she met ms richmond ms richmond died on date the parties stipulate that on that date she still owned her phc stock so it is not disputed that the value of that stock is included in her taxable_estate financial information the parties have stipulated that as of date phc held a portfolio with a value of dollar_figure as follows asset government bonds and notes preferred stocks common_stock sec_1 cash and equivalents receivables security deposit total fair_market_value dollar_figure big_number big_number big_number big_number big_number phc’s common stocks were invested in major industries with of the stock concentrated in four companies exxon mobil merck co inc general electric co and pfizer inc as is noted above approximately of the dollar_figure of phc’s total assets--ie dollar_figure--consists of unrealized_appreciation the parties agree that the capital_gain tax_liability built in to that appreciation but not yet due was dollar_figure as of the date of the decedent’s death phc had outstanding liabilities apart from any bicg tax_liability of dollar_figure accordingly phc had a net asset value nav of dollar_figure ie dollar_figure in total assets less dollar_figure in liabilities the estate_tax_return on date the co-executors of the decedent’s estate amanda zerbey and john w lyle filed a form_706 united_states estate and generation-skipping_transfer_tax return before doing so the estate retained a law firm to prepare the estate_tax_return and retained the certified public accounting firm of belfint lyons shuman p a belfint to value the phc stock for purposes of the estate_tax_return the accountant who did the valuation was peter winnington mr winnington graduated with a bachelor of science degree in accounting from the university of delaware in and he received his master of science degree in taxation from widener university in mr winnington has been employed as an accountant with belfint since date and he currently chairs the firm’s corporate service_department and sits on the firm’s executive committee mr winnington has experience in public accounting involving audits management advisory litigation support and tax planning and preparation services mr winnington became a c p a in the state of delaware in and a certified financial planner in and is a member of the american institute of ms zerbey is the surviving executrix of the decedent’s estate as mr lyle died on date certified public accountants aicpa the delaware society of certified public accountants dscpa and the wilmington tax group mr winnington has appraisal experience ie having written valuation reports and having testified in court but he does not have any appraiser certifications the co-executors provided to mr winnington information about stock transactions in the 1990s as well as some valuations for prior estates that included phc stock which mr winnington used to value the decedent’s interest in phc using this information together with additional information already in belfint’s possession ie audit reports corporate tax returns and investment reports of phc as well as knowledge of the history of the company and the pattern for its shareholders to hold their stock long term mr winnington prepared a draft report that valued the decedent’s interest in phc at dollar_figure using a capitalization-of-dividends method he provided the unsigned draft of the valuation report to the executors and to the return preparer and he was never asked to finalize his report without further consultation with mr winnington the estate reported the value of ms richmond’s interest in phc as dollar_figure on the federal estate_tax_return filed with the irs the notice_of_deficiency and the petition on date the irs issued a statutory_notice_of_deficiency to the estate determining an upward valuation of the decedent’s interest in phc to dollar_figure this adjustment increased the estate_tax liability by dollar_figure in addition the notice_of_deficiency determined a gross_valuation_misstatement penalty of dollar_figure pursuant to sec_6662 the notice_of_deficiency made no other adjustments to the gross_estate besides the valuation of the decedent’s interest in phc the estate timely filed a petition with this court seeking a redetermination of the deficiency and the penalty determined in the notice_of_deficiency the commissioner’s expert at trial the commissioner offered john a thomson as an expert in business valuation the court accepted mr thomson as a business valuation expert and received his written report into evidence as his direct testimony mr thomson valued the decedent’s interest in phc by the cost approach using a discounted net asset method using phc’s stipulated nav of dollar_figure mr thomson the notice_of_deficiency does not specify what valuation method the irs auditor used to value the decedent’s interest in phc and does not explain to what extent if any his method allowed discounts for tax attributable to built-in_gain for lack of control or for lack of marketability calculated the decedent’ sec_23 interest of phc’s nav to be dollar_figure ie of the total nav he then applied a discount of to adjust for the fact that the decedent held only a minority interest and he applied a discount of to adjust both for the lack of marketability of non-publicly traded shares and for the bicg tax overall mr thomson applied a discount resulting in the value of the decedent’ sec_23 interest in phc being reduced to dollar_figure although the court independently calculates the decedent’ sec_23 interest to be dollar_figure ie dollar_figure times instead of dollar_figure we ignore this difference as de_minimis of mr thomson’ sec_36 marketability discount was a discount for bicg tax in his report prepared before trial mr thomson’s discount for lack of marketability including bicg tax was set pincite but at trial he increased it to mr thomson’s overall discount can be expressed by this equation discount for lack of control - discount for lack of control x discount for lack of marketability dollar_figure x or the commissioner’s expert report asserts a value of dollar_figure rounded to dollar_figure however the adjustment in the lack of marketability discount made at trial ie increasing it from to reduced the commissioner’s asserted value of the decedent’ sec_23 interest in phc to dollar_figure the estate’s expert the estate offered robert schweihs as an expert in valuation the court accepted him as an expert in business valuation and received his written report into evidence as his direct testimony mr schweihs valued the decedent’s interest in phc by relying primarily on the capitalization-of-dividends method an income approach in so doing mr schweihs used a dividend growth model which computes a principal value pv as follows pv e g k - g where e expected amount of economic_income in the period immediately past k discount rate or required rate of return g expected growth rate of earnings annually compounded into perpetuity in addition to calling mr schweihs as an expert witness the estate also called as a fact witness mr winnington the accountant who prepared phc’s valuation report for the estate_tax_return although mr winnington gave factual testimony about his valuation report which formed the basis for the value reported on the estate_tax_return the estate did not proffer mr winnington as a valuation expert and instead requests that we adopt mr schweihs’s appraised value the commissioner does not dispute that the capitalization-of-dividends method can sometimes be used to value stock and does not dispute mr schweihs’s equation but does dispute both the appropriateness of using that method in this instance and the appropriateness of some of the values mr schweihs used see part iii below using a discount rate k of a long-term growth rate g of and the decedent’s share of phc’s dividends in see p above as the e mr schweihs valued the decedent’s interest in phc as of date to be dollar_figure as follows pv dollar_figure -0 dollar_figure dollar_figure therefore notwithstanding the estate’s starting valuation of dollar_figure as reported on the estate_tax_return and the commissioner’s starting valuation of dollar_figure as determined in the notice_of_deficiency --with a difference of more than dollar_figure million--by the time of trial the difference in valuations had narrowed considerably the decedent’s interest in phc was worth dollar_figure according to the estate and dollar_figure according to the commissioner--a difference of not quite dollar_figure million as an alternative to his capitalization-of-dividends valuation mr schweihs also valued the decedent’s interest in phc using the net asset valuation method ie proposing corrections to mr thomson’s net asset valuation and reached a we are unable to reconcile mr schweihs’s value of dollar_figure with the calculation above of dollar_figure we assume that the discrepancy is due at least in part to rounding and we do not consider it to be material value of only dollar_figure starting with the same nav as the commissioner’s expert--dollar_figure--mr schweihs reduced phc’s nav by dollar_figure--ie of phc’s bicg tax rather than the bicg discount of dollar_figure--ie of dollar_figure--that mr thomson allowed mr schweihs then applied an discount for lack of control as compared to mr thomson’s as well as a discount for lack of marketability as compared to mr thomson’ sec_21 this method valued phc’s net assets after these discounts and the dollar-for-dollar reduction for bicg tax at dollar_figure the decedent’ sec_23 interest was therefore valued by the estate’s expert at dollar_figure using the net asset value method ultimate findings we find that in order to account for the capital_gain tax_liability built in to its assets phc’s net asset value of dollar_figure should be discounted by dollar_figure ie the commissioner’s concession of of phc’s nav to dollar_figure we further find that the decedent’ sec_23 interest therein ie dollar_figure should be further discounted by for lack of control and by for lack of marketability so that the decedent’s interest in phc had a fair_market_value of dollar_figure at the decedent’s date of death i introduction opinion we must determine the fair_market_value of the decedent’s interest in phc as of the date of her death the value of the decedent’s interest was included in the value of her gross_estate and was reported on the estate_tax_return at dollar_figure relying on mr schweihs’ testimony the estate now concedes a higher amount and argues that the correct fair_market_value is dollar_figure almost dollar_figure million more in his notice_of_deficiency the commissioner valued the decedent’s interest in phc at dollar_figure relying on mr thomson’s expert testimony the commissioner now argues that the fair_market_value is dollar_figure almost dollar_figure million less which we regard as a partial concession see estate of hinz v commissioner tcmemo_2000_6 finding that the commissioner conceded his valuation position as determined in the notice_of_deficiency by arguing for a lower fair_market_value on brief in general the irs’s notice_of_deficiency is presumed correct and the petitioner has the burden of proving it to be wrong 290_us_111 see also rule a 708_f3d_507 3d cir aff’g tcmemo_2012_70 but in this case the estate argues that the burden_of_proof has shifted however both sides put on expert testimony as to the value of the property at issue and we are able to decide that value on the preponderance_of_the_evidence we therefore need not address the allocation of the burden_of_proof with respect to the valuation issue ii general principles of estate_tax_valuation sec_2001 imposes a tax on the transfer of a decedent’s taxable_estate and sec_2001 provides that the tax is imposed on the amount of the taxable_estate the value of the gross_estate includes the value at the time of his death of all the decedent’s property real or personal tangible or intangible wherever situated sec_2031 411_us_546 for this purpose value means fair_market_value which 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 sec_20_2031-1 estate_tax regs valuation is ultimately a question of fact 94_tc_193 if the property to be valued is stock of a closely_held_corporation actual arm’s-length sales of such stock in the normal course of business within a reasonable_time before or after the valuation_date are the best criteria of market_value 79_tc_938 see also sec_20_2031-2 through c if it is not possible to value the stock by such sales then the fair_market_value is to be determined by taking into consideration the company’s net_worth prospective earning power and dividend-paying capacity and other_relevant_factors and the weight to be accorded such evidentiary factors depends upon the facts of each case id para f i n general an asset-based method of valuation applies in the case of corporations that are essentially holding corporations while an earnings-based method applies for corporations that are going concerns estate of smith v commissioner tcmemo_1999_368 see also revrul_59_60 sec_5 1959_1_cb_237 the parties disagree about whether that generality is correct in this case the parties rely principally on expert testimony to establish the fair_market_value of the decedent’s interest in phc courts routinely consider expert witnesses’ opinions in deciding such issues however we are not bound by the opinion of any expert witness and may accept or reject such testimony in the exercise of our sound judgment 304_us_282 estate of newhouse v commissioner t c pincite although we may accept an expert’s opinion in its entirety we may instead select what portions of the opinion if any to accept 86_tc_547 74_tc_441 because valuation involves an approximation the figure at which we arrive need not be directly traceable to specific testimony if it is within the range of values that may be properly derived from consideration of all the evidence estate of heck v commissioner tcmemo_2002_34 the parties disagree over the appropriate valuation method to be used-- either the capitalization-of-dividends approach or the nav approach--and the appropriate discounts if the nav approach is used we now address those issues iii choice of valuation method to value the decedent’s interest in phc the commissioner used the net- asset-value approach and the estate used the capitalization-of-dividends approach we believe that the nav approach better determines phc’s value the theory behind the income capitalization valuation method is that if an asset produces a predictable income stream the market_value of the asset can be ascertained by calculating the present_value of that future income stream phc did have a history of reliably paying out dividends and over the preceding years its distributions had increased by about per year predictable annual dividend payments were phc’s stated goal and would presumably be the subjective primary investment goal of someone purchasing a minority interest in phc so the estate used this method the estate’s expert assumed that that annual increase in dividend payments would continue indefinitely he determined that the market rate of return for a company with a comparable risk profile was rounded to and he assumed that phc would realize that rate of return indefinitely the estate’s expert calculated the capitalization rate of by subtracting the annual dividend growth rate from the market rate of return for a comparable risk investment the estate’s expert then divided the decedent’s expected dividend return for the following year ie dollar_figure dollar_figure x by the capitalization rate ie to calculate for those future dividends a present_value of dollar_figure dividend capitalization is one method for valuing a business and this method may be entirely appropriate where a company’s assets are difficult to value for example a company that does not hold a portfolio of publicly_traded_securities but instead operates a business may have assets--ie a conglomeration of tangible assets acquired and depreciated over a period of years and intangible assets customer lists assembled work force know-how etc --that are difficult to value the business may seem to be more than the sum of its parts in such a case the value of the business may be better determined by projecting its income stream and discounting it to present_value however by definition the capitalization-of-dividends valuation method is based entirely on estimates about the future--the future of the general economy the future performance of phc and the future dividend payouts by phc--and even small variations in those estimates can have substantial effects on the value determined the estate’s valuation method therefore ignores the most concrete and reliable data of value that are available--ie the actual market prices of the publicly_traded_securities that constituted phc’s portfolio of course the net- asset-value method comes with its own difficulties and uncertainties in this case determining the amounts of the discounts discussed below but the nav method does begin by standing on firm ground--stock values that one can simply look up in shannon p pratt robert f reilly and robert p schweihs valuing a business the analysis and appraisal 4th ed mr schweihs and his colleagues state that the dividend capitalization approach to value is sensitive to the constant annual income stream in perpetuity or a constant annualized rate of growth or decline in the economic_income variable being capitalized in perpetuity obviously this constant growth rate projection is rarely met in the real world they observe id pincite that the gordon growth model is extremely sensitive to growth rate assumptions and that c hanges in the growth rate projected sometimes seemingly small can result in striking changes in the example given in the estate’s expert’s book a change in assumed growth rate can result in more than an change in the indicated value moreover the estate’s valuation method assumes that the only thing a potential investor will consider when contemplating whether to buy phc stock is the present_value of the dividend stream that the stockholder can expect to receive however in date a potential investor would have known that--as the parties have stipulated--phc’s portfolio consisted primarily of securities whose values could have been computed without controversy to total dollar_figure million ie phc’s net asset value before discounts with which the commissioner’s method begins where the assets themselves are thus easily valued valuing the holding_company instead by the income approach would essentially overlook that fact surely a relevant and helpful fact which we think an investor was not likely to overlook but was instead likely to take as his starting point in addition the commissioner criticized the estate’s use of a expected rate of return because the ibbotson’s study from which he derived that rate used a period ie that was different from the period mr schweihs had used to calculate phc’s dividend growth rate ie and we believe the criticism is valid to correct for this discrepancy the court independently calculated the actual rate of return ie asset growth plus dividends_paid for phc using phc’s historic data and found the compound annual growth rate to be not but rather only we believe that in date a potential investor in phc would have considered the post-1970 data most relevant and would have expected this rate of return not the rate of return assumed by the estate when we correct the estate’s calculation by using an expected rate of return of and keeping the annual dividend growth rate constant pincite the present_value of future dividends is about dollar_figure million higher-- ie dollar_figure rounded --than as calculated by the estate this confirms the sensitivity inherent in using the capitalization-of-dividends valuation method which in our opinion makes it less reliable for such reasons courts are overwhelmingly inclined to use the nav method for holding_companies whose assets are marketable_securities see eg estate of litchfield v commissioner tcmemo_2009_21 with respect to stock in closely held real_estate holding_companies and investment companies such as lrc and lsc the net asset valuation method is often accepted as the preferred method estate of smith v commissioner tcmemo_1999_368 estate of ford v commissioner tcmemo_1993_580 affd 53_f3d_924 8th cir revrul_59_60 at sec_5 c b we note that the value of the decedent’s interest in phc calculated using the net asset value method dollar_figure as discussed below is relatively close to the value of the decedent’s interest in phc using the capitalization-of-dividends method dollar_figure using the rate of return as corrected by the court the estate cites three cases to support its income capitalization valuation of holding companies--kohler v commissioner tcmemo_2006_152 barnes v commissioner tcmemo_1998_413 and estate of campbell v commissioner t c memo 1991-615--but those cases are clearly distinguishable from the instant case in each of those cases the company to be valued held stock in a closely held operating company not publicly traded stock or was itself an operating company as a result the underlying assets of those companies were difficult to value phc’s primary assets on the other hand are marketable_securities which have ascertainable market values moreover those market values inherently reflect the market’s judgment as to the projected income streams of each stock and therefore reflect the future income stream of phc for that reason a properly discounted net asset valuation of phc indirectly takes into account the expected dividend stream that underlies the estate’s valuation method we therefore follow this court’s consistent precedent of using net asset valuations for companies with holdings like phc iv the value of the decedent’s interest in phc the parties agree on the dollar_figure million net asset value of phc in date and although the estate does not agree that the nav method is the more appropriate method both parties agree in principle that if the nav method is used there must be discounts from that dollar_figure million net asset value to account for a the bicg tax for which phc would eventually be liable b the lack of marketability of phc’s non-publicly traded shares and c the lack of control inherent in the decedent’ sec_23 interest in phc a discount for bicg liability the parties agree that phc’s unrealized_appreciation on its assets was dollar_figure which if the assets had been sold on the date of death would have given rise to a capital_gain tax_liability of dollar_figure assuming a combined federal and state tax_rate the parties further agree that the value of phc should be discounted to some extent to account for the bicg tax attributable to that unrealized_appreciation however the quantum of that discount is in dispute notice_of_deficiency a zero discount the irs’s notice_of_deficiency seems to make no discount for the bicg tax--a position that the commissioner does not defend and for good reason an investor could have easily replicated phc in date by contributing dollar_figure million to his own new holding_company and then having it purchase the very same types of securities that were in phc’s portfolio no investor interested in owning such a company would have been indifferent to the fact that acquiring phc meant acquiring an eventual liability of dollar_figure million an investor would therefore have insisted on paying less than dollar_figure million to acquire phc if phc had offered no discount an investor would simply buy the stocks and be better off that is the market would have required a discount and any fair market valuation must reflect a discount the estate’s expert of the bicg tax on the other end of the spectrum the estate contends that phc’s value should be discounted by of the dollar_figure bicg liability to support this contention the estate relies on opinions by the courts of appeals for the fifth and eleventh circuits that have held that in a net asset valuation the value should be reduced dollar for dollar by the amount of a bicg tax_liability the court_of_appeals for the fifth circuit reasoned that the starting point for the asset-based approach in this case is the assumption that the assets are sold the starting point for the earnings-based approach is that the corporation’s assets are retained--are not sold so consistent with that asset-based starting point the built-in_gain would see 507_f3d_1317 estate of dunn v commissioner f 3d pincite 267_f3d_366 5th cir finding that the tax_court improperly determined only a partial discount for capital_gains_tax liability inherent in a bequest of stock because the tax_court failed to use a truly hypothetical willing buyer vacating and remanding tcmemo_1999_43 give rise to a current tax_liability reducing value estate of 301_f3d_339 5th cir rev’g and remanding tcmemo_2000_12 however other courts of appeals and this court have not followed this discount approach and we consider it plainly wrong in a case like the present one the relevant inquiry is of course what price a willing buyer and seller would agree to and it is clear that they would not agree to a discount to demonstrate this fact phc with assets worth dollar_figure million but burdened by an dollar_figure million bicg tax can be compared to a hypothetical holding_company hhc that is identical to phc except that hhc is burdened not by any bicg tax but by an dollar_figure million note payable that is due tomorrow no investor would be indifferent to this distinction and treat phc and hhc as if they were equivalent the investor knows that if he buys hhc then tomorrow he must pay estate of 155_f3d_50 ndollar_figure 2d cir where there is a relatively sizable number of potential buyers who can avoid or defer the tax the fair_market_value of the shares might well approach the pre-tax market_value of the real_estate vacating and remanding tcmemo_1997_483 estate of welch v commissioner 208_f3d_213 wl at 6th cir approving the eisenberg method of valuation rev’g and remanding without published opinion tcmemo_1998_167 see eg 110_tc_530 estate of jensen v commissioner tcmemo_2010_182 off the dollar_figure million note and have a portfolio not of dollar_figure million worth of stock but only dollar_figure million and in the future--beginning tomorrow--he will receive the capital_gains and the dividends generated by that smaller dollar_figure million portfolio on the other hand the investor also knows that if instead he buys phc then he may defer the payment of the dollar_figure million bicg tax as long as he retains the appreciated stock in the future--until he sells off the appreciated stock over time and incurs the tax piecemeal over that period--he will receive the capital_gains and dividends generated by the entire dollar_figure million portfolio phc is simply worth more than hhc because a prospective bicg tax_liability is not the same as a debt that really does immediately reduce the value of a company dollar for dollar a discount on the other hand illogically treats a potential liability that is susceptible of indefinite postponement as if it were the same as an accrued liability due immediately we do not adopt this approachdollar_figure we do not face here a circumstance in which the facts about the assets and the market would make it inevitable that any informed buyer would expect to liquidate the company immediately and thus immediately bear the tax_liability for the built-in_gain even if in such a hypothetical case the appropriate discount might be argued to be as much as of the bicg tax the facts in this case show that a rational buyer might intend as phc did intend to continue to hold at least some the portfolio for a period of years in order to benefit from the divi- dends generated by and the further appreciation experienced by the appreciated stock in a case like this one therefore a dollar-for-dollar discount is unwarranted it stands to reason that a potential buyer would be willing to pay more for a company with a contingent_liability of dollar_figure million than he would pay for a company otherwise equivalent but that had an unconditional liability of dollar_figure million payable now likewise the seller of the company with the contingent future liability would demand a higher price than the seller of a company with the unconditional current_liability as a result despite contrary holdings by some courts we find that a discount would be unreasonable because it would not reflect the economic realities of phc’s situation the commissioner’s expert of the bicg tax the commissioner’s expert mr thomson proposes a discount for bicg tax which at the entity level equates to dollar_figure ie of the net asset value of dollar_figure and of the bicg tax_liability of dollar_figure we note that the commissioner’s expert included the bicg discount as part of the lack of marketability discount that was applied at the individual level we do not find that approach especially helpful in this case as the bicg tax_liability is a liability of the entity which affects its net asset value we find it appropriate to determine the bicg tax_liability at the entity level when subsequently applying the other discounts we apply them seriatim as mr thompson did and as we approved in estate of magnin v commissioner tcmemo_2001_31 81_tcm_1126 ndollar_figure rather than simply adding the discount percentages together as a combined discount as mr schweihs did for reasons we now explain we find his method to be problematic but we find his dollar_figure million bottom line--which we take as a concession by the commissioner--to be reasonable for reasons different from those he advances to reach this dollar_figure million bicg tax discount mr thomson analyzed the correlation between unrealized_appreciation ie built-in_gain and nav discounts for closed-end funds as of date he compiled data from closed-end funds with unrealized_appreciation accounting for to of the total net asset value and he was unable to find any statistical correlation between the bicg discount that could be observed on sales and the unrealized_appreciation of the seven closed-end funds he examined he therefore concluded that in the case of companies with unrealized_appreciation that consists of as much a sec_46 of the company’s value which he rounds up to buyers are indifferent to the bicg tax_liabilities on that appreciation when purchasing an interest in a closed-end fund by mr thomson’s reckoning then a potential buyer would be indifferent to phc’s bicg tax to the extent it is attributable to the portion of its the commissioner characterizes mr thomson’s method as the method that was accepted in 110_tc_530 mr thomson was the expert in estate of davis he did use there a formula similar to what he uses here and in estate of davis the court did ultimately adopt a valuation close to that offered by mr thomson however we see nothing in the estate of davis opinion to endorse the particulars of mr thomson’s method unrealized_appreciation that is equal to of its dollar_figure nav ie tax attributable to dollar_figure phc’s unrealized_appreciation accounts for dollar_figure of its value ie approximately of the total nav of dollar_figure so the remaining appreciation ie the amount of unrealized_appreciation above of nav or dollar_figure less dollar_figure is dollar_figure ie approximately of nav mr thomson concluded that a dollar-for-dollar discount over of the tax exposure was appropriate this seems to mean that mr thomson allowed a dollar-for-dollar discount for the tax attributable to the appreciation over of phc’s nav ie a dollar-for-dollar discount for the tax attributable to dollar_figure in appreciation ie a discount of dollar_figure when using a combined federal and state capital_gains_tax rate applying an effective_tax_rate of to this gain equal to of phc’s nav ie the portion of phc’s unrealized_appreciation for which the tax_liability would be afforded a dollar-for- dollar discount mr thomson figured that the allowable discount for bicg should be ie time sec_37 rounded up to dollar_figure since mr thomson rounded this discount to we treat a bicg discount equal to of phc’s nav--or dollar_figure million--as the commissioner’s concession this reasoning is not supported by the evidence we are unconvinced that a buyer would be wholly indifferent to the tax implications of built-in_gain that constitutes up to half of a company’s assets furthermore mr thomson points to no data to show that once a fund’s unrealized_appreciation exceed sec_50 of its nav there would then begin to be a correlation between nav discount and the unrealized_appreciation above nor is there evidence that the discount would simply be dollar for dollar for the portion in excess of and not something more--eg an increase in elasticity price sensitivity for bicg liability once it reaches a certain point he presented no data at all concerning funds with built-in_gain constituting more than of nav as a result we cannot endorse mr thomson’s approach to calculating the bicg discount but we view the resulting discount amount--dollar_figure--to be a concession on the commissioner’s part our conclusion present_value of the bicg tax_liability if as we hold the bicg tax_liability cannot be disregarded in valuing phc but if as we also hold phc’s value cannot be reasonably discounted by that liability dollar for dollar then the most reasonable discount is the present_value of the cost of paying off that liability in the future see estate of jensen v commissioner tcmemo_2010_182 estate of litchfield v commissioner t c memo the commissioner’s expert did not use this present_value approach because he observed that at phc’s historic rate for turning over its securities it would take years before all the stock had been sold and all the built-in_gain had been taxed if the dollar_figure million of bicg tax were discounted over that period on the assumption that phc’s stocks would be gradually sold and its bicg tax would be gradually incurred over years on an average of dollar_figure per year then the present_value of the dollar_figure million liability would be only dollar_figure assuming a discount rate however this 70-year assumption would mistakenly allow phc’s unique subjective investment goals to dictate the value of the company whereas what we seek is a fair market value--the price at which phc would change hands between a willing buyer and a willing seller not the price that a particular seller might demand or that a particular buyer might be willing to pay and therefore not a price that assumes subsequent management of the company by a specific owner as the estate rightly admittedly what we ultimately value here is not the entirety of phc but rather a minority interest in it and it can be observed that the acquirer of a mere minority interest is bound to the investment decisions of the majority and he might therefore suppose that phc’s philosophy and history portended a 70-year turnover period and therefore a long deferral of the bicg tax yielding a very small discount however this observation about the minority shareholder’s being bound to the majority’s investment decisions properly pertains to the quantum of the discount that must be made on account of the lack of control that a minority continued acknowledged the willing buyer and the willing seller are hypothetical not actual persons and each is a rational economic actor that is each seeks to maximize his advantage in the context of the market that exists at the valuation_date the advice that phc received to diversify its portfolio ie to sell stock more quickly than its 70-year trend would call for indicates that a rational actor would expect a turnover period shorter than years phc’s decision not to follow that advice was not irrational but it was particular to phc’s subjective goals even assuming that the phc management would indefinitely follow its traditional philosophy and would sell stock only at the 70-year pace and assuming that phc shareholders would refuse to sell at prices that presumed a shorter turnover that refusal would not affect the fair_market_value of phc it would continued owner will experience discussed below the bicg tax for which we now determine a discount is on the other hand an entity-level attribute of phc as a whole and not of a particular interest in phc a purchaser of phc stock might later owe capital_gains_tax if he sells that stock at a gain but he will never be liable for tax on phc’s gains from the sale of its holdings the commissioner similarly explained for this purpose fair_market_value is the price that a hypothetical willing buyer would pay a hypothetical willing seller the particular characteristics of these hypothetical persons are not necessarily the same as those of any specific individual or entity and are not necessarily the same as those of the actual buyer or the actual seller instead indicate that phc’s particular managers and owners were willing to forfeit or forgo some of phc’s fair_market_value in order to pursue other aims the estate put on no evidence as to the length of the period that a typical investor would consider likely or optimal for turning over phc’s stock apart from the general fact that phc’s advisors repeatedly suggested that phc sell stock in order to diversify but asserted only phc’s particular historic rate yielding a 70-year turnover period and to the estate’s detriment a relatively small dollar_figure million bicg tax_liability discount mr thomson’s testimony on this score--ie that notwithstanding phc’s historic turnover rate a potential investor would expect that a portfolio like phc’s would turn over within a period of to years--is not rebutted and we find it reasonable a present-value approach that uses either a 20-year or a 30-year holding_period and uses the different discount rates employed in various contexts in this case yields the following range of present values for the dollar_figure million bicg discount rate year sec_30 years as calculated by p using ibbotson’s data as used by p in the capitalization of dividend model as calculated by the court using phc’s historic data generally accepted rate of return dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number since the commissioner’s dollar_figure million concession falls comfortably within this range of dollar_figure to million we use that figure as a result on the basis of these findings and the record before us we find a dollar_figure bicg discount to be reasonable in this case b discount for lack of control a minority discount is a discount that a buyer would demand for the lack of control the buyer will have over how his investment will be managed eg disposition of assets payment of distributions or appointment of management the parties agree that a discount for lack of control is proper if a net asset valuation is used in this case however the measure of that discount remains in dispute the commissioner’s expert used a data set consisting of the net asset values and trading prices of closed-end funds for the week of date he then analyzed the percentage difference between the net asset value and trading price if negative a discount if positive a premium overall this methodology is sound and appears to be a reasonable way to calculate an appropriate discount associated with lack of control though we find a correctable flaw in the data set itself the commissioner’s expert found the mean ie the average of the premiums and discounts of all data points to be -6 however he did not use this number as the discount rather he observed that the decedent and one a potential purchaser of a minority interest in phc would observe certain disadvantages that might result from lack of control such as an inability to overcome phc’s historic devotion to maximizing dividends when that approach might cause it to miss other opportunities that would produce not steady dividends but capital growth likewise a minority shareholder in phc would be unable to compel the company to follow professional advice and diversify optimally though this approach has the corresponding advantage of deferring the bicg tax on phc’s appreciated holdings other owner each owned about of phc and that the next largest holding was only about his expert report therefore concluded that even though the decedent did not control the company the decedent’ sec_23 interest was a large and influential block of phc’s stock so that its lack of control was somewhat mitigated and he reduced the discount to -6 because of the low dispersion of the remaining ownership_interest in phc and ease of management he did not explain how he chose -0 as the amount of the appropriate reduction and it appears to be simply a visceral reduction for which we do not see the justification the estate’s expert used the same data but simply selected the median ie the middle value of the data set -8 as the appropriate discount because the commissioner’s expert incorrectly selected a number based upon misinterpretation of the factors identified in mr thomson’s report for which he cited as a supposed example that the holder of this interest cannot be a the phrase ease of management in his report may be shorthand for mr thompson’s reckoning as explained in his testimony that because phc engaged wilmington trust as its investment_advisor we have a professional management here at phc too so it’s not as if we just have a family doing everything by themselves however in pursuit of its distinctive not to say eccentric investment philosophy phc disregarded wilmington trust’s professional advice to further diversify it therefore appears that lack of control of phc might indeed have had visible continuing effects that might concern an investor and might require a greater discount director however this example apparently reflects the estate’s expert’s erroneous assumption--corrected by the time of trial--that a phc director must be a member of the pearson family such a restriction might indeed aggravate lack of control and might increase the appropriate discount but it did not exist here an examination of the data set shows that among the funds there are three outliers that skew the mean and whose relevance or reliability mr thomson did not show removing these outliers--ie the highest two values and the lowest value --yields a mean minority discount of -7 which is comfortably close to the estate’s median as a result we conclude that a discount for lack of control of is reasonable in this case c discount for lack of marketability a prospective investor is likely to pay more for an asset that will be easy to sell and less for an asset that may be difficult to sell in this case phc owns easy- to-sell publicly traded stocks but we value an interest in phc itself which is a the highest two values reflect premiums of and with the next highest premium being only these two remarkable premiums are unexplained in our record and we cannot tell how they relate to the remainder of the data set nor what if anything they could suggest about the appropriate minority discount for a company like phc we therefore disregard them as outliers at the other end of the spectrum the lowest value reflects a discount of we disregard it as an outlier since the next highest discounts are and family-owned non-publicly traded company the stock of which has no ready market the parties agree that a marketability discount--ie a discount attributable to the cost and difficulty of finding a willing buyer for a non-traded closely held interest--is appropriate here if phc is valued by a net asset valuation method however the quantum of that discount remains in dispute to determine the appropriate discount for lack of marketability the commissioner’s expert examined seven studies of restricted_stock which is identical to freely traded stock of a public company except that it is restricted from being traded on an open market for a certain period of time the studies compared two types of data the selling prices of the restricted stocks with the selling prices of the corresponding unrestricted shares and the selling prices of shares in closely held companies at their pre-ipo level versus their subsequent post-ipo price and measured the difference between its restricted value and its the commissioner’s expert also examined but did not rely on studies comparing the sale price of closely held company shares to the prices of shares at subsequent initial public offerings of the same companies the estate argues that the commissioner’s expert is therefore subject_to criticism as in 110_tc_530 in which we discussed the limitations of restricted_stock studies and gave more weight to ipo studies however there is no absolute rule that for purposes of determining a marketability discount ipo studies are superior to restricted_stock studies since in other circumstances we have preferred the latter see estate of giustina v commissioner tcmemo_2011_141 the estate’s expert presented no analysis of ipo studies or of what discount they might suggest here so the estate’s argument does not convince us non-restricted value to quantify a discount for lack of marketability the seven studies produce lack-of-marketability discounts ranging from to with an average discount of mr thomson chose to use the very bottom of this range--26 --as his starting point for determining lack of marketability for phc stock because most of the studies dealt with stock in operating companies inherently more risky than stock in a company that holds publicly traded shares mr thomson then further reduced the discount to for various reasons--eg phc paid consistent dividends phc had a very small amount of debt and phc was managed by professional investors although these reasons would likely warrant consideration mr thomson provided no basis for the quantum of the adjustment attributable to each furthermore we are unconvinced that mr thomson’s low starting point--26 --was warranted because of his summary observation that most of the studies dealt with riskier operating companies again the estate’s expert did not perform an independent analysis for lack of marketability instead mr schweihs accepted mr thomson’s general approach and data but he simply chose the very top of the range of the study’s marketability discounts--ie --arguing that the seven studies that were used to derive this discount are based on entities whose stock unlike phc’s would relatively soon be freely marketable he contended that stock like that in the seven studies whose public trading is restricted for only a defined period during which private trades may be made may be less discounted in value than stock like phc’s whose non-public status is of indefinite duration the parties seem to agree that the general range of marketability discounts relevant for consideration in this case i sec_26 to with an average discount of and we are unconvinced by either party’s rationale for deviating from this generality we therefore find that a marketability discount of --ie the average of the data sets--is reasonable in this case d conclusion on the basis of the foregoing we find that the value of the decedent’ sec_23 interest in phc at the time of her death is dollar_figure figured thus assets of phc less liabilities less bicg discount nav of phc interest in nav less loc discount of dollar_figure less lom discount of dollar_figure value of decedent’s interest in phc dollar_figure - big_number - big_number big_number big_number - big_number big_number - big_number big_number v accuracy-related_penalty generally a penalty is imposed on any portion of an underpayment_of_tax required to be shown on a return where the underpayment is attributable to a substantial estate_tax_valuation understatement sec_6662 b an estate_tax_valuation understatement is treated as substantial where the value of any property required to be reported on an estate_tax_return is reported pincite or le sec_29 the estate_tax_return at issue here was filed on date sec_6662 was amended for returns filed after date to provide that a valuation_understatement is substantial if the value of any property continued of the correct value sec_6662 the commissioner bears the burden of production with respect to the penalty determined under sec_6662 see sec_7491 116_tc_438 the estate reported the value of the decedent’s interest in phc to be dollar_figure on the estate_tax_return given that we have determined the proper value of the decedent’s interest in phc was dollar_figure the amount reported on the estate_tax_return was less than of the proper value and a substantial valuation_understatement therefore exists for purposes of sec_6662 therefore the commissioner has met his burden under sec_7491 however the penalty under sec_6662 b and g will not apply to any portion of an underpayment if it is shown that there was a reasonable_cause for such portion and that the taxpayer acted in good_faith with respect to such portion see sec_6664 emphasis added the regulations provide that whether an underpayment_of_tax is made in good_faith and due to reasonable_cause will depend upon the facts and circumstances of each case sec_1_6664-4 income_tax regs reasonable_cause may involve reliance on a continued required to be reported on an estate_tax_return is reported pincite or less of the correct value before date that figure wa sec_50 see pension_protection_act of pub_l_no sec a b stat pincite professional tax advisor but such reliance does not necessarily demonstrate reasonable_cause and good_faith and r easonable cause and good_faith ordinarily is not indicated by the mere fact that there is an appraisal of the value of property id in determining whether a taxpayer acted reasonably and in good_faith with regard to the valuation of property factors to be considered include the methodology and assumptions underlying the appraisal the appraised value the circumstances under which the appraisal was obtained and the appraiser’s relationship to the taxpayer or to the activity in which the property is used id to establish good_faith taxpayers cannot rely blindly on advice from advisers or on an appraisal 131_tc_8 citing kellahan v commissioner tcmemo_1999_210 and estate of goldman v commissioner t c memo mr lyle who was deceased at the time of trial was the co-executor of the estate was a c p a and was primarily responsible for obtaining the valuation ms zerbey the other co-executor who attended business school and had some modest experience in financial matters allowed mr lyle to be the principal contact with the accountant mr winnington at the belfint firm who was retained to value the decedent’s interest in phc ms zerbey testified that mr lyle kept her informed and she knew that mr winnington was selected to value the decedent’s interest in phc and that two prior valuations were being used as guidelines according to mr winnington mr lyle provided him with sufficient information to value the decedent’s interest in phc mr winnington is a c p a who is knowledgeable about phc mr winnington testified that his fee was not contingent on the value he reached and that mr lyle did not influence the value ultimately reported on the estate_tax_return although mr winnington has some appraisal experience ie having written valuation reports and having testified in court he does not have any appraiser certifications the estate did not proffer him as an expert witness and did not demonstrate that he is qualified as an expert in valuation on the record before us we cannot say that the estate acted with reasonable_cause and in good_faith in using an unsigned draft report prepared by its accountant as its basis for reporting the value of the decedent’s interest in phc on the estate_tax_return mr winnington is not a certified appraiser the estate never demonstrated or discussed how mr winnington arrived at the value reported on the estate return except to say that two prior estate transactions involving phc stock used the capitalization-of-dividends method for valuation furthermore the estate did not explain--much less excuse--whatever defects in mr winnington’s valuation resulted in that initial dollar_figure million value’s being abandoned in favor of the higher dollar_figure million value for which the estate contended at trial consequently the value reported on the estate_tax_return is essentially unexplained the estate observes that four substantially different values were reached by four professionals--mr winnington dollar_figure million the estate’s expert dollar_figure million the commissioner’s expert dollar_figure million and the irs auditor dollar_figure million --and the estate argues that this fact demonstrates the difficulty of valuing the decedent’s interest in phc while we do not disagree with the estate’s assertion that the decedent’s interest in phc may be difficult to value we believe that this further supports the importance of hiring a qualified_appraiser in order to be able to invoke reasonable_cause in a case of this difficulty and magnitude the estate needed to have the decedent’s interest in phc appraised by a certified appraiser it did not instead the estate relied on the valuation by mr winnington but did not show that he was really qualified to value the decedent’s interest in the company the dollar_figure million value reported on the estate_tax_return was less than of even the dollar_figure million value defended by the estate’s own expert and if the court had adopted the dollar_figure million value the return would still reflect a substantial valuation_understatement that would warrant the accuracy-related_penalty that is even by the estate’s lights the value on the estate_tax_return needed explaining but no explanation was given given that the commissioner has met his burden to show that the accuracy- related penalty applies the burden shifted to the estate to show why it should be excused from the penalty the estate failed to make such a showing as a result we find that the estate has not demonstrated that it acted with reasonable_cause and in good_faith in reporting the value of the decedent’s interest in phc on the estate_tax_return as a result the commissioner’s imposition of an accuracy-related_penalty under sec_6662 b and g will be sustained decision will be entered under rule


third party communication date of communication month dd yyyy cca_2014081415400001 id uilc number release date from sent thursday date pm to cc bcc subject re tefra question yes the form 872-p extends the partner’s sec_6501 period for partnership and affected items section d was amended in to allow refund claims for non-computational affected items under normal non-tefra refund procedures thus a partner can generally rely on sec_6511 for non-computational affected items generally only adjustments to partnership items and resulting computational affected items are considered attributable to partnership items and thus subject_to the restrictions of sec_6511 and sec_7422