Opinion ID: 357068
Heading Depth: 2
Heading Rank: 2

Heading: the equation of value with costs

Text: 62 The second aspect of the district court's treatment of the constructive dividend issue which we find troublesome centers on its theory of measurement. 63 If we assume that a dividend is found to exist the subject of discussion and remand in the preceding section the district court must then compute the amount of the benefit conferred. Section 301 of the Code directs that the amount of a distribution of property to a noncorporate shareholder shall be measured as follows: the amount of the money received, plus the fair market value of other property received. (emphasis added). Thus, in determining the amount of taxable income embodied within a constructive dividend the court must diminish the value of the benefit conferred by the amount of any payment made by the shareholder in return. 64 The sticking point, for present purposes, is the concept of fair market value. The district court measured the value of the benefit conferred by computing the costs incurred by the corporation in supplying the benefit. Leaving aside, for a moment, the types of expenses included by the district court in the computation of costs, we first focus on the correctness of the equation of value and cost. 65 There is ample authority to support the use of costs as an equivalent of value for the purposes of a constructive dividend determination. See, for example, Walker v. Commissioner of Internal Revenue, 362 F.2d 140 (7th Cir. 1966), cert. den. 385 U.S. 865, 87 S.Ct. 124, 17 L.Ed.2d 92 (1966). However, a careful reading of this line of authority raises grave questions concerning the propriety of such an action in the present case. 66 One of the primary motivations behind the district court's use of costs as an equivalent of value was its apparent belief that the Corporation would not have undertaken the land clearing project unless such a project was profitable. In essence, this position provides that had the district court utilized the fair market value established by the taxpayers' witnesses, such a value, multiplied by the number of acres cleared, would have been less than the costs incurred by the Corporation, as those costs were computed by the district court. 67 There are two serious problems with the district court's rationale. We agree that corporations are, for the most part, governed by the profit motive in their choice of undertakings. However, in the land clearing business, the price of a project is determined prior to the accrual of expenses. That is, in the land clearing business, a bid is made on a project on the basis of projected expenses, long before those expenses ultimately are incurred. 21 Notwithstanding the fact that in the case sub judice, we are confronted with a closely held corporation, the structure of the land clearing industry suggests that a project might, upon completion, yield less revenue than initially had been anticipated. In fact, testimony indicated that this was not a unique occurrence. 22 This might be particularly true in a project of several years duration. 68 Secondly, the district court decided the project was unprofitable because it compared the fair market value figures testified to at trial with direct and indirect costs. Included in the category of indirect costs were a pro rata share of overhead and of the depreciation attributable to the machines involved in the Yazoo project. Without commenting on whether indirect costs belong in the computation of a constructive dividend, we suggest that their inclusion in the determination of the profitability of this operation may have produced a skewed resulting interpretation of profitability. 23 69 The Yazoo project was particularly large. The Corporation's indirect costs essentially were fixed. That is, the Corporation would incur certain costs whether or not the Yazoo project was undertaken. Salaries and depreciation would not be altered by the presence or absence of a further project unless the project was so large that it required the Corporation to hire further personnel and/or machines. Thus, the decision to undertake the Yazoo project for payments which exceeded the direct costs incurred, although less than the sum of indirect and direct costs, might have been premised on a concept of marginal profitability. 24 Although the concept of marginal profitability necessarily entails the presumption that there were no other jobs of a nature similar to the Yazoo project but of greater profitability, we offer the concept as an indication of the potential inaccuracy of the district court's premise. 25 70 Given the above two criticisms of the district court's premise, we suggest that its assumptions about profitability, without more, would not support an otherwise unsupportable decision to utilize costs as the measurement of the fair market value of a benefit conferred. By the above discussion, we do not intend to require a district court to undertake, in every case, the complex albeit elusive, determinations alluded to above. However, when a court assumes that a corporation was involved in an unprofitable venture without such further inquiry, that assumption may be incorrect. Without such further inquiry here, it was an inappropriate premise upon which to structure the treatment of the transaction in the present case because this untested premise was the basis for the trial court's decision to use costs as a measure of value an equation which is the exception rather than the norm. 71 We believe that the cases which have utilized costs as a measurement of fair market value in the constructive dividend context are distinguishable. 72 The cases supporting the use of costs stand for the proposition that cost is an acceptable measure of value when there is no credible evidence of fair market value or when evidence of fair market value exists but is clearly rebutted. We analyze them in detail because they shed much light on the inexplicable quality of the district court's decision to disregard the expert testimony provided in the present case. As the court stated in United Aniline, supra, it is permissible to measure the value of the benefit conferred as a constructive dividend through a computation of costs in the absence of any direct evidence of fair value. 316 F.2d at 705. And, in Walker, supra, the court justified the use of costs where there was sufficient expert testimony rebutting the taxpayer's assertions of fair market value. 362 F.2d at 143. 26 73 The other cases cited for their use of costs as a measure of value similarly are distinguishable. First, in Goldstein v. Commissioner of Internal Revenue, 298 F.2d 562 (9th Cir. 1962), the evidence of fair market value introduced by taxpayer was exceedingly weak. The selling price of the property at issue was in excess of even the most persuasive evidence of fair market value. Although there was some expert testimony supporting the stockholder's fair market valuation, its validity was seriously undercut by the circumstances of the underlying transaction. The stockholder, himself, had paid far less for the property only three weeks prior to the sale to the corporation. In addition, the corporation, prior to the purchase, was leasing the land under a sale-leaseback arrangement which, in toto, would invest eventual ownership in the corporation at a price far below the price it decided to pay the stockholder. Finally, and of equal significance, the stockholder's experts did not demonstrate that their opinions were predicated on the existence of the above recited circumstance. In essence, appellant neglect(ed) to explain the lack of any direct evidence that either of these valuations took the effect of the lease into consideration. 298 F.2d at 567. 74 Second, the Tax Court case of Lester E. Dellinger, 32 T.C. 1178 (1959), further strengthens our suspicions concerning the district court's treatment of valuation in the case sub judice. In Dellinger, costs were utilized because fair market value did not accurately reflect value in light of the fact that the shareholder himself sold the property in question for an amount greater than the value suggested by his evidence as to fair market value. 32 T.C. at 1183, 1184. Moreover, taxpayer's evidence of fair market value consisted of only the vague testimony of the petitioner himself. Not only is it clear that he had no qualifications to express an acceptable opinion as to such values, but, in addition, his testimony was inherently improbable and unreasonable. 32 T.C. at 1185-6. Compounding these problems from the court's perspective was the failure of taxpayer to offer, as a witness in support of his valuation, the real estate appraiser best qualified to testify as to the value of the land in issue. 32 T.C. at 1186. Clearly, taxpayer had not met his burden of proof. See, also, Honigman v. Commissioner of Internal Revenue, 466 F.2d 69 (6th Cir. 1972). 75 Finally, perhaps the classic example of the relationship of costs and valuation is found in Commissioner of Internal Revenue v. Riss, 374 F.2d 161 (8th Cir. 1967). There, the court was confronted with a constructive dividend comprised of a residence occupied by the stockholder's family; insurance and operating costs of cars utilized by stockholder's family; club bills; and a trip to Puerto Rico. 76 As to the residence, the court, in opposition to the Tax Court's decision in Riss, computed its value on the basis of the expenses and depreciation related thereto that is, costs. Significantly, evidence of the fair market value of the residence was not provided to the Tax Court. Compounding this problem was the fact that a qualified real estate expert testified that the high cost of maintaining this property made it difficult to rent at any price. Further, rentals of comparable residences indicated that the value chosen by the Tax Court was wholly inconsistent with the little evidence of fair rental value that could be ascertained. In short, the Tax Court's fair rental figure was decidedly unsupported by all credible evidence and that evidence of fair market value which did relate to this residence, albeit tangentially, supported a figure arrived at on the basis of cost. 77 Thus, the Riss court determined that cost was a more reliable measurement of value when there was an absence of direct evidence of fair market value and a presence of evidence suggesting the inappropriateness of fair market value as the mode of measurement. This interpretation was borne out by the Riss court's treatment of the benefit embodied in the personal car provided for the stockholder. Because evidence of fair market value was introduced as to this item and because no evidence was introduced with respect to the total operating cost of the car, the court's decision to utilize fair market value instead of costs was entirely consistent with its overall approach to valuation in that case. 374 F.2d at 170 (emphasis added). 78 It is noteworthy that the favored place of fair market value in the hierarchy of modes of valuation is bolstered by the Code itself. Regulation 1-301.1(j) delineates the concept of a constructive dividend in terms of fair market value. Likewise, I.R.C. § 301(b)(1)(A) speaks of distributions of property to non-corporate distributees in terms of the fair market value of the property received. 79 The equation of value with costs is, therefore, not the norm but the exception. With this in mind, we focus on the present case. 80 In determining the current value of the economic benefit conferred, it is clear that the taxpayer never loses the burden of proving the Commissioner's determination erroneous. Crosby, 496 F.2d at 1390. 27 Loftin and Woodard do not argue for the adoption of a contrary proposition. Instead, appellants suggest that the evidence they introduced in support of the valuation of $50 per acre was sufficiently strong that the district court's failure to utilize such a valuation can only be explained by a disregard for the appropriate legal standard a standard favoring the use of fair market value over the use of cost for purposes of valuation. 81 The evidence relating to value which was before the district court consisted of the testimony of three expert witnesses, all provided by the taxpayers. 82 As a preliminary matter, we note that while the weight attributable to the opinions of these witnesses is hotly contested, the fact that they are experts is not. The district court permitted these witnesses to offer their opinions in the land clearing field after an objection to their qualifications to render such testimony. 28 App. 483-85. While this action did not determine the weight which should attach to their testimony nor its credibility, it did establish that their testimony was admissible as the testimony of experts in the relevant area. F.R.Ev. 702; 3 Weinstein's Evidence, P 702(01). 83 The three witnesses who testified at trial Bill Moore, W. G. Boykin and W. B. Holloway all rendered opinions as to the fair market value of the land clearing operation. 29 No evidence was offered by the Government in rebuttal. Instead, it relied on cross-examination. 30 84 The first witness, Moore, testified that he was familiar with the land in question before and after the clearing operation was completed. 31 Moore was himself a land clearer whose operations were proximate to the Yazoo clearing in time and geography. His typical clearing operation consisted of shearing, piling, burning, cleaning and discing. 32 He explicitly indicated that stumps would not be removed in a clearing effort; instead, they would be cut down to the surface. 33 When asked to estimate the fair market value of the work performed by the Corporation, he emphatically stated that $50 per acre would be the maximum compensation a land clearer could and would expect to receive for the Yazoo clearing. 34 According to Moore, the economic environment surrounding the land clearing business in the years in question was intensely competitive. Thus, a typical clearer would be delighted to receive such a price for the efforts required at Yazoo at that time. 35 85 The second witness, Boykin, was involved primarily in the land clearing business also in the period and geographic area present in this case. 36 Like Moore, Boykin's clearing experience included cutting, piling, sweeping, burning and ditching. 37 He too emphasized that stumps were not removed. 38 Although he noted that the performance of ditching and discing at a site was dependent on the party's wishes, as reflected in a contract, he also clearly indicated that his fair market value estimate was predicated on an understanding of the condition of the land prior to and subsequent to the clearing operation. To infer that he may have taken into account any discing and ditching done would not be unwarranted. 39 There is no evidence to suggest otherwise. Like Moore, Boykin placed the maximum value for such clearing at $50 per acre, noting, as had Moore, that the cost per acre would only decrease as the number of acres to be cleared increased. 40 86 Taxpayers' final witness was Holloway, the accountant whose clientele included several substantial land clearing entities that had cleared land near the Yazoo project during the years in question. 41 When asked about his familiarity with the work actually performed on the Yazoo site, Holloway testified that he had seen the property and that the clearing performed amounted to a normal operation. 42 Once again, he considered $50 per acre to be top dollar for that operation. 43 Indeed, he expressly indicated that the only clearing jobs which would command a better price would be those involving a very small amount of acreage. 44 87 We offer this synopsis of the expert testimony not in an effort to assess their credibility a job exclusively within the province of the district court. Rather, we offer it because our review of its content leaves us puzzled as to the rationale underlying the district court's decision to utilize costs as a measure of value instead of the fair market value. 88 The Government did not introduce a shred of affirmative evidence to contradict the above testimony. Cross-examination revealed only that these experts were not wholly familiar with the precise work done in the clearing operation. While this could have been important, we believe that its edge was blunted by testimony in the record which suggested that the operation was not unusual in nature that unrebutted testimony being provided by the above witnesses and the taxpayers themselves. 89 Moreover, the Government did not introduce evidence suggesting that the operation was unusual. 45 Indeed, two of the three witnesses had done a fair amount of clearing themselves in and around Yazoo and, therefore, were familiar with the types of operations performed in the course of a clearing project in that area. The court's speculation that tree stumps may have been removed, thereby increasing the cost per acre, is without any support in the record. 46 Significantly, the testimony of the three witnesses was that it would be highly unusual for such an action to be undertaken. 90 It is difficult to understand the motivation of the Government and the court in suggesting that something special was done on the Yazoo property. Just because a closely held corporation was performing work for its stockholders does not mean, ipso facto, that the work was customized. The record indicates that the only work performed of an unusual nature was that which was done prior to the actual clearing. In essence, this work consisted of the repair of cabins already in existence on the land and the establishment of a better drainage network. The outside figure for this work was set at $22,000. 47 This hardly would be a decisive piece of work in a project which cost, under the Government's own estimate, $500,000. Furthermore, Woodard's own testimony indicated that he wanted the corporation to clear the land fairly well so that he could sell it. This statement, which is asserted by the Government in support of its belief that special work was done on this land of which the expert witnesses were not aware, is equally susceptible to a contrary interpretation. This was not a piece of property which the buyers were seeking to have custom crafted for their own personal enjoyment. It was, instead, a piece of property which they eventually would seek to sell. 48 91 There were other criticisms leveled at the deficiency of the expert testimony in this matter. 49 It is true, as the Government contends, that none of the witnesses bid on this land. However, no one could bid on this land because it was never opened to competitive bidding. Indeed, if the Government's criticism was accepted, no witness could have qualified as an expert in this matter. 92 It is also true, as the Government asserted, that none of these witnesses had cleared property of such grand proportions. However, the applicability of this criticism also is highly suspect given the uncontradicted testimony in the record compelling the conclusion that the costs of clearing only decrease as the amount of acreage grows larger. 50 93 Finally, perhaps the most incomprehensible criticism leveled by the Government at the expert testimony is that it was all irrelevant because the existence of a contract between the taxpayers and their corporation prior to 1965 was never proven. The testimony as to value was offered in order to determine the value of the benefit conferred, not the accuracy of any price agreed upon by the parties. 51 A valuation had to be performed for constructive dividend purposes, irrespective of the existence of a contract. Indeed, the existence of a contract setting the price at $50 per acre the figure taxpayers seek to establish would not have been conclusive even on taxpayers' behalf. 94 At the same time that the Government was criticizing the taxpayers' offerings, it inadequately explained its own shortcomings in this area. When questioned by taxpayers' attorney as to its failure to introduce rebuttal evidence on the issue of value, the Government Agent responded that 95 to have taken the fair market value, we would have had to call in an engineer agent and a forestry agent and have them come in and value it. We decided not to do it. 96 App. 1051-52. 52 Are we to conclude that the only reason the Government did not attempt to measure the value of the benefit conferred in fair market value terms was that it was inexpedient to do so? Surely, this would not pass as an ample justification for the court's ultimate determination on the valuation issue given that taxpayers have offered substantial testimony on this issue. 97 In sum, value is the overriding concept in the measurement of a constructive dividend. While the vagaries of any competitive situation often render elusive the measurement of value, there was a substantial amount of unshaken expert testimony produced at trial by the taxpayers. The testimony offered by the taxpayers produced a factual context far different from those cases in which courts correctly chose to equate value with costs. Taxpayers' witnesses in the case sub judice were fairly knowledgeable with regard to the land clearing business and the actual land in question, unlike the witnesses offered in cases like Goldstein, supra. The district court's decision to utilize costs to measure value in light of the presence of such testimony and the Government's failure to contradict that testimony, suggests that the lower court was operating either under an improper construction of the pertinent legal standard or under a belief that the witnesses were not credible. 53 98 Taxpayers had the burden of proof on the value issue. However, unlike United Aniline or Walker, supra, taxpayers did act to meet that burden. 99 Whether the district court traversed the incorrect legal path or incorrectly traversed the correct legal path is a matter which is not susceptible to determination by this court at this time. Therefore, we direct the district court to reconsider the manner of measuring value that it employed should it decide first, on remand, that an economic benefit was conferred on a shareholder in his capacity as such without expectation of repayment.