STATE OF WILLIAM J. DESMOND, DECEASED, DONN KEMBLE, EXECUTOR, Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

UNITED STATES TAX COURT, No. 26237-96, T.C. Memo 1999-76; 1999 Tax Ct. Memo LEXIS 84 (March 10, 1999)

C. COURT'S ANALYSIS AND CONCLUSIONS

[W]e are free to accept or reject in full or in part experts' opinions proffered by the parties.  Each of the experts' reports is susceptible to criticism. We however believe the fair market value reached in the HML report [the estate's expert] better represents the fair market value of decedent's interest. Because of the limitations imposed by respondent on BVS [looking only at marketability discount], we reject the BVS report and adopt in part, as explained infra, the HML report.
 

1. VALUATION METHODS ACCEPTED BY COURT
The HML report [submitted by the estate's expert] determined the weighted average unadjusted value based on the three different valuation methods was $ 10,196,000. HML's application of the asset method was vague and generally unhelpful. Furthermore, we believe HML may have improperly applied that method. We do not rely on this method to determine the value of decedent's interest.

Respondent does not object to HML's computations of the unadjusted value under the income method and the market method. We find HML's conclusions as to the unadjusted values under these two methods reasonable, and we conclude that the unadjusted value under the income method is $ 8,109,000 and under the market method is $ 10,410,000. Furthermore, we conclude each method deserves equal weight.


2. LACK OF MARKETABILITY DISCOUNT
a. AVAILABILITY OF THE DISCOUNT
A lack of marketability discount reflects the absence of a recognized market for closely held stock. See Mandelbaum v. Commissioner, T.C. Memo. 1995-255; Estate of Trenchard v. Commissioner, T.C. Memo. 1995-121; Rev. Rul. 77-287, 1977-2 C.B. 319. Neither party disputes that the Deft stock is closely held stock which is not readily tradable. We therefore shall apply a lack of marketability discount to the unadjusted values under both methods.
b. PROPER ELEMENTS IN THE DISCOUNT
HML applied a 25-percent lack of marketability discount to the weighted average unadjusted value. HML considered numerous factors, including Deft's potential environmental liabilities, in determining the amount of the discount.

Courts have consistently recognized that potential liabilities can affect the value of corporate stock. See Estate of Davis v. Commissioner, 110 T.C. at 552, 553, 560; Estate of Hall v. Commissioner, 92 T.C. at 329, 341-342; Payne v. Commissioner, T.C. Memo. 1998-227; Estate of Mitchell v. Commissioner, T.C. Memo. 1997- 461; Sackett v. Commissioner, T.C. Memo. 1981-661; Richards v. Commissioner, T.C. Memo. 1976-380. We believe a hypothetical buyer of decedent's interest in Deft would consider these potential liabilities when negotiating a purchase price. We find that these potential liabilities must be taken into account in the valuing of decedent's interest.

Respondent argues that applying a discount for Deft's potential environmental liabilities is improper because these liabilities have already been included in the unadjusted value calculation under the income method and the market method. We agree with respondent as to the market method but disagree as to the income method.

Under the income method, HML discounted Deft's future cash flows to present value using a discount rate determined by the Capital Asset Pricing Model (CAPM). The discount rate represents the company's expected rate of return on equity.

The CAPM uses several variables including a variable representing the company's volatility relative to market returns (Beta). Deft's Beta was determined based upon the Betas of eight similar paint and finishing companies. Respondent contends that these paint and finishing companies had Betas considerably higher than other companies' because most paint and finishing companies have potential environmental liabilities that make the return on investment in these companies more volatile. Respondent argues that these Betas already include the potential environmental liabilities of these companies; therefore, it is improper to also consider these liabilities in determining the proper discount.

We disagree with respondent. Respondent provided no evidence at trial that the Betas of the eight comparable paint companies were higher than normal due to potential environmental liabilities faced by these companies.

We conclude that the unadjusted value under the income method did not include Deft's potential environmental liabilities, and HML's consideration of Deft's potential environmental liabilities within the lack of marketability discount was proper. Thus, we shall apply a discount to the unadjusted value under the income method for the potential environmental liabilities.

Under the market method, HML utilized the average price to earnings multiple for two similar paint and finishing companies in determining the unadjusted value. Respondent contends that these multiples already include the potential environmental problems faced by the similar companies; therefore, it is improper to also consider these liabilities in determining the proper discount.

Respondent's expert testified that paint and finishing companies trade at lower multiples as a result of the potential environmental liabilities associated with the industry. Petitioner did not provide any other explanation for the lower multiples. We conclude that the multiples used by HML took into account the potential environmental liabilities of the comparable companies; therefore, we shall not apply a discount to the unadjusted value under the market method for the potential environmental liabilities.

c. COMPUTING THE DISCOUNT
We must determine an appropriate lack of marketability discount for decedent's interest. We base our finding on a consideration of all of the evidence in the record, paying special attention to the presence or absence of the factors discussed in Rev. Rul. 77-287, 1977-2 C.B. 319.

The following factors favor a high lack of marketability discount: (1) There was no public market for Deft's stock; (2) Deft's profit margins were below the industry average; (3) all stock in Deft was subject to a restrictive share agreement which provided that a shareholder could transfer his or her stock to a nonshareholder only after the shareholder offered the shares to the remaining shareholders; (4) given the size and low profitability of Deft, a public offering of the stock was unlikely in the future; (5) the size of the interest is so large that it may be hard to find potential buyers in the future who could finance such a purchase; and (6) where not already considered, Deft has large potential environmental liabilities.

Only one factor favors a low lack of marketability discount: Deft had an historical favorable distribution policy (it distributed most of the company's earnings to its shareholders through higher-than-market compensation in the past).

We conclude that a 30-percent lack of marketability discount is appropriate for the Deft stock. Of this 30-percent discount, 10 percent is attributable to Deft's potential environmental liabilities. We shall apply the 30-percent lack of marketability discount to the unadjusted value we determined under the income method. We however shall apply only a 20-percent lack of marketability discount to the unadjusted value we determined under the market method because as discussed supra, the environmental liabilities have already been included in the unadjusted value under that method.


3. CONTROL PREMIUM
[50] A control premium may be necessary when valuing an interest which gives its holder unilateral power to direct corporate action, select management, decide the amount of distributions, rearrange the corporation's capital structure, and decide whether to liquidate, merge or sell assets. See Estate of Newhouse v. Commissioner, 94 T.C. at 251-252. Petitioner's expert testified that a holder of decedent's interest would have the power (under California law) to sell all of Deft's assets, dissolve the company, and do virtually anything he or she wanted to do with Deft. Decedent's 81.93-percent interest is a controlling interest. HML applied a control premium of 25 percent in its calculations under the market method only.

[51] Whether or not a control premium is appropriate depends on the valuation method employed in reaching the unadjusted value of the stock. Where the method used values the stock as if it were a controlling interest, no control premium is necessary because the control aspect has already been accounted for within the unadjusted value. See Pratt et al., Valuing A Business: The Analysis and Appraisal of Closely Held Companies 303-306 (3d ed. 1996).

[52] The income method assumed the continuation of Deft's present policies and did not account for a change in control. This method therefore produced an unadjusted value based on a minority interest. Id. at 195. Thus, it would be proper to apply a control premium to the unadjusted value under this method. Id.

[53] The market method is based on comparisons with publicly traded stocks. This method produces an unadjusted value which represents the value of a minority interest, and it generally would be proper to apply a control premium to the unadjusted value under this method. Id. at 162.

[54] HML determined that a 25-percent control premium was appropriate under the market method. We find HML's determination reasonable, and we conclude that a control premium of 25 percent is appropriate. We shall apply this premium to the unadjusted value we determined under the income method. n6

n6 HML already included the control premium in its unadjusted value determined under the market method; therefore, we shall not apply a separate control premium to the unadjusted value under that method.

4. CONCLUSION
Utilizing the income method and the market method, we find the fair market value of decedent's interest in Deft on the alternate valuation date was:
Income
Market 
Unadjusted Value (expert's report)
$ 8,109,000
$ 10,410,000 
Less Marketability Discount: 
Nonenvironmental 
20%
(1,621,800)
20% 
(2,082,000) 
Environmental 
10%
(810,900) 
0% 
Add Control Premium (already included in expert's report for market method - see fn6) 
25%
2,027,250
0% 
Fair Market Value of 100% interest 
7,703,550
8,328,000
x Decedent's Interest
81.93%
6,311,519
81.93%
6,823,130 
x Weight Given 
50%
3,155,759
50%
3,411,565 
Fair Market Value of Decedent's Interest  6,567,324