Estate Disputes Tax Court Valuation of Decedent's Stock in Closely Held Business

Beatrice Dunn's estate tax return reported the FMV of her 493,000 shares in Dunn Equipment Inc. to be $1.6 million, and the IRS's deficiency notice asserted that the FMV was $2.2 million. The court found that the estate's expert incorrectly capitalized the company's net income while the IRS's expert placed too much weight on the FMV of the corporation's assets. The court concluded that the value of Dunn's stock was best represented by a combination of an earnings-based value using capitalization of net cash flow and an asset-based value using the corporate assets' FMV, with an appropriate discount for lack of marketability and super-majority control. The court determined the FMV of Dunn's 62.96 percent interest to be $3.5 million and applied a 15 percent discount for lack of marketability and a 7.5 percent discount for lack of super- majority control. (For a summary of that opinion, see Tax Notes, Jan. 17, 2000, p. 362; for the full text, see Doc 2000-1641 (31 original pages) or 2000 TNT 9-9 .)

The estate argues that the Tax Court committed reversible error by determining the fair market value of the stock under a weighting approach that allocated 65 percent of the value based on a net asset value approach and 35 percent based on an income approach for what the court acknowledged to be an operating (rather than an asset holding) company. The estate further asserts that the court also clearly erred when it failed to take into account virtually all of the tax effect of Dunn Equipment's unrealized gains in determining value under the net asset value approach.

CERTIFICATE OF INTERESTED PERSONS

[1] The undersigned counsel of record certifies that the following listed persons have an interest in the outcome of this case. These representations are made in order that the Judges of this Court may evaluate possible disqualification or recusal.

A. PARTIES

[2] Appellant, the Estate of Beatrice Ellen Jones Dunn, Jesse L. Dunn, III, Independent Executor (the "Estate"), respectfully requests oral argument. The major issue in this appeal involves the Tax Court's erroneous determination of the fair market value of the stock in Dunn Equipment, Inc. ("Dunn Equipment" or the "Company") transferred by Beatrice Ellen Jones Dunn ("Decedent" or "Mrs. Dunn") at her death. Oral argument is sought to aid the Court's understanding of the issues involved in this appeal.

TABLE OF CONTENTS

[3] The Estate appeals a final judgment from the United States Tax Court. This Court has jurisdiction pursuant to Title 26 U.S.C. section 7482.

STATEMENT OF ISSUES

[4] The ultimate issue in this case is whether the Tax Court erred in determining the fair market value of the 492,610 shares (the "Stock") of Dunn Equipment transferred by Mrs. Dunn.

[5] To address this primary issue, the Court will need to address two independent subissues:

[6] 1. Whether the Tax Court erred by determining the fair market value of the Stock under a weighting approach that allocated 65% of the value based on a net asset value approach and 35% based on an income approach for what the Court determined to be an operating (rather than an asset holding) company.

[7] 2. Whether the Tax Court erred when it failed to take into account virtually all of Dunn Equipment's unrealized gains in determining the fair market of the Stock value under the net asset value approach.

STATEMENT OF THE CASE

A. COURSE OF PROCEEDINGS AND DISPOSITION IN THE COURT BELOW. ¹

[8] This case arises from the Notice of Deficiency issued by the Commissioner of Internal Revenue (the "Commissioner") on November 11, 1994, alleging an estate tax deficiency of $238,515.05 against the Estate of Beatrice Ellen Jones Dunn, Deceased, Jesse L. Dunn, III, Independent Executor. (Doc. 1)

[9] Trial was held on June 11, 1996, in Houston, Texas, the Honorable Judge Joseph Gale of the United States Tax Court presiding. The issue addressed at trial was the determination of the fair market value of 492,610 shares (62.96%) of stock of Dunn Equipment, Inc.

[10] Judge Gale issued his memorandum decision on January 12, 2000, holding that the fair market value of the 492,610 shares of stock was $2,738,558. (Op. at 31)

[11] The Tax Court's final decision was entered on July 25, 2000. (Doc. 40) The Estate filed a timely notice of appeal. (Doc. 42)

B. STATEMENT OF FACTS.

[12] Beatrice Ellen Jones Dunn died on June 8, 1991 (the "Valuation Date"). (Stipulation 2) On the Valuation Date, Mrs. Dunn owned 62.96 percent of the total outstanding shares of Dunn Equipment, a family owned and operated company originally formed in 1949. (Stipulation 8)

1. DUNN EQUIPMENT.

[13] Mrs. Dunn, her son Jesse L. Dunn, III ("Mr. Dunn"), and her grandson Peter Dunn were the directors of Dunn Equipment. Mr. Dunn was President of Dunn Equipment, and Peter Dunn was Vice- President. Mrs. Dunn owned 492,610 (or 62.96%) of the 782,455 outstanding shares. Mr. Dunn owned 243,770 (or 31.12%) of the shares. In his capacity as the trustee of a trust, Mr. Dunn held 20,445 (or 2.61%) of the shares. The remaining 3.31% of the shares were owned by family members or long time employees. (Op. at 2-3)

[14] Dunn Equipment's primary business consisted of renting heavy equipment such as cranes, air compressors, backhoes, manlifts, sanders, and grinders (collectively, the "equipment") to refinery and petrochemical businesses. (Stipulation 11; Op. at 3) Dunn Equipment operated from four locations in Texas and had approximately 134 employees. (Stipulation 12)

[15] On the Valuation Date, Dunn Equipment had been in the heavy equipment rental business for more than 40 years and was the largest heavy equipment rental business in its area of operation. From 1987 through the Valuation Date, the heavy equipment rental market became increasingly competitive because cranes become [sic] more readily obtainable and hourly rental rates declined. (Stipulation 15; Transcript 17; Op. at 4) Because of the intense competitiveness in the market, Dunn Equipment had not increased its rental rates for more than 10 years. (Transcript 17; Op. at 4)

[16] The Company's direct operating expenses increased significantly from 1988 through the Valuation Date, as Dunn Equipment began to rent equipment from third parties on a break-even basis when its own equipment was leased out. (Op. at 5) During this time, Dunn Equipment's profit margins were being squeezed to an inadequately thin level. (Exhibit 14 at p. 55) To remain competitive, the Company continuously had to replace its equipment, spending an average of $2 million per year for such replacements. (Op. at 4-5) These large annual capital expenditures left Dunn Equipment with little or no net cash flow from which to either reduce its debt or pay dividends. (Exhibit 14 at p. 51) As of the Valuation Date, Dunn Equipment had total outstanding debt of $7,343,161, resulting in a debt to equity ratio of over 6.5 to 1. (Transcript 30) Dunn Equipment did not pay any dividends from 1987 through 1991. (Op at 5) The Company's average net income over the five year period before the Valuation Date was a mere $175,731. (Exhibit 14 at p. 53, Table 16) The Tax Court found that the Company's average net cash flow over the four year period leading up to the Valuation Date was just $286,421. (Op. at 21)

[17] The Tax Court determined that the fair market value of Dunn Equipment's assets and the book value of those assets on the Valuation Date was as follows:

                                           Net Asset Value

[18] William H. Frazier of Howard Frazier Barker Elliott, a senior member of the American Society of Appraisers, prepared an expert valuation report that was introduced at trial by the Estate. Mr. Frazier has over 20 years of valuation experience, with a concentration of effort in the valuation of closely held entities. (Exhibit 14 -- Opinion Letter; Transcript at 12-13)

[19] Mr Frazier computed the value of the Stock under both an income approach (i.e., what would be realized if the Company was operated on a go-forward basis) and a liquidation approach (i.e., what would be realized if the Company sold its assets and was liquidated). Mr. Frazier opined that a buyer of the Stock would realize a return on the investment in one of two ways, either by operating Dunn Equipment as a going concern or by liquidating the Company and selling its assets. Mr. Frazier opined that a buyer of the Stock would most likely desire to liquidate Dunn Equipment because of its low anticipated returns. However, Mr. Frazier also recognized that because the buyer would have less than two-thirds of the stock of the Company required to compel a liquidation under Texas law /2/, there would be a chance that the buyer could not garner the necessary votes to compel liquidation. (Exhibit 14 at pp. 55-57)

[20] Because a buyer might be forced to operate Dunn Equipment long-term despite the buyer's economic motivation to liquidate, Mr. Frazier weighted the valuation results determined under the income and liquidation approaches 50/50. Implicit in Mr. Frazier's analysis was that the buyer would expect that there was at least a 50% chance that the buyer could garner the remaining 3.7% of the stock to achieve a two-thirds vote to permit liquidation. (Exhibit 14 at pp. 55-57) Mr. Frazier also testified, however, that if it was assumed that there was little chance that a liquidation would occur, the income approach should predominate over the net asset value approach, since the hypothetical buyer of the stock would achieve most of its return through the receipt of dividends and not through the sale of assets, since an income approach is most applicable for an operating business. (Transcript 20-24, 84-85)

[21] Under the capitalization of average earnings (net income) method, Mr. Frazier capitalized the after-tax profits of the Company to determine the overall entity value. (Exhibit 14 at p. 47) The capitalization rate reflects the future risk inherent in such factors as the corporation's ability to grow and remain profitable, the national economy, inflation, etc. (Exhibit 14 at p. 47) Mr. Frazier determined that a capitalization rate of approximately 21.67% would be appropriate for Dunn Equipment for the following reasons: (a) low profitability with high debt; (b) volatile earnings history; (c) sales dependent on one industry -- the petrochemical industry; (d) lack of geographic diversification; (e) highly competitive environment; (f) no real dividend-paying capacity; and (g) business relationship depending on one man -- Jesse Dunn. (Exhibit 14 at pp. 52-54) ³

[22] Mr. Frazier determined that the Company's average net income for the years 1987 through 1991 was $175,731. (Exhibit 14 at p. 53, Table 16). After applying the capitalization rate of 21.67% to the average net income of $175,731, and applying a lack of marketability discount of 15%, Mr. Frazier's income approach resulted in a value of $689,300 for all of the shares of Dunn Equipment at the Valuation Date. (Exhibit 14 at p. 54, Table 17)

[23] Under the net asset method, a company's assets are restated to fair market value, and the existing liabilities are subtracted in order to determine a company's value. (Exhibit 14 at p. 50) Upon liquidation or a sale of the Company's assets, Dunn Equipment would be subject to a corporate level tax of 34% on the difference between the fair market value of its assets and the net book value of those assets. (Exhibit 14 at p. 57) ⁴ Mr. Frazier determined a net asset value before the corporate level tax in the amount of $7,519,439. (Exhibit 14 at p. 60, Table 18) Mr. Frazier determined a deferred tax liability (at a 34% tax rate) for the unrealized corporate level tax in the amount of $2,417,415. (Exhibit 14 at p. 60, Table 18) After reducing the net asset value before taxes by the deferred corporate level tax liability, and after applying the marketability discount of 15%, Mr. Frazier determined the net asset value method resulted in an entity-level value of $4,336,700 for the Company as of the valuation date. (Exhibit 14 at p. 60, Table 18)

[24] The combination of Mr. Frazier's two methodologies (income and asset value approaches), after applying the 50-50 weighting, resulted in a fair market value of $1,582,185 for the Stock on the Valuation Date. (Exhibit 14 at p. 68; Stipulation 9)

3. THE TAX COURT'S OPINION.

[25] The Tax Court explicitly found that Dunn Equipment was an operating company, not an asset holding company. (Op. at 11) The Tax Court determined the fair market value of the Stock under both an earnings-based approach and a net asset-based approach. Under its earnings-based approach, the Tax Court determined that the average net cash flow for the four-year period prior to the valuation date was $286,421. (Op. at 21) The Court then applied a 21.67% capitalization rate (the capitalization rate determined by Mr. Frazier) to the average net cash flow and determined that the fair market value of the entity under an earnings-based approach, before discounts, was $1,321,740. ⁵ (Op. at 21) Under its asset-based approach, the Tax Court determined that the net asset value of Dunn Equipment was $7,922,892. (Op. at 29) In determining net asset value, the Tax Court reduced the net asset value by only 5% of the amount of the Company's built-in gain of $7,109,000 ($355,450). (Op. at 29) The Tax Court limited the discount to 5%, rather than the 34% tax that will occur when the Company is liquidated or the assets are sold, on the theory that "only if the buyer intended to liquidate in the short term would that buyer seek a substantial reduction for built-in capital gain." (Op. at 28) This rationale demonstrates the Tax Court's error.

[26] After determining the gross values under the earnings and asset-based approaches, the Tax Court weighted the two approaches to determine the overall value of the Company. Despite its findings that Dunn Equipment was primarily an operating company and that the hypothetical buyer would have little chance of liquidating the entity (thus being forced to operate the Company as a going concern), the Court gave 65% weight to the asset-based value of $7,922,892 and 35% weight to the earnings-based value of $1,321,740, resulting in an overall value of $5,612,489. (Op. at 30) The Court determined that the fair market value of the decedent's 62.96% interest in Dunn Equipment, before applying the appropriate discounts, was $3,533,623. (Op. at 30)

[27] The Court then applied a 15% lack of marketability discount and a 7.5% discount for lack of supermajority control (i.e., for the fact that the Stock was less than 66-2/3%). The Court thus determined that the fair market value of the Stock on the Valuation Date was $2,738,558. (Op. at 30-31)

SUMMARY OF THE ARGUMENT

[28] The primary issue in this case is the fair market value of the 62.96% interest in Dunn Equipment transferred by Beatrice Dunn as a result of her death. For two independent reasons, the Tax Court erred reversibly in determining that the fair market value of the Dunn Equipment stock transferred by Mrs. Dunn was $2,738,558.

[29] First, the Tax Court erred by determining the fair market value of the Stock under a weighting approach that allocated 65% of the value based on a net asset value approach and 35% based on an income approach for what the Court determined to be an operating (rather than an asset holding) company. As a general rule, earnings are a better measure of value for operating companies and assets are a better criteria of value for holding or investment companies. Despite the fact that the Tax Court specifically found that (1) Dunn Equipment was an operating company, and (2) there was a low likelihood that the hypothetical buyer of Mrs. Dunn's 62.96% interest could convince the remaining shareholders to liquidate the entity, the Tax Court erroneously determined the fair market value of the stock under a weighting approach which allocated 65% of the value determined under the asset approach and 35% of the value under an earnings based approach. The Tax Court's factual finding that the hypothetical buyer would not likely be able to liquidate the entity and would be forced to operate the underperforming company on a going concern basis necessitates the legal conclusion that greater than 50% weight be accorded to the earnings based approach. After all, the Tax Court's findings of fact demonstrate that the hypothetical buyer would realize the return on investment through the income generated by the Company, not through a sale of its assets.

[30] Second, the Tax Court erred reversibly when it failed to take into account virtually all of the tax effect of Dunn Equipment's $7.1 million of unrealized gain on its appreciated assets in determining the value of the Company under the Tax Court's asset based approach. If the Company's assets were sold or the Company was liquidated, it is undisputed that a corporate level tax of 34% on the unrealized appreciation would be incurred. In determining value under the asset based approach, the Tax Court reduced the net asset value by only 5% of the built-in gain on the theory that "only if the buyer intended to liquidate in the short term would that buyer seek a substantial reduction for built-in capital gain." (Op. at 28) The largest portion of the Company's unrealized gain was the $7.1 million of unrealized gain inherent in the Company's rental equipment. Because similar assets could be purchased on the market, unencumbered by the Company's corporate level built-in gain, and because it is undisputed that the appreciated equipment would be sold by the Company in the ordinary course of business, the Tax Court clearly erred when it limited the discount for the built-in gains to 5% of the built-in gains, rather than 34% that is actually imposed by the Internal Revenue Code.

ARGUMENT AND AUTHORITIES

[32] Likewise, where the determination of fair market value has been held to be a mixed question of law and fact, "the factual premises [are] subject to review on a clearly erroneous standard, and the legal conclusion[s are] subject to de novo review." In re T-H New Orleans Ltd. P'ship, 116 F.3d 790, 799 (5th Cir. 1997). Circuit Courts have not been reluctant to reverse lower court holdings where valuation factual findings were based on, or intertwined with, legal conclusions. See, e.g., Adams v. United States, 218 F.3d 383, 391 (5th Cir. 2000) (reversing valuation determination where, to arrive at value, trial court drew improper legal conclusions regarding impact of state law on property rights); Estate of Palmer v. Comm'r, 839 F.2d 420, 423-24 (8th Cir. 1988) (reversing value finding where court used incomparable sales to determine value, leading to the court "to select the wrong method of valuation"); Amerada Hess Corp. v. Comm'r, 517 F.2d 75, 82 (3d Cir. 1975) (reversing trial court determination of value where trail court failed to use correct standard of valuation applicable to factual situation at hand); Ahmanson Found. v. United States, 674 F.2d 761, 772 (9th Cir. 1981) (reversing district court's finding of value where court concluded that valuation method would be the same for charitable deduction purposes and for gross estate purposes); Bar L Ranch, Inc. v. Phinney, 426 F.2d 995, 1001 (5th Cir. 1970) (reversing determination regarding value of promissory note where district court's factual finding involved legal conclusion that underlying value of property securing note was not to be taken into account); B.F. Sturtevant Co. v. Comm'r, 75 F.2d 316, 324 (1st Cir. 1935) (reversing trial court's finding of value, holding that although courts and juries often have to determine value even when value cannot be arrived at by mathematical computations, good business judgment must rule, "and a failure or refusal to exercise that judgment constitutes an error of law").

[33] Although computation of actual dollar worth in the context of fair market value is a factual matter, the trial court's choice of valuation method or methods is a matter of law to be reviewed de novo. See generally Ahmanson, 674 F.2d at 761; see also, e.g., Estate of Palmer, 839 F.2d at 423 (citing Powers v. Comm'r, 312 U.S. 259, 260 (1941) ("But the question of what criterion should be employed for determining the 'value' of the gifts is a question of law."); Amerada Hess, 517 F.2d at 82; Richardson v. Comm'r, 151 F.2d 102, 103-105 (2d Cir. 1945).

[34] Finally, although a trial court's factual findings on value are given deference, that deference does not render this Court's review "a mere rubber stamp." Morrison v. Mahaska Bottling Co., 39 F.3d 839, 847 (8th Cir. 1994) (quoting Estate of Palmer, 839 F.2d at 423). Rather, when factual findings regarding valuation issues are clearly erroneous, the Circuit Courts consistently reverse those findings. E.g., id. (reversing trial court's determination of book value because court ignored factors affecting value, such as wrongful depletion of company assets); Estate of Kaplin v. Comm'r, 748 F.2d 1109, 1111 (6th Cir. 1984) (reversing Tax Court's findings as to fair market value given that court ignored tax-assessed value as well as value in arm's-length sale); Estate of Kaplin v. Comm'r, 815 F.2d 32, 33-34 (6th Cir. 1987) (reversing Tax Court again given that court failed to follow Circuit Court's specific directions regarding evidence of fair market value); Alvary v. United States, 302 F.2d 790, 795-96 (2d Cir. 1962) (reversing trial court's finding regarding value where court disregarded evidence as to value of real estate); Miller v. United States, 235 F.2d 553, 556 (6th Cir. 1956) (reversing trial court's valuation finding where court used post valuation date information to determine value).

B. THE TAX COURT ERRED REVERSIBLY BY DETERMINING THE FAIR MARKET

[36] Rev. Rule 59-60, 1959-1 C.B. 237 (1959) sets forth the criteria to be considered in valuing shares of capital stock of closely held corporations for estate and gift tax purposes. Estate of Newhouse v. Comm'r, 94 T.C. 193, 217 (1990). Section 4 of Rev. Rule 59-60 provides that the following factors, although not inclusive, are fundamental and require careful analysis in each case:

a. The nature of the business and the history of the enterprise

The valuation of closely held corporate stock entails the

[38] The Tax Court found that Dunn Equipment is an operating company. (Transcript 34-35; Op. at 11) As the Tax Court stated, "it is well established that, as a general rule, earnings are a better criterion of value for operating companies and that assets are a better criteria of value for holding or investment companies." (Op. at 11) ⁷ The Tax Court concluded that a "hypothetical investor [in Dunn Equipment] would give earnings value SUBSTANTIAL weight" (Op. at 11) (emphasis added), while giving only "SOME weight to asset-based value as well . . . ." (Op. at 12) (emphasis added). Despite its own findings, the Tax Court refused to follow the general rule and gave greater weight to the net asset value approach because, in its view, "the earnings value is too low, primarily because Dunn Equipment was engaged in a cyclical business, and it was at the low point of the cycle at the valuation date." (Op. at 14) It is this weighting choice by the Tax Court that this Court may review de novo under the standards articulated in Ahmanson, 674 F.2d at 761-62; Estate of Palmer, 839 F.2d at 423; Powers, 312 U.S. at 260; Amerada Hess, 517 F.2d at 82; and Richardson, 151 F.2d at 103-05. As discussed above, although the finding of fair market value itself is a question of fact, the Tax Court's choice of valuation methodology is a question of law to be reviewed de novo.

[39] The Tax Court's legal conclusion would be perfectly logical if there was a future expectation that Dunn Equipment's business would move in an upward direction or that competition in the industry would decrease. However, there was no evidence introduced at trial to show that the business cycle was expected to improve or that competition in the equipment leasing business would decrease. In fact, the evidence demonstrated the opposite. Even Mr. Dunn, the Company's President, acknowledged that "I had no idea how long it would take" to work out Dunn Equipment's business problems. (Transcript 145-46)

[40] As of the Valuation Date, the long-term economic outlook in Dunn Equipment's industry was flat. (Transcript 123-24) Long-term earnings growth was only estimated to be 4%, below the then current rate of inflation. (Transcript 123-24, Exhibit 14 at p. 54) During the five years before the Valuation Date, Dunn Equipment's heavy equipment rental business had become increasingly competitive. (Stipulation 15; Exhibit 14 at p. 55) There was an abundance of highly substitutable equipment available in the Company's market. (Exhibit 14 at p. 55) But construction activity was not adequate to cause high utilization of that equipment. (Exhibit 14 at p. 55) Consequently, competition centered on price, which squeezed profit margins to an inadequately thin level. (Exhibit 14 at p. 55) Despite the fact that rental rates had declined over the prior ten years, Dunn Equipment was required to spend $2 million per year for new equipment just to maintain its market share. The Company had $7,343,160 of debt on the Valuation Date, a 6.5 to 1 debt equity ratio. (Exhibit 14 at p. 17) The Company could not borrow additional funds. (Transcript at 38-39) In fact, the Company was only able to secure its most recent borrowings because of the personal guarantee of Mr. Dunn and cross collateralization with other Dunn family assets (a benefit a third party hypothetical buyer of the Stock would not have). (Transcript at 38-39) There was no reasonable expectation that conditions would change. (Exhibit 14 at p. 55) ⁸

[41] Despite the dismal future of the Company, the Tax Court opined that because it would be difficult to obtain the necessary two-thirds vote required by Texas law to liquidate the entity, the hypothetical buyer would be forced to operate the entity long term but would place most of its weight on the value of the Company's assets -- a value that the hypothetical buyer under the Tax Court's findings would have no reasonable expectation of realizing. ⁹ There is no dispute that the Company was worth less under an earnings-based approach than under a net asset value/liquidation approach -- the Company simply was not performing. That is why Mr. Frazier opined that the hypothetical buyer would seek to liquidate the entity. But Mr. Frazier also realized that because of the likely action of the remaining shareholders, there was a chance that the buyer could not obtain the necessary two-thirds vote to liquidate the entity, and thus weighted the income approach and net asset value approach 50/50. ¹⁰

[42] The Tax Court found, however, that Mr. Frazier overestimated the likelihood of liquidation. (Op. at 13) The Tax Court opined that it would be difficult to obtain approval of enough additional stockholders to compel liquidation, given "the Company's history, its community ties, and its relationship with its employees." (Op. at 13) While the Tax Court's finding that the likelihood of liquidation was very low may be logical, that factual finding, which implies that the Company would be operated on a long term basis, necessitates the legal conclusion that greater than 35% weight being accorded to the income approach. After all, the hypothetical buyer would realize a return on investment in one of two ways: (1) by operating Dunn Equipment as a going concern, or (2) by seeking to liquidate Dunn Equipment and distributing the net proceeds from the sale of its assets. Under the Tax Court's finding that liquidation was not likely, the investor's return must be recognized primarily through the income to be generated by the Company, not through a sale of its assets. ¹¹ Therefore, the Court erred reversibly in its legal conclusion that a 65% weight on the asset approach was appropriate, while only a 35% weight on the income approach was proper. In fact, given the Tax Court's factual finding that there was little chance of liquidation, the proper legal conclusion to be drawn would be the reverse of the Tax Court's erroneous conclusions, such that a 65% weight be accorded to the income approach and a 35% weight accorded to the asset approach.

[43] Accordingly, the Estate requests this Court to find that the Tax Court erred in applying a 65% weight to the asset approach and only a 35% weight to the income approach in determining the overall value of Dunn Equipment on the Valuation Date. The Estate requests this Court to reverse the Tax Court decision, to remand this case to the Tax Court, and to direct the Tax Court to determine the overall value of Dunn Equipment under a weighting approach that applies a greater weight to the income approach than is applied to the asset approach.

C. THE TAX COURT CLEARLY ERRED WHEN IT FAILED TO TAKE INTO ACCOUNT

[45] In determining value under the net asset value approach, the Tax Court reduced the net asset value by only 5% of the built-in gain, resulting in a total discount for the built-in gain of $355,450. (Op. at 29) Dunn Equipment's unrealized gain consisted primarily of the $7,117,638 unrealized gain inherent in the Company's rental equipment. ¹² Because similar assets could be purchased on the market, unencumbered by the Company's corporate level built-in gain, and because it is undisputed that the equipment would be sold in the ordinary course of business after the Valuation Date, the Tax Court clearly erred when it limited the discount for built-in gains to 5% of the built-in gains, rather than 34% imposed by the Internal Revenue Code.

[46] The built-in gain discount is allowed when it is apparent that the hypothetical buyer would have taken into account the tax consequences of the built-in gain when arriving at the amount the buyer would be willing to pay for the stock. Estate of Davis v. Comm'r, 110 T.C. 530, 550-54 (1998); Estate of Borgatello v. Comm'r, T.C.M. (CCH) 260 (2000). The liability for built-in gains taxes should, in almost all cases, be reflected in the value of the stock of a corporation that owns significantly appreciated assets. As explained by Dr. Shannon Pratt in his expert report filed with the Court,

Under the standard of fair market value, the premise is very

[47] It is also abundantly apparent that the gain will be recognized in the present case, and that a buyer would take those tax consequences into account in formulating a purchase price. The Tax Court specifically found that "in order to remain competitive, Dunn Equipment continuously had to replace its equipment and spent an average of $2 million per year for such replacements." (Op. at 4-5) There is simply no dispute that if Dunn Equipment desired to maintain market share, the Company would be required to continue to expend large sums of money annually to replace its equipment. As the Company's equipment is sold and replaced, a corporate level tax of 34% on the $7,117,638 of appreciation in the Company's equipment inventory would be realized.

[48] The Tax Court's limitation of the corporate level tax to 5% of the appreciation was based upon the erroneous assumption that "only if the buyer intended to liquidate in the short term, would that buyer seek a substantial reduction for built-in capital gain." (Op. at 28) But the Tax Court acknowledged that the Company was selling its equipment "as part of its ongoing operations." (Op. at 29, fn. 12) The Commissioner's expert also recognized that "the Company is selling assets on a recurring basis." (Transcript 171) Even if Dunn Equipment business was continued, rather than liquidated, the continuous replacement of equipment to the tune of $2 million per year, simply to remain competitive, would require Dunn to recognize its corporate level gain as it sold and replaced its equipment in the normal course of business. Thus, the Company's recognition of its $7 million of unrealized gain was clearly inevitable, whether Dunn Equipment continued to operate or was liquidated.

[49] In an apparent attempt to downplay the inevitable tax that would be recognized as the Company sold its equipment in the normal course of business, the Tax Court engaged in speculation, unsupported by any evidence, as to how the buyer might avoid the inevitable corporate level tax on the sale of equipment. The Tax Court opined "that the hypothetical buyer who did not wish to continue operating the company, and who was able to convince additional shareholders to form a supermajority, had other options besides liquidation. A new owner who wished to change the business of the company into, for example, construction rather than equipment rental, would not have a need to buy new equipment every few years, and could use the equipment the company owned for its entire useful life, eliminating the realization of built-in gain." (Op. at 28) The Tax Court also found that this goal could be accomplished by "forming a new corporation engaged in the construction business." (Op. at 28)

[50] The Tax Court's unsupported speculation is a clear deviation from the hypothetical willing buyer/willing seller test and as such, constitutes reversible error. See Estate of Bright v. United States, 658 F.2d 999, 1005-06 (5th Cir. 1981) (en banc); LeFrak v. Comm'r, 66 T.C.M. (CCH) 1297, 1299 (1993) ("The standard is an objective test using hypothetical buyers and sellers in the marketplace, and is not a personalized one which envisions a particular buyer and seller.") In reality, the Tax Court erroneously focused on investment value to one particular buyer -- a buyer who might be interested in moving Dunn Equipment from the equipment rental business it had been in since 1949 to a completely new line of business. But the test under which the Court was required to determine the fair market value of the Stock involves a "hypothetical buyer" and a "hypothetical seller," both of whom have "reasonable knowledge of relevant facts" as of the Valuation Date. Treas. Reg. section 20.2031-1(b); Estate of Bright, 658 F.2d at 1006; Estate of Mueller v. Comm'r, 63 T.C.M. (CCH) 3027-16 (1992) ("The 'willing buyer' is supposed to be a hypothetical amalgam of potential buyers in the marketplace."); Steinberg v. Comm'r, 46 T.C.M. (CCH) 1238, 1258 (1983) ("A particular actual seller may be able to realize less or more than the value determined under the objective willing buyer, willing seller test for various reasons. This, however, has never been considered to affect the determination of fair market value under the willing buyer, willing seller concept."). The Tax Court's focus on a strategic buyer, rather than the hypothetical buyer, was clearly erroneous.

[51] But even assuming that the Tax Court was allowed to engage in such speculation, there is no evidence to support the Court's analysis. First, the chemical and petrochemical industry was beginning to feel the effects of over capacity at the Valuation Date. (Exhibit 14 at pp. 45-46) Construction activity in the Company's marketplace was "sluggish." (Exhibit 14 at p. 46) Second, Dunn Equipment had obligations to its existing customers. It would take many months, if not years, to transition into a new business. Third, Dunn Equipment's primary workers were crane operators, not construction workers. (Exhibit 14 at p. 1) Logic dictates that crane work constitutes only a very small part of the activities of a construction company. To support an economic justification for owning over $10 million in cranes (the gross value before liabilities), a construction business would have to be immense -- vastly larger than the value of the assets held by Dunn Equipment. The Tax Court simply had no evidence to demonstrate that Dunn Equipment was in any way suited to be a construction company or that the remaining shareholders would support the change of business. ¹⁴ The assumption that Dunn Equipment, which had been in the equipment rental business for over 40 years, was going to reincarnate itself as a construction company, is, with all due respect to the trial court, outside the bounds of belief.

[52] This is not the first time that Judge Gale has dealt with unsupported theories of capital gains tax avoidance in connection with the valuation of corporate stock. In Estate of Jameson v. Comm'r, 77 T.C.M. (CCH) 1383, 1395-96 (1999), Judge Gale specifically and properly rejected unsupported theories of capital gains tax avoidance. In Jameson, the Commissioner's expert asserted that various tax strategies would allow the buyer to avoid the recognition of the unrealized capital gains of the company at issue. The Court held that those strategies could at best defer the recognition of gain, but not avoid it. Id. at 1395-96. The Commissioner likewise argued on brief that the taxpayer could simply "hire some creative and resourceful tax practitioner" and since "'someone might think of a way to avoid the tax effect of an immediate liquidation,' the tax on built-in capital gains is only speculative." Id. at 1396. Judge Gale properly rejected the unsupported speculation of the Commissioner and its expert, holding that "we do not think Mr. Burns has demonstrated any real possibilities for avoidance of the built-in capital gains tax by Johnco, let alone done so in a manner sufficient to prevent petitioner from being able to carry its burden of final persuasion." Id. Unfortunately, Judge Gale did not follow his own admonition in the present case.

[53] In addition, Dunn Equipment was losing money at the Valuation Date, had almost $8 million in long-term debt, and had little cash flow. Under these circumstances, it is completely irrational for the Tax Court to conclude, without any supporting evidence, that Dunn would move into a new line of business. The Tax Court's unsupported speculation that the hypothetical buyer might completely change Dunn Equipment's primary line of business, in support for its decision to limit the unrealized capital gains discount, was clearly erroneous and should be reversed. See Dunlap v. Oldham Lumber Co., 178 F.2d 781, 783 (5th Cir. 1950) ("We of course recognize the rule that if there is substantial evidence to support the finding of the trial Court . . . and the finding is not clearly erroneous this finding should be sustained, but in this case the evidence is wholly insufficient to sustain the finding of the Court.").

[54] Accordingly, the Estate requests this Court to determine that the Tax Court erred in limiting the discount for unrealized gains to only 5% of the unrealized gain, rather than 34% of the unrealized gain. The Estate further requests this Court to reverse the Tax Court's decision, to remand this case to the Tax Court, and to direct the Tax Court to apply a discount for unrealized gains that is consistent with the actual rate of the unrealized gains that the hypothetical buyer of the Stock would be faced with (i.e., 34% of the $7,117,638 of appreciation in Dunn Equipment's equipment inventory) in determining the fair market value of the entity under the asset based approach.

PRAYER

[55] For the reasons stated above, Appellant, the Estate of Ellen Beatrice Jones Dunn, Deceased, Jesse L. Dunn, III, Independent Executor, respectfully requests this Court to reverse the judgment of the Tax Court and to remand this case to the Tax Court for determinations consistent with the relief requested, and to grant the Estate such other and further relief to which it may be entitled.

Respectfully submitted,

[56] I hereby certify that the foregoing BRIEF OF APPELLANT has been filed, in both paper and electronic format, in the office of the Clerk for the United States Court of Appeals for the Fifth Circuit, and a true and correct copy of the same, in both paper and electronic format, has been provided to counsel listed below in the manner indicated on this 27th day of November, 2000.

John W. Porter

Pursuant to 5TH CIR. R. 32.2.7(c), the undersigned certifies that this brief complies with the type-volume limitations of 5TH CIR. R. 32.2.7(b).

1. EXCLUSIVE OF THE EXEMPTED PORTIONS IN 5TH CIR. R. 32.2.7(b)(3),

² Texas corporate law requires the approval of at least 66-2/3 percent of the outstanding shares to liquidate the entity. See Tex. Bus. Corp. Act Ann. art. 6.03 (West 1991). (Op. at 13)

³ Mr. Frazier's capitalization rate was computed as follows:

          Long-Term U.S. Government Bond Rate             8.47%

⁵ Computed as $286,421/2167.

⁶ The Estate is not appealing the Tax Court's determination of the value of the entity under the earnings based approach, or its application of a 15% discount for lack of marketability and a 7.5% discount for lack of super majority control.

⁷ Courts have consistently held that earnings are a better criterion of value for operating companies and assets are a better criterion for investment or holding companies. See, e.g., Comm'r v. McCann, 146 F.2d 385 (2d Cir. 1944) (L. Hand, J.) (value of stock in corporation "is the sum which represents the current estimate of the present value of its future earnings and of its final liquidation."); Estate of Titus v. Comm'r, 57 T.C.M. (CCH) 1449, 1454 (1989) ("A buyer or investor would be more interested in the earning capacity of the business as a going concern"); Estate of Kirpatrick v. Comm'r, 34 T.C.M. (CCH) 1490, 1500 (1975) (giving "primary consideration" to earnings where subject corporation "was clearly an operating company actively engaged in selling products and services to the general public.").

⁸ The review appraisal introduced by the Commissioner did not dispute the existence of those poor conditions. (See Exhibit 11)

⁹ The Tax Court found that the Company's average net cash flow in the four years before the Valuation Date was $286,421. The portion of that cash flow attributable to the Estate's interest (62.96%) was $180,330. (Op. at 21) At the Tax Court's fair market value of $2,738,558, the hypothetical buyer of the Stock would earn approximately $110,000 per year on the investment. At that rate, it would take fifteen years, not taking into account the time value of money, for the buyer to recoup his investment.

¹⁰ The Tax Court found that it would be difficult to convince an additional 3.71% of the Dunn Equipment stockholders to liquidate the Company. (Op. at 13) Mr. Dunn testified that, despite the problems facing Dunn Equipment, "I gave my employees my word, as well as my family, my word, that we were going to work our way out." (Transcript 145-46) That is why liquidation was never considered as an option by the Dunn family. (Transcript 146) Mr. Dunn's loyalty to his employees is entirely expected, given that his family had been in this business for over 40 years and the relationship with many of the employees reached back two generations. The hypothetical buyer is not motivated, however, by such feelings. The question for the hypothetical buyer is what am I willing to pay for this interest, knowing that I may not be able to obtain the necessary votes to liquidate the entity, and then knowing that I may have to accept a return in form of dividends from the corporation over the reasonably foreseeable future?

¹¹ Mr. Frazier's 50/50 weighting of the net asset value and income based approach was based on the assumption that there was at least a 50% chance that the hypothetical buyer could convince the necessary number of additional shareholders to liquidate the entity. (Exhibit 14 at pp. 55-57). But Mr. Frazier also testified that if it was assumed that there was little chance that a liquidation would occur, the income approach should predominate over the asset approach because the buyer will achieve a return on investment through the receipt of dividends, not a sale of assets. (Transcript 20-24, 84- 85)

¹² The unrealized gain on the equipment is slightly higher than the Company's overall unrealized gain because the Company has other assets that have a basis higher than their fair market value. (Exhibit 14 at p. 59)

¹³ The Tax Court attempted to distinguish Dunn Equipment from the situation where the company owns appreciated publicly traded stock (as the Tax Court faced in Estate of Davis) on the grounds that the primary assets are equipment, not publicly traded stock. (Op. at 27) But it is undisputed that on the Valuation Date "there was an abundance of highly substitutable equipment available in Dunn's market." (Ex. 14 at p. 55) Given that such equipment was readily available, a hypothetical buyer could simply purchase the equipment on the market and no built in gain would come along with the newly purchased assets. In this light, the Tax Court's distinction based on the nature of Dunn Equipment's assets falls flat.

¹⁴ Although there is no evidence to support the Tax Court's finding that the remaining shareholders would support a complete shift in the Company's line of business, the fact that those shareholders would oppose a liquidation leads to the inference that they would oppose such a change. Dr. Shannon Pratt also opined that if the Company completely changed its line of business that dissenting shareholders' rights under Texas law would be triggered. (Transcript 204)