In a terse and unusually critical opinion, the Ninth Circuit Court of Appeals, over a dissent, has reversed the Tax Court’s controversial decision in Estate of Simplot (see Tax News, Oct. 1999), remanding the case and ordering that judgment be entered in favor of the estate, annulling the deficiency of $2.16 million. 87 AFTR 2d ¶2001-2165 (5/14/2001).
The capital structure of J.R. Simplot consisted of two classes of authorized stock: 76 shares of Class A voting common, and 141,289 shares of Class B nonvoting common. The decedent had owned 18 shares of Class A stock. The estate obtained a valuation of its stock from Morgan Stanley, and reported the Class A and Class B shares as worth $2,650 per share. Asserting that the Class A shares were worth $801,994 per share, the IRS assessed a deficiency of $17.66 million and penalties of $7.06 million.
After hearing valuation experts from both sides, the Tax Court ultimately assigned a premium to the Class A shares equal to 3% of the equity of the company, or $24.9 million. After dividing the premium by the total number of Class A shares, and assigning a 35% discount for lack of marketability, the Tax Court concluded that Class A shares were worth $215,539 per share, and found a deficiency of $2.16 million.
The Ninth Circuit stated that the Tax Court had articulated the correct “willing buyer and willing seller” standard in its opinion, but had departed from that standard, improperly constructing a hypothetical sale “in a vacuum isolated from the actual facts that affect value.”
The appeals court also faulted the Tax Court for determining the premium for all Class A shares as a block, and then dividing the premium by the number of Class A shares. By so doing, the Tax Court “valued an asset not before it — all the Class A stock representing complete control.” Under the applicable regulations, the appeals court stated, the fair market value of each unit of property must be ascertained, which in this case was a share of Class A stock.
The Ninth Circuit also found error in the Tax Court’s assignment of any premium to the Class A shares, stating that “[e]ven a controlling block of stock is not to be valued at a premium for estate tax purposes” unless the IRS can show that a purchaser could take economic advantage justifying the premium. Were the company to liquidate, the Class B shareholders would actually fare better than the Class A shareholders, and any premium paid for the Class A shares would be lost.
The Ninth Circuit criticized the Tax Court for engaging in improper “speculation” as to events that might occur after the valuation date. Although the Tax Court assumed the company would continue to profit after Simplot’s death, the Ninth Circuit dryly observed that “speculation is as easily made that the company would go downhill when its founder retired.”