Dunn v. C.I.R., 00-60614.
| Citation | 301 F.3d 339 |
| Decision Date | 01 August 2002 |
| Docket Number | No. 00-60614.,00-60614. |
| Parties | Beatrice Ellen Jones DUNN, Deceased, Estate of, Jesse L. Dunn III, Independent Executor, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. |
| Court | United States Courts of Appeals. United States Court of Appeals (5th Circuit) |
John W. Porter (argued), Stephanie Loomis-Price, Baker Botts, Houston, TX, for Petitioner-Appellant.
Karen D. Utiger (argued), Teresa Ellen McLaughlin, Tax Div., Eileen J. O'Connor, Asst. Atty. Gen., U.S. Dept of Justice, Charles Casazza, Clerk, U.S Tax Court, Richard W. Skillman, Chief Counsel, IRS, Washington, DC, for Respondent-Appellee.
Appeal from the Decision of the United States Tax Court.
Before SMITH, DUHÉ, and WIENER, Circuit Judges.
The sole issue presented by this appeal from the United States Tax Court (the "Tax Court") is the fair market value of a block of common stock in Dunn Equipment, Inc. ("Dunn Equipment" or the "Corporation") owned by the late Beatrice Ellen Jones Dunn (the "Decedent") on the date of her death (the "valuation date") for purposes of calculating the estate tax owed by Petitioner-Appellant Estate of Beatrice Ellen Jones Dunn, Deceased (the "Estate"). The Tax Court valued the Decedent's shares higher than had the Estate on the Form 706 (the "estate tax return" or the "return") filed by Jesse L. Dunn III, the Decedent's Independent Executor (the "Executor") but lower than had Respondent-Appellee Commissioner of Internal Revenue (the "Commissioner"). We conclude that the Tax Court erred as a matter of law in the valuation methodology that it selected and applied to facts that are now largely uncontested by virtue of stipulations, concessions, and non-erroneous findings of that court. This legal error produced an incorrect valuation and thus an erroneous final Tax Court judgment as to the Estate's tax deficiency, requiring remand to that court.
We hold that the correct methodology for determining the value of Dunn Equipment as of the valuation date requires application of an 85:15 ratio, assigning a weight of 85% to the value of the Corporation that the Tax Court determined to be $1,321,7401 when using its "earnings-based approach" and a weight of 15% to the value that the court determines on remand using its "asset-based approach" but only after recomputing the Corporation's value under this latter approach by reducing the market value of the assets2 by 34% of their built-in taxable gain — not by the 5% as previously applied by that court — of the built-in gain (excess of net sales value before taxes over book value) of the assets, to account for the inherent gains tax liability of the assets.
We therefore remand this case to the Tax Court for it to (1) redetermine the asset-based value using a 34% reduction for built-in tax liability; (2) recalculate the fair market value of the Corporation based on that 85:15 weighting ratio; (3) calculate the value of the Estate's ratable portion of the total value of the Corporation as thus redetermined; (4) discount the value of that ratable portion by 22.5% for lack of market and lack of super-majority; (5) based on that result, redetermine the estate tax liability of the Estate as well as any resulting overpayment of such taxes by the Estate; and (6) render a final judgment consistent with this opinion and our judgment.
In November, 1994, approximately three and one-half years after the Decedent's death and two and one-half years after her estate tax return was filed, the Commissioner issued a notice of deficiency, assessing additional estate taxes of $238,515.05. This litigation ensued. In an amended answer filed in the Tax Court, the Commissioner increased the asserted estate tax deficiency to approximately $1,100,000. This deficiency was predicated on the Commissioner's contention that the Decedent's 492,610 shares of common stock in Dunn Equipment, a closely-held, family-operated corporation, was undervalued in the estate tax return. The Commissioner argued that such stock should be valued solely on the basis of the fair market value of its assets, discounted only for lack of a market and lack of a super-majority, and with no reduction for built-in tax liability of those assets and no consideration whatsoever of an earnings or cash flow-based approach to valuation.
In June, 1996, trial was held in the Tax Court to determine the fair market value of Decedent's block of stock in Dunn Equipment. Approximately three and one-half years after trial, the Tax Court issued its Memorandum Findings of Fact and Opinion ("the Tax Court opinion"). The court concluded that the subject block of stock, which constituted 62.96% of the issued and the outstanding shares of Dunn Equipment's capital stock, was worth $2,738,558 on the valuation date. After the Tax Court entered its final judgment some six months later, the Estate timely filed a notice of appeal.
Based in principal part on stipulations, uncontested evidence,3 and concessions the Tax Court found the following facts. Decedent, a longtime resident of Texas, died there on June 8, 1991 at the age of 81. The Executor, Decedent's son, is also a Texas resident, and the Estate was administered there.
Dunn Equipment was incorporated in Texas in 1949. It had been family owned and operated throughout its entire existence. The Corporation actively operated its business from four locations in Texas and, on the valuation date, employed 134 persons, three of whom were executives and eight of whom were salesmen.
Dunn Equipment owned and rented out heavy equipment, and provided related services, primarily in the petroleum refinery and petrochemical industries. The personal property rented from the Corporation by its customers consisted principally of large cranes, air compressors, backhoes, manlifts, and sanders and grinders. The Corporation frequently furnished operators for the equipment that it rented to its customers, charging for both equipment and operators on an hourly basis. For example, the Corporation's revenues resulted in significant part from the renting of large cranes, with and without operators. For the four fiscal years preceding the valuation date, equipment rented with operators furnished by the Corporation produced between 26.3% and 32.7% of the Corporation's revenues. On the valuation date, Dunn Equipment's assets comprised the aforedescribed heavy equipment, plus industrial real estate valued at $1,442,580 and a townhouse valued at $35,000, prepaid expenses of $52,643, and prepaid interest of $671,260.
In addition to the shares owned by the Decedent, shares in Dunn Equipment constituting 31.12% of the issued and outstanding common stock were owned individually by Jesse L. Dunn III (the Decedent's son and executor), who also held title to an additional 2.61% as a trustee. Shares representing the remaining 3.31% of the Corporation's issued and outstanding stock were owned in combination by other family members and employees of the Corporation.
The Corporation's Board of Directors consisted of the Decedent; her son and executor, Jesse; and her grandson, Peter Dunn (Jesse's son). Jesse was President, Peter was Vice President, and the Decedent was Secretary-Treasurer. The Tax Court found that compensation paid to the officers of Dunn Equipment was lower than that paid to officers of similarly situated companies.
Over the course of its 42 years of operation preceding the valuation date, Dunn Equipment had emerged as the largest heavy equipment rental business in its part of Texas, holding a substantial share of that market. By virtue of its market dominance and reputation for dependable service, the Corporation was historically able to command rates above the market average. From 1987 through the valuation date, a decline in the worldwide price of feed stock for the oil refining and petrochemical industries created a favorable business climate for the Corporation's principal customers, and Dunn Equipment's gross revenues increased during that period.
During the same period, however, the heavy equipment rental market became increasingly competitive, as equipment such as cranes became more readily available and additional rental companies entered the field. This in turn caused hourly rental rates to decline and flatten. In fact, increased competition prevented Dunn Equipment from raising its rental rates at any time during the period of more than ten years preceding the valuation date. These rates remained essentially flat for that 10-year period. The same competitive factors forced the Corporation to replace its equipment with increasing frequency, reaching an average new equipment expenditure of $2 million per annum in the years immediately preceding the valuation date.
In addition to the increased annual cost and frequency of replacing equipment during the years of flat rental rates that preceded the Decedent's death, the Corporation's operating expenses increased significantly, beginning in 1988, and continued to do so thereafter: The ratios of direct operating expenses to revenue escalated from 42% in 1988 to 52% in the 12-month period that ended a week before the Decedent's death. The effect of the increase in direct operating expenses on the Corporation's cash flow and profitability was exacerbated by a practice that Dunn Equipment was forced to implement in 1988: meeting its customers' demands by leasing equipment from third parties and renting it out to the Corporation's customers whenever all of its own equipment was rented out to other customers. Although this practice, which continued through the valuation date, helped Dunn Equipment keep its customers happy and retain its customer base, the Corporation was only able to break even on these re-rentals, further depressing its profit margin.
Based on the foregoing factors, the Tax Court concluded that the Corporation had no...
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