Estate of Lauder v. Commissioner

• Decision Date: 30 December 1992
• Docket Number: Docket No. 21525-87.
• Citation: 64 T.C.M. 1643
• Parties: Estate of Joseph H. Lauder, Deceased, Leonard A. Lauder and Ronald S. Lauder, Executors v. Commissioner.
• Court: U.S. Tax Court

64 T.C.M. 1643

T.C. Memo. 1992-736 Estate of Joseph H. Lauder, Deceased, Leonard A. Lauder and Ronald S. Lauder, Executors v. Commissioner.

Docket No. 21525-87.

United States Tax Court.

Filed December 30, 1992.

Albert H. Turkus, Ira T. Wender, Bernard J. Long, Jr., Corinne M. Antley, and Maria L. Olsen, for the petitioner. John A. Guarnieri and Clement Shugerman, for the respondent.

Memorandum Findings of Fact and Opinion

HAMBLEN, Chief Judge:

Respondent determined a deficiency of $42,702,597.67 in the Federal estate tax due from the Estate of Joseph H. Lauder (petitioner). In Estate of Lauder v. Commissioner [Dec. 46,918(M)], T.C. Memo. 1990-530, we denied petitioner's motion for partial summary judgment that restrictive shareholder agreements, to which Joseph H. Lauder (Joseph or decedent) was a party, control the question of the value of stock in a closely held corporation for purposes of the Federal estate tax. We found that Joseph's health was satisfactory and normal for a man of his age on the dates that the shareholder agreements were executed. Nonetheless, we concluded that further factual development would be necessary to aid the Court in determining whether the shareholder agreements were intended to serve as a device to pass Joseph's stock to the natural objects of his bounty for less than an adequate and full consideration in money or money's worth. Sec. 20.2031-2(h), Estate Tax Regs.¹

Findings of Fact

Some of the facts have been stipulated and are so found. The stipulations of facts and attached exhibits are incorporated herein by this reference.

Joseph H. Lauder died testate at age 81 in the State of New York on January 16, 1983, survived by his wife, Estee Lauder (Estee), and his two sons, Leonard A. Lauder (Leonard) and Ronald S. Lauder (Ronald). (References to the Lauders are to Estee, Joseph, Leonard, and Ronald collectively.)

I. Background

A. Estee Lauder, Inc.

Estee Lauder became interested in skin care and cosmetics as a young girl while assisting her uncle, a chemist, with the preparation of skin creams in a laboratory behind her family's house. Estee and Joseph entered the cosmetics business just after World War II.

On May 20, 1958, Fragrance Products Corp. was incorporated under the laws of the State of New York. In 1963, the name of the company was changed to Estee Lauder, Inc. (ELI). At all times pertinent hereto, ELI and its subsidiaries and affiliates were engaged in the manufacture and distribution of cosmetics, fragrances, and related products.

In the beginning, ELI sold four basic skin care products through a few beauty salons in New York City. Estee and Joseph were ELI's sole employees and business was conducted in the rented basement of a building in New York City.

Saks Fifth Avenue was the first specialty store to carry ELI's products. Through the mid-seventies, the Lauders maintained a policy of distributing ELI's products exclusively through high-end specialty and department stores.

Leonard and Ronald began working part-time for the business during their early teenage years, delivering orders and doing odd jobs. Leonard, who is 11 years older than Ronald, joined the business on a full-time basis in 1958 after graduating from the University of Pennsylvania and serving in the United States Navy. At that time, ELI generated annual sales of $800,000 and its facilities were so small that Leonard shared an office with Estee, served as the only salesman, and was also responsible for public relations, product advertising, marketing, and package delivery. Leonard became president of ELI in 1973.

Ronald joined the business on a full-time basis in 1967. Prior to that time, Ronald attended the University of Pennsylvania, studied international business at the University of Brussels (while working in ELI's factory in Belgium), and served in the United States Coast Guard. Initially, Ronald serviced two major accounts and was coordinator of marketing groups. Ronald became ELI's vice president for marketing and sales in 1973.

Estee attributed the success of the business to the family's hard work. The Lauders shared the view that it was of utmost importance to keep the business in the family. As one of the few privately held cosmetics companies, the Lauders believed that ELI operated at a substantial advantage over its competitors. In their view, ELI was in a position to take more risks and move more aggressively than publicly held companies. Further, market share and sales could be built without concerns of showing an immediate profit.

At various times, the Lauders have been urged to make a public stock offering. The Lauders have remained opposed to such suggestions. Prior to 1975, the Lauders never engaged an investment banker or other outside consultant for this purpose nor did they solicit or receive any information regarding the price that their shares would bring in a public offering.

ELI common stock has never been publicly traded. From March 31, 1967, through December 14, 1976, the Lauders owned all of ELI's outstanding common stock. Although persons and organizations other than the Lauders and their immediate family have owned stock in ELI and its affiliates, the Lauders have always maintained control over ELI. ELI preferred stock has been owned by the Lauders and various organizations, including schools, museums, a hospital, and the Lauder Foundation.

The Lauders intend that a third generation of their family eventually will manage and control the family business. To this end, Estee and Joseph's grandchildren have joined the business in entry level positions commensurate with their respective ages and experience.

B. Operating Divisions and Related Corporations

As of 1974, ELI had three major operating divisions: Estee Lauder U.S.A., Clinique, and Estee Lauder, International.

1. Estee Lauder. U.S.A.

During the period in question, Estee Lauder U.S.A. maintained three separate product lines: Fragrances, makeup, and skin care treatment. Estee Lauder U.S.A. relied heavily on sales of a fragrance, Youth Dew, first introduced to the market in 1953. In 1974, 1975, and 1976, Youth Dew sales were approximately $35.8 million, $35.7 million, and $37.5 million, respectively. To reduce its reliance upon Youth Dew, Estee Lauder U.S.A. introduced several new products during the late sixties and early seventies, including the fragrances "Estee", "Azuree", "Aliage", and "Private Collection".

2. Clinique and The Hypo-allergenic Rule

The Clinique division appears to have originated in 1968. C.L. Allergenics, Inc., was organized as a New York corporation on December 13, 1973. Its name was subsequently changed to Clinique Laboratories, Inc. (Clinique) on December 28, 1973. Clinique products are marketed as fragrance-free and allergy-tested to attract women with sensitive skin and younger women who want a more natural look from their cosmetics.

From 1973 through 1976, ELI owned all of Clinique's class A common stock which represented 80 percent of Clinique's voting stock. During this same period, Leonard and Ronald owned all of Clinique's class B common stock which represented 20 percent of Clinique's voting stock. ELI was entitled to a preference as to Clinique's first $750,000 in earnings available for dividends as well as 50 percent of any earnings in excess of that amount. Leonard and Ronald were entitled to 50 percent of Clinique's earnings available for dividends in excess of $750,000.

Clinique initially acted as a cash drain on ELI causing overall losses through 1970. However, Clinique experienced extraordinary success and rapid growth during the years 1972 through 1976, with gross profits from domestic sales increasing from $5.1 million in 1972 to $26.6 million in 1976. During 1976, Clinique accounted for approximately 15 percent of ELI's total sales. Its fast growth was in part related to the small base from which it started. The executive head of the Clinique division had the impression that some others in ELI and the industry considered Clinique to be a fad.

In February 1974, the Food and Drug Administration (FDA) issued a proposed rule to require extensive testing and proof to support the use of the terms "hypo-allergenic" or "allergy tested" in describing a cosmetics product (the hypo-allergenic rule). Although the hypo-allergenic rule was eventually issued in final form, its effective date was stayed on July 23, 1975, pending the outcome of a lawsuit brought by Clinique and Almay, Inc., challenging its validity.

On June 30, 1976, the hypo-allergenic rule was upheld in Almay, Inc. v. Weinberger, 417 F.Supp. 758 (D.D.C. 1976). However, the District Court's decision was subsequently vacated and remanded in Almay, Inc. v. Califano, 569 F.2d 674 (D.C. Cir. 1977), on the ground that the hypo-allergenic rule was arbitrary and capricious. The rule was revoked effective March 14, 1978.

While the hypo-allergenic rule was pending and in effect, Almay, Inc., removed hypo-allergenic labeling from its packaging. Thereafter, its sales growth stagnated and a newly introduced product failed to gain market share. Following the Court of Appeals decision, Almay, Inc., resumed using the hypo-allergenic labeling, and its sales increased soon thereafter. Although the Clinique division was affected by the rule, ELI's audited financial statements for the years 1972 through 1976 do not mention the hypo-allergenic rule.

3. International

The International division markets all of ELI's principal products overseas. From its origination in 1961 until 1974, International remained in a "startup" phase, requiring large outlays of capital and producing few returns. During this period, cosmetics markets in many foreign countries were difficult to penetrate by virtue of trade barriers ranging from secret lists of prohibited ingredients to specialty store boycotts. During the years 1974, 1975, and 1976 International's gross profits were $29.7 million, $41.5 million, and $51.5 million,...