Estate of McGill v. C.I.R., 060484 FEXTAX, 21876-81

Docket Nº:21876-81.
Opinion Judge:COHEN, Judge:
Attorney:L. William Schmidt, Jr., John A. Wallace, Michael C. Russ, L. Joseph Loveland, and Peter J. Genz for the petitioner. Benjamin A deLuna, for the respondent.
Case Date:June 04, 1984
Court:United States Tax Court

48 T.C.M. (CCH) 239




No. 21876-81.

United States Tax Court

June 4, 1984

L. William Schmidt, Jr., John A. Wallace, Michael C. Russ, L. Joseph Loveland, and Peter J. Genz for the petitioner.

Benjamin A deLuna, for the respondent.


COHEN, Judge:

Respondent determined a deficiency of $5,595,018 in the Federal estate tax of petitioner. After concessions by the parties, the sole issue for decision is the date-of-death value of voting trust certificates representing decedent's beneficial interest in stock of a closely-held corporation.


Some of the facts have been stipulated and are so found.

Madeline F. McGill (decedent) died on October 2, 1977. J. R. Hanna was appointed the personal representative of her estate. Hanna timely filed the estate tax return with the Internal Revenue Service in Denver, Colorado. Among the items in decedent's gross estate reported on the return were voting trust certificates representing the beneficial interests in 6,180 shares of Class A common voting stock (50 percent of the outstanding Class A shares) and 144,056 shares of Class C common nonvoting stock (41.54 percent of the outstanding Class C shares) of the Wright & McGill Co. (" WMG" ), a Colorado corporation with its principal place of business in Denver, Colorado. Hanna valued the voting trust certificate representing the Class A shares at $74,160 ($12 per share), and he valued the voting trust certificate representing the Class C shares at $1,440,560 ($10 per share). In the notice of deficiency, respondent valued the Class A shares at $5,568,798 ($901.10 per share) and the Class C shares at $3,991,202 ($27.71 per share).

Description and History of WMG

The predecessor to WMG was formed in 1925 by decedent's husband, Andrew D. McGill, to manufacture and sell tied flies used for fishing. At the date of decedent's death, WMG was engaged in the manufacture of fishhooks, fishing rods and reels, and other fishing tackle. The fishhooks were manufactured at a plant in Denver and generated approximately two-thirds of WMG's total sales. The rest of WMG's total sales was attributable to sales of fishing rods and other fishing tackle manufactured at a plant in Aurora, Colorado.[1]

WMG produced high-quality fishhooks and sold them under the " Eagle Claw" brand name. They were WMG's most profitable and most successful product line. The fishhooks were manufactured in a multi-step, largely automated process that employed highly sophisticated and complex machinery pioneered by Andrew McGill and built to company specifications. None of this machinery was patented.

The production of a saleable fishhook involved an integrated manufacturing process that used not only metal forming machines, but also heat-treating equipment, plating equipment, quality control equipment, bulk loose hook equipment, weedless loose hook equipment, shipping room equipment, finished goods equipment, warehouse equipment, bulk hook storage equipment, hook sorting equipment, and tumbling equipment. Approximately 20 of the metal forming machines were in operation at the date of decedent's death. To run these machines, WMG maintained a staff of highly-skilled operators. It generally took 4 years of training before an operator could become skilled in all aspects of operating a specific machine. Extensive training was also needed to operate the other machinery used in the production process, such as the heat-treating and plating machines. To keep all of its various machinery operational, WMG maintained a complete machine shop and did all of its repairs in-house. The complexity of the machines was such that considerable down time was experienced despite a regular preventative maintenance schedule.

A third party seeking to purchase the metal forming machines used by WMG would have had to purchase all of the machinery used by WMG, as well as acquire the services of WMG's trained personnel, to produce a finished fishhook and to operate the machines profitably. The machines had no utility apart from their limited and specialized roles in the production of fishhooks.

Because of their small size and mundane character, fishhooks were difficult to market by themselves. Rods and reels, on the other hand, were the " glamour" items in the fishing tackle industry and attracted most of the attention at trade shows and on store shelves. In addition, WMG marketed its fishhooks through a number of manufacturer's representatives who were paid on commission and preferred to sell rods and reels because the fishhook business was highly seasonal, whereas rods and reels sold well in both the fishing season and the Christmas shopping season. Although foreign competition made WMG's production of fishing tackle considerably less profitable than the production of fishhooks, because of the marketing synergism created by selling fishhooks together with rods and reels, WMG found it necessary to sell the rods and reels in order to enhance its sales in the more profitable fishhook line.

Business Conditions on Valuation Date

At the date of decedent's death, WMG controlled approximately 70 percent of the entire domestic fishhook market. Its principal competitor was Mustad, a Norweigian manufacturer of quality fishhooks that was rapidly moving into the domestic market and undercutting WMG's prices. Other foreign manufacturers were producing low-priced fishhooks that were also attracting WMG's customers, and WMG faced considerable pressure to lower its prices. WMG management viewed the foreign competition as a serious, long-term threat that would eventually cause a substantial erosion of WMG's domestic market share unless it was directly confronted. Thus, in July 1977, WMG reduced the price of its fishhooks.

In addition, foreign manufacturers of fishing rods, with their access to cheap labor, were providing strong competition to domestic manufacturers, including WMG. A substantial portion of WMG's inventory consisted of rods, much of which was obsolete because of the rapid style turnover that is characteristic of the rod industry. As a result, the rod inventory could only be sold at a fraction of its carrying cost. Although rods accounted for only 22 percent of WMG's total sales, rod inventory constituted more than 40 percent of total inventory. The rest of WMG's inventory contained a considerable amount of excess stock, not saleable at regular prices due to WMG's general policy of building inventories, its low inventory turnover, and its failure to maintain inventory controls.

WMG owned insurance policies on decedent's life in the face amount of $1.5 million. The date of death cash surrender value of $260,474.46 was listed as an asset on WMG's financial statement for the fiscal year ended June 30, 1977. A deferred compensation contract between WMG and decedent also became operative upon her death, and WMG was obligated to pay $50,000 per year for 10 years to decedent's estate, adjusted annually for inflation.

Other assets owned by WMG at the date of death included life insurance policies on the lives of other key employees with a combined cash value of $126,357 and the real estate supporting the manufacturing facilities in Denver and Aurora.

At the time of decedent's death, WMG had a strong liquid position and a healthy current asset to current liability ratio. All of WMG's assets were then in use in the operation of the business, however; none of the noninventory assets were being held for investment purposes.

Despite its healthy balance sheet. WMG was experiencing a significant decline in earnings. Although gross sales were increasing slightly, net after-tax income (exclusive of nonrecurring items) had declined from $658,737 in fiscal 1974 to $375,592 in fiscal 1977, a drop of approximately 43 percent. Expressed as a percentage of sales, net income declined from 4.6 percent in fiscal year 1974 to 2.3 percent in fiscal year 1977. During that same period, WMG's return on equity declined from 7.8 percent to 3.4 percent. Its gross profit margin declined from 40.5 percent to 37.2 percent.

For the 3-month period ended September 30, 1977, WMG reported a loss of $383,779, exclusive of nonrecurring items, the worst quarterly result in its history. Although this quarter was typically not a strong quarter due to the seasonal nature of WMG's business, the results were at sharp variance with the results of the same quarter in preceding years. For example, the quarter ended September 30, 1974, yielded a net profit of $146,191, and the quarter ended September 30, 1975, yielded a net profit of $37,811. The loss in the quarter ended September 30, 1977, was due, in part, to the aforementioned pricecutting decision made in July 1977. Although WMG's sales increased in general during the years 1972 through 1977, the rate of increase in sales declined approximately from 17 percent in 1973 to approximately 10 percent in 1977. WMG used the LIFO (last-in, first-out) method of inventory accounting for both financial accounting and Federal income tax purposes, which method was adopted during the 1974 fiscal year. Its internal cost of sales figures were kept on a FIFO (first-in, first-out) basis with annual adjustments made to convert the figures to LIFO.

In the quarter ending just prior to decedent's death, sales declined 21 percent compared to the sales for the corresponding quarter of fiscal 1976. The decline in sales was matched by a decline in WMG's order backlog at the quarter's end, which was approximately $1 million less than the order backlog at September 30, 1976, and which had deteriorated...

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