Gross, Jr. v. Comm. of Internal Revenue

• Decision Date: 27 October 2000
• Docket Number: 2257,Nos. 99-2239,s. 99-2239
• Citation: 272 F.3d 333
• Parties: (6th Cir. 2001) Walter L. Gross, Jr. and Barbara H. Gross (99-2239); Calvin C. Linnemann and Patricia G. Linnemann (99-2257), Petitioners-Appellants, v. Commissioner of Internal Revenue, Respondent-Appellee. Argued:
• Court: U.S. Court of Appeals — Sixth Circuit

Page 333

272 F.3d 333 (6th Cir. 2001)

Walter L. Gross, Jr. and Barbara H. Gross (99-2239); Calvin C. Linnemann and Patricia G. Linnemann (99-2257), Petitioners-Appellants, v. Commissioner of Internal Revenue, Respondent-Appellee.

Nos. 99-2239, 2257

UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT

Argued: October 27, 2000

Decided and Filed: November 19, 2001

On Appeal from the United States Tax Court. Nos. 97-04460; 97-04469. James S. Halpern, Tax Court Judge.

Gerald J. Rapien (argued and briefed), James J. Ryan (briefed), TAFT, STETTINIUS & HOLLISTER, Cincinnati, Ohio, for Appellants.

David I. Pincus (argued and briefed), UNITED STATES DEPARTMENT OF JUSTICE, APPELLATE SECTION TAX DIVISION, Washington, D.C., A. Wray Muoio (briefed), Tax Division, Department of Justice, Washington, D.C., for Appellee.

Before: DAUGHTREY and CLAY, Circuit Judges; COHN, Senior District Judge. ^*

CLAY, J., announced the judgment of the court and delivered an opinion, in which DAUGHTREY, J., and COHN, D. J., concurred except as to Part II.B.1. COHN, D. J. (pp. 31-39), delivered a separate opinion, in which DAUGHTREY, J. concurred, which constitutes the opinion of the court on the issue addressed in Part II.B.1.

OPINION

CLAY, Circuit Judge.

Taxpayers, Walter L. and Barbara H. Gross, Jr., along with Calvin C. and Patricia G. Linnemann, appeal from the order of the United States Tax Court valuing certain gifts of corporate stock at $10,910 per share. To the extent that the valuation was based upon the use of a contested valuation approach, I would find that the tax court's decision was clearly erroneous; and would therefore reverse the tax court's decision and remand for further proceedings. However, inasmuch as Judge Daughtrey and Judge Cohn find that the tax court did not clearly err in concluding that it was appropriate not to tax affect the stock in order to determine its fair market value, the tax court's decision is AFFIRMED.

FACTS

The common question presented by this consolidated appeal is the fair market value of certain shares of corporate stock transferred as gifts by Taxpayers Walter L. Gross, Jr., and Patricia G. Linnemann to their respective children. Taxpayers Barbara H. Gross and Calvin C. Linnemann, the wife and husband of the aforementioned taxpayers, are parties because they consented to having the gifts made by their respective spouses as also having been made one-half by them for federal gift tax purposes. The shares in question are shares of stock of Pepsi-Cola Bottlers, Inc. ("G&J"), an Ohio corporation that bottles and distributes various beverages in Ohio and Kentucky. G&J's business operations can be traced back to a partnership formed in the 1920s between two married couples, Isaac N. and Esther M. Jarson and Walter L. and Nell R. Gross. This business was incorporated in 1969. By the time the questioned gifts were made in 1992, the founders of the corporation were deceased and ownership of G&J had devolved to their relatives: the Gross family group (which included members of the Linnemann family) and the Jarson family group. Directly and through voting trusts, each family group owned 50% of the outstanding shares of stock of G&J.

By a written agreement dated November 1, 1982,G&J's shareholders elected to be taxed as a small business corporation ("S corporation"), pursuant to Subchapter S of the Internal Revenue Code, I.R.C. §§ 1361-1379, for at least 10 years. This subchapter was enacted to eliminate the tax disadvantages that might dissuade small businesses from adopting the corporate form and to lessen the tax burden on such businesses. The statute accomplishes these goals by means of a pass-through system under which corporate income, losses, deductions, and credits are attributed to individual shareholders in a manner akin to the tax treatment of partnerships. See I.R.C. §§ 1366-1368; Bufferd v. Commissioner, 506 U.S. 523, 524-25 (1993). In practical terms, this means that the corporation pays no state or federal income tax. See I.R.C. §§ 1361-1363; Ohio Rev. Code Ann. § 5733.09(B) (Banks-Baldwin 1995). Rather, the Scorporation passes its income through to its shareholders, who report their pro rata shares of that income on their individual tax returns. See I.R.C. § 1366. G&J maintained Scorporation status through July 31, 1992, at which time there were no plans to change its Scorporation status.

Also in 1982, the members of the Gross/Linnemann family group entered into an agreement restricting the transferability of their G&J stock. This restrictive agreement permitted certain transfers within the Gross/Linnemann family group, but provided that if other transfers were attempted, the G&J stock would be purchased by the family group at book value. ¹ More importantly, the agreement also restricted any transfers that would jeopardize G&J's S corporation status. This agreement was still in effect as of July 31, 1992.

At that time, G&J was the third largest independent bottler of Pepsi-Cola products. G&J had an exclusive franchise agreement to distribute these products within several geographic territories. These products, including the brand names Seven-Up, Dr. Pepper, and five variations of Pepsi-Cola, were distributed to over 24,000 customers including wholesale and retail outlets. G&J's operational infrastructure included plants, warehouses, over 800 vehicles, and over 11,000 soft drink vending machines. From 1988 to 1992, G&J enjoyed steady increases in its operational income, total income, and distribution to shareholders. In addition, G&J's shareholder distributions nearly totaled the company's entire income for each of these years.

On July 31, 1992 Walter Gross gave each of his three children 124.5 shares of G&J stock, and Patricia Linnemann gave each of her two children 187.5 shares of G&J stock. The gifts to each child represented less than one percent of the corporation's outstanding shares. Walter Gross and his wife Barbara each reported one-half of the asserted value of the gifts to their children on a timely filed Form 709, United States Gift (and Generation Skipping Transfer) Tax Return ("Form 709"). Patricia Linnemann and her husband Calvin did the same with respect to the gifts to their children. In reporting these gifts ro the IRS, the Grosses and Linnemanns ("Taxpayers") relied on an appraisal report prepared by Business Valuations, Inc. This report, dated July 22, 1992, valued the G&J stock at $5,680 per share as of May 31, 1992. Based upon this report, the Grosses reported a total gift value of $2,121,480 and the Linnemanns reported a total value of $2,130,000. Upon receiving the report of these gifts, the Commissioner of Internal Revenue ("Commissioner") issued notices of deficiency to Taxpayers based on his valuation of the stock at a much higher amount, $11, 738.00. The Commissioner later agreed that the shares had a value of no more than $10,910 as of the gift date. Taxpayers challenged the Commissioner's determinations in the United States Tax Court.

At trial, both parties relied on expert testimony to establish the value of the shares of G&J stock. Taxpayers relied upon the Testimony of David O. McCoy and Charles A. Wilhoite. McCoy, a business appraiser, prepared a report valuing the common shares of G&J. He was accepted as an expert witness and his report was accepted into evidence as direct testimony. McCoy also prepared an additional report rebutting the testimony of the Commissioner's lone expert witness. Wilhoite is an appraiser and valuation expert who prepared a second rebuttal report in response to the Commissioner's expert. Wilhoite was accepted as an expert on appraisal and valuation methodology and his report was also accepted into evidence as his direct testimony. The Commissioner called Mukesh Bajaj, Ph.D., as an appraisal expert. Bajaj presented two reports, one valuing minority interests in G&J as of the gift date, and one in rebuttal to McCoy's first report. Bajaj was accepted as an expert witness and his reports were accepted into evidence as his direct testimony.

The experts on either side determined the value of the G&J stock using "income approaches" in which a company's fair market value is determined by calculating the present value of its projected future income. One approach used by both parties was the "discounted future cash flow" approach. ² Experts on both sides also agreed that the value of the shares should be discounted to reflect the fact that, as shares of a closely held S corporation, they are not readily marketable. But two basic disagreements distinguished the experts' calculations of the value of G&J stock.

The first disagreement was whether, under the discounted future cash flow approach, to reduce the corporation's projected future income by deducting hypothetical corporate income taxes even though as an S corporation G&J did not pay income taxes. This process is known as "tax affecting." McCoy testified that in 1992 various professional associations published standards governing the conduct of professional business appraisers and that professional appraisers were ethically bound to follow those standards, citing a publication entitled the Uniform Standards of Professional Appraisal Practice ("USPAP"). This document requires appraisers to be aware of, understand, and correctly employ recognized methods and techniques necessary to produce a credible appraisal (the "standards rule"). McCoy testified that in order to comply with the standards rule, and produce a credible appraisal, it was necessary for professional appraisers to "tax affect" the earnings of an S corporation. In order to "tax affect" G&J's stock, McCoy introduced a fictitious tax burden, equal to an assumed corporate tax of 40%, which he then applied to reduce the estimated future income of G&J. Both McCoy and Wilhoite testified that despite some growing controversy surrounding the issue, use of a 40% tax affect was the accepted practice at the time...