                        T.C. Memo. 2002-80



                      UNITED STATES TAX COURT



  ESTATE OF WILLIAM G. ADAMS, JR. DECEASED, GEORGE W. SAENGER,
                     EXECUTOR, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 14698-99.             Filed March 28, 2002.



     George W. Saenger, pro se.

     James E. Gray and Steven Webster, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined a $635,018.85

deficiency in the estate tax of the Estate of William G. Adams,

Jr. (decedent).   After concessions, the sole issue for decision

is whether the fair market value of decedent’s 61.59-percent

interest in Waddell Sluder Adams & Co., Inc. (WSA), on September
                                 - 2 -

28, 1995, was $1,746,000, as respondent determined, or $920,800,

as the estate contends.   We hold that it was $1,161,705.

     Unless otherwise specified, section references are to the

Internal Revenue Code as amended and in effect on the date of

decedent’s death, and Rule references are to the Tax Court Rules

of Practice and Procedure.

                          FINDINGS OF FACT

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

A.   Decedent and the Executor

     Decedent, who lived in Asheville, North Carolina, died

testate on September 28, 1995.    When he died, he owned 178 shares

of WSA voting common stock, which was 61.59 percent of its

outstanding stock.   Voting common stock was WSA’s only

outstanding stock when decedent died.

     George W. Saenger, the executor of decedent’s estate, lived

in Asheville, North Carolina, when the petition was filed.

B.   Waddell Sluder Adams & Co., Inc.

     1.   Insurance Business

     WSA has been an S corporation since the early 1970s.    It has

two components, a retail insurance agency and a managing general

insurance agency (MGA).   In 1995, the retail agency generated 5

percent of WSA’s revenue, and the MGA generated 95 percent.   The

retail agency sells insurance to the public.
                                - 3 -

     When decedent died, and until the time of trial, WSA had a

contract with the Maryland Casualty Co. (MCC) to be an MGA.      The

contract provides that MCC is the sole supplier of insurance to

the MGA and that WSA has the exclusive right to sell personal and

commercial lines of insurance for MCC in 17 counties in western

North Carolina.   In 1995, 68 to 72 percent of WSA’s business came

from personal lines.    WSA was MCC’s only MGA in 1995.   MCC or WSA

could terminate the contract at any time by giving 180 days’

written notice to the other party.

     WSA sells insurance for MCC through about 42 independent

retail insurance agents.    Independent agents may obtain insurance

for their customers from any insurance company.    WSA processes

insurance applications from customers of the retail agents and

makes underwriting decisions.    If WSA accepts an application, it

sets the premium, issues the policy to the retail agent, and pays

the premium to MCC.    MCC then pays part of the premium to WSA.

WSA uses these funds to pay its expenses and the retail agents

and keeps the excess as profit.    The retail agents have contracts

with WSA which establish the amounts of commissions they will

receive for selling MCC products.    WSA would not be a viable

business without its relationship with MCC or if it could not

sell personal lines of insurance.
                                    - 4 -

       2.      Key Personnel

               a.   Decedent

       Decedent began working for WSA in the mid-1940s.        He became

president of WSA around 1972, and he worked for WSA until April

or May 1995.        He worked fewer hours in his later years.   His

primary function in those later years was to set wage and bonus

levels for WSA officers.

               b.   Robert B. Gelder, Jr.

       Robert B. Gelder, Jr. (Gelder), was born in 1949 and has

lived in Asheville, North Carolina, since 1953.        He graduated

from the University of North Carolina.        He worked for 5 years for

NCNB (now Bank of America).        He began working for WSA in 1976.

       Gelder spent his first year at WSA learning the insurance

business.       In 1976, WSA’s insurance underwriting was divided

between property and casualty lines of coverage.        Gelder became

the manager for personal and commercial lines of casualty

insurance after 15 months at WSA.        He began to perform

underwriting services, i.e., to assess risk for applicants of

property insurance policies, around 1982.        He developed marketing

skills and gained experience in all aspects of underwriting for

WSA.    He developed and maintained a close relationship with the

independent agents who sold WSA products and with MCC personnel.

He became the sole liaison between WSA and MCC beginning around

1982.       He began managing WSA around 1987.   He became the general
                                 - 5 -

manager and president of WSA in 1994.       In 1995, his duties

included maintaining WSA’s relationship with MCC and the retail

agents in western North Carolina.     He has performed all of the

management functions for WSA since 1995.

     Gelder has no written employment contract or noncompete

agreement with WSA.   WSA had no other employee who could replace

Gelder in 1995.   Gelder’s compensation and dividends from WSA for

1991-95 were as follows:

                   1991      1992          1993       1994      1995

     Wages     $234,700    $258,100      $299,600   $381,200   $381,465
     Dividends   76,614      83,581        84,247    108,889    167,239
       Total    311,314     341,681       383,847    490,089    548,704

           c.   Julia Adams Slipher

     Julia Adams Slipher (Slipher) is decedent’s daughter.

Slipher began working for WSA in 1977 as an assistant bookkeeper.

She later began underwriting personal lines of insurance, and she

was responsible for underwriting property insurance coverage for

commercial middle markets (not otherwise described in the record)

in 1995.   Slipher could not have done Gelder’s job in 1995.

     3.    Officers and Employees

     On September 28, 1995, WSA’s officers were Gelder

(president), Slipher (vice president and secretary), and decedent

(treasurer).    On that date, WSA had 16 employees in addition to

Gelder, Slipher, and decedent.
                                - 6 -

     4.    Stock Holdings on September 28, 1995

     On September 28, 1995, decedent, Gelder, and Slipher owned

WSA’s stock as follows:

                                                      Percentage
    Shareholder           No. of shares                of total

William G. Adams, Jr.           178                      61.59
Robert B. Gelder, Jr.           105                      36.33
Julia Adams Slipher               6                       2.08
  Total                         289                     100.00

     5.    Zurich Insurance Group’s Purchase of MCC

     The Zurich Insurance Group (Zurich) purchased MCC in the

late 1980s.   Zurich considered implementing a “service center”

concept for MCC, which would have caused WSA to lose underwriting

authority, eliminated the need for WSA to serve as an MGA or as a

retail agency, and eliminated the work done with WSA by the

independent agents throughout western North Carolina.     WSA

opposed imposition of the service center concept in the 17

counties which it serviced, and Zurich eventually abandoned the

concept.   Through considerable effort, Gelder maintained and

improved WSA’s relationship with Zurich.

     6.    Pending Litigation

     The North Carolina Rate Bureau represents insurance

companies before the Insurance Commissioner of North Carolina.

In 1994, the Rate Bureau commenced litigation with the Insurance

Commissioner which potentially affected WSA.   If the Rate Bureau

had prevailed, WSA would have been required to pay about $407,000
                                 - 7 -

to Zurich to be refunded to WSA’s customers.       That litigation was

pending on September 28, 1995.

                               OPINION

A.   Contentions of the Parties

     The estate contends that the value of decedent’s 178 shares

of WSA stock (a 61.59-percent interest) on September 28, 1995,

was $920,800.    Respondent contends that the value was $1,746,000

on that date.1

     A tax is imposed on the fair market value of the decedent’s

property on the date of death.    Secs. 2001, 2031.        The fair

market value of property is “the price at which the property

would change hands between a willing buyer and a willing seller,

neither being under any compulsion to buy or to sell and both

having reasonable knowledge of relevant facts.”       Sec. 20.2031-

1(b), Estate Tax Regs.; sec. 25.2512-1, Gift Tax Regs.          The

estate bears the burden of proof.2       Rule 142(a)(1).

     Both parties rely on the testimony of experts to establish

the fair market value of decedent’s WSA stock.       We may accept or

reject expert testimony according to our own judgment, and we may


     1
        In objecting to the estate’s proposed ultimate finding of
fact, respondent contends that the fair market value was
$1,757,911. However, respondent’s proposed ultimate finding of
fact is that the value of decedent’s interest in WSA was
$1,746,000, the value that respondent determined. Respondent
does not explain this difference.
     2
        The estate concedes that sec. 7491 does not apply because
the examination began before July 22, 1998.
                               - 8 -

be selective in deciding what parts of an expert's opinion, if

any, we accept.   Helvering v. Natl. Grocery Co., 304 U.S. 282,

295 (1938).

     Herbert T. Spiro (Spiro) testified for respondent.    F.

Foster Shriner (Shriner) testified for the estate.3    Shriner and

Spiro estimated, and computed the present value of, future

returns an investor would receive from an investment in WSA.

They did so by calculating the present value of the stream of

estimated future cashflows to WSA.     Spiro concluded that the fair

market value of the shares at issue was $1,904,403 on September

28, 1995; Shriner concluded that it was $920,800.

B.   Spiro’s and Shriner’s Expert Reports

     We believe that Shriner’s approach for estimating the value

of WSA stock (before applying a discount for lack of

marketability) was more thorough than Spiro’s.    Spiro did not

speak with anyone from MCC or investigate the pending




     3
        Kevin M. Stipe also testified for the estate. However,
the estate does not rely on Stipe’s estimate even though it was
more favorable to the estate than Shriner’s estimate. We do not
consider Stipe’s estimate of value.
                                 - 9 -

litigation.4    Shriner did those things, and reasonably concluded

that it was unlikely that WSA would survive without Gelder.

C.   Whether Shriner Properly Estimated Gelder’s Future
     Compensation

     Respondent contends that Shriner underestimated future net

cashflows by overestimating future compensation to Gelder.    On

the basis of Spiro’s testimony, respondent contends that Shriner

should have used $125,000 per year as Gelder’s future

compensation.    We disagree.

     Gelder’s salary in 1995 was $381,465 and his salary and

dividends totaled $548,704.     Spiro acknowledged that Gelder was a

key employee, and that no one would buy WSA without Gelder.    We

do not believe that Gelder could have been replaced for $125,000

per year.

     Respondent contends that WSA could have found a suitable

replacement for Gelder in 1995 and that Gelder had no attractive

employment alternative.    We disagree.   Slipher testified that it

was unlikely that anyone could assume Gelder’s responsibilities

because few people understood as well as did Gelder the market,

the industry, underwriting, and management as they affect WSA.


     4
         In his report, Spiro said:

     Not having interviewed persons in authority at The
     Maryland in 1995, it is impossible to determine
     conclusively whether or not The Maryland would have
     cancelled or materially modified WSA’s personal lines
     underwriting authority upon the transfer of Mr. Adams’
     interest to another party.
                               - 10 -

     Spiro projected Gelder’s future salary based on the salary

of the top 10 percent of underwriters, even though Gelder spent

only 10 or 15 percent of his time underwriting.    Spiro’s

methodology ignores the fact that Gelder did much more than

underwriting.

     Shriner used insurance industry data for officers and

managers to estimate Gelder’s future compensation.      That data

shows that officers of companies in the insurance industry with

assets of $1 million received compensation of 14.6 percent of

gross revenues.    Shriner estimated that future compensation of

WSA officers would be 14.7 percent of WSA’s gross revenues.      We

believe that Shriner reasonably estimated Gelder’s future

compensation.

     Respondent contends that Shriner should have assumed that

WSA would make payouts to investors at the middle of the year

(midyear convention) rather than at the end of the year (yearend

convention).    Respondent contends that Shriner’s approach is

incorrect because he “artificially treats net cashflows as not

received until the end of each year.”    We disagree.    There is

support for use of the yearend convention on the grounds that

payment at the end of the year is better than payment in the

middle of the year because payment at the end of the year enables

the managers to see how the year has turned out.    Pratt, Cost of

Capital, Estimations and Applications 30-31 (1998).      We do not
                              - 11 -

apply the midyear convention here because respondent offered no

evidence that WSA would pay its investors at the middle of the

year rather than at the end of the year.

D.   Estimating the Discount and Capitalization Rates

     Shriner used the income capitalization method and Spiro used

the discounted cashflow method to estimate the fair market value

of WSA stock.   In the discounted cashflow method, a discount rate

is applied to a series of future cashflow periods (e.g., each

year in the future that the asset will produce a return on

investment) to estimate present value.   In the income

capitalization method, the future cashflow of a single period

(e.g., the next year) is estimated.    An estimated growth rate is

applied to project the cashflow for that single period into the

future.   An estimated discount rate is applied to reduce the

projected future cashflows to present value.   A capitalization

rate combines the estimated growth rate and the discount rate.

It is applied to the estimated future cashflow of the single

period.   Neither party contends that the other’s method is

inappropriate here.

     Both experts began their analyses by estimating a discount

rate to apply to WSA’s projected net cashflow using the “build-

up method”.   They both used a rate of return on risk-free

investments (risk-free rate) of 6.86 percent, which was the 30-

year Treasury rate for August 1995.
                                - 12 -

     1.   Added Risk Premiums

     Both experts increased the 6.86-percent rate to account for

risks that an investor in WSA would assume; i.e., “added risk

premiums”.

     Spiro and Shriner both added a 7.03-percent equity risk

premium5 to account for the fact that the rate of return on stock

is less certain than on U.S. Treasury obligations.   They obtained

this value, which is based on investment returns of C

corporations, from Stocks, Bonds, Bills, and Inflation: 1995

Yearbook by Ibbotson Associates, Inc.

     Both experts added a 5.25-percent risk premium to account

for the fact that WSA was a small company.   Both experts based

this added risk premium on data from Ibbotson Associates.

     Spiro also added a 10-percent risk premium to account for

potential loss of personal lines of underwriting authority and

the fact that WSA is an S corporation.   Shriner added a 9.03-

percent risk premium (7.03 percent for WSA’s tenuous relationship

with Zurich and 2 percent for its thin management and the

importance of Gelder).   The sum of the risk-free rate and added

risk premiums equaled a discount rate of 29.14 percent for Spiro

and 28.17 percent for Shriner.



     5
        Adding the equity risk premium to the risk-free rate is a
widely accepted method. Brealey & Myers, Principles of Corporate
Finance 146-147 (5th ed. 1996); Pratt, Cost of Capital,
Estimation and Applications 62 (1998).
                              - 13 -

     2.    Deriving a Capitalization Rate

     Shriner derived a capitalization rate of 20.53 percent from

his estimated discount rate and from his estimated future average

annual growth rate of 6.34 percent for WSA.6   Respondent does not

dispute Shriner’s estimated growth rate or capitalization rate.

We accept Shriner’s estimate of a capitalization rate of 20.53

percent.   However, we do not accept an increase that Shriner made

to that rate for reasons discussed next.

     3.    Whether Shriner Properly Converted the Capitalization
           Rate From an After Corporate Tax Rate to a Before
           Corporate Tax Rate

     The net cashflow and the capitalization rate used to compute

the fair market value of the WSA stock should have the same tax

character; i.e., before corporate tax or after corporate tax.

See Gross v. Commissioner, T.C. Memo. 1999-254 (both the discount

rate and cashflow should be before shareholder tax or after

shareholder tax), affd. 272 F.3d 333 (6th Cir. 2001).   See

generally Black & Issom Associates, Fundamentals, Techniques and

Theory of Capitalization/Discount Rates, ch. 5, at 23 (1995);

Ibbotson Associates, Stocks, Bonds, Bills and Inflation:

Valuation Edition 1999 Yearbook; Pratt, supra at 151-152, 155.




     6
        The capitalization rate is generally derived by reducing
the discount rate by the expected long-term stable growth rate of
net cashflows to the investment being valued. Pratt, supra at
21-23.
                               - 14 -

     The estate contends that Shriner’s estimates of WSA’s

prospective net cashflows are before corporate tax.    The estate

also contends that Shriner properly converted the capitalization

rate from an after corporate tax rate to a before corporate tax

rate to match estimated prospective net cashflows and that the

conversion increased his capitalization rate from 20.53 percent

to 31.88 percent.   We disagree with the estate on both points.

     We disagree that Shriner’s estimates of WSA’s prospective

net cashflows are before corporate tax because it is appropriate

to use a zero corporate tax rate to estimate net cashflow when

the stock being valued is stock of an S corporation.    Gross v.

Commissioner, supra.    WSA is an S corporation, and its cashflows

are subject to a zero corporate tax rate.   Thus, Shriner’s

estimates of WSA’s prospective net cashflows are after corporate

tax (zero corporate tax rate) and not before corporate tax as the

estate contends.

     We disagree that Shriner properly converted the

capitalization rate because there was no need to do so.   The

parties agree that Shriner’s estimated capitalization rate

(before he converted it to before corporate tax) is an after

corporate tax rate.    Thus, as in Gross, the tax character of

Shriner’s estimate of WSA’s prospective net cashflows matches

that of the unconverted capitalization rate because both are

after corporate tax.   It follows that Shriner should not have
                                  - 15 -

converted the capitalization rate from after corporate tax to

before corporate tax because the tax character of both his

estimated net cashflows for WSA and unconverted capitalization

rates is after corporate tax.

       We conclude that Shriner improperly increased the

capitalization rate from 20.53 percent to 31.88 percent.7

       4.      Conclusion

       The following shows the value of decedent’s interest in WSA

on September 28, 1995, before applying a discount for lack of

marketability:

     Normalized net cashflows                             $595,746
     Capitalization rate                                   ÷ 20.53%
                                                     1
     Capitalized net cashflows – total entity          $2,901,831
     Equity interest of 61.59 percent                      x .6159
                                                      2
     Value of decedent’s interest                       $1,787,238
       1
            $595,746/.2053 = $2,901,831.
       2
            Before discount for lack of marketability.

E.     Discount for Lack of Marketability

       Both experts applied a discount for lack of marketability

because there was no ready market for WSA stock on September 28,

1995.       We agree that a discount for lack of marketability is

appropriate.



       7
        The result here of a zero corporate tax on estimated
prospective cashflows and no conversion of the capitalization
rate from after corporate tax to before corporate tax is
identical to the result in Gross v. Commissioner, T.C. Memo.
1999-254, affd. 272 F.3d 333 (6th Cir. 2001), of zero corporate
tax rate on estimated cashflows and a discount rate with no
conversion from after corporate tax to before corporate tax.
                              - 16 -

     Shriner applied a 20-percent discount for marketability.     To

calculate the marketability discount, he first derived a 32.89-

percent discount by averaging the discounts found in various

restricted stock studies.   He reduced that amount to 20 percent

to account for his belief that the insurance industry was more

stable than the general market.

     Like Shriner, Spiro found that the average marketability

discount based on restricted stock studies was between 30 and 35

percent.   Spiro also found that initial public offering studies

show an average marketability discount of nearly 45 percent.

Spiro considered the fact that WSA’s very specialized operations

would limit potential buyers and detract from the stock’s

marketability.   He also considered the size of the block of stock

and elements of control which could enhance marketability.   After

listening to testimony at trial, he stated that a discount for

lack of marketability of 40 or 45 percent would be appropriate to

account for the risk due to the pending Rate Bureau litigation.

We conclude that a 35-percent discount for lack of marketability

applies.

     We disagree with Shriner’s reduction from about 33 percent

to 20 percent because we do not believe WSA was as stable as the

insurance industry average.   We disagree with Spiro’s increase

from 35 percent to 45 percent, not because the Rate Bureau

litigation should not be considered, but because we believe a 35-
                             - 17 -

percent discount adequately takes into account WSA’s

vulnerabilities.

F.   Conclusion

     The fair market value of decedent’s interest in WSA on

September 28, 1995, is $1,161,705 ($1,787,238 x .65).

     Because of concessions and the foregoing,



                                             Decision will be

                                   entered under Rule 155.
