                          T.C. Memo. 2003-251



                        UNITED STATES TAX COURT



              JOHANN T. AND JOHANNA HESS, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



        Docket No. 10468-01.             Filed August 20, 2003.


        Timothy C. Frautschi and Maureen A. McGinnity, for

petitioners.

     George W. Bezold and Mark J. Miller, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:     Respondent determined a deficiency of $261,950

in petitioner Johann Hess’s Federal gift tax for taxable year

1995.    Respondent also determined a deficiency of $261,950 in

petitioner Johanna Hess’s Federal gift tax for taxable year 1995.

The issue for decision is the fair market value under section
                                - 2 -

25011 of 10 shares of stock in a certain company, Hess

Industries, Inc., that Mr. Hess gave to an irrevocable trust for

the benefit of his daughter.

                          FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.    At the time of filing the

petition, petitioners resided in Granger, Indiana.    Petitioners

are husband and wife.

     Petitioners owned stock in Hess Industries, Inc. (HII).      HII

is a closely held C corporation, which was formed in July 1977.

HII, through its subsidiaries, primarily manufactures metal

processing machines and automation systems for the automotive

industry.   The industry in which HII and its subsidiaries

operates is cyclical.    HII’s principal customer markets

(automotive and steel processing) are also cyclical.     HII relies

heavily on long-term contracts for special machines that take

more than a year to complete.    It builds special machines, often

one-of-a-kind.    HII acquires its business on the basis of bids.

HII’s sales and earnings are erratic and not readily predictable.

     HII operates on a fiscal and taxable year ending on July 31

of each year.    Through 1995, HII accounted for its sales on a


     1
      All section references are to the Internal Revenue Code in
effect for the taxable year in issue, and all Rule references are
to the Tax Court Rules of Practice and Procedure.
                                   - 3 -

completed contract basis, meaning a sale is not booked until 95

percent of the costs of the contract are expended and the

equipment is substantially complete.

        As of November 1995, HII held stock in four subsidiaries:

Hess Engineering, Inc. (HEI), Capital Technologies, Hess MAE, and

X-Cel Steel Fabricating.       HEI is a wholly owned subsidiary of

HII.2       It is HII’s largest subsidiary, and it operates as a

consulting engineering firm, engages in the business of designing

special machines, and also manufactures equipment for the steel

wheel and metal process industries.        Capital Technologies, the

second largest subsidiary, builds tools and dies for the

automotive and appliance industries, and also builds factory

automation systems for the automotive industry.        Hess MAE builds

straightening machines and spin-forming lathes.        X-Cel Steel

Fabricating fabricates and supplies steel weldments and burnouts

for the machine building industries, including HII’s affiliates.

        In February 1977, HEI hired Fritz Kucklick as vice president

of sales and service.       Mr. Kucklick had previously worked with

Mr. Hess at Grotnes Machine Works, where Mr. Hess was the

director of engineering and Mr. Kucklick was a project engineer.

Mr. Kucklick assumed responsibility at HEI for application

engineering; preparation of quotations, cost estimates, and



        2
      Between 1977 and 1995, HII made a number of acquisitions,
and the company grew to 400 employees.
                                - 4 -

customer presentations; and service.    Mr. Hess’s responsibilities

were product design, purchasing, production, oversight, and

general management.    From the outset of Mr. Hess’s and Mr.

Kucklick’s discussions regarding HEI’s employment of Mr.

Kucklick, they agreed that Mr. Kucklick would have the

opportunity to purchase stock to become an owner in HEI.    Mr.

Kucklick entered into an employment agreement, which gave him the

option to purchase up to 25 percent of HEI stock.    In 1977, Mr.

Kucklick purchased 12 shares of HEI stock.    At that same time,

Mr. Kucklick and Mr. Hess entered into an agreement to exchange

all of their shares of HEI stock for an equal number of shares of

HII stock.    Mr. Kucklick then became an officer and director of

HII.

       From 1979 to 1989, Mr. Kucklick had primary responsibility

for both HEI’s and HII’s customer relationships.    He was the

point man for all domestic and international customers, traveled

extensively, and got to know the customers personally.    Mr.

Kucklick was also intimately involved in establishing pricing

formulas.

       Mr. Hess, Mrs. Hess, Mr. Kucklick, and HII executed a

stockholders agreement (the stockholders agreement) dated

September 1, 1989.    The stockholders agreement restricted the

transfer of HII’s stock by the shareholders.    It provided a right

of first refusal in favor of HII and the other shareholders
                               - 5 -

before a shareholder could transfer his or her stock.    The

agreement also provided, regarding the purchase price:

          d. Determination of Purchase Price. Except as
     otherwise provided in this Agreement, the Corporation
     and each Stockholder agree that the purchase price per
     share for the Shares of any Stockholder sold and
     purchased pursuant to this Agreement shall be (i) in
     the case of a bona fide offer by a third party, the
     price offered by the prospective purchaser named in the
     Offer to Sell (the “Offer Price”) or (ii) in all other
     circumstances, the Adjusted Value Per Share determined
     pursuant to Subsection 2.d.(2) hereof.

               *      *   *    *       *   *   *

               (2) Adjusted Value Per Share. The “Adjusted
          Value Per Share” is equal to X divided by Y,
          where:

               “X” is an amount equal to the greater of (i)
               eight times the average earnings of the
               Corporation before taxes for the
               Corporation’s three most recent fiscal years
               ending on the Valuation Date, as determined
               in accordance with generally accepted
               accounting principles consistently applied,
               or (ii) two times the net worth of the
               Corporation as of the Valuation Date,
               determined in accordance with Subsection
               2.d.(3) hereof; and

               “Y” equals the number of issued and
               outstanding shares of common stock of the
               Corporation as of the Valuation Date.

The agreement provided, however, that HII and its stockholders

could agree in writing among themselves to a specified value per

share to govern purchases for the time period specified in the

written agreement.3   The initial employment agreement with Mr.


     3
      The stockholders agreement was applicable only in the
                                                   (continued...)
                                - 6 -

Kucklick contained a covenant by Mr. Kucklick not to compete with

HEI during the term of his employment and for 2 years thereafter

at any location within a 300-mile radius of South Bend, Indiana.

This 2-year covenant not to compete remained in effect under the

stockholders agreement.

     In the 1990 time frame, approximately 50 percent of HII’s

overall sales and 80-90 percent of its overall earnings were

attributed to HEI.   In 1990, Mr. Kucklick became president of HEI

and was responsible for the management and operation of that

subsidiary.   At that time, Mr. Hess’s responsibilities shifted to

HII’s other subsidiaries.    Customer relationships continued to be

one of Mr. Kucklick’s major strengths, and he remained very

involved in sales for HEI.   He was recognized as one of the

foremost experts in the field of wheel-making manufacturing, and

under his leadership, HEI had received a number of prestigious

awards.

     In the second half of 1994, Mr. Kucklick told Mr. Hess that

he wanted to sell his shares of HII stock and plan for his

retirement.   In November 1994, Mr. Hess and Mr. Kucklick




     3
      (...continued)
limited circumstances identified in the agreement. One of the
principal circumstances identified in the agreement was the death
of one of the shareholders. In that circumstance, the
shareholder’s heirs or estate would receive a put to the
corporation for the formula price stated in the agreement.
                               - 7 -

personally negotiated the basic terms of a transaction4 whereby:

(a) HII would redeem Mr. Kucklick’s stock; (b) Mr. Kucklick would

enter into an employment agreement; (c) Mr. Kucklick agreed to a

covenant not to compete; and (d) Mr. Kucklick would be paid $4

million.5   The price to be paid in this transaction was not

determined by, and did not involve, an appraiser, and it was not

determined by reference to the pricing formula in the

stockholders agreement.

     On February 26, 1995,6 Mr. Hess and Mr. Kucklick

contemporaneously entered into three formal agreements to

memorialize the terms of their deal:   (1) A redemption agreement

(the redemption agreement); (2) an employment agreement (the

employment agreement); and (3) an unsecured installment note (the

installment note).

     The redemption agreement provided for the redemption of Mr.

Kucklick’s shares and included the covenant not to compete and


     4
      Mr. Hess and Mr. Kucklick were not represented by attorneys
until the basic terms of this transaction were put into writing.
     5
      In agreeing to pay this amount, Mr. Hess testified that he
took into consideration: (1) Mr. Kucklick’s longstanding (18
years) service, contributions, and self-sacrifice toward the
growth and success of the company; (2) Mr. Kucklick’s belief that
he had overpaid for shares relative to Mr. Hess’s investment; and
(3) Mr. Hess’s desire to make a payment that was fair to Mr.
Kucklick on which he could live comfortably and that the company
could afford.
     6
      On Feb. 26, 1995, Mr. Hess held 80 shares, Mrs. Hess held
20 shares, and Mr. Kucklick held 12 shares of the outstanding
stock of HII.
                                - 8 -

Mr. Kucklick’s agreement to enter into an employment agreement.

The redemption agreement required HII to pay Mr. Kucklick $1

million at closing and to deliver the installment note in the

principal amount of $2,953,642.56 for the balance, a total

payment of $3,953,642.56.7    The redemption agreement terminated

the stockholders agreement.

     The redemption agreement contained an 8-year, worldwide

covenant not to compete (the 8-year covenant) to commence after

Mr. Kucklick retired from HII and its subsidiaries.    The duration

and the scope of the 8-year covenant were very important

provisions to Mr. Hess and HII.    Mr. Hess believed that the 8-

year covenant was important to him, because Mr. Kucklick was

still relatively young,8 and with his knowledge and contacts, he

could set up a competing company, he could consult, and he could

be a partner in, or work for, another company.    Mr. Hess believed

that without the 8-year covenant, Mr. Kucklick could have done

considerable damage to HII, perhaps resulting in millions of

dollars in lost profits in a relatively short time period.

     With respect to the duration of the 8-year covenant, Mr.

Kucklick originally wanted it to cover the period of his

employment and 2 years thereafter, the same duration as the


     7
      Mr. Hess derived the total payment by reducing his $4
million offer to reflect an increase in the interest rate for the
installment note.
     8
      Mr. Kucklick was approximately 50 years old in 1994.
                                - 9 -

parties’ previous agreements.   Mr. Hess, on the other hand,

insisted that the covenant extend 8 years after the termination

of Mr. Kucklick’s employment.   With respect to the scope of the

covenant, Mr. Kucklick originally wanted to be able to sell

technical consulting services to rim, wheel, or ring

manufacturers worldwide, other than direct competitors of HII.

Mr. Kucklick also proposed that the covenant not to compete apply

only to machinery, not machine tools, and only to the extent that

HII was manufacturing such machinery as of the termination of Mr.

Kucklick’s employment.   In contrast, Mr. Hess insisted that Mr.

Kucklick disclose in advance the nature and duration of his

proposed consulting services and that HII retain the right to

veto any such agreement.   He also insisted on a much broader

worldwide covenant not to compete covering all products

manufactured or marketed by HII or any of its subsidiaries.     The

restrictions that Mr. Hess insisted upon were reflected in the

redemption agreement.

     The employment agreement provided that Mr. Kucklick would

work full time for HII for 3 years at a base salary of $135,000

per year.   Mr. Kucklick would continue as president of HEI

subject to HII’s discretion to reassign him.   Mr. Kucklick

retired from his employment with HII and its subsidiaries in

1998, after he completed the 3-year period specified in the

employment agreement.
                              - 10 -

     The installment note obligated HII to pay the principal of

$2,953,642.56 in 12 equal quarterly installments, with interest

accruing at 6.5 percent.   The 6.5-percent interest rate specified

in the installment note was below the prevailing market rate of 9

percent.   The note was for a period of 3 years.

     Mr. Hess and Mr. Kucklick treated the redemption, the

employment agreement, and the 8-year covenant as a package deal.

They did not separately negotiate the value of Mr. Kucklick’s

shares and the value of the 8-year covenant, nor did they ever

discuss making any separate payment for, or allocation of the

amount paid for, that covenant.   The redemption agreement, which

was executed on February 26, 1995, did not specifically allocate

any of the purchase price to the 8-year covenant, and it did not

provide for separate consideration.    It provides:

          THEREFORE, in consideration of the mutual
     agreements and covenants set forth herein, the
     sufficiency of which consideration is expressly
     acknowledged, the parties agree as follows:

          1. Redemption of Shares. At the closing on the
     Closing Date * * *, Kucklick will surrender to the
     Corporation certificate number 2, representing the
     Shares, and the Corporation shall repurchase and redeem
     the Shares for the consideration set forth below. Such
     repurchase is a complete redemption of all of the stock
     of the Corporation owned by Kucklick and is intended to
     qualify as a complete redemption pursuant to the
     provisions of Section 302(b)(3) of the Internal Revenue
     Code of 1986, as amended * * *

          2. Payment for Shares. In full payment for the
     Shares and in complete termination of Kucklick’s entire
     equity interest in the Corporation, at the closing on
     the Closing Date, the Corporation shall pay to Kucklick
                                - 11 -

     the aggregate sum of $3,953,642.56 (the “Redemption
     Price”), payable as follows:

                (a)   The sum of $1,000,000 by check; and

               (b)    By delivery of the Corporation’s
          unsecured   installment note (the “Note”) in the
          principal   amount of $2,953,642.56. The Note shall
          be in the   form of Exhibit A hereto.

HII and Mr. Kucklick have consistently treated the price paid

under the redemption agreement as paid exclusively for the 12

shares of stock that were redeemed.      Thus, HII has treated the

price paid as the cost of treasury stock, and Mr. Kucklick has

treated it as a capital gain.

     HII’s consolidated and consolidating financial statements

for its years ended July 31, 1994, and 1995 include projections

for the years ending July 31, 1996, through 1998.      HII prepares

financial projections as a normal practice to motivate its

employees.   HII’s philosophy in establishing projections is to

provide goals that will take a lot of effort to achieve.      The

projections typically are made on the basis of information from

the subsidiaries regarding outstanding quotations without

considering customers’ price negotiations.      The projections

typically cover a period of 12 to 18 months into the future.

However, the projections that HII prepared for the years ending

July 31, 1996, and 1998 cover a period of 3 years and are not

made on the basis of input from HII’s subsidiaries.      The purpose

of HII’s projections for 1996 to 1998 was to “pump up the
                              - 12 -

troops,” demonstrating to employees what they could earn in

bonuses, deferred income, and profit sharing under a new plan if

they worked hard, HII had a lot of luck, and everything fell into

place.

     HII’s projections historically have been unreliable,

particularly with respect to net income, because of the

difficulty in predicting the costs to complete contracts for

large custom machines.9   HII’s projections were even more

unreliable for the years 1996 through 1998.   HII did not use the

1996-98 projections for purposes of analyzing cashflow to finance

plant expansion.   Instead, it greatly reduced net income in its

cashflow analysis because it knew the goals in the projections

probably would not be reached.

     On paper, HII had an outstanding year in 1995, exceeding by

more than $2 million its budgeted sales of $62.23 million.    HII



     9
      For example, HII originally budgeted net income for the
fiscal year ending July 31, 1992, at $4,287,948. For the first 6
months of that fiscal year, its actual net income was only
$973,917. HII made a midyear adjustment of budgeted net income
to $2,809,895. Its actual net income for the fiscal year ending
July 31, 1992, was $1,851,347 (only 43 percent of the original
budgeted net income and 66 percent of the midyear adjusted net
income). For the fiscal year ending July 31, 1994, HII budgeted
first quarter net income at $597,655. It actually suffered a
loss of $282,794 for the first quarter. For the first 6 months
of fiscal year 1994, HII had a net loss of $293,890, as opposed
to budgeted net income of $1,186,800. At the end of 8 months,
HII had net income of $82,044, as compared with budgeted net
income for that period of $2,384,217. For fiscal year 1995,
HII’s budgeted net income was $5,380,000. Its actual reported
net income was $4.17 million, a shortfall of 22 percent.
                               - 13 -

realized net income of $4.17 million as compared with budgeted

net income of $5.38 million.   As of November 15, 1995, the first

quarter financial results for fiscal year 1996 were available.

HII’s business plan for fiscal year 1996 called for approximately

$77 million in revenue, building upon the record year in 1995.

HII actually realized only $3 million in revenues for the first

quarter.   Further, although HII had forecast an annual net profit

of approximately $7 million for fiscal year 1996, it actually had

a net loss of $700,000 for the first quarter.

     On November 15, 1995, Mr. Hess gave 10 shares of HII stock

to an irrevocable trust for the benefit of his daughter.     Under

section 2513, petitioners elected to treat Mrs. Hess as the donor

of one-half of the gift of stock that Mr. Hess had made.10

Petitioners filed Forms 709, U.S. Gift (and Generation-Skipping

Transfer) Tax Return, for their taxable year 1995.   The gift tax

returns that petitioners filed reported the fair market value of

the HII stock to be $120,000 per share at the time of the gift.

     Respondent issued gift tax statutory notices of deficiency

to Mr. Hess and Mrs. Hess for their taxable year 1995.

Respondent determined that the value of the HII stock on November

15, 1995, was $253,000 per share.




     10
      Immediately before the gift, 100 shares of HII stock were
outstanding of which Mr. Hess owned 80 shares and Mrs. Hess owned
20 shares.
                              - 14 -

                              OPINION

     This case involves the valuation for gift tax purposes of 10

shares of the outstanding stock of a closely held C corporation.

Under section 2501(a)(1), a tax is imposed for each calendar year

on the transfer of property by gift during such calendar year by

any individual.   If the gift is made in property, the value of

the property at the date of the gift shall be considered the

amount of the gift.   Sec. 2512(a).    The value of property for

gift tax purposes 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.11    Sec. 25.2512-1, Gift

Tax Regs.

     Generally, in valuing shares of a closely held corporation,

actual arm’s-length sales of stock in the normal course of

business within a reasonable time before or after the valuation

date are the best indicators of fair market value.     Estate of



     11
      The willing buyer and willing seller are hypothetical
persons, rather than specific individuals or entities, and their
characteristics are not necessarily the same as those of the
donor and the donee. McCord v. Commissioner, 120 T.C. 358, 373
(2003). The hypothetical willing buyer and seller are presumed
to be dedicated to achieving the maximum economic advantage.
Estate of Curry v. United States, 706 F.2d 1424, 1429 (7th Cir.
1983). This advantage must be achieved in the context of market
conditions, the constraints of the economy, and the financial and
business experience of the corporation existing at the valuation
date. Estate of Newhouse v. Commissioner, 94 T.C. 193, 218
(1990).
                                 - 15 -

Andrews v. Commissioner, 79 T.C. 938, 940 (1982).12       However,

where actual sales prices are unavailable, the value of the

shares is determined by taking into account the company’s net

worth, prospective earning power and dividend-paying capacity,

and other relevant factors.13     Sec. 25.2512-2(f), Gift Tax Regs.;

see also Rev. Rul. 59-60, 1959-1 C.B. 237.       These factors cannot

be applied with mathematical precision, and, therefore, the

weight to be given to each factor must be tailored to account for

the particular facts of each case.        Estate of Andrews v.

Commissioner, supra at 940-941.

     As is often the case where the value of stock in a closely

held corporation is at issue, the separation in the values that

the parties and their experts argue is substantial.       The gift tax

returns that petitioners filed reported the fair market value of

a minority interest in HII stock as $120,000 per share.14        In the


     12
      Since the same factors are used for gift and estate tax
purposes in determining the fair market value of property, we
cite both gift and estate tax cases. See Ward v. Commissioner,
87 T.C. 78, 101 (1986); Estate of True v. Commissioner, T.C.
Memo. 2001-167.
     13
      The regulations provide that some of the “other relevant
factors” to consider are: The goodwill of the business; the
economic outlook in the particular industry; the company’s
position in the industry and its management; the degree of
control of the business represented by the block of stock to be
valued; and the values of securities of corporations engaged in
the same or similar lines of business which are listed on a stock
exchange. Sec. 25.2512-2(f), Gift Tax Regs.
     14
          The gift tax values which petitioners reported on their
                                                       (continued...)
                                - 16 -

statutory notices of deficiency issued to Mr. Hess and Mrs. Hess,

respondent determined that the fair market value of HII stock was

$253,000 per share on the date of the gift.    Petitioners’ expert,

Gregory S. Heebink, concluded that the fair market value of HII

stock was $128,000 per share.    Respondent’s expert, Eric

Engstrom, concluded that the fair market value of HII stock was

$269,000 per share.15

     We are not bound by the opinion of any expert witness, and

we may accept or reject expert testimony in the exercise of sound

judgment.   Estate of Newhouse v. Commissioner, 94 T.C. 193, 217

(1990).   Further, we are entitled to accept the opinion of one

party’s expert over the opinion of the other party’s expert, and

we are also entitled to accept certain portions of the opinion of

an expert while rejecting the remaining portions.    McCord v.

Commissioner, 120 T.C. 358, 374 (2003).    Moreover, the figure at

which we arrive need not be directly traceable to specific



     14
      (...continued)
gift tax returns were made on the basis of an appraisal by Gary
G. Gaynor, petitioners’ and HII’s accountant and tax adviser.
Mr. Gaynor concluded that the fair market value of a minority
interest in HII’s stock as of July 31, 1995, was $120,000 per
share. Petitioners request that we consider Mr. Gaynor’s
conclusion because he was very familiar with HII’s business. We
do not consider Mr. Gaynor’s conclusion in our determination of
the value of the HII shares. Mr. Gaynor was not offered as an
expert, his report was not accepted as the report of an expert
witness, and he did not testify at trial.
     15
      Respondent does not request that we find an additional
deficiency on the basis of his expert’s conclusion.
                               - 17 -

testimony if it is within the range of values that may be

properly derived from consideration of all the evidence.      Id.

After considering the parties arguments, all the facts and

circumstances relevant to this case, and the opinions of

petitioners’ and respondent’s experts, we conclude that the fair

market value of the shares of HII stock that Mr. Hess gave to the

trust falls somewhere in the middle of the range of values

suggested by the parties and their experts.16

Mr. Heebink’s Expert Opinion

     Mr. Heebink arrived at a value of $128,000 per share for the

HII stock.17   His valuation relied upon a discounted cashflow

analysis and a market comparable analysis.   However, as we

explain in more detail below, Mr. Heebink’s valuation analysis

relies upon an adjustment to HII’s financial information, which

resulted in a significant decrease in HII’s earnings figures for



     16
      Generally, the Commissioner’s determination of fair market
value bears a presumption of correctness, and the burden of
proving that determination is incorrect rests with the taxpayer.
See Rule 142(a). However, in certain circumstances, the burden
of proof as to that determination shifts to the Commissioner
under sec. 7491(a). Petitioners do not argue that sec. 7491(a)
applies, and the record does not disclose the date the
examination commenced.
     17
      Mr. Heebink prepared four reports for this case. He
determined the fair market value of HII shares as of Nov. 11,
1995; he prepared a supplemental report in which he addressed
items that respondent’s expert relied upon in his report; he
valued HII shares as of Feb. 26, 1995, the date the redemption
agreement was executed; and he valued the 8-year covenant as of
that date.
                               - 18 -

its 1995 fiscal year.    Since we conclude that this adjustment

should not have been made, Mr. Heebink’s valuation analysis

significantly understates the value of HII stock.

     For HII’s 1995 fiscal year, Mr. Heebink adjusted HII’s cost

of sales upward and thus its earnings figures downward by

approximately $2.5 million.    He used this adjusted cost of sales

in developing his cost of sales assumption for his discounted

cashflow analysis and the adjusted earnings amount in his market

comparable analysis.    This adjustment was made on the basis of

information contained in a 1997 memorandum from personnel at HII

to Mr. Heebink regarding a purported overstatement of 1995 income

attributable to an alleged understatement of reserves for

expenses associated with machine construction projects for 1995.

We cannot agree that Mr. Heebink properly adjusted earnings to

account for the alleged understatement.

     Petitioners have not established the existence of an

understatement of reserves for 1995, the nature of the

understatement, or its amount.    We cannot conclude from the

evidence presented that a hypothetical buyer or seller would have

discovered, or even considered, the understatement of reserves in

1995, at the time of the gift.    Indeed, the 1997 memorandum from

HII personnel that Mr. Heebink relied upon in making the

adjustment states rather equivocally:
                              - 19 -

     Dear Mr. Heebink:

     The Actual Income reported for 1995 was probably
     overstated, based on additional costs incurred over
     amounts reserved on jobs reported as Sold/Shipped at
     the end of the year. We have attempted to quantify
     what those impacts might have been based on an outlook
     as of November 11, 1995. In addition, since the 1996
     forecast was based on 1995 results, that forecast was
     overly optimistic.

HII’s financial statement for 1995 was not restated to reflect

the alleged understatement of reserves.18   HII’s income tax

return for 1995 was not amended to reflect the alleged

understatement.   HII had a substantial tax liability for its 1995

fiscal year.   HII reported taxable income of $5,990,541 and a

total tax of $2,042,501.   HII’s 1995 return was prepared by Mr.

Gaynor in or about November 13, 1995.   Any additional expenses

represented by the alleged reserves were deducted in later years.

     The alleged understatement was not discovered by HII’s

accountant, Gary Gaynor, in his appraisal of HII as of July 31,

1995, and even petitioners admit that the alleged understatement



     18
      Petitioners allege that HII did not restate its financial
statement for 1995 because bonuses and profit sharing had been
paid to employees on the basis of the originally reported
results, and management did not want to penalize employees and
destroy morale based on errors and misstatements by a few people.
Petitioners also allege that HII did not want to incur the
expense of redoing its financial statements and audits. However,
petitioners do not explain how HII’s employees would have been
affected by a restatement. We are not satisfied that this factor
and the expense of redoing the financial statements and audits
fully explain HII’s failure to restate its financial statement
considering the extent of the alleged understatement of reserves
and the resulting overstatement of earnings.
                              - 20 -

was not quantified by HII management at the time of the gift.19

Petitioners fail to convince us that the alleged understatement

was known or knowable as of the gift date.   Further, as a general

rule, subsequent events are not considered in fixing fair market

value, except to the extent that they were reasonably foreseeable

at the date of valuation.   First Natl. Bank of Kenosha v. United

States, 763 F.2d 891, 894 (7th Cir. 1985); Estate of Gilford v.

Commissioner, 88 T.C. 38, 52 (1987).   The record reflects that

the alleged understatement was not discovered or quantified until

1997, almost 2 years after the gift of HII stock and after the

audit of petitioners’ gift tax returns.   On the basis of the

evidence in the record, we are not convinced that the discovery

of the alleged understatement was reasonably foreseeable on the

gift date.20

     The adjustment proposed in the 1997 memorandum should not

have been considered in valuing the HII stock.21   Making this


     19
      Petitioners allege that HII management informally
recognized the understatement of reserves as of Nov. 15, 1995,
but they had not quantified the amounts. They allege that the
understatement would have been discovered and quantified by an
investor conducting due diligence as of the date of the gift. We
are not convinced that due diligence or any other investigation
would have sufficiently disclosed the alleged understatement.
     20
      Mr. Engstrom testified that, in his opinion, the
adjustment was not foreseeable as of the valuation date.
     21
      Petitioners also allege that HII failed to follow the
substantial completion accounting rules in booking its sales for
1995; i.e., it booked sales prematurely. They claim that if
                                                   (continued...)
                             - 21 -

adjustment resulted in a significant understatement of the value

that Mr. Heebink derived in his valuation analysis.

Nevertheless, we believe Mr. Heebink’s valuation analysis is

entitled to some consideration.   Although his valuation analysis

should not have included the adjustment for the alleged

understatement of reserves, that analysis provides some

indication of the fair market value of HII stock.   Mr. Heebink’s

analysis was thorough, and his investigation leading up to that

analysis included a site visit and interviews with HII personnel.

Mr. Heebink prepared additional reports to supplement his

principal report.

     Further, Mr. Heebink’s valuation analysis, unlike Mr.

Engstrom’s analysis, gave consideration to an income-based

method, the discounted cashflow method.   Generally, in valuing

the shares of an operating company such as HII, primary

consideration should be given to earnings.   See Rev. Rul. 59-60,



     21
      (...continued)
HII’s 1995 financial statement had been restated to correct these
errors and to account for the understatement of reserves, HII’s
pretax income would have been reduced by approximately $3.5
million. Petitioners fail to convince us that there was a
premature booking of income or that the premature booking of
income was known or reasonably foreseeable on the valuation date.
Further, it does not appear that these alleged errors were
identified until trial, and Mr. Heebink did not make any
adjustments with respect to any premature booking of income in
his reports. These alleged errors were not discovered by Mr.
Gaynor. HII’s financial statement for 1995 was not restated, and
its income tax return for 1995 was not amended to reflect these
errors.
                               - 22 -

sec. 5(a), 1959-1 C.B. at 242.   However, respondent argues that

the discounted cashflow method should not be used where future

income is unpredictable, as with HII, and “the results of such an

analysis provide little, perhaps no, indication of value and

should be accorded like weight.”   We agree that an income-based

method, such as the discounted cashflow method, is not

particularly reliable where the subject company’s future income

is relatively unpredictable.   See Wall v. Commissioner, T.C.

Memo. 2001-75; Pratt et al., Valuing Small Businesses and

Professional Practices 257 (3d ed. 1998).    Petitioners agree that

HII’s sales and earnings are erratic and not readily predictable.

Given these circumstances, we are not convinced that the value

Mr. Heebink derived under the discounted cashflow method is

entitled to the weight that he gave to it.   However, we believe

Mr. Heebink’s conclusions with respect to the discounted cashflow

analysis are entitled to some consideration.22


     22
      Mr. Engstrom gave no weight to the discounted cashflow
method because small changes in certain assumptions resulted in
large changes in the value of HII shares. Indeed, Mr. Engstrom
opined that if HII’s expenses were increased or decreased by 1
percent of sales, it would result in a $67,000 per share increase
or decrease in the value of HII shares. He also opined that a 1-
percent increase in the discount rate would cause the implied
value to go down by $21,000 per share; a 1-percent decrease in
the discount rate would cause the implied value to go up by
$26,000 per share; and a combination of a decrease in expenses by
1 percent of sales and a 1-percent decrease in the discount rate
would result in the implied value to go up by about $100,000 per
share. As we explain later on, we do not agree that this
requires us to completely reject the discounted cashflow method
                                                   (continued...)
                                - 23 -

     Another factor which makes Mr. Heebink’s analysis less

persuasive is his application of a minority interest discount to

the total business enterprise value he determined in his

analysis.     A significant component of this total business

enterprise value is attributable to his market comparable

analysis.     Applying a minority interest discount to the market

comparable analysis, which already reflects transactions

involving minority interests, is inappropriate.     See Estate of

Mitchell v. Commissioner, T.C. Memo. 2002-98 (if the stock to be

valued by the market approach represents a minority interest, no

discount for the lack of control is applied because the method

reflects a minority interest).

     We do not agree with respondent that Mr. Heebink’s

discounted cashflow analysis is entitled to no consideration.       We

will consider Mr. Heebink’s valuation analysis, bearing in mind

the circumstances identified above, especially the fact that his

analysis significantly understated the value of HII stock in

making the erroneous adjustment for the alleged understatement of

reserves.23


     22
      (...continued)
in valuing HII stock. However, we agree that it detracts from
the persuasiveness of Mr. Heebink’s conclusions.
     23
      Mr. Heebink does not present an alternative valuation
which does not contain this adjustment; however, it is clear that
this adjustment, if corrected, would bring Mr. Heebink’s
conclusions considerably closer to those of Mr. Engstrom’s.
                                                   (continued...)
                                    - 24 -

Mr. Engstrom’s Expert Opinion

     Mr. Engstrom concluded that the fair market value of a

minority interest in the common stock of HII, as of November 15,

1995, was $269,000 per share.24       He relied upon four valuation

methods, and he applied varying weights to the per share values

computed under those methods, to arrive at the fair market value

of $269,000 per share:

    Valuation Method                Per Share Value   Weight Applied

  Net asset value method               $119,000           10%
  Prior stock transaction method        329,500           40
  Stockholder agreement method          380,000           10
  Guideline public company method       219,000           40




     23
      (...continued)
Indeed, respondent points out that the adjustment for the alleged
understatement accounts for the biggest difference between the
values derived by Mr. Heebink in his market comparable analysis
and by Mr. Engstrom in his guideline companies analysis.
Respondent submits that without this adjustment, HII’s debt-free
earnings would have increased by approximately $1.5 million
($2.46 million x 39-percent income tax rate) to a total of $3.9
million ($2,434,000 + $1.5 million); after applying his current
earnings multiplier of 10.7 to the $1.5 million increase, total
enterprise value would have increased approximately $16 million
or $160,000 per share before discounts; and its per share value
would have increased to $223,000 after applying a 15-percent
minority discount and a 30-percent marketability discount.
     24
      The report that Mr. Engstrom prepared was the second
report that Philip Schneider & Associates, Inc., prepared for
respondent. The first report arrived at a value of $253,000 per
share, the amount that respondent determined in the statutory
notices of deficiency issued to petitioners.
                              - 25 -

We discuss these valuation methods in turn.

     Net Asset Value Method

     Mr. Engstrom used the net asset value method25 as an asset-

based approach to his valuation of HII stock.   Mr. Engstrom

assumed that the book value of HII’s assets and liabilities

provided a reasonable approximation of fair market value.     He

determined that the fair market value of the stockholders’ equity

in HII was $18,640,000 (book value) on a controlling, marketable

basis as of November 15, 1995.

     Both parties agree that the value Mr. Engstrom derived under

the net asset value method provides some indication of the fair

market value of HII stock on the gift date.   However, they

disagree regarding the weight to be given that value.   Mr.

Engstrom applied only 10-percent weight to his net asset value

analysis because he concluded that HII “is a very profitable

company, and it appears that the company had a significant amount

of goodwill as of November 15, 1995.”   Petitioners argue that Mr.

Engstrom’s net asset value analysis supports the value they

reported on their gift tax returns, and they suggest that the

value derived under that analysis is entitled to more weight than

was given in Mr. Engstrom’s report.




     25
      The net asset value method is based upon the net value of
a company’s assets less liabilities, after adjusting both to fair
market value using a going-concern assumption.
                                - 26 -

     In valuing stock of a closely held corporation, one of the

factors to be considered is the book value of the stock.       See

Rev. Rul. 59-60, sec. 4.01(c), 1959-1 C.B. at 238.     Thus, the

value derived under the net asset value method is entitled to

some weight in valuing HII stock.     However, in deciding the

relative weight to give to the net asset value in valuing a

corporation, we must consider the extent to which the company is

actively engaged in producing income as opposed to simply holding

property for investment.     See Estate of Andrews v. Commissioner,

79 T.C. at 945; Estate of Ford v. Commissioner, T.C. Memo. 1993-

580, affd. 53 F.3d 924 (8th Cir. 1995).     If the company is an

operating company as opposed to a holding company, the net asset

value method should be accorded less weight.     See Ward v.

Commissioner, 87 T.C. 78, 102 (1986).

     HII and its subsidiaries represent an ongoing business

actively engaged in producing income as opposed to simply holding

assets for investment.     HII was relatively profitable in the

years leading up to the valuation date.     Indeed, HII experienced

a “banner year” in fiscal year 1995 with $64.25 million in sales

and $4.17 million in net income.     The financial information for

the prior fiscal years indicated that HII was a growing company,

and HII’s financial projections reflected that HII expected to

expand upon its growth and profitability in the years that

followed the gift.   Under these circumstances, the net asset
                              - 27 -

value is not particularly reflective of the fair market value of

HII stock.   Although we agree with petitioners that the net asset

value is entitled to some weight in valuing HII, the net asset

value method in this case fails to identify other elements of

value in HII which we believe a hypothetical buyer and seller

would have considered as of the gift date.   For example, we are

convinced that HII had a significant element of intangible value

in its goodwill.26




     26
      “The essence of goodwill is a preexisting business
relationship founded upon a continuous course of dealing that can
be expected to continue indefinitely.” Canterbury v.
Commissioner, 99 T.C. 223, 247 (1992) (citing Computing &
Software, Inc. v. Commissioner, 64 T.C. 223, 233 (1975)). It is
the value of a trade or business that is attributable to the
expectancy of continued customer patronage. Boe v. Commissioner,
307 F.2d 339, 343 (9th Cir. 1962), affg. 35 T.C. 720 (1961); sec.
1.197-2(b)(1), Income Tax Regs. Respondent requests that we find
as fact, and petitioner agrees, that HII acquires its business on
the basis of bids without much continuing or recurring customer
relationships. Petitioners point to this requested finding and
suggest that HII did not have a significant amount of goodwill.
However, petitioners also argue in the context of the redemption
transaction, and Mr. Hess’s testimony makes clear, that HII had
established customer relationships through Mr. Kucklick, and Mr.
Kucklick could have exploited those relationships if he had left
HII. We find HII had a considerable element of goodwill or other
intangible value. See Rev. Rul. 59-60, sec. 4.02(f), 1959-1 C.B.
at 241:

     While the element of goodwill may be based primarily on
     earnings, such factors as the prestige and renown of
     the business, the ownership of a trade or brand name,
     and a record of successful operation over a prolonged
     period in a particular locality, also may furnish
     support for the inclusion of intangible value. * * *
                             - 28 -

     Stockholders Agreement Method

     Mr. Engstrom relies upon the valuation formula contained in

the September 1, 1989, stockholders agreement as an indication of

the fair market value of HII stock.   Applying the valuation

formula, he determined that the value of the company was equal to

$38 million, or $380,000 per share,27 as of November 15, 1995.

This amount represents the value he derived under the net worth

(book value) formula; i.e., the higher value derived under the

formula in the stockholders agreement.

     Respondent argues that although the redemption agreement

terminated the stockholders agreement, the values derived under

it reflect an agreed methodology for establishing fair market

value between knowledgeable parties and as such are part of the

facts and circumstances that may be taken into consideration in




     27
      Mr. Engstrom determined that the valuation formula would
most likely be applied to transactions involving minority
interests, because the owner of a controlling interest would most
likely liquidate his ownership interest through a sale of the
entire company. Mr. Engstrom opined that the formula price, 2
times book value, contained built-in marketability and minority
interest discounts. We are not persuaded that this is the case.
The formula provision by its terms applies to both the majority
shareholder, Mr. Hess, and the minority shareholder, Mr.
Kucklick, in the circumstances specified in the agreement. We
also point out that Mr. Engstrom applied discounts in his net
asset value analysis. Respondent submits that the indicated
value under the stockholders agreement would be $242,250
($380,000 x .85 x .75), if the discounts determined by Mr.
Engstrom were applied.
                               - 29 -

establishing value.28   Mr. Heebink did not consider the formula

in the stockholders agreement in his valuation analysis.

Moreover, petitioners contend that formula does not provide a

reliable indicator of the fair market value of HII stock as of

November 15, 1995.

     A stockholders agreement which restricts the sale or

transfer of stock is not determinative for gift tax purposes;

however, it is a factor to be considered, with other relevant

factors, in determining fair market value.   Rev. Rul. 59-60, sec.

8, 1959-1 C.B. at 243; see also Ward v. Commissioner, supra at

105; Estate of Lauder v. Commissioner, T.C. Memo. 1994-527.     We

agree that the stockholders agreement provides some indication of

value; however, we are convinced the value derived under the

formula provision is much greater than the fair market value of

HII stock.

     First, the buy-sell agreement upon which respondent’s expert

relies was not in effect at the time of the gift.   That agreement

was terminated as of the date of the redemption of Mr. Kucklick’s

shares on February 26, 1995.   No transactions ever occurred under

the stockholders agreement.




     28
      Mr. Engstrom testified that the valuation formula in the
stockholders agreement, just like a prior stock transaction,
would influence “people’s opinion as to what the value of the
stock is.”
                              - 30 -

     Also, the agreement was among Mr. Hess, Mrs. Hess, Mr.

Kucklick, and HII.   It provided specific rights and obligations

with respect to those shareholders.    It defined their

relationship as shareholders and accounted for factors peculiar

to that relationship.   Although we disagree with petitioners’

contention that the agreement was not entered into at arm’s

length, we do agree that factors, other than those factors that a

hypothetical buyer might consider, went into the agreement.

Indeed, Mr. Hess testified on this point:

          There were a couple of important points that took
     place at that time. First of all, my wife became--my
     wife, Johanna Hess, became a shareholder; therefore,
     she had to be included in a stockholder’s agreement.
     Secondly, at that point, the company had grown in size
     very substantially and in net assets; we were able to
     afford to buy substantial life insurance on Mr.
     Kucklick’s and my lives--the company was able to.

          And we wanted to make sure at that point in time
     that, first of all, both families would be taken care
     of in case of death of one of the partners and,
     secondly, also, that any stock repurchase by the
     company under the agreement would be done in a very
     orderly fashion--

Mr. Hess testified that the pricing formula allowed for a higher

price in the case of death of one of the shareholders which could

be funded in part with the life insurance proceeds.

     It is also clear that the shareholders were not bound to the

value per share derived under the formula provision, since they

could agree in writing among themselves to a specified value per

share.   Further, the stockholders agreement was applicable only
                                - 31 -

in the limited circumstances identified in that agreement.

Principally, if any of the three shareholders had died, that

shareholder’s heirs or that shareholder’s estate would have had a

put to the corporation for the formula price under the

agreement.29    It is not at all clear whether the formula in the

agreement applies to voluntary sales among shareholders.

Respondent relies upon the phrase “in all other circumstances”

which appears in the formula, and he contends that the formula

clause applies to voluntary sales among shareholders as well as

other sales and purchases.    The formula covers only shares that

are “sold and purchased pursuant to this Agreement”.    The

agreement by its terms applies only to offers to sell arising

from a shareholder’s intent to transfer or encumber shares,

deemed offers to sell in the case of bankruptcy or insolvency of

a shareholder, and mandatory offers to sell coincident to the

termination of a shareholder’s employment by HII.30

     In these circumstances, we cannot agree that the

stockholders agreement is determinative of the fair market value

of HII stock.    We consider the value that Mr. Engstrom determined




     29
      Respondent agrees the formula provision was binding only
in certain circumstances not involved in this case.
     30
      Mr. Kucklick referred to pricing formulas in negotiating
for a higher price as part of the redemption transaction;
however, the final purchase price was not determined on the basis
of the pricing formula in the stockholders agreement.
                               - 32 -

under that agreement; however, we give it relatively little

weight.

     Prior Stock Transaction Method

     Mr. Engstrom relied upon the February 26, 1995, redemption

of Mr. Kucklick’s 12 shares of common stock.    He concluded that

since the redemption occurred in close proximity to the gift date

for the HII shares, the purchase price of Mr. Kucklick’s shares

provided a reliable indication of the fair market value of HII

stock.    Mr. Engstrom concluded that the values of the 8-year

covenant and the 3-year employment agreement were not material,

and his valuation assumes that the entire purchase price in the

redemption transaction was a payment for the 12 shares of common

stock.    Mr. Engstrom determined that the price that Mr. Kucklick

received in the redemption transaction indicates that the fair

market value of HII stock was approximately $329,500 per share as

of November 15, 1995.    Mr. Engstrom gave a significant amount of

weight, 40 percent, to the value resulting from his prior stock

transaction method.    We agree with Mr. Engstrom that the

proximity of the redemption transaction in relation to the gift

of shares makes that transaction relevant to the question of fair

market value of HII stock.    See Rabenhorst v. Commissioner, T.C.

Memo. 1996-92.    However, we are not convinced that the value Mr.

Engstrom derived from that transaction accurately reflects the

value of HII stock.
                               - 33 -

     First, it appears that at least some portion of the purchase

price was attributable to the 8-year covenant.   Mr. Kucklick

posed a significant competitive threat to HII and its future

profitability given his age, his experience in the metal forming

and cutting industry, his knowledge, and his customer contacts.

For these reasons, and to protect his investment in HII, Mr. Hess

insisted upon a broad and relatively lengthy covenant not to

compete.   Although the parties did not specifically allocate any

amount of the purchase price to the 8-year covenant, it is clear

that this covenant was a key component of the agreement and

represented valuable consideration coming from Mr. Kucklick.    Mr.

Hess testified with respect to the $3.95 million purchase price:

“I considered the price basically a package deal for all the

services past, for the stock, for the noncompete, for the

employment, continuing employment and his willingness to train

people at Hess Engineering during that time.”    He testified that

the entire purchase price of $3.95 million was allocated to the

redemption of Mr. Kucklick’s shares to provide favorable tax

treatment to Mr. Kucklick.31


     31
      Respondent suggests that petitioners must present strong
proof that the redemption agreement does not accurately reflect
the agreement of the parties that nothing should be allocated to
the 8-year covenant. Generally, taxpayers cannot ignore the
unambiguous terms of a binding agreement, and they must present
“strong proof” that an allocation of consideration in an
agreement is other than that specified. Meredith Corp. & Subs.
v. Commissioner, 102 T.C. 406, 438 (1994); Steel v. Commissioner,
                                                   (continued...)
                              - 34 -

     Petitioners also argue that the redemption agreement was not

entered into at arm’s length, and, therefore, is not reflective

of fair market value.   We cannot agree with this contention.   We

do agree, however, that there were present considerations that

would not be present if the seller in that transaction were not

Mr. Kucklick and if the buyer were not HII.   There were certain

elements of consideration exchanged which cannot be quantified.

We agree that the redemption transaction provides some indication

of the value of HII stock; however, we are convinced that the

particular circumstances of that transaction indicate that the

value of HII stock was less than the value that Mr. Engstrom

derived from that transaction.32




     31
      (...continued)
T.C. Memo. 2002-113; see also Kreider v. Commissioner, 762 F.2d
580 (7th Cir. 1985), affg. T.C. Memo. 1984-68. However, in the
instant case, the agreement and the allocation therein represent
a transaction which is entirely collateral to Mr. Hess’s gift of
HII shares and the valuation of those shares. We are not
persuaded that the strong proof rule applies in these
circumstances.
     32
      Mr. Engstrom did not apply a minority interest discount to
the value he derived from the redemption transaction, because he
concluded that Mr. Kucklick’s shares represented a minority
interest in HII stock. Petitioners argue that the redemption of
Mr. Kucklick’s stock did not involve a minority interest, because
Mr. Hess and Mr. Kucklick treated each other as equals in all
aspects of their relationship at HII. However, the redemption
was clearly of a minority interest in HII stock, regardless of
whether Mr. Hess and Mr. Kucklick treated each other as equals.
Further, there is evidence that they were not in fact equals in
all such aspects. Indeed, the negotiations leading up to the
redemption transaction suggest this much.
                              - 35 -

     In Mr. Heebink’s valuation analysis, he did not rely upon

the transaction involving the redemption of Mr. Kucklick’s

shares.   However, Mr. Heebink prepared two additional reports and

a supplemental report, in which he concluded separate values for

Mr. Kucklick’s redeemed shares and the 8-year covenant.    Mr.

Heebink determined the value of the 8-year covenant using an

income analysis estimating the opportunity losses (focusing on

HEI) that would occur if Mr. Kucklick were allowed to compete.

The opportunity losses were projected over an 8-year period

beginning after the completion of the 3-year period of the

employment agreement.   Mr. Heebink applied a discount rate to

discount the future cashflows he determined to present value.    He

concluded that the value of the 8-year covenant was $2 million.

He allocated $2 million of the purchase price stated in the

redemption agreement to the 8-year covenant, and he also

allocated $100,000 to the favorable financing contained in the

installment note.   He determined that the redemption transaction

reflected a value of $104,000 per share for HII stock after

applying a 15-percent minority interest discount and a 30-percent

marketability discount.

     We find Mr. Heebink’s attempts to quantify the value of the

8-year covenant flawed.   His analysis fails to consider the

intentions of the parties to that agreement, and, instead, he

seeks to calculate the value of the covenant on the basis of
                                - 36 -

potential opportunity losses.    We are not persuaded that the

parties considered the potential opportunity losses, that

potential opportunity losses in this instance provide an

acceptable measure of value for a covenant not to compete, and

that Mr. Heebink’s determinations and calculations of those

opportunity losses are correct.33   We are not convinced that HII

or a hypothetical “buyer” would pay the present value of

potential opportunity losses for a covenant not to compete.      As

Mr. Engstrom testified in rebuttal:      “if the projected losses

were $2 million, then there’d be no reason why Hess would be

willing to pay $2 million, because then they’d be in the same

position they would have been in if the covenant had never been

entered into in the first place.”    Further, we are not convinced

that HII would pay Mr. Kucklick a salary of only $135,000 per

year during the 3-year term of the employment agreement, yet pay

Mr. Kucklick $2 million for the 8-year covenant not to compete.

Again, as Mr. Engstrom testified:    “if he was willing to work

full time for the company and not work for anyone else for

$135,000 per year, there’s no reason to believe you’d have to pay

him substantially more than that to not work.”

     We are not persuaded by Mr. Heebink’s attempts to quantify

the value of the 8-year covenant.    We cannot agree that the 8-


     33
      For example, Mr. Heebink’s analysis assumes that HII would
realize losses immediately upon Mr. Kucklick’s leaving and
competing against HII.
                                - 37 -

year covenant had a value of $2 million.    Instead, we believe

that the value of the 8-year covenant was less, and the value of

the redeemed stock was much greater than the amounts determined

by Mr. Heebink.

     Guideline Companies Analysis

     Mr. Engstrom also relied upon a guideline companies analysis

based on comparisons with publicly traded stocks.    He determined

that the fair market value of HII stock was $29,197,000 on a

minority, marketable basis.    After applying a marketability

discount of 25 percent, Mr. Engstrom determined the fair market

value of HII stock to be $21.9 million, or $219,000 per share.

He gave a significant amount of weight, 40 percent, to the value

resulting from the guideline companies analysis.

     In his guideline companies analysis, Mr. Engstrom relied

solely on price/earnings ratios (P/E ratio(s)) to compare HII to

the guideline companies.34    Petitioners argue that Mr. Engstrom’s

use of P/E ratios to compare HII to the guideline companies was

erroneous.   They claim that P/E ratios are a “crude measure” for

calculating value and do not consider important differences in

interest levels, tax levels, and depreciation levels between the

subject company (HII) and the guideline companies.    Petitioners


     34
      Mr. Engstrom determined the P/E ratios from Value Line
Investment Survey, a publication that does not provide
information for other measures of performance such as EBIT
(earnings before interest and taxes) and EBITDA (earnings before
interest, taxes, depreciation, and amortization).
                               - 38 -

contend that Mr. Engstrom should have used other measures of

comparison besides P/E ratios.

     We agree with petitioners that Mr. Engstrom’s guideline

companies method would have been more complete and more

persuasive if it had employed additional measures of comparison.

See Wall v. Commissioner, T.C. Memo. 2001-75.   However, it is

clear that P/E ratios bear a well-recognized relationship in the

valuation of companies, Learner v. Commissioner, T.C. Memo. 1983-

122, and Mr. Engstrom’s reliance on P/E ratios was not inherently

flawed.35   Petitioners base their objections to Mr. Engstrom’s

analysis on his failure to consider certain pretax methods of

comparison such as EBIT (earnings before interest and taxes) or



     35
      The P/E ratios of publicly held companies do not compare
to the P/E ratios of a closely held company if the companies
themselves are not comparable. Learner v. Commissioner, T.C.
Memo. 1983-122. Whether the stock price of one company with a
given earnings stream will be similar to that of another company
with the same earnings depends upon a wide variety of factors,
including management policy, management ability, past
performance, and dividend policy. Id. Although petitioners
suggest that the guideline companies do not compare to HII, we
point out that two of the four guideline companies used by Mr.
Engstrom in his analysis, Giddings & Lewis, Inc., and Monarch
Machine Tool Co., were companies used by HII to “benchmark” its
performance; three of the four guideline companies used by Mr.
Engstrom, Cincinnati Milacron, Inc., Giddings & Lewis, Inc., and
Monarch Machine Tool Co., were also used by Mr. Heebink in his
market comparable analysis; and the remaining company, Gleason
Corp., builds machines for the manufacture of gears, and its
major customers are in the automotive and truck industries. Mr.
Engstrom made appropriate adjustments to the P/E ratios from the
guideline companies to account for differences in size and net
profit margins. With these adjustments, we find the companies
selected by Mr. Engstrom comparable to HII.
                               - 39 -

EBITDA (earnings before interest, taxes, depreciation and

amortization).   However, they fail to explain how consideration

of those measures would have influenced or changed Mr. Engstrom’s

conclusions.36   Mr. Engstrom’s explanations were thorough and

complete, and it was his opinion that those measures would not

have affected his analysis.   He agreed that significant

differences in interest, taxes, level of debt, etc., might

necessitate adjustments to make the companies more comparable.

However, imposing those adjustments where the differences are not

significant runs the risk of imposing “your judgment over the

actual data that’s in there” and the risk “that your subjective

determination is wrong.”

     The P/E ratios for the guideline companies that Mr. Engstrom

selected were based on those companies’ earnings for the two most

recent quarterly filings and the forecasts of the earnings for

the next two cycles.37   The P/E ratio for HII, however, was based

on that company’s financial information for the fiscal year



     36
      Mr. Heebink’s testimony in rebuttal regarding the use of
P/E ratios was somewhat confusing. He could not explain why
these other items are necessarily important or how they might
have influenced or changed Mr. Engstrom’s conclusions. Mr.
Heebink testified in the context of what an “acquirer” would
consider in a “typical mergers-and-acquisitions situation”,
wherein he claims P/E ratios would seldom be used.
     37
      This information was derived from Value Line Investment
Survey, which uses the most recent 6-month period reported to the
Securities & Exchange Commission and an estimate of the next 6-
month period.
                              - 40 -

ending July 31, 1995.   Petitioners claim that good appraisal

practice requires use of the same period of time for the

guideline companies and the subject company.    We agree with

petitioners that the preferable comparison of historical and/or

projected earnings should be made using consistent time periods.

However, petitioners do not explain how the use of consistent

time periods in the instant case would change Mr. Engstrom’s

conclusions.   Although this flaw in Mr. Engstrom’s analysis leads

us to question its persuasiveness, we are not convinced that it

renders his analysis wholly erroneous.

     Mr. Engstrom relied solely on HII’s fiscal year 1995

financial information in making his conclusions.    Fiscal year

1995 was a “banner year” for HII.    It realized sales and net

income exceeding the sales and net income that it realized in

prior years.   Petitioners contend that it was in error to rely

solely on the fiscal year 1995 information.    Respondent argues

that use of the fiscal year 1995 information alone was justified

because HII was experiencing strong growth, which HII’s

projections indicated would continue, and “it comports with

common sense that more current information and expectations are

more indicative of the value that an investor would place on

stock than are historic earnings.”

     We might agree with respondent that the hypothetical buyer

would give primary consideration to the most recent year’s
                               - 41 -

financial information in purchasing stock of a company.   However,

we also believe that a hypothetical buyer would consider a

company’s historical earnings placing greater emphasis on

relevant information from the more recent years.   This is

especially true of companies, such as HII, which are in cyclical

industries and use the completed contract method of accounting.

In these circumstances, the use of longer periods of time or

averages over “a peak to trough sort of cycle” would seem

preferable.   Thus, we agree with petitioners that reliance solely

on financial information for one particular year might overstate

the fair market value of stock in a company.   At the same time,

reliance on more recent financial information might be justified

in certain circumstances.38   For example, Mr. Engstrom testified:


     38
       We also point out that Rev. Rul. 59-60, sec. 4.02(d),
1959-1 C.B. at 241, states on the subject of future earning
power:

     Potential future income is a major factor in many
     valuations of closely-held stocks, and all information
     concerning past income which will be helpful in
     predicting the future should be secured. Prior
     earnings records usually are the most reliable guide as
     to the future expectancy, but resort to arbitrary five-
     or-ten-year averages without regard to current trends
     or future prospects will not produce a realistic
     valuation. If, for instance, a record of progressively
     increasing or decreasing net income is found, then
     greater weight may be accorded the most recent years’
     profits in estimating earning power. * * *

Rev. Rul. 59-60, supra, “has been widely accepted as setting
forth the appropriate criteria to consider in determining fair
market value”. Estate of Newhouse v. Commissioner, 94 T.C. at
                                                   (continued...)
                                   - 42 -

            Well, with regard to these particular industries
       and with regard to Hess, I mean, even though they are
       in a cyclical industry, it appeared that they were
       going through a period of secular growth, which would
       mean a growth without regard to the normal patterns of
       the industry.

            And, certainly, that’s borne out in the growth
       rate of the company’s sales, the growth rate of the
       company’s earnings and the budget data regarding what
       expectations were for the future. So for this
       particular company, I don’t think that it’s appropriate
       to measure it over a period of years.

Under these circumstances, we cannot agree that Mr. Engstrom’s

use of the 1995 fiscal year information alone renders his

analysis unreliable.39       We are not convinced that his reliance on

the 1995 financial information necessarily overstates the fair

market value of HII stock.       Nevertheless, we recognize this

possibility and consider it in reaching our conclusions.

       Petitioners also suggest that Mr. Engstrom should have made

a downward adjustment to the P/E ratios to reflect the fact that

HII’s asset utilization (sales to total assets) was higher than

that of the guidelines.       In Mr. Heebink’s market comparable

analysis, he made a downward adjustment to reflect the

differences in HII’s asset utilization.       According to Mr.


       38
            (...continued)
217.
       39
      Mr. Heebink testified generally regarding the benefits and
preferability of using longer periods for comparison and the
potential of an overstatement when using financial information
for only 1 year. However, he did not testify regarding whether
the use of a longer period or averages would have affected Mr.
Engstrom’s conclusions.
                               - 43 -

Heebink, “Asset utilization affects earnings growth because a

company with low asset utilization can increase earnings through

more efficient management of assets.”   Mr. Engstrom, on the other

hand, made a 35-percent adjustment to the P/E ratio he derived

from the guideline companies to account for the fact that the

average net profit margin of the guideline companies was

approximately 35 percent less than HII’s net profit margin.

According to Mr. Engstrom, “Companies with higher profit margins

tend to have lower price/earnings ratios because it is more

difficult for the company to achieve future growth.”   We agree

with respondent that these adjustments were designed to capture

the same thing, HII’s relative difficulty of achieving future

growth.40   Thus, we cannot agree that Mr. Engstrom’s analysis was

flawed in this respect.


     40
      Mr. Engstrom agrees that HII had a higher return on assets
than the guideline companies; this results in greater risk, and
normally this risk translates into a lower price earnings
multiple. However, Mr. Engstrom testified that this “was one of
the primary issues that we addressed when we were looking at an
appropriate price earnings multiple” for HII. He further
testified that he made two adjustments:

     One is the adjustment for size, and one’s an adjustment
     for other factors. And if you look at the text of our
     report, the primary motivation of that other adjustment
     factor was the fact that Hess’s profit margins are
     higher than the guideline companies’.

          So it’s taking account of the fact that their
     profitability is higher. And whether you’re measuring
     that profitability in terms of profit margins or in
     terms of returns on assets, it’s higher, and therefore
     we would reduce the multiple.
                              - 44 -

     Petitioners also claim that Mr. Engstrom erred in failing to

consider HII’s financial information for the most recent quarter

before the gift of shares; i.e., the quarterly results for August

to October 1995.   We are not convinced that this was error.

Indeed, petitioners’ expert did not consider this information in

his market comparable analysis.    Also, Mr. Gaynor did not update

his valuation for the gift tax returns to account for HII’s

performance after July 31, 1995.   Further, Mr. Engstrom explained

that a prospective buyer might ask questions regarding the more

recent quarterly information, but would not consider a loss in

that quarter overly alarming where the company uses the completed

contract method of accounting.

     Although we question certain aspects of Mr. Engstrom’s

guideline companies analysis, and we cannot agree that the value

he derived under that analysis is entitled to the weight he gave

it, i.e., 40 percent, we find that value provides at least some

indication of the fair market value of HII stock.   Indeed, it

appears to us that the major separation in the value that Mr.

Heebink derived in his market comparable analysis and in the

value that Mr. Engstrom derived in his guideline companies

analysis is attributable to the erroneous $2.5 million adjustment

that Mr. Heebink made to cost of sales in his analysis.   See

supra note 23.
                                - 45 -

     Discounted Cashflow Method

     Mr. Engstrom considered the discounted cashflow method and

determined that the fair market value of common stock in HII was

$25,566,478, or $256,000 per share as of November 15, 1995.      He

concluded that this amount supported his conclusions with respect

to his overall valuation analysis.       Mr. Engstrom gave no weight

to that amount because he concluded that relatively small changes

in certain assumptions which were used resulted in large changes

to the indicated value of the company.

     We cannot agree that this provides a basis for wholly

rejecting a discounted cashflow analysis.      Indeed, as Mr. Heebink

testified, this same problem is apparent in other valuation

methods.   It is axiomatic that even small changes in certain

assumptions in a valuation analysis can result in dramatic

changes in the value derived.    Of course, in the case of certain

companies, the distortions in value may be more pronounced.

However, this does not preclude any reliance on a discounted

cashflow analysis, and we would in those circumstances apply less

weight to the value derived thereunder.41


     41
      Respondent argues on brief that “Mr. Engstrom’s conclusion
that the DCF method did not provide reliable information is
completely correct * * *. Any conclusion reached using it should
be disregarded.” Respondent discussed Mr. Engstrom’s discounted
cashflow method in his reply brief; however, he considers any
errors in that method “irrelevant”, since Mr. Engstrom did not
rely on the discounted cashflow method. It is clear to us that
respondent places no reliance upon Mr. Engstrom’s discounted
                                                   (continued...)
                              - 46 -

Other Items

     In a letter of intent dated September 28, 1994, Dover

Diversified proposed to purchase all the outstanding stock of HII

for $44 million or approximately $393,000 per share.      Throughout

these proceedings, respondent has alluded to this letter of

intent as evidence of the fair market value of HII stock.42

However, we are not convinced that the proposed purchase price is

a reliable indicator of the fair market value of HII stock.     The

letter of intent was not binding on the parties, and Dover

Diversified decided not to purchase HII.   It is not at all clear

whether Dover Diversified conducted the type of investigation or

due diligence which might produce a reliable value indicator.

Neither petitioners’ expert nor respondent’s expert relied upon

the letter of intent.   Indeed, Mr. Engstrom testified:

          To the extent that there is an amount that was
     communicated in the letter of intent as a possible
     acquisition price, then, you know, possibly there’s
     some valuation information. But, as we said in our
     report, we didn’t place any reliance upon it. So it’s
     pretty weak valuation information.



     41
      (...continued)
cashflow method. We likewise give Mr. Engstrom’s discounted
cashflow analysis no weight.
     42
      Respondent’s position on this item is confusing.
Considerable time was spent at trial and on brief regarding the
letter of intent. However, respondent’s expert did not rely upon
that item, and respondent does not object to petitioners’
requested finding of fact that “The Dover Diversified non-binding
letter of intent is not a reliable indicator of the value of
HII’s stock.”
                                - 47 -

We likewise do not rely upon the letter of intent.

     At trial, Mr. Hess testified to a number of factors which

petitioners argue a hypothetical buyer would have considered in

purchasing shares of HII stock:     (1) The trend toward the use of

aluminum wheels was creating competition for HEI’s steel wheel

manufacturing customers; (2) the penetration of HEI’s most

prominent competitor, Fontijne, into the American market with the

advantage of favorable exchange rates; (3) HEI’s and Hess MAE’s

dependence on exclusive license agreements; (4) HII’s continued

problems with technical and sales employees;43 (5) the costs to

support HII’s new sales and service organization in Switzerland;

and (6) the scheduled retirement of Mr. Kucklick in February

1998.     The experts discussed several of these items in their

general discussions of the economy and the industry in which HII

and its principal customers were involved.     These items were

factored into their various analyses, and we have considered them

as part of our discussion relating thereto.44




     43
      We note that petitioners’ expert indicated that employee
turnover had not been a significant problem.
     44
      Other than Mr. Hess’s testimony, we have no basis from
which to conclude that the remaining factors were apparent at the
time of the gift, whether they would have been considered by a
hypothetical buyer, and to what extent these factors would affect
the fair market value of HII stock.
                              - 48 -

Discounts

     The parties and their experts agree that a 15-percent

minority interest discount should be applied where appropriate to

reflect the lack of control inherent in a minority interest in

HII stock.   They also agree that a marketability discount is

appropriate to reflect the lack of a ready market for the HII

stock on the gift date.   However, they disagree as to the

appropriate marketability discount to be applied:   Mr. Heebink

applied a 30-percent discount, and Mr. Engstrom applied a 25-

percent discount.

     Our review of Mr. Heebink’s report shows a potential overlap

and an apparent failure to make a proper separation between the

lack of control and the lack of marketability apparent in a

minority interest in HII.   See Estate of Andrews v. Commissioner,

79 T.C. at 953 (explaining the difference between minority

interest discount and marketability discount).   Mr. Heebink

states that “Minority interest shares are significantly less

marketable and liquid than controlling interest shares because

few investors are interested in minority interest investments in

closely held companies”, and he concludes:

     Considering that this valuation relates to a minority
     interest in a company with extensive owner involvement,
     significant technical expertise, high earnings and
     profitability variation, and above average automobile
     industry concentration, a 30% marketability and
     liquidity discount was selected for Hess Industries.
                               - 49 -

This potential overlap and the apparent failure to separate the

minority interest and marketability discounts cause us to

question Mr. Heebink’s conclusion.      On the other hand, Mr.

Engstrom’s conclusion of a 25-percent marketability discount is

reasonable under the circumstances of this case.      Where

appropriate, we consider a 15-percent minority interest discount

and a 25-percent marketability discount in determining the fair

market value of HII stock.

Conclusion

      The record reflects a range of values per share for HII

stock, which we summarize as follows:

      Redemption analysis - Mr. Heebink1                $104,000
      Net asset value analysis - Mr. Engstrom1           119,000
      Valuation analysis - Mr. Heebink1                  128,000
      Guideline companies analysis - Mr. Engstrom2       219,000
      Prior redemption transaction - Mr. Engstrom3       329,500
      Stockholders agreement - Mr. Engstrom3             380,000

      1
        Minority interest and marketability discounts applied.
      2
        Marketability discount applied only.
      3
        No discounts applied.
Because valuation necessarily results in an approximation, the

valuation figure we determine need not be one as to which there

is specific testimony as long as it is within the range of values

that may properly be arrived at from consideration of all the

evidence.    See Estate of Magnin v. Commissioner, T.C. Memo. 2001-

31.   After considering all the evidence, the values that

petitioners’ and respondent’s experts derived in their various

analyses, other factors, and appropriate minority interest and
                             - 50 -

marketability discounts, we find that the value of HII stock

falls somewhere in the middle of this range of values.   We hold

that the value of the shares of HII stock that were gifted on

November 15, 1995, was $200,000 per share.


                                           Decision will be entered

                                      under Rule 155.
