                        T.C. Memo. 2000-191



                      UNITED STATES TAX COURT



      ESTATE OF EMILY F. KLAUSS, DECEASED, JOHN G. KLAUSS,
               INDEPENDENT EXECUTOR, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5578-97.                   Filed June 27, 2000.



     Wayne R. Mathis, for petitioner.

     Gerald L. Brantley, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined a deficiency in

petitioner’s estate tax of $1,801,053.

     After concessions, the sole issue for decision is whether

the fair market value of 184 shares of Green Light Chemical Co.,

Inc., owned by Emily F. Klauss (decedent) on February 1, 1993,
                                 - 2 -

was $1,810,000, as petitioner contends; $2,713,000, as respondent

contends; or some other amount.    We hold that it was $2,150,000.

       Section references are to the Internal Revenue Code as in

effect when decedent died.    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

       Decedent died on February 1, 1993 (the valuation date), in

San Antonio, Texas.     Her husband, William J. Klauss, predeceased

her.    Decedent’s son, John G. Klauss (John Klauss), is the

independent executor of decedent’s estate.    He lived in Helotes,

Texas, when he filed the petition in this case.

B.     Green Light Chemical Co., Inc.

       1.   Formation

       William J. Klauss cofounded the Klauss-White Co. in 1946.

It changed its name to the Green Light Co., Inc. (Green Light),

in 1960.    He ran the company until the mid-1970's, and he died in

1982.

       John Klauss worked for Green Light for 38 years.   He began

running the company in the mid-1970's, and he was the chairman of

the board on February 1, 1993.    He retired in 1994.
                               - 3 -

     2.    Ownership

     Green Light is a closely held corporation.   Of the 460

outstanding shares of stock in Green Light, 184 shares were

included in decedent’s gross estate under section 2044.

Decedent’s children owned the remaining shares of Green Light

stock when she died.

     Green Light has never paid dividends.

     3.    Products and Operations

     Green Light formulates and markets (but does not

manufacture) insecticides, weed killers, fungicides, plant foods,

and other products for home and garden use.   Green Light sells

its products to distributors, who sell them to retailers, such as

Walmart and grocery and hardware stores.   Green Light’s primary

market in 1993 was the home and garden market.    It did not sell

to farms, ranches, or golf courses.    Green Light’s sales volumes

vary greatly according to weather conditions and the planting

season.   Its products are manufactured primarily in the fourth

quarter of the calendar year, and it ships most of its products

in December and January.   Green Light bills its customers 90 days

after shipment and receives most of its revenue in May and June.

     In 1993, Green Light sold its products primarily in Texas,

Oklahoma, Louisiana, New Mexico, Colorado, and Arizona.   Its top

five customers accounted for about 71 percent of its sales in its
                                - 4 -

1992 fiscal year.1    More than 36 percent of Green Light’s sales

in fiscal year 1992 were to Central Garden.

     4.     Green Light’s Environmental Claims, Products Liability
            Insurance, and Risks of Litigation

     The Texas Water Commission (later the Texas Natural

Resources Conservation Commission (TNRCC)) told Green Light in

August 1991 that soil at its San Antonio facility was

contaminated with chlordane and xylene.    The TNRCC ordered Green

Light to submit a corrective action plan within 30 days.    Green

Light denied that its property was contaminated, and had not

submitted a plan as of the time of trial.

     Green Light had $500,000 of products liability insurance in

1993, with a $50,000 deductible.    It would have cost Green Light

about $250,000 more to increase its 1992 products liability

insurance coverage to $2 million, with a $1,000 deductible.    As

of February 1, 1993, Green Light was a defendant in at least six

products liability lawsuits resulting from the alleged

misapplication of some of its products.    Green Light faced

potential liability of more than $100 million in these lawsuits.

     5.     Sale of Green Light to Employee Stock Ownership Trust

     On November 30, 1994, all of the stock of Green Light was

sold to an employee stock ownership trust created by the

employees of Green Light.

C.   Decedent’s Estate Tax Return

     1
          Green Light used a fiscal year ending June 30.
                               - 5 -

     Petitioner attached to the estate’s Federal estate tax

return an appraisal of decedent’s minority interest in Green

Light prepared by Clark C. Munroe (Munroe).   Munroe estimated,

and petitioner reported on that return, that the fair market

value of decedent’s 184 shares of Green Light stock was

$1,810,000 as of February 1, 1993.

D.   Notice of Deficiency

     Respondent determined in the notice of deficiency that the

fair market value of decedent’s 184 shares of Green Light stock

was $4,080,200.   Respondent now concedes that the value of

decedent’s stock was not more than $2,713,000.

                              OPINION

     The issue for decision is the fair market value of

decedent’s 184 shares of Green Light stock on the day decedent

died, February 1, 1993.

A.   Fair Market Value

     Fair market value 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 the relevant facts.   See United

States v. Cartwright, 411 U.S. 546, 551 (1973); sec. 20.2031-

1(b), Estate Tax Regs.; sec. 25.2512-1, Gift Tax Regs.2   If


     2
        Petitioner bears the burden of proving that respondent’s
determination in the notice of deficiency is erroneous. See Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
                                 - 6 -

selling prices for stock in a closely held corporation are not

available, then we decide its fair market value by considering

factors such as the company’s net worth, earning power, dividend-

paying capacity, management, goodwill, and position in the

industry, as well as the economic outlook in its industry and the

values of publicly traded stock of comparable corporations.         See

Estate of Andrews v. Commissioner, 79 T.C. 938, 940 (1982); sec.

25.2512-2(f), Gift Tax Regs.

     Both parties called expert witnesses to give their opinions

about the value of decedent’s Green Light stock on February 1,

1993.   Bruce Johnson (Johnson) testified at trial for petitioner,

and David Fuller (Fuller) testified for respondent.         The record

also contains the expert report of Munroe, who could not testify

because of illness.   Petitioner based the value reported in the

estate tax return on Munroe’s appraisal, which is almost

identical to petitioner’s position at trial.          The opinions of the

expert witnesses and the positions of the parties as to the fair

market value of decedent’s shares of Green Light stock are as

follows:

Petitioner’s                             Deficiency
 return and      Petitioner’s            notice and       Respondent’s
the petition    expert Johnson             answer         expert Fuller

 $1,810,000       $1,800,000             $4,080,200        $2,713,000
                                - 7 -

     The experts each used the income capitalization3 and market

or public guideline company4 methods to estimate the value of

decedent’s Green Light stock.    Johnson and Fuller used the same

guideline companies:   Scotts Co. (Scotts), American Vanguard

Corp. (American Vanguard), Lesco, Inc. (Lesco), and Vigoro Corp.

(Vigoro).   Johnson and Fuller primarily disagree as to:   (1)

Whether to apply a small-stock premium and (2) whether to adjust

the multiple for the growth rates of Green Light and the

guideline companies.

B.   Stock Value Before Considering Discounts

     1.     The Small-Stock Premium

     Johnson applied a small-stock premium of 5.2 percent in

calculating the discount rate5 he used to approximate the return

required by investors in the smallest quintile of the public

stock market.    Respondent contends that Johnson was incorrect in

applying a small-stock premium.    We disagree.




     3
        The income capitalization method is used to estimate the
fair market value of income-producing property by considering the
present value of the future stream of income to be produced by
that property. See Estate of Bennett v. Commissioner, T.C. Memo.
1989-681, affd. 935 F.2d 1285 (4th Cir. 1991).
     4
        The market or public guideline company method compares
the company being valued with similar, publicly traded (i.e.,
"guideline") companies.
     5
        The discount rate is the total of the risk-free rate, the
equity risk premium, the small-stock premium, and the specific
risk premium.
                                 - 8 -

     Johnson reasonably based the small-stock premium he used in

his report on data from Ibbotson Associates.6    Later data from

Ibbotson Associates7 show that the small-stock premium has

declined since about 1983 or 1984, but that small capitalization

stocks were yielding higher average returns than large

capitalization stocks in 1993.

     Respondent attached to respondent’s opening brief an

appendix which shows that large capitalization stocks have

outperformed small stocks since about 1988.     We do not consider

the information in the appendix because respondent provided no

source for it.

     Respondent relies on an article by Bajaj & Hakala,

“Valuation for Smaller Capitalization Companies”, published in

Financial Valuation:   Businesses and Business Interests, ch. 12A

(Hanan & Sheeler ed. 1998), for the proposition that there is no

small-stock premium.   We find Johnson’s analysis to be more

persuasive.

     Fuller testified that it is appropriate to use the Ibbotson

Associates data from the 1978-92 period rather than from the

1926-92 period because small stocks did not consistently


     6
        See Ibbotson Associates, Stocks, Bonds, Bills &
Inflation, 1993 Yearbook 128 (Ibbotson 1993); see also Estate of
Hendrickson v. Commissioner, T.C. Memo. 1999-278 (citing id. at
125).
     7
        See Ibbotson Associates, Stocks, Bonds, Bills &
Inflation, 1999 Yearbook 121 (Ibbotson 1999).
                                 - 9 -

outperform large stocks during the 1980's and 1990's.      We give

little weight to Fuller’s analysis.      Fuller appeared to

selectively use data that favored his conclusion.      He did not

consistently use Ibbotson Associates data from the 1978-92

period; he relied on data from 1978-92 to support his theory that

there is no small-stock premium8 but used an equity risk premium

of 7.3 percent from the 1926-92 data (rather than the equity risk

premium of 10.9 percent from the 1978-92 period).      If he had used

data consistently, he would have derived a small-stock premium of

5.2 percent and an equity risk premium of 7.3 percent using the

1926-92 data, rather than a small-stock premium of 2.8 percent

and an equity risk premium of 10.9 percent using the 1978-92

data.

     We conclude that Johnson appropriately applied a small-stock

premium in valuing the Green Light stock.

     2.      Growth Rate

        Johnson derived price/earnings multiples from the guideline

companies that he adjusted to account for differences between

their expected growth rates and that of Green Light.      He selected

a 5-percent growth rate for Green Light and used growth rates for

the guideline companies ranging from 14.3 to 15.5 percent.




        8
        The Ibbotson Associates data for 1978-92 show a 2.8-
percent small-stock premium. See Ibbotson Associates (1993),
supra at 128.
                              - 10 -

     Respondent contends that Johnson incorrectly assumed that

Green Light would grow at 5 percent.   Shortly before trial, Green

Light’s management told Johnson that it had projected that Green

Light would grow at a rate of 5 to 10 percent in 1993.9    We

disagree with respondent’s contention that Johnson incorrectly

assumed that Green Light would grow at 5 percent because Fuller

also used a 5-percent growth rate for Green Light.   Respondent

contends that Johnson selected incorrect growth rates for the

guideline companies because the sources of his data were

unreliable.   We disagree in part.   Johnson reasonably selected

growth rates for Green Light and the guideline companies other

than American Vanguard using financial data relating to periods

before the valuation date.   See Estate of Jung v. Commissioner,

101 T.C. 412, 423-424 (1993); Estate of Newhouse v. Commissioner,

94 T.C. 193, 217 (1990).

     Johnson chose a 15-percent growth rate for American Vanguard

in part because its earnings grew 33 percent annually from 1988

to 1992, and its export sales grew from $800,000 in 1990 to $4.7

million in 1993.   However, in light of the fact that the earnings

of Green Light grew faster than those of the guideline companies


     9
        In 1999, Bruce Johnson (Johnson) interviewed Forrest Gray
(Gray), the secretary and treasurer of Green Light, about the
anticipated future growth rate of Green Light as of the valuation
date. Gray told Johnson that, in 1993, the management of Green
Light expected the company to grow at a rate of 5 to 10 percent
per year.
                              - 11 -

from 1990 to 1992, Johnson’s use of a 15-percent growth rate for

American Vanguard was too generous.    We believe Johnson should

have used a 5-percent growth rate for American Vanguard since

that is the growth rate he used for Green Light and its earnings

were growing faster than those of the guideline companies.

     Johnson’s analysis was more persuasive than Fuller’s.

Fuller did not adequately consider the differences between Green

Light and American Vanguard, the guideline company he considered

to be the most comparable.   For example, he gave little weight to

the facts that:   Green Light does not manufacture products; its

product lines are far less diverse than those of the guideline

companies; its five largest customers accounted for more than 70

percent of its sales; it sells its products regionally, not

nationally; its primary market in 1993 was limited to the home

and garden market and did not include agribusinesses or golf

courses; and it had minimal insurance coverage for products

liability and environmental claims.    He did not adjust the

multiples for American Vanguard for customer concentration,

product mix, geographic diversification, or market segment

factors.   We think his failure to do so was improper given the

differences between Green Light and American Vanguard.
                               - 12 -

     3.   Other Differences Between the Analyses of Johnson and
          Fuller

          a.   Fuller’s Use of the CAPM Method

     Fuller calculated his discount rate using the capital asset

pricing model (CAPM).10   In contrast, Johnson used a discount

rate based on the build-up method.11    We believe that Fuller

should not have used the CAPM in this case.    Green Light should

not be valued by using the CAPM method because Johnson and Fuller

agreed that it had little possibility of going public.    See

Estate of Maggos v. Commissioner, T.C. Memo. 2000-129; Estate of

Hendrickson v. Commissioner, T.C. Memo. 1999-278; Furman v.

Commissioner, T.C. Memo. 1998-157.




     10
        The capital asset pricing model (CAPM) is used to
estimate a discount rate by adding the risk-free rate, an
adjusted equity risk premium, and a specific risk or unsystematic
risk premium. The company’s debt-free cash-flow is then
multiplied by the discount rate to estimate the total return an
investor would demand compared to other investments. See Furman
v. Commissioner, T.C. Memo. 1998-157.
     11
        Under the build-up method, an appraiser selects an
interest rate based on the interest rate paid on governmental
obligations and increases that rate to compensate the investor
for the disadvantages of the proposed investment. See Estate of
English v. Commissioner, T.C. Memo. 1985-549.
                              - 13 -

          b.    Fuller’s Selection of a Beta

     In applying the CAPM method, Fuller chose a beta12 of .7 to

estimate Green Light’s systematic risk.   An average amount of

risk is represented by a beta of 1.    A beta of 70 percent would

be correct if an investment in Green Light were 30 percent less

risky than a composite investment of the Standard & Poor’s 500

Stock Composite Index (S&P 500).   We disagree with Fuller’s use

of a .7 beta because Green Light was a small, regional company,

had customer concentrations, faced litigation and environmental

claims, had inadequate insurance, was not publicly traded, and

had never paid a dividend.   A beta cannot be correctly calculated

for the stock in a closely held corporation; it can only be

correctly estimated on the basis of the betas of comparable

publicly traded companies.   See Estate of Hendrickson v.

Commissioner, supra; Furman v. Commissioner, supra.    Fuller

stated that he selected the beta based on a review of comparable

companies.   However, he did not identify these comparable

companies or otherwise give any reason for his use of a .7 beta.

We believe Fuller’s use of a .7 beta improperly increased his

estimate of the value of the Green Light stock.




     12
        Beta is a measure of systematic risk; that is, risk that
is unavoidable and that affects the value of all assets. Beta
measures the volatility of a stock’s return as compared to the
market as a whole. See Furman v. Commissioner, supra; Pratt et
al., Valuing a Business 166 (3d ed. 1996).
                             - 14 -

     4.   Risk of Litigation and Environmental Remediation

     Johnson and Fuller substantially agreed about the potential

effects of products liability litigation and environmental claims

on the value of Green Light stock.    Johnson reduced his estimate

of the value of Green Light by $921,000 on the basis of the

$252,000 cost to Green Light of increasing its products liability

insurance and John Klauss’ estimate that it would have cost Green

Light about $250,000 in 1993 to pay fines and remediation costs,

such as excavation, transportation, and capping costs, and lab

analysis, disposal, and environmental engineer’s and attorney’s

fees to resolve the TNRCC enforcement action.   In contrast,

Fuller discounted his estimate by 10 percent, which had the

effect of reducing the stock value by $1,130,000, in part because

counsel for Green Light stated that its maximum liability for the

litigation claims would be 10 percent.   We agree with Johnson’s

approach because we believe he more accurately accounted for the

effects on the value of Green Light of the litigation and

environmental claims.

     5.   Conclusion

     We conclude that Johnson’s analysis was more persuasive than

Fuller’s, except for his use of a 15-percent growth rate for

American Vanguard.
                             - 15 -

C.   Conclusion

     Johnson and Fuller agree that the appropriate discount for

lack of marketability is 30 percent.   Taking into account the

adjustment made to the growth rate of American Vanguard, we

conclude that the fair market value of decedent’s 184 shares of

Green Light stock was $2,150,000 on February 1, 1993.


                                         Decision will be entered

                                   under Rule 155.
