                        T.C. Memo. 2000-298



                      UNITED STATES TAX COURT



 ESTATE OF JAMES J. RENIER, DECEASED, KENT L. RENIER AND DUBUQUE
        BANK & TRUST COMPANY, CO-EXECUTORS, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 2976-98.            Filed September 25, 2000.



     James L. Malone III and Sheri L. Everson, for petitioner.

     James S. Stanis and David S. Weiner, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GALE, Judge:   Respondent determined a deficiency in Federal

estate tax of $326,382.08 and an addition to tax under section

6662(a) of $64,471.42 against the Estate of James J. Renier

(estate).

     After concessions, we must decide the following:
                                 - 2 -

     1.    What was the fair market value of the 22,100 shares of

stock in the Renier Company held by James J. Renier (decedent) at

his death on April 10, 1994 (valuation date).

     2.    Whether the estate is liable for an addition to tax

under section 6662(a) for a substantial estate or gift tax

valuation understatement.1

     Unless otherwise noted, all section references are to the

Internal Revenue Code in effect as of the date of decedent’s

death, and all 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.     We

incorporate by this reference the stipulation of facts and

attached exhibits.     At the time of filing the petition, co-

executor Kent L. Renier resided, and co-executor Dubuque Bank &

Trust Company had its principal place of business, in Dubuque,

Iowa.     Decedent resided in Dubuque, Iowa, on the date of his

death, and his will was probated in the Iowa District Court for

Dubuque County.




     1
       The estate also alleged in the petition that respondent
erred in disallowing a deduction by the estate for charitable
bequests totaling $12,500. However, the estate made no argument
at trial or on brief concerning that allegation, and we consider
it abandoned. See Rybak v. Commissioner, 91 T.C. 524, 566 n.19
(1988); Bowman v. Commissioner, T.C. Memo. 1997-52 n.1, affd.
without published opinion 149 F.3d 1167 (4th Cir. 1998).
                               - 3 -

     Since 1899, the Renier family has conducted a retail

business in Dubuque.   Beginning in the 1950's, the Renier Company

(Renier) switched its business focus from musical instruments to

the sale of televisions and stereo equipment.    In the 1980's, it

expanded its product mix to include video camcorders and VCR’s.

     On the valuation date, televisions and VCR’s comprised 47

percent of Renier’s sales, with audio systems and components

making up another 40 percent, and camcorders and car stereos

constituting 10 percent.   Another 2 percent of Renier’s sales

consisted of batteries and electronic accessories, while the

remaining 1 percent consisted of cordless telephones.    The

national annual compound rate of growth from 1989 through 1993

for televisions and VCR’s was 4.99 percent; for audio systems and

components, 3.07 percent; for camcorders and car stereos, 3.27

percent; for batteries and electronic accessories, 9.44 percent;

and for cordless telephones, 5.95 percent.    When weighted to

reflect the percentage of sales by Renier for each product area,

the national annual compound rate of growth for Renier’s product

mix from 1989 through 1993 was 4.15 percent.    Renier’s actual

sales increased at a compound rate of 8.3 percent from July 1988

through June 1993.   However, the majority of Renier’s growth

during that period occurred between July 1, 1992, and June 30,

1993, during which time sales increased 22.7 percent in part as a

result of a major flood in the area that caused many residents to

replace their consumer electronic products.    Considering only
                               - 4 -

July 1988 through June 1992, Renier’s compound annual growth was

just 3.8 percent.

     Renier’s retail operation consisted of a single 7,200-

square-foot store located in a strip mall in Dubuque.    Renier was

open for business 68 hours per week: 11 hours a day on Monday

through Friday, 8 hours on Saturday, and 5 hours on Sunday.      In

1994, the city of Dubuque had an estimated population of 57,840.

Dubuque’s population had declined over 7 percent since 1980 and

was not expected to grow rapidly after the valuation date.

     On the valuation date, Renier had seven employees, including

Kent and Maria Renier, decedent’s son and daughter-in-law (Kent

and Maria).   Kent served as store manager and as a salesperson,

and Maria performed clerical and bookkeeping functions.    Kent was

also responsible for about one-third of Renier’s total sales.      At

various times during the 5 years and approximately 9 months

preceding the valuation date, decedent and five other members of

his family were employed by Renier.    Until September 1993,

decedent remained active in the business, meeting customers and

handling Renier’s advertising and finances.    After September

1993, health problems prevented decedent from working the sales

floor, but he continued to be involved in Renier’s advertising

and finances.

     Renier’s primary competition consisted of national retail

chains which operated stores in the Dubuque area.    These chain

stores offered a much broader consumer electronics product
                              - 5 -

selection than did Renier and included such stores as Wards, Wal-

Mart, K-Mart, Target, Radio Shack, and Sears.   Additional

competition came from local independent businesses in Dubuque

that sold consumer electronic products.

     The Dubuque area retail environment became more competitive

in the 1980's and early 1990's as large discount stores, chain

stores, and warehouse clubs increased product offerings and

offered low prices to gain market share.   These larger businesses

purchased inventory at low prices due to volume purchases,

utilized sophisticated inventory control systems to manage

inventory, and effectively leveraged advertising expenditures due

to the operation of numerous retail outlets.

     Although Renier could not purchase inventory at the prices

available to the chains and discount stores, it was able to

achieve some discounts through participation in a buying

cooperative made up of independent retailers.   In addition,

because Renier was not highly leveraged and maintained ample

working capital, it was further able to reduce its inventory

costs by taking advantage of prompt payment discounts offered by

many vendors.

     Renier computed its income for tax and financial reporting

purposes on the basis of a fiscal year ending June 30.   Renier’s

pretax profit margin from July 1, 1988, through the valuation

date substantially exceeded the national industry average for

retailers of consumer electronics.    However, no meaningful growth
                                - 6 -

trend during this period is discernible, because for some time

prior to its fiscal year ended June 30, 1993, Renier

overestimated its cost of goods sold as the result of an error in

its inventory accounting system and, consequently, underreported

its net income.    This error was addressed in 1996, at which time

Renier filed amended corporate income tax returns for 1993 and

1994, reporting increased taxable income for those years.     These

changes resulted in Renier’s having additional income tax

liabilities totaling $137,038 for the period beginning July 1,

1992, and ending on the valuation date,2 which Renier paid in

1996.    Renier also revised its financial statements to reflect

the changes.    After the revisions, Renier had total pretax net

income from July 1, 1988 through the valuation date of $879,597,

and after-tax net income of $579,367.

     Decedent became president of Renier in the 1960's and served

in that position until his death.    At his death, decedent owned

22,100 of the 25,000 outstanding shares of Renier’s common stock.

Renier’s shares have never been listed on any stock exchange or

available on any over-the-counter market and have never been

publicly traded or privately traded.

     The co-executors hired Jules Steinberg to appraise Renier’s

shares for estate tax purposes.    Based on Mr. Steinberg’s

     2
       Renier had increased tax liability for its 1993 fiscal
year of $108,495 and increased tax liability of $28,543, on a
prorated basis, for the first 9.33 months of Renier’s 1994 fiscal
year that occurred prior to the valuation date.
                                  - 7 -

appraisal, the estate reported decedent’s interest in Renier at a

value of $729,742, or $33.02 per share, on the valuation date.

In the notice of deficiency, respondent valued decedent’s

interest in Renier at $1,633,000, or $73.89 per share, on the

valuation date.

                     ULTIMATE FINDING OF FACT

     The fair market value of decedent’s 22,100 shares of Renier

on the valuation date was $952,000, or $43.08 per share.

                              OPINION

I.   Renier’s Fair Market Value

     We must decide the fair market value of decedent’s shares of

stock in Renier on the valuation date.     Both parties rely on

expert opinions to support their claimed values.

     Fair market value is defined as “‘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.’”     United

States v. Cartwright, 411 U.S. 546, 551 (1973)(quoting sec.

20.2031-1(b), Estate Tax Regs.).     The best method to value a

corporation’s stock is to rely on actual arm’s-length sales of

the stock within a reasonable period of the valuation date.       See

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

Since Renier’s stock was never publicly or privately traded, all

the experts used less direct methods of valuation.
                                - 8 -

     Expert opinions sometimes aid the Court in determining

valuation; other times, they do not.    See Laureys v.

Commissioner, 92 T.C. 101, 129 (1989).    We evaluate such opinions

in light of each expert’s qualifications and all other evidence

of value in the record.    See Estate of Newhouse v. Commissioner,

94 T.C. 193, 217 (1990).   We are not bound, however, to accept

any expert opinion when that opinion contravenes our judgment.

See id.   We may accept an expert opinion in its entirety, see

Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C.

441, 452 (1980), or we may selectively use any portion thereof,

see Parker v. Commissioner, 86 T.C. 547, 562 (1986).

     A.   The Experts

     Respondent presented the testimony and expert report of

Leonard J. Sliwoski to support the deficiency determination.     The

estate presented the testimony and expert reports of Yale Kramer,

of McGladrey & Pullen, LLP, and Allan L. R. Lannom, of Houlihan

Valuation Advisors, to support the reported value of Renier’s

stock.

     Respondent’s expert, Mr. Sliwoski, considered an asset,

income, and market approach to value Renier and concluded that an

income approach, using the capitalized value of expected future

earnings, should be used exclusively.    Based on this approach,

Mr. Sliwoski concluded that Renier had a total value of

$1,847,698 and that decedent’s 88.4 percent interest therein had

an approximate value of $1,633,000 on the valuation date.
                               - 9 -

     The estate’s first expert, Mr. Kramer, also considered an

asset, income, and market approach and ultimately concluded that

Renier’s valuation should be based on an average of the results

indicated by the income and market approaches.   Through this

averaging process, Mr. Kramer concluded that Renier’s shares had

an estimated value of $36.89 per share and that decedent’s 22,100

shares therefore had a total value of $815,158.50 on the

valuation date.

     The estate’s second expert, Mr. Lannom, did not use an asset

or income approach but made two market approach calculations

using data on the sales of privately held companies supplied by

the Institute of Business Appraisers.   In addition, Mr. Lannom

applied four different “rules of thumb” to value Renier.    Using

his market approach and rules of thumb, Mr. Lannom arrived at

various values for Renier ranging from a low of $946,000 to a

high of $1,100,000.   Mr. Lannom then added a “key-man” discount

equal to 10 percent of the value of the operating assets.

Finally, Mr. Lannom concluded that decedent’s 88.4-percent

interest in Renier was worth approximately $852,000 on the

valuation date.3




     3
       Although Mr. Lannom testified that his estimate of the
value of decedent’s interest in Renier was $825,000, the
calculations in his report, as amended in his trial testimony,
indicate that he actually concluded that decedent’s interest was
worth $852,000 and apparently made a transposing error.
                                - 10 -

     We place no weight on Mr. Lannom’s opinion.     His report

contains no explanation of, or analytical support for, the

various “rules of thumb” employed in reaching several of its

valuation estimates.    Thus, we are largely unable to assess the

merits of Mr. Lannom’s conclusions.      See Rule 143(f)(1).    To the

extent we are able to form a judgment, we find his analysis

unpersuasive.    One of his market approach calculations and three

of his rules of thumb used gross revenue as the primary

determinative factor, without taking profitability into account.

This raises doubts about the basis for his conclusions, given

that Renier’s profitability was high in relation to the industry

average.    Furthermore, while Mr. Lannom’s second market approach

calculation used Renier’s earnings and one of his rules of thumb

used Renier’s cash-flow, Mr. Lannom provided no justification for

the earnings and cash-flow figures he used.      Finally, Mr.

Lannom’s report provided no factual support for his “key-man”

discount.    Because of the summary nature and obvious shortcomings

of Mr. Lannom’s report, we give it no further consideration.

     Both Mr. Sliwoski and Mr. Kramer ultimately concluded that

their asset approaches did not account for the goodwill inherent

in Renier as a going concern.     We therefore restrict our analysis

to the income and market approaches as applied to Renier by Mr.

Sliwoski and Mr. Kramer.     We now consider each in turn.

     B.    Income Approach
                              - 11 -

     In connection with their respective income approaches to

valuation, both Mr. Sliwoski and Mr. Kramer concluded that some

of Renier’s assets were not necessary for its core retail

operation.   After excluding the income and expenses associated

with these “nonoperating” assets, both experts estimated the

value of Renier’s “operating” assets on the valuation date by

capitalizing an estimate of Renier’s expected future income.

Each expert then added his income-based valuation of Renier’s

operating assets to an asset-based estimate of the nonoperating

assets to produce a total valuation figure.

     As part of their income capitalization approaches, the

experts agreed that the appropriate starting point for estimating

Renier’s expected future income was to take an average of

Renier’s historical reported net income.4   The experts further

agreed that it was necessary to make certain adjustments to

     4
       Although Mr. Sliwoski believed that cash-flow, rather than
net income, was the appropriate income base to capitalize, he
concluded that net income was an adequate approximation for cash-
flow. In reaching this conclusion, he assumed that Renier’s
accounts receivable and inventory levels were sufficient as of
the valuation date to sustain probable future growth, that
required equipment additions would equal Renier’s depreciation
expense, and that no interest-bearing liabilities, other than
short-term liabilities, would be required to finance probable
future sales growth. In addition, as discussed infra, since Mr.
Sliwoski used a capitalization rate based on returns to both
equity and debt, it was necessary for him to add back Renier’s
interest expense to the income base used in his capitalization
formula.
     Mr. Kramer used net income as his base for capitalization
but believed that an adjustment to the capitalization rate was
required to account for the fact that he was employing net income
rather than cash-flow as his base.
                               - 12 -

reported net income in order to “normalize” it; that is, to

convert Renier’s historical average net income into income that a

hypothetical purchaser could expect in the future, by eliminating

anomalous transactions and capital structures.    However, the

experts exhibited significant differences regarding the necessary

“normalizing” adjustments.    They also had significant differences

in computing the capitalization rate that should be applied to

normalized income and, to a lesser extent, differences in the

methodology for valuing Renier’s nonoperating assets.    The

foregoing differences produced dramatically different results.

Mr. Sliwoski valued Renier’s operating assets at $1,293,760, to

which he added his estimate of the value of Renier’s nonoperating

assets of $553,938,5 for a total value of $1,847,698 on the

valuation date.    Mr. Kramer’s income approach, by contrast,

resulted in a value for Renier’s operating assets of $450,104;

i.e., an amount approximately two-thirds lower than Mr.

Sliwoski’s computation.    The difference in Mr. Kramer’s estimate

for Renier’s nonoperating assets was not as dramatic; Mr.

Kramer’s estimate was $470,9256 versus Mr. Sliwoski’s $553,938.

     5
       Although Mr. Sliwoski recognized he had double counted a
liability of $137,038, he did not modify his computations to
correct for this error. Had he done so, Renier’s nonoperating
assets would have increased by $137,038, and its total value
would have equaled $1,984,736. In any event, respondent has not
sought an increase in his deficiency determination in connection
with this error.
     6
         Unlike Mr. Sliwoski’s value for nonoperating assets, this
                                                     (continued...)
                              - 13 -

Mr. Kramer’s value estimates for Renier’s operating and

nonoperating assets produced a total value of $921,029 on the

valuation date.

     We shall consider their differences.

          1.   Computation of Normalized Income

     The experts agreed that the starting point for computing

normalized income should be the average of Renier’s reported net

income7 for the 69.33-month period preceding the valuation date,

July 1, 1988,8 through April 10, 1994 (base period9).   Further,

to avoid “unwarranted controversy”, Mr. Kramer adopted several of

Mr. Sliwoski’s normalizing adjustments.   Prior to normalizing,


     6
      (...continued)
number is corrected to account for the double counting of a
$137,038 liability in Mr. Kramer’s original report.
     7
       Mr. Sliwoski started with pretax net income and, after
making his normalizing adjustments, subtracted Federal and State
income taxes at an estimated combined rate of approximately 38
percent. Mr. Kramer started with after-tax net income and, when
making normalizing adjustments, also accounted for the income tax
impact of the normalizing adjustments, at an estimated income tax
rate of 34 percent. Except for the difference in assumed income
tax rates, their respective methodologies to account for taxes
would produce the same result.
     8
       Although Mr. Kramer’s report states that he used the
period from July 1, 1989, through the valuation date, an
examination of the data in the exhibits to his report shows that
the period used included the fiscal year starting July 1, 1988,
as well.
     9
       Although Mr. Sliwoski treats the period from July 1, 1988,
through the valuation date as consisting of 5.778 years, and Mr.
Kramer uses at various times 69.33 and 69.333 months to describe
this period, for the sake of consistency, we have adopted (and
treat the experts as having adopted) a base period of 69.33
months.
                                - 14 -

Renier had pretax net income of $879,597 during the base period

and after-tax net income of $579,367.    The experts had

differences in their normalizing adjustments as follows.

                    a. Reasonable Compensation for Related-Party
                    Employees

     There is a large difference in the experts’ approaches in

accounting for excess compensation paid to related-party

employees.   During the base period, Renier employed decedent and

several members of his family, including Kent and Maria on the

valuation date.   Both Mr. Sliwoski and Mr. Kramer concluded that

related-party employees were overcompensated, necessitating a

normalizing adjustment to reported net income to approximate

income if only arm’s-length amounts had been paid for the

services rendered.    The experts dispute, however, the amount of

overcompensation.

     To compute a reasonable compensation amount for the services

provided by related parties, Mr. Sliwoski assumed that during the

base period Renier required the services of only two family

members, one providing management and sales services and the

other serving as bookkeeper and office manager.    Kent and Maria,

respectively, were providing these services on the valuation

date.   Using data from a 1991 Dubuque area wage survey, Mr.

Sliwoski concluded that for Renier’s fiscal year ended June 30,

1991, the retail manager/salesperson would earn approximately

$19.23 per hour and work 2,080 hours per year (40 hours per
                               - 15 -

week), for an annual salary of $39,998.    He further concluded

that a bookkeeper/office manager for Renier with Maria’s

qualifications reasonably would have been paid $7.37 per hour and

worked 2,080 hours per year, for a total annual salary of

$15,330.    To these amounts, Mr. Sliwoski added a fringe benefit

equal to 20 percent of base wages for each employee.    Finally,

Mr. Sliwoski adjusted these results using changes in the consumer

price index for 1989 through 1994 to determine reasonable

compensation for each year in the base period.    Mr. Sliwoski then

treated all compensation to related employees that exceeded the

foregoing amounts, plus associated payroll taxes, as excess

compensation that should be added back to produce normalized

income.    This resulted in increases to Renier’s reported net

income for the base period of $357,789, or an average of $61,925

per year.

     Mr. Kramer, by contrast, calculated the excess compensation

to related employees to be only $15,000 per year, which he

divided by 12 and then multiplied by 69.33 to arrive at a total

excess compensation of $86,663 during the base period.    In

reaching the $15,000 per year figure, Mr. Kramer concluded that

approximately 15 percent of the time devoted to management duties

by related parties was attributable to duplicated effort and

therefore constituted excess compensation.

     After considering the reasonable compensation adjustments

proposed by each expert, we conclude that neither accurately
                             - 16 -

accounts for Renier’s related-party excess compensation.     Mr.

Kramer’s method was unsupported by any objective criteria; his

report’s assertion that there was a duplication of effort equal

to 15 percent of the amounts paid to related-party management

appears to be no more than a conclusory guess.   The estate cites

no data to support the claim that the sales, management, and

bookkeeping functions being performed by related parties were

actually worth $120,000 per year in the Dubuque area.   In

addition, the estate concedes on brief that in Renier’s fiscal

year ended June 30, 1990, Mark Renier, decedent’s other son, was

paid $100,000 in excess compensation.   Mr. Kramer’s report,

however, fails to account for this figure.   For these reasons, we

find more reliable Mr. Sliwoski’s approach based on actual data

from a Dubuque area wage survey.

     While we find satisfactory Mr. Sliwoski’s basic methodology

of attempting to estimate the “market” replacement cost of the

necessary services that were provided by related parties, and

treating the excess of the amounts actually paid over their

market value as a normalizing add-back to income, we nevertheless

believe that Mr. Sliwoski’s estimate of the replacement cost of

the sales and management services provided by related parties

significantly understates the services’ value.   Mr. Sliwoski

assumed that the sales and management functions being performed

by Kent could be accomplished in a 40-hour work week.   Kent

testified that he worked in excess of 70 hours per week.     While
                              - 17 -

this claim might be inflated, the record establishes that Renier

was open 68 hours per week.   We do not believe that Kent’s sales

and management functions could be duplicated with a 40-hour work

week at $19.23 per hour, plus 20 percent in fringe benefits (or

total annual compensation of approximately $48,000), as Mr.

Sliwoski’s postulates.   If one considers only Kent’s sales

function, his annual compensation would exceed $40,000,10 before

considering his multiple management and administrative duties.

In addition, Mr. Sliwoski failed to consider that except for the

last approximately 7 months of the base period, decedent also

actively assisted in Renier’s operation.   We therefore do not

believe Mr. Sliwoski’s computations of reasonable compensation

for the sales and management functions performed by related

parties are reliable.

     On this record, we have no alternative but to substitute our

best judgment of the value of the sales and management services

that were performed by Kent as of the valuation date (and various

other family members during the base period).   Taking into

account the hours claimed in Kent’s testimony, it is our judgment

that the sales and management functions performed by him could be

accomplished in a 60-hour work week.   Using Mr. Sliwoski’s

     10
       Respondent conceded that Kent was responsible for
approximately one-third of Renier’s annual sales of $1.5 million.
If Kent received a commission of 6 to 8 percent on those sales, a
commission which Mr. Sliwoski himself conceded was reasonable in
the business, plus benefits equal to 20 percent of this amount,
his compensation as a salesman would have exceeded $40,000.
                              - 18 -

documented wage and benefit figures, this assumption produces an

annual compensation package of $71,997 (60 hours at $19.23 per

hour times 52 weeks plus 20-percent fringe benefits).    If this

amount is adjusted for inflation for each of the years in the

base period,11 the total for the period is $418,117.    When added

to Mr. Sliwoski’s reasonable compensation estimate for the

bookkeeping/office manager functions performed by Maria

($106,832) (the rate and hours assumptions for which we find

satisfactory), and increased by Renier’s average payroll tax

expense of 6.76 percent,12 the total reasonable compensation

expense for related-party employees for the base period is

$560,436.   When this amount is subtracted from Renier’s actual

compensation to related-party employees during the base period of

$788,889,13 the excess compensation to related-party employees

equals $228,453, or an average of $39,540 per year.    Thus, we

conclude that a normalizing adjustment in this amount to Renier’s



     11
       Mr. Sliwoski used the consumer price index (CPI)
published by the U.S. Census Bureau to adjust for inflation. We
make a similar adjustment in our computation. See U.S. Census
Bureau, Statistical Abstract of the United States, The National
Data Book 495 (119th ed., 1999).
     12
       Renier’s average payroll tax expense was derived from the
average payroll tax rate incurred by Renier during the base
period. The difference between this rate and the statutory rate
of 7.65 percent applicable during most of the base period is
presumably due to fringe benefits not subject to payroll tax.
See secs. 3111, 3121(a).
     13
       Actual related-party compensation figures were taken from
Mr. Sliwoski’s report; Mr. Kramer provided no comparable figures.
                             - 19 -

reported net income is appropriate.

                 b. Adjustment for Income From Excess Working
                 Capital

     Both experts agreed that Renier’s cash and short-term

investments exceeded its working capital needs, that the excess

should be treated as a nonoperating asset, and consequently that

the interest earned by the excess should be subtracted from

reported net income as a normalizing adjustment.    They disagreed,

however, on the size of Renier’s excess working capital and the

method of its calculation.

     Mr. Sliwoski concluded that Renier only required working

capital equal to 7 days of annual sales (7/365 of annual sales),

which resulted in estimated working capital needs during the base

period ranging from $24,417 for 1989 to $35,152 for the partial

year ending on the valuation date.    Consequently, Mr. Sliwoski

made a normalizing adjustment that subtracted all interest earned

by Renier during the base period and added back an estimated

amount of interest14 that would have been generated by the

working capital he estimated was needed.

     Mr. Kramer concluded that Renier required working capital

equal to 2 months of average operating expenses during the base

period, plus 1.5 times average monthly inventory purchases in

1994, or $259,205 on the valuation date, leaving $362,038 in

     14
       Mr. Sliwoski computed interest for this purpose at a rate
of 5 percent. To avoid “unwarranted controversy”, Mr. Kramer
adopted the same rate for purposes of his computations.
                               - 20 -

excess working capital on that date.    To account for the interest

generated by this excess working capital, Mr. Kramer took the

excess working capital amount on the valuation date, multiplied

it by 5 percent,15 divided the result by 12 (to get a monthly

figure) and then multiplied that amount by 69.33 months.    The

result was then subtracted from reported net income as a

normalizing adjustment.    Using this formula, Renier’s excess

working capital generated $104,584 in interest over the base

period.16

     As to which expert’s methodology best adjusts for excess

working capital, we believe that Mr. Sliwoski’s formula

substantially underestimates Renier’s working capital needs.      For

example, for the year ended June 30, 1989, Mr. Sliwoski estimated

Renier would require working capital of just $24,417.    However,

Renier’s financial statement for that year indicates that it


     15
          See supra note 14.
     16
       In his report, Mr. Kramer assumed Renier had only
$225,000 in excess working capital, which would have generated
approximately $65,000 in interest over the base period. Mr.
Kramer’s computation of excess working capital, however, does not
account for the double-counted liability of $137,038 conceded
during trial by both experts. When this double counting is
corrected, it results in a reduction in Renier’s liabilities of
$137,038 and a corresponding increase in total assets. Because
Renier’s working capital requirements using Mr. Kramer’s formula
are unaffected by this correction, Mr. Kramer’s computation of
excess working capital would increase by $137,038 as a result,
from $225,000 to $362,038. Therefore, under Mr. Kramer’s
formula, the interest generated over the base period from the
increased figure for excess working capital is $104,584, rather
than $65,000.
                              - 21 -

spent $920,861 on inventory purchases and had operating expenses

of $363,304, for total expenditures of $1,284,165.   Thus,

although Renier had outlays averaging over $107,000 per month in

fiscal 1989, Mr. Sliwoski assumed Renier would require less than

one-fourth of that amount as working capital.   This estimate is

unduly low, particularly in light of the fact that Renier paid

for its inventory with cash in order to take advantage of early

payment cash discounts offered by trade creditors.   Mr.

Sliwoski’s estimates for the other years are no more reasonable.

Given the obvious shortcomings of Mr. Sliwoski’s working capital

estimates, we reject his methodology in favor of that used by Mr.

Kramer, which not only left sufficient working capital to cover

Renier’s operating expenses but also provided additional working

capital to purchase inventory with cash.   Based on Mr. Kramer’s

formula, as adjusted to account for the double-counted liability

of $137,038, we conclude that $104,584 should be subtracted from

Renier’s reported net income as a normalizing adjustment to

account for the interest generated by its excess working capital.

                  c. Spread for Cost-of-Goods-Sold Adjustment

     The parties agree that for a number of years Renier had used

an incorrect inventory accounting system that overstated cost of

goods sold.   The errors in cost of goods sold were corrected by

means of adjustments to the 1993 and 1994 fiscal years, which

resulted in reported net income for those years that

substantially exceeded amounts in the preceding 4 years.     The
                              - 22 -

experts disagree on the appropriate normalizing adjustment for

the correction of the inventory error.

     Mr. Sliwoski believed that, since average income for the

69.33-month base period (including the correction years) was

being used, no further adjustment was necessary.   The averaging

of the correction years’ income with the income of the 4

precorrection years (which income was almost certainly

understated) would produce an accurate average for the 69.33-

month period, in his view.   This position effectively “spread”

the cost of goods sold adjustment over the 69.33-month base

period.

     Mr. Kramer, however, believed that the cost-of-goods-sold

adjustment should be spread over 10 years, on the grounds that

Renier had sold the same product line for approximately 20 years

and “it was estimated” that the erroneous inventory method had

been used “for at least half of that period”.   As a result, Mr.

Kramer spread the cost-of-goods-sold adjustment over a 10-year

period and excluded from normalized income some 50.67 months’

worth of the adjustment which fell outside the base period.

     With respect to the cost-of-goods-sold adjustment, we

conclude that the estate has failed to show error in respondent’s

approach.   The estate has offered scant evidence of the nature of

the inventory adjustment; there is no evidence in the record of

the exact nature or duration of the error in accounting for cost

of goods sold.   Such evidence was presumably available to the
                              - 23 -

estate or executors.   On this record, we do not believe the

estate has shown that a 10-year spread of the inventory

adjustment is appropriate.   We accordingly conclude that Mr.

Sliwoski’s treatment of the cost-of-goods-sold adjustment in

computing normalized income is the appropriate one.
                                - 24 -

                   d.   Adjustment for Partial Year

     The experts also disagree on how to “annualize” the income

from the partial fiscal year from July 1, 1993, through the April

10, 1994, valuation date for purposes of computing average income

for the base period.    Mr. Sliwoski extended the partial year

income data pro rata to a full fiscal year, added this amount to

the net income from the previous 5 years and divided the result

by 6.    Mr. Kramer, on the other hand, simply added the net income

from the 9.33 months of the partial fiscal year to the income

from the previous 5 years, divided the result by 69.33 months,

and multiplied the result by 12 to compute the average.

     The estate finds fault with Mr. Sliwoski’s approach, and we

agree.    By simply extending the results of the 9.33 months of the

partial fiscal year pro rata into 12 months, Mr. Sliwoski

effectively postulates level income over each month of the fiscal

year.    We agree with the estate that this approach distorts

Renier’s income.    The first 9.33 months of Renier’s fiscal year

include the holiday season, a period of high retail volume.      The

assumption that the average of the first 9 months of the fiscal

year would be replicated in the last 3 is highly unlikely.      In

addition, both sides have conceded that 1994 income was

anomalous, due to the correction of the inventory error.    As a

result, we believe a more accurate average is achieved by

averaging the actual results of the first 9.33 months of fiscal

1994 with the preceding 5 fiscal years, as Mr. Kramer has done.
                                - 25 -

                    e. Inclusion of Interest Expense

     Because Mr. Sliwoski used a capitalization rate that

incorporated an assumed cost of debt that a purchaser of

decedent’s interest would incur to effect the purchase, he was

required for consistency to add back Renier’s interest expense to

his income base, so that normalized income would approximate the

investment return available to both equity and debt.   Mr. Kramer

used a simpler “return on equity” to formulate the capitalization

rate he employed.    As more fully discussed infra, we conclude

that the appropriate capitalization rate is a simple return on

equity as used by Mr. Kramer, since the interest being valued

here is an equity interest.    Accordingly, it is not appropriate

to add back Renier’s interest expense when computing expected

future income available to equity alone.

                    f. Adjustment for Income Taxes

     Both experts account for the effect of income taxes as part

of normalizing Renier’s income.    Mr. Sliwoski normalized reported

pretax net income and then adjusted for Federal and State income

taxes at an assumed combined rate of approximately 38 percent,

whereas Mr. Kramer used reported after-tax net income, and then

adjusted for income taxes associated with the net impact of the

normalizing adjustments using the average of the actual combined

Federal and State income taxes paid by Renier over the base

period.   Mr. Sliwoski provided no justification for his assumed

rate, while Mr. Kramer’s rate reflected Renier’s historic
                                 - 26 -

average.     Because Mr. Kramer’s approach is consistent with

Renier’s actual income tax liabilities over the base period, we

believe it is more accurate.     We therefore adopt his method of

using after-tax net income and taking account of the income tax

effect of normalizing adjustments at Renier’s historic average

rate of 34 percent.

                    g.   Conclusion

        Based on the foregoing, we conclude that the following

normalizing adjustments should be made to Renier’s reported net

income after taxes for the base period:

                  Adjustments to Base Period Net Income
                    (negative amounts in parentheses)
    Excess related-party compensation                     $228,453
    Interest generated by Renier’s excess working         (104,584)
         capital
    Depreciation1                                          35,012
    Property taxes1                                         1,782
    Automotive expenses1                                    6,650
    Capital loss1                                           9,219
    Rental income1                                         (6,000)
    Total adjustments before tax                          170,532
    Tax on adjustments (at blended Federal and State      (57,981)
         rate of 34 percent)
    Total adjustments after tax                           112,551
1
  The experts agreed to the normalizing adjustment amounts with
respect to depreciation, property taxes, automotive expenses,
capital loss, and rental income.
                                - 27 -

By adding $112,551 in adjustments to Renier’s after-tax net

income for the base period of $579,367, we arrive at normalized

income for the period of $691,918.       By dividing this figure by

the 69.33 months in the base period and multiplying the result by

12, we calculate Renier’s expected future annual income available

to equity at $119,761.

          2. Calculating the Capitalization Rate

     The experts reached widely divergent conclusions regarding

the appropriate rate to use in capitalizing Renier’s expected

future income.   Mr. Sliwoski concluded that the rate should be 10

percent, whereas Mr. Kramer set it at 22 percent.      The principal

source of this difference concerns whether the capitalization

rate should be computed based on the return on equity that a

hypothetical buyer would require (Mr. Kramer’s view) or should

consist of a weighted average of the return on equity as well as

the return on an assumed amount of debt that a hypothetical buyer

would incur to acquire decedent’s interest in Renier (Mr.

Sliwoski’s view).    In addition, the experts disagreed regarding

the estimate of the rate of growth in Renier’s future earnings

that should be factored into the computation of the

capitalization rate.

                    a. Weighted Average Cost of Capital or Return
                    on Equity

     Mr. Sliwoski estimated the return on equity that a

hypothetical buyer would require in calculating a value for
                                  - 28 -

Renier at 24.76 percent, quite close to Mr. Kramer’s estimate of

24.90 percent.     Mr. Sliwoski then reduced this required rate of

return by 6 percent to account for Renier’s estimated growth

after the valuation date.17      Mr. Sliwoski also believed that the

capitalization rate should reflect a “weighted average cost of

capital”; that is, a blending of the rate of return on equity

with the cost of debt incurred in a hypothetical purchase, which

rate he estimated would be 2 percent above prime, or 8.45

percent, on the valuation date.       Mr. Sliwoski further computed an

after-tax cost of the debt by discounting it 38 percent.        Using

the assumption that a purchase of decedent’s interest would be

financed 65.5 percent with debt and 34.5 percent with equity, Mr.

Sliwoski computed the weighted average cost of capital as

follows:

          Weighted Average Cost of Capital Per Mr. Sliwoski
                                 Before Tax                 After Tax
                 Percentage of     Cost of                   Cost of
  Financing        Financing      Financing   Income Tax    Financing
  Component        Component      Component   Adjustment    Component
Debt                65.5%          8.45%        62.0%         3.43%
Equity              34.5%         18.76%          NA          6.47%
Total                                                         9.90%
                                                                or
                                                           approximately
                                                               10%

Thus, the effect of Mr. Sliwoski’s weighted average is to reduce

the capitalization rate from 18.76 percent (24.76 percent



     17
       Mr. Kramer also believed that Renier’s estimated growth
rate should reduce its capitalization rate.
                              - 29 -

estimated return on equity less 6-percent growth rate in

earnings) to 10 percent.

     We are not persuaded by Mr. Sliwoski’s approach.      This Court

has often rejected the use of a weighted average cost of capital

in valuing an equity interest in a closely held corporation.

See, e.g., Estate of Hall v. Commissioner, 92 T.C. 312, 341

(1989); 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.       This approach has

also been criticized in valuation commentary.      See Bogdanski,

Federal Tax Valuation, par. 3.05[5][b] (1996 & Supp. 1999), and

authorities therein cited.   Although respondent cites Gross v.

Commissioner, T.C. Memo. 1999-254, as support for the use of this

method, we note that in that case, the corporation’s actual

borrowing costs were incorporated in the formula.      Here, Mr.

Sliwoski has relied entirely on a set of assumptions about the

cost and amount of debt that a hypothetical purchaser of Renier

would incur.   The estate argues, and presented evidence, that

these assumptions were unrealistic.    We agree.    A local banker

testified that financial institutions in the area would not have

extended an acquisition loan with respect to a retail business

like Renier at anywhere near the amount postulated by Mr.

Sliwoski and, further, would have required personal guaranties.

Such guaranties raise the effective cost of borrowing.      See Pratt

et al., Valuing Small Businesses and Professional Practices 220
                                - 30 -

(3d ed. 1998) (“it seems reasonable to recognize a premium of

upwards of three percentage points to the face value interest

rate if personal guarantees are required.”).     We do not have

confidence that Mr. Sliwoski’s attempt to estimate a weighted

cost of capital is reliable, even if we were satisfied that it

represents an appropriate approach for valuing an equity

interest.     Consequently, we reject the capitalization rate

proposed by Mr. Sliwoski and conclude instead that the

appropriate capitalization rate is one based upon a return to

equity alone, as proposed by Mr. Kramer.

                    b. Computation of Capitalization Rate Based on
                    Equity Return

     As previously noted, Mr. Sliwoski and Mr. Kramer largely

agreed on the rate of return on equity that a purchaser of Renier

would require.     Mr. Sliwoski concluded that an equity investor

would require a 24.76-percent rate of return, while Mr. Kramer

concluded that an equity investor would require a 24.90-percent

return.     The discrepancy between the two figures can be

attributed to the risk-free rate of return employed by each

expert.18    Mr. Sliwoski chose as his risk-free rate the 7.26-

percent return from 30-year U.S. Treasury bonds on the valuation

date, while Mr. Kramer utilized the 7.40-percent rate of return

on 20-year U.S. Treasury bonds.     This 0.14-percent rate


     18
       While the experts’ other assumptions also differ, these
differences are exactly offsetting.
                                - 31 -

difference equals the difference between Mr. Sliwoski’s required

rate of return on equity of 24.76 percent and Mr. Kramer’s rate

of 24.90 percent.    In the instant case, the correct risk-free

rate is that of 20-year U.S. Treasury bonds used by Mr. Kramer.

We so conclude because both experts developed their estimates of

the required rate of return on equity using data from Ibbotson

Associates, which publishes equity risk premium data related to

20-year coupon bond maturities, but no such risk premium data for

30-year maturities.19    For this reason, we find more appropriate

Mr. Kramer’s required rate of return on equity of 24.90 percent.

                    c. Estimate of Earnings Growth Rate

     Both experts agreed that the required rate of return on

equity used to convert expected future earnings into a value

figure should be adjusted to account for the estimated rate of

growth in Renier’s earnings after the valuation date.     The

experts disagreed, however, in their estimates of Renier’s long-

term growth rate.    Mr. Sliwoski reduced his required rate of

return on equity by 6 percent to account for expected growth in

Renier’s future income stream, while Mr. Kramer reduced his

required rate of return by only 3 percent.

     We do not believe either expert used a reasonable estimate

of the rate of growth.    Mr. Sliwoski derived his 6-percent growth

     19
       See Ibbotson Associates, Stocks, Bonds, Bills &
Inflation: 1994 Yearbook, 146; see also Pratt et al., Valuing a
Business, The Analysis and Appraisal of Closely Held Companies
163, n.10 (3d ed. 1996).
                               - 32 -

rate based on growth within the consumer electronic products

industry and normal inflationary price increases, while Mr.

Kramer limited his growth rate to the rate of inflation.    Neither

of these estimates finds support in the record.    Mr. Sliwoski’s

6-percent growth rate is based on the consumer electronics

industry as a whole and is not tailored to Renier’s specific

product mix.    Renier did not sell personal computers or cellular

telephones, both of which exhibited very high growth rates and

were included in Mr. Sliwoski’s growth-rate estimate.    As our

findings indicate, the national annual compound growth rate for

the items in Renier’s product mix, weighted to reflect the

percentage of sales of each, was only 4.15 percent from 1989

through 1993.    Although Renier’s actual sales increased at a

compound rate of 8.3 percent from July 1988 through June 1993,

the majority of that increase occurred in Renier’s fiscal year

ended June 30, 1993.    Sales in that year, however, were

substantially boosted as a result of a major flood in the spring

of 1993.20   If Renier’s fiscal year ended June 30, 1993, is

excluded, Renier’s compound growth rate equals just 3.8 percent,

or slightly less than the national average for Renier’s product

mix.    We are thus faced with the problem of how to account for

Renier’s bumper sales during 1993, only a portion of which should

       20
       Although the flood likely also boosted sales in the
fiscal year that began on July 1, 1993, Mr. Sliwoski did not
factor any of this period into his estimate of Renier’s growth
rate.
                                - 33 -

be projected into the future as sustainable growth.     Mr. Kramer

addressed this issue by adding 5 percent to Renier’s expected

future annual income prior to capitalization.     We agree that this

method correctly accounts for the recent strength in Dubuque’s

retail economy, while excluding growth attributable to the area’s

1993 flood.    We therefore conclude that the most accurate long-

term growth assumption for Renier is 4.15 percent.     However, we

also believe it is appropriate to adopt Mr. Kramer’s methodology

of adding 5 percent to Renier’s expected future annual income to

account for the recent strength in Dubuque’s retail economy.      In

further support of this conclusion, we note that Renier faced

stiff competition from a number of much larger chain retailers,

including K-Mart, Radio Shack, Sears, and Wal-Mart, putting in

doubt Renier’s ability to sustain a high sales growth rate after

the valuation date.

                    d. Conclusion: Income Valuation of Renier’s
                    Operating Assets

     Based on the foregoing, we conclude that the appropriate

capitalization rate on the valuation date equaled 20.75 percent;

namely, Mr. Kramer’s discount rate of 24.9 percent, less an

estimated long-term growth rate of 4.15 percent.     Furthermore, as

previously discussed, this capitalization rate should be applied

to 105 percent of Renier’s expected future annual income, or

$125,749.     Dividing this amount by the capitalization rate, we
                                 - 34 -

conclude that Renier’s operating assets had a value of $606,019

on the valuation date.

          3.   Valuing Renier’s Nonoperating Assets

     Finally, to arrive at a total value for Renier, each expert

added to his income valuation of Renier’s operating assets his

estimate of the asset value of Renier’s nonoperating assets.    The

biggest discrepancy in the experts’ valuation of the nonoperating

assets concerns their computation of Renier’s excess working

capital. (Under both experts’ methodology, their estimate of

excess working capital is added to nonoperating assets.)    Because

we previously rejected Mr. Sliwoski’s estimate of Renier’s

working capital requirements, we adopt Mr. Kramer’s figure and

conclude that Renier had excess working capital of $362,038.    The

experts largely agreed with respect to the value of Renier’s

remaining nonoperating assets, which Mr. Sliwoski valued at

$105,036 and which Mr. Kramer, using primarily Mr. Sliwoski’s

figures, valued at $108,887.21    To the extent Mr. Kramer’s value

exceeds Mr. Sliwoski’s, we consider the amount conceded by the

estate and therefore conclude that Renier had nonoperating assets

totaling $470,925.



     21
       The remaining nonoperating assets consisted of a
residence and two cars. Mr. Sliwoski valued the residence at
$81,686 and the two cars at $9,500 and $13,850, respectively, for
a total of $105,036. Mr. Kramer valued the residence at $86,975
and the two cars at $8,938 and $12,974, respectively, for a total
of $108,887.
                               - 35 -

     C.    Market Approach

     Mr. Kramer also used a market approach to value Renier,

while Mr. Sliwoski considered but ultimately rejected this

approach.    Typically, a market approach valuing the stock of a

closely held company involves three considerations:      Past

transactions in the company’s stock, past offers to purchase the

company, or, if neither of these is available, the market values

of stocks of comparable companies.      See sec. 20.2031-2(a)-(f),

Estate Tax Regs.; Rev. Rul. 59-60, 1959-1 C.B. 237.

     Mr. Kramer concluded that a market approach comparing Renier

to publicly traded companies was inappropriate because there were

no publicly traded companies sufficiently similar to Renier to

provide an adequate basis for comparison.      Instead, Mr. Kramer

utilized a market approach which he termed the “business broker

method”.    In Mr. Kramer’s analysis, the business broker method

postulates that the purchase price of a business equals the

market value of the inventory and fixed assets plus a multiple of

the seller’s discretionary cash-flow, defined as the total cash-

flow available to the owner of the business.      Seller’s

discretionary cash-flow is computed by adding owner’s

compensation, depreciation, and interest expense to pretax

income.    The multiple applied to seller’s discretionary cash-flow

is determined based on the strengths and risks associated with a

particular business; such multiples commonly range between 1 and
                               - 36 -

2.    In Mr. Kramer’s judgment, the appropriate multiple for

valuing Renier was 1.5.

      We do not find Mr. Kramer’s application of the business

broker method helpful in valuing Renier.    Mr. Kramer provided no

justification for the multiple he chose to apply to Renier’s

discretionary cash other than his own judgment.    In the absence

of any underlying data supporting Mr. Kramer’s selection of a

multiple, we are unable to assess its appropriateness.      See Rule

143(f)(1).    Thus, on this record the reliability of the business

broker method has not been established.

      D. Conclusion

       Both experts used an asset approach to value Renier’s

nonoperating assets and concede that such an approach would be

inappropriate to value Renier’s operating assets.    We agree with

their conclusions in this regard.    As Mr. Sliwoski also

disregarded his market approach and as we have rejected Mr.

Kramer’s business broker method, we conclude that the income

approach provides the best method for valuing Renier’s operating

assets.    Therefore, with nonoperating assets of $470,925, using

an asset approach, and operating assets of $606,019, using an

income approach, we find Renier had a fair market value on the

valuation date of $1,076,944, or $43.08 per share.    Consequently,

we further conclude that decedent’s 22,100 shares in Renier on

that valuation date had a value of $952,000.

II.    Addition to Tax
                               - 37 -

     Respondent also determined that the estate was liable for an

addition to tax under section 6662(a), which imposes a 20-percent

addition for certain underpayments of tax.   The addition is

imposed where there is an underpayment of estate tax resulting

from a substantial estate tax valuation understatement.   See sec.

6662(b)(5).   A substantial tax estate valuation understatement

occurs if the value of any property claimed on an estate tax

return is 50 percent or less of the amount determined to be

correct.   See sec. 6662(g)(1).   In the instant case, the estate

reported Renier’s stock on its return as having a value of $33.02

per share.    As we have found that the correct value is $43.08 per

share, no substantial estate or gift tax valuation understatement

has occurred.   Given our conclusion, we need not address whether

the estate qualifies for the reasonable cause exception contained

in section 6664(c)(1).

     To reflect the foregoing,

                                          Decision will be entered

                                     under Rule 155.
