In Estate of Heck v. Commissioner, the Tax Court rejected use of the market approach in valuing a minority interest in an S corporation because the expert relied on only one comparable sale.

The dispute concerned the estate of Richie Heck, who at the time of her death in February 1995, owned 630 shares of F. Korbel & Bros., Inc. The Heck family had purchased a controlling interest in Korbel in 1954 and owned the company outright or in trust.

Korbel, a California S corporation, produced economically priced champagne. In 1991, it had entered into an exclusive distribution agreement with Brown-Forman. The agreement granted Brown-Forman the right of first refusal on any stock sales outside the Heck family. In question was the value of Heck’s stock, which the IRS valued at $47,900 per share and the taxpayer valued at $26,000 per share.

To determine the value, the IRS expert used both the market and income approaches, giving the market approach a weight of 30 percent because of the "lack of perfect comparables." He also applied a "liquidity" discount (15 percent to stock, 25 percent to land), a minority discount (25 percent to land and excess cash), and a 10 percent discount for risks associated with S corporations, including potential loss of S status and potential shareholder tax liability.

The taxpayer’s expert relied exclusively on the income approach, rejecting the market approach because of lack of comparables. He applied a 25 percent marketability discount and another 10 percent discount to reflect the negative impact of Brown-Forman’s right of first refusal.

Comparables Weren’t Similar Enough
In making its decision, the court noted that the major disagreement centered on the market approach and use of the guideline company method. The IRS expert had identified 11 companies similar to Korbel and rejected nine of them. The remaining two, however, were different from Korbel in a number of key respects, including size, product line, and marketing strategies. The court concluded that while it had allowed a small number of guideline companies in the past, the companies had been in the same line of business, not just a similar one.

"As similarity to the company to be valued decreases," the court explained, "the number of required comparables increases in order to minimize the risk that the results will be distorted to attributes unique to each of the guideline companies. In this case, we find that Mondavi and Canandaigua were not sufficiently similar to Korbel to permit the use of a market approach based upon those two companies alone."

The court also observed that although the IRS expert cited two comparables in his report, he had actually used only one in his market approach valuation. The court found that use of one comparable has been rejected in the past because "one company may have unique individual characteristics that may distort the comparison."

Although the two experts agreed on the elements of the discounted cash flow method under the income approach, they disagreed on the computation. Finding neither side completely persuasive, the court accepted portions of both experts’ testimony. The court accepted the taxpayer’s 25 percent marketability discount and allowed the 10 percent discount for Brown-Forman’s right of first refusal, arriving at a fair market value of $32,174 per share.