Reprinted from Mercer Capital’s – Vol. 9, No. 1, 1997.

A 1997 case illustrates the complexities that can evolve in the valuation of debt securities and the weight the Tax Court applies to an appraiser’s effort to obtain and verify information on a particular interest to be valued. Of special interest in Evelyn T. Smith, Executrix of the Estate of Verna Mae Crosby v. Internal Revenue Service, No. 1:94-CV-460RR, U.S. District Court for the Southern District of Mississippi Southern Division, filed in February 1996, is the Court’s acknowledgment of the “willing buyer/willing seller” concept in its proper context. In this case, the appraiser was held to the same level of due diligence that a prospective buyer would put forth in obtaining information on a debt instrument at the original valuation date.

The Facts of the Case

The case involved a note from St. Regis Paper Company (“St. Regis”) which was held by the Estate of Verna Mae Crosby (“the Estate”) following her death. When the estate tax return was filed, the Estate retained Mercer Capital to value the note. The valuation issue was heard in Federal District Court when the Executrix sought a refund of estate taxes paid to the IRS.

The original note was issued by St. Regis on May 17, 1977 to Mr. L. O. Crosby, husband of Verna Mae Crosby (the decedent). The note had a principal balance of $10,312,000, and was payable in twenty annual, equal installments of principal of $515,600. Six percent simple interest, computed from the inception of the note to the date of redemption, was added to each principal payment, resulting in annual payments successively larger due to the increasing amount of interest added to each installment.

The annual principal payments were made in a timely manner by St. Regis to Mr. Crosby until his death. Upon his death he bequeathed a two-thirds interest in the note to Mrs. Crosby and a one-third interest to a charitable foundation. Some years later (1981), exchange promissory notes were issued to Mrs. Crosby and the charitable foundation, thus eliminating the two-thirds ownership interest in the original note held by Mrs. Crosby. This fact, however, was not known by the Estate until later. The face amount of the exchange promissory note for Mrs. Crosby (now a 100% ownership interest) was $5,499,733 at the date of issuance and provided for yearly principal payments of $343,733. The terms of the exchange notes were structured identically to the original note, and total interest payments increased each year. The last payment was to be made in May 1997.

Taxpayer Files For Refund

In January 1985, St. Regis was merged into Champion International Corporation (“Champion”), which assumed responsibility for the note. Mrs. Crosby died in April 1988. At that time, the unpaid principal on the note was $3,437,733 and the remaining (nominal) interest totaled $4,124,800. An estate tax return was filed on behalf of the Estate which concluded the correct value of the decedent’s interest was $3,348,500 for purposes of computing the estate tax liability. The value was based on an appraisal prepared by Mercer Capital. An IRS audit concluded the value of the interest in the note to be $4,400,000, which implied a deficiency in tax payment by the Estate of $410,838 plus interest to the present or a total payment of $714,195. Contemporaneously with the payment, the Estate filed a claim for a full refund of the estate taxes and interest paid.

Experts Consider Impact of Unknown Events

The Mercer Capital appraisal and the IRS appraisal (which was prepared by another valuation firm) were both based on Mrs. Crosby’s original two-thirds interest in the note.

Z. Christopher Mercer, ASA, CFA prepared the valuation for the Estate and testified at trial. Shortly prior to trial, it was discovered that the original promissory note had, in fact, been reissued by St. Regis as two exchange promissory notes. Upon learning this fact, the Estate’s expert, Mr. Mercer, prepared an addendum to his valuation since the original note was discounted because of the undivided two-thirds interest. The Mercer Capital valuation was revised upward to $3,553,222. The IRS’ expert testified that this fact had no impact on his valuation.

Experts Disagree on Premium to Required Rate of Return

The experts were generally in agreement on the methodology used to value the note and used similar approaches. They differed substantially on the adjustment necessary to account for the differences between the Estate’s promissory note and the publicly traded debt of Champion. Both experts discounted the cash flows that would be derived from the note using base rates determined from Champion’s publicly traded debt.

The IRS’ expert added 0.5% to his base discount rate determined from Champion’s publicly traded debt. Mercer made a series of adjustments and set forth the rationales which are summarized in Figure 1. Mercer acknowledged that the adjustments were based on experience and reason, rather than market data, but compared his final discount rate to alternative, risky investments.

It was evident to the Court, as it would be to a lay person, that there were significant differences in the publicly traded debt of Champion and the one page note held by the Estate, including:

  • The publicly traded debt was well documented. The prospectus supplements for each of Champion’s publicly traded debt instruments were in excess of twenty pages in length. The indenture agreements ranged to hundreds of pages and included financial statements, legal opinions, the notes and other information, all of which would be available to a prospective purchaser of the publicly traded debt.
  • The debt of Champion is tradable on a public exchange, in denominations as low as $1,000. The note held by the Estate was not divisible.
  • The Champion debt also had significant legal protection in the event of default and had restriction on the business operation of Champion (including “anti-junking” protections) to provide further security and comfort to a holder of the debt instruments.

The Court agreed that none of these factors were present in the Estate’s note. Mercer testified that the absence of these factors was an important consideration for hypothetical potential buyers for the note. He then went on to explain why a number of categories of potential investors would be precluded from acquiring the note.

Court Considers Lack of Information Significant

Of major concern to Mercer Capital, and apparently the Court, was Mercer Capital’s inability to obtain necessary information from Champion to value the note in 1988. Efforts to obtain information about the note were ultimately acknowledged with a one-page letter indicating that Champion was the successor of St. Regis and was “responsible” for the promissory note. (This letter did not reference the later- discovered exchange promissory notes.) The IRS’ expert did not make an independent attempt to contact Champion. One month prior to trial, however, the trial lawyer for the IRS deposed a representative of Champion.

While the representative was able to acknowledge and confirm Champion’s responsibility for the note, as well as a number of factors for which Mercer Capital applied discounts (or premiums to the required rate of return), it is important to note that the IRS’ expert did not have this information in hand at the time of his appraisal. This information only became available prior to the trial, and only upon subpoena by the Department of Justice.

The Court’s conclusion, after careful review of the facts, swung heavily on the fact that both experts, in their reports, referred to their appraisals as fair market value appraisals, which is defined as the price that would be agreed upon by a good faith purchaser and a good faith seller, both being aware of all relevant facts and neither being under any duress.

The “relevant facts” were those that existed in 1988 when Mercer originally valued the note. The Court agreed that the information that was obtained, or unable to be obtained, by Mercer Capital at that time, was the only information relevant to the valuation of the note issue. The IRS’ deposition of a Champion representative which was obtained prior to trial was deemed to be irrelevant when attempting to determine the value as of April 1988. In addition, the Court noted that the deposition did not refute the factors considered in the Mercer Capital valuation.

The Estate was awarded a full refund of the deficiency, along with statutory interest from the date of payment in 1993.


This case covers a number of general concepts that are important in the valuation of any debt instrument or, more generally, in the valuation of closely held business interests. Not all the factors have been discussed in this article because of space limitations:

  • “Hypothetical willing buyers” in the context of Revenue Ruling 59-60 consist of buyers with the interest and capacity to purchase the subject investment.
  • The effort required by a “willing purchaser” to obtain relevant information about the investment.
  • The appearance of advocacy by an appraiser which is harmful to credibility.
  • The information relevant to an appraisal that was known or reasonably knowable at the valuation date.
  • Factors which limit the marketability of securities which should be considered in an appraisal.

If you would like a copy of this case or to discuss a valuation issue in confidence, please give one of our professionals a call.

Reprinted from Mercer Capital’s – Vol. 9, No. 1, 1997.