Estate of Lauder v. Commissioner

MEMORANDUM FINDINGS OF FACT AND OPINION

HAMBLEN, Chief Judge: Respondent determined a deficiency of $ 42,702,597.67 in the Federal estate tax due from the Estate of Joseph H. Lauder (petitioner). In Estate of Lauder v. Commissioner, T.C. Memo. 1990-530, we denied petitioner's motion for partial summary judgment that restrictive shareholder agreements, to which Joseph H. Lauder (Joseph or decedent) was a party, control the question of the value of stock in a closely held corporation for purposes of the Federal estate tax. We found that Joseph's health was satisfactory and normal for a man of his age on the dates that the shareholder agreements were executed. Nonetheless, we concluded that further factual development would be necessary to aid the Court in determining whether the shareholder agreements were intended to serve as a device to pass Joseph's stock to the natural objects of his bounty for less than an adequate and full consideration in money or money's worth. *785 Sec. 20.2031-2(h), Estate Tax Regs. ¹

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulations of facts and attached exhibits are incorporated herein by this reference.

Joseph H. Lauder died testate at age 81 in the State of New York on January 16, 1983, survived by his wife, Estee Lauder (Estee), and his two sons, Leonard A. Lauder (Leonard) and Ronald S. Lauder (Ronald). (References to the Lauders are to Estee, Joseph, Leonard, and Ronald collectively.)

I. Background

A. Estee Lauder, Inc.

Estee Lauder became interested in skin care and cosmetics as a young girl while assisting her uncle, a chemist, with the preparation of skin creams in a laboratory behind her family's house. Estee and Joseph entered the cosmetics business just after World War II.

On May 20, *786 1958, Fragrance Products Corp. was incorporated under the laws of the State of New York. In 1963, the name of the company was changed to Estee Lauder, Inc. (ELI). At all times pertinent hereto, ELI and its subsidiaries and affiliates were engaged in the manufacture and distribution of cosmetics, fragrances, and related products.

In the beginning, ELI sold four basic skin care products through a few beauty salons in New York City. Estee and Joseph were ELI's sole employees and business was conducted in the rented basement of a building in New York City.

Saks Fifth Avenue was the first specialty store to carry ELI's products. Through the mid-seventies, the Lauders maintained a policy of distributing ELI's products exclusively through high-end specialty and department stores.

Leonard and Ronald began working part-time for the business during their early teenage years, delivering orders and doing odd jobs. Leonard, who is 11 years older than Ronald, joined the business on a full-time basis in 1958 after graduating from the University of Pennsylvania and serving in the United States Navy. At that time, ELI generated annual sales of $ 800,000 and its facilities were so small that*787 Leonard shared an office with Estee, served as the only salesman, and was also responsible for public relations, product advertising, marketing, and package delivery. Leonard became president of ELI in 1973.

Ronald joined the business on a full-time basis in 1967. Prior to that time, Ronald attended the University of Pennsylvania, studied international business at the University of Brussels (while working in ELI's factory in Belgium), and served in the United States Coast Guard. Initially, Ronald serviced two major accounts and was coordinator of marketing groups. Ronald became ELI's vice president for marketing and sales in 1973.

Estee attributed the success of the business to the family's hard work. The Lauders shared the view that it was of utmost importance to keep the business in the family. As one of the few privately held cosmetics companies, the Lauders believed that ELI operated at a substantial advantage over its competitors. In their view, ELI was in a position to take more risks and move more aggressively than publicly held companies. Further, market share and sales could be built without concerns of showing an immediate profit.

At various times, the Lauders*788 have been urged to make a public stock offering. The Lauders have remained opposed to such suggestions. Prior to 1975, the Lauders never engaged an investment banker or other outside consultant for this purpose nor did they solicit or receive any information regarding the price that their shares would bring in a public offering.

ELI common stock has never been publicly traded. From March 31, 1967, through December 14, 1976, the Lauders owned all of ELI's outstanding common stock. Although persons and organizations other than the Lauders and their immediate family have owned stock in ELI and its affiliates, the Lauders have always maintained control over ELI. ELI preferred stock has been owned by the Lauders and various organizations, including schools, museums, a hospital, and the Lauder Foundation.

The Lauders intend that a third generation of their family eventually will manage and control the family business. To this end, Estee and Joseph's grandchildren have joined the business in entry level positions commensurate with their respective ages and experience.

B. Operating Divisions and Related Corporations

As of 1974, ELI had three major operating divisions: Estee*789 Lauder U.S.A., Clinique, and Estee Lauder, International.

1. Estee Lauder, U.S.A.

During the period in question, Estee Lauder U.S.A. maintained three separate product lines: Fragrances, makeup, and skin care treatment. Estee Lauder U.S.A. relied heavily on sales of a fragrance, Youth Dew, first introduced to the market in 1953. In 1974, 1975, and 1976, Youth Dew sales were approximately $ 35.8 million, $ 35.7 million, and $ 37.5 million, respectively. To reduce its reliance upon Youth Dew, Estee Lauder U.S.A. introduced several new products during the late sixties and early seventies, including the fragrances "Estee", "Azuree", "Aliage", and "Private Collection".

2. Clinique and The Hypo-allergenic Rule

The Clinique division appears to have originated in 1968. C.L. Allergenics, Inc., was organized as a New York corporation on December 13, 1973. Its name was subsequently changed to Clinique Laboratories, Inc. (Clinique) on December 28, 1973. Clinique products are marketed as fragrance-free and allergy-tested to attract women with sensitive skin and younger women who want a more natural look from their cosmetics.

From 1973 through 1976, ELI owned all of Clinique's*790 class A common stock which represented 80 percent of Clinique's voting stock. During this same period, Leonard and Ronald owned all of Clinique's class B common stock which represented 20 percent of Clinique's voting stock. ELI was entitled to a preference as to Clinique's first $ 750,000 in earnings available for dividends as well as 50 percent of any earnings in excess of that amount. Leonard and Ronald were entitled to 50 percent of Clinique's earnings available for dividends in excess of $ 750,000.

Clinique initially acted as a cash drain on ELI causing overall losses through 1970. However, Clinique experienced extraordinary success and rapid growth during the years 1972 through 1976, with gross profits from domestic sales increasing from $ 5.1 million in 1972 to $ 26.6 million in 1976. During 1976, Clinique accounted for approximately 15 percent of ELI's total sales. Its fast growth was in part related to the small base from which it started. The executive head of the Clinique division had the impression that some others in ELI and the industry considered Clinique to be a fad.

In February 1974, the Food and Drug Administration (FDA) issued a proposed rule to require *791 extensive testing and proof to support the use of the terms "hypo-allergenic" or "allergy tested" in describing a cosmetics product (the hypo-allergenic rule). Although the hypo-allergenic rule was eventually issued in final form, its effective date was stayed on July 23, 1975, pending the outcome of a lawsuit brought by Clinique and Almay, Inc., challenging its validity.

On June 30, 1976, the hypo-allergenic rule was upheld in Almay, Inc. v. Weinberger, 417 F.Supp. 758 (D.D.C. 1976). However, the District Court's decision was subsequently vacated and remanded in Almay, Inc. v. Califano, 569 F.2d 674 (D.C. Cir. 1977), on the ground that the hypo-allergenic rule was arbitrary and capricious. The rule was revoked effective March 14, 1978.

While the hypo-allergenic rule was pending and in effect, Almay, Inc., removed hypo-allergenic labeling from its packaging. Thereafter, its sales growth stagnated and a newly introduced product failed to gain market share. Following the Court of Appeals decision, Almay, Inc., resumed using the hypo-allergenic labeling, and its sales increased soon thereafter. Although the Clinique*792 division was affected by the rule, ELI's audited financial statements for the years 1972 through 1976 do not mention the hypo-allergenic rule.

3. International

The International division markets all of ELI's principal products overseas. From its origination in 1961 until 1974, International remained in a "startup" phase, requiring large outlays of capital and producing few returns. During this period, cosmetics markets in many foreign countries were difficult to penetrate by virtue of trade barriers ranging from secret lists of prohibited ingredients to specialty store boycotts. During the years 1974, 1975, and 1976, International's gross profits were $ 29.7 million, $ 41.5 million, and $ 51.5 million, respectively.

4. Mentzer Holdings, Inc.

Mentzer Holdings, Inc. (Mentzer), was organized as a Delaware corporation on March 18, 1975, to serve as a holding company for the shares of Estee Lauder Cosmetics, Ltd. (U.K.). Estee Lauder Cosmetics, Ltd. (U.K.), markets cosmetics and fragrances in the United Kingdom. Prior to March 1975, the stock of Estee Lauder Cosmetics, Ltd. (U.K.), was owned by the Lauders and ELI. Mentzer was organized in part to enable the Lauders*793 to avoid potential estate tax liability in the United Kingdom.

5. EJL Corporation

EJL Corporation (EJL) was organized as a Delaware corporation on December 14, 1976, to serve as a holding company for ELI (and its subsidiaries) and Mentzer. From 1976 through February 1991, EJL's voting common stock was owned by the Lauders directly. Other than 2,100 shares of nonvoting common stock that were contributed to the University of Pennsylvania in 1976 (and later redeemed by EJL in 1981), EJL's nonvoting common stock was at all times owned by the Lauders, either directly or as trustees for certain trusts established for the children of Leonard and Ronald.

EJL preferred stock has been owned by the Lauders and various organizations, including schools, museums, a hospital, and the Lauder Foundation.

6. Aramis, Inc.

Aramis, Inc., was founded by the Lauders as a separate corporation in 1965 to manufacture and market a complete line of fragrances and related products for men. Aramis products were marketed and distributed jointly with ELI products.

II. The Industry

The third quarter of 1973 marked the beginning of a serious recession in the United States. The recessionary*794 cycle reached its lowest point during the second quarter of 1975. The recession was exacerbated by many factors, including the effects of rising oil prices and the tightening of the money supply by the Federal Reserve. The economy appeared to be recovering by the latter part of 1975 and the early part of 1976.

During the period in question, the potential for profitability in the cosmetics and toiletries industry was above average as compared to other manufacturing industries. Industry sales were made through a variety of retail outlets and door-to-door. The products sold through retail outlets included both mass market items sold in supermarkets and drug stores and prestige cosmetics lines sold in high-end specialty and department stores. Retail competition was strong, and advertising outlays, such as gift-with-purchase advertising, reduced profits. A relatively small group of companies generated a substantial portion of retail sales with six companies accounting for 40 percent of total retail sales in 1975.

During the early seventies, several pharmaceutical companies entered the cosmetics industry through the acquisition of established companies. For example, Squibb acquired*795 Lanvin-Charles of the Ritz, Eli Lilly acquired Elizabeth Arden, and Colgate-Palmolive acquired Helena Rubenstein.

Designer fragrances were first introduced to the market during the seventies. In addition, mass market sales grew during this period reflecting a trend toward one-stop shopping.

During the early seventies, the number of "doors", the industry term for retailing locations, increased. Between 1971 and 1975, sales of cosmetics, toiletries, and women's fragrances increased on an industry-wide basis by 31.7 percent, reflecting average annual growth in excess of 7 percent.

Fragrance sales are very seasonal with the high point of sales occurring during the Christmas holidays.

III. Marketing and Financial Performance

A. Marketing

ELI promoted its products as high quality lines and priced them at prestige levels. During the period 1974 though 1976, ELI's revenues were derived primarily from sales of fragrances for women.

The Lauders have always considered their reliance on high-end specialty and department stores as the exclusive means for distributing ELI products to be a key element of their success. During the period in question, the Lauders were the industry*796 leaders in marketing to high-end specialty and department store chains, with Revlon, Inc. (Revlon), providing substantial competition. During this period, Revlon introduced higher-priced luxury products often designed to challenge ELI products.

The Lauders' unique marketing plan provided ELI with many advantages over its competitors. In particular, the Lauders were very selective in choosing specific retailers, individual stores within a particular retail chain, and the specific geographic areas where ELI products would be sold. Through this program, the Lauders were able to ensure that ELI products would be distributed to those individual stores with strong cosmetics departments.

The Lauders aggressively promoted ELI products. Prior to opening a new account, a senior sales representative would work with the store's management to develop an 18-month "action plan". Due to their marketing and promotional skills, the Lauders often would find themselves managing a major portion of a store's total cosmetics promotion budget. In return, these stores would pay a large percentage of ELI's in-store personnel and promotional costs, whereas most of ELI's competitors were required to *797 absorb all of these expenses. As a consequence of their in-store managerial role, the Lauders were able to access a department store's 5-year plan for new store openings, allowing the Lauders to target new opportunities at an earlier stage than their competitors. Finally, the Lauders would demand, and almost always receive, the best counter location for displaying ELI products within each store.

Once a retail location was established, the Lauders would use the store's customer lists to send mailers or billing inserts advertising gift-with-purchase sale promotions. These promotions, although expensive, were very successful. Sales representatives would also organize bridal shows and free demonstrations. ELI's competitors in the cosmetics industry generally remained committed to costly mass market media advertising campaigns.

B. Financial Performance

During 1974, the cosmetics and toiletries industry experienced an average return on equity of 16.6 percent. During 1974, ELI experienced a return on equity of 29.9 percent.

During the years 1972 through 1976, ELI's net sales grew at a compound annual rate of 24.1 percent. In absolute terms, its net sales grew from $ 95.4 million*798 for 1972 to $ 226.4 for 1976. Some of ELI's sales growth was attributable to "pipelining" products in international markets. ²

For the years 1972 through 1976, ELI's net income grew at an annual compound rate of 18.8 percent. ELI experienced a decline in net income in 1975 from the prior year. Between 1974 and 1976, ELI's net income (before extraordinary credits) increased from $ 8 million to $ 10.3 million. During this same period, the total value of ELI's assets (book value) increased from $ 76.6 million to $ 123.5 million.

In a July 15, 1975, article appearing in Forbes magazine, Leonard was quoted as predicting that ELI's sales and profits would "at least double in the next three to five years."

ELI did not pay substantial dividends during the years 1974 *799 through 1976. Earnings generally were reinvested in the business during this period.

In 1975, ELI engaged an investment banking firm, Warburg Paribas Becker, Inc. (Warburg), to assist in raising capital. At the time, ELI was considering a private placement of $ 15 million of debt securities. In conjunction with the proposed private placement, Warburg was supplied with ELI's financial statements. In November 1975, Warburg released a detailed private placement memorandum to at least one insurance company considered to be a potential investor for the proposed offering. In 1976, the Lauders decided to withdraw from the transaction.

C. Financial and Tax Accounting Records

From 1972 through 1977, ELI and EJL operated on a fiscal year ending June 30 for financial statement and tax accounting purposes. ELI's audited financial statements were prepared by Arthur Anderson & Co. during the period in question. Prior to the fiscal year ending June 30, 1974, financial statements were prepared on a combined basis for ELI, its subsidiaries, and affiliated companies, including Aramis, Inc. Thereafter, ELI's financial statements were prepared on a consolidated basis with its subsidiaries*800 only.

During the period 1970 through 1977, ELI maintained unaudited financial statements for internal purposes with respect to some of its divisions. These statements did not fully eliminate the effect of intercompany transactions on the financial results.

During this period, ELI had no overall interdepartmental budgeting plan or costing system. As a consequence, inventory did not always correspond with sales forecasts.

D. Management

ELI relied on Leonard, and to a lesser extent Estee, for managerial decisions. From 1974 through 1976, and thereafter, Joseph was executive chairman of the board of directors and treasurer, Estee was chairman of the board, Leonard was president and a director, and Ronald was vice president and a director.

On January 16, 1983, the date of decedent's death, decedent, Estee, and Leonard continued to hold the same positions. At that time, Ronald was executive vice president and a director.

IV. Shareholder Agreements and Related Transactions

A. The Trademark Agreement

In the late sixties, ELI began to explore the possibility of raising funds through various outside sources, including loans from commercial banks and the private *801 placement of securities with insurance companies and other institutional investors. ELI was unsuccessful in raising such funds due in large part to the fact that ELI did not possess outright ownership of many of the trademarks and other assets conducive to its continued growth and profitability.

Recognizing that "the goodwill of [ELI] is symbolized by the name Estee Lauder and the Estee Lauder Trademark and Dependent Trademarks," Estee and ELI entered into an agreement, dated December 19, 1969, whereby Estee agreed to sell to ELI all of her right, title, and interest in the trademark for the name and style "Estee Lauder" as well as all dependent trademarks. In consideration for the trademarks, ELI promised to pay Estee an annual royalty of 3 percent of its net sales or a minimum of $ 1.2 million annually for her life. While ELI was authorized to terminate the agreement after 15 years, Estee could only terminate the agreement upon the default of ELI.

B. The Worsfold Agreement

In January 1960, Robert Worsfold (Worsfold) ³ joined the International division in an executive capacity. By 1975, Worsfold was president of International and an executive vice president of ELI.

*802 Sometime in late 1970 or early 1971, Worsfold was offered a position with Lanvin, Charles of the Ritz. As an inducement to retain Worsfold as an employee, Leonard arranged for ELI to transfer 297 shares of Estee Lauder Hemisphere Corp. (Hemisphere), an ELI subsidiary operating in the Caribbean, into trust for Worsfold's benefit with Leonard acting as trustee. Pursuant to an agreement (the Worsfold agreement) dated September 3, 1971, ELI agreed to purchase the shares from the trust at a specified formula price if the trustee desired to sell. The formula price was based on 10 times Hemisphere's average earnings for the 3 fiscal years preceding the sale, reduced by the par value of any outstanding preferred stock and any accrued dividends. In no event was the formula price to be less than book value. Worsfold did not negotiate the formula price because it was his understanding that he would earn a $ 1 million bonus pursuant to the agreement if he enhanced Hemisphere's operations.

On January 11, 1974, the Worsfold agreement was amended to permit ELI to purchase the shares from the trust under an installment plan. On the same day, ELI purchased the shares for $ 1 million to be *803 paid in installments.

C. The Clinique Agreement

On December 1, 1973, ELI, Clinique, Leonard, and Ronald executed a shareholder agreement (the Clinique agreement) restricting the transfer of Clinique stock. The price at which shares could be offered for sale under the Clinique agreement was limited by a formula based on book value.

D. The ELI Agreement

On May 28, 1974, ELI common stock (voting and nonvoting) was owned as follows:

On this date, the Lauders and ELI executed a document entitled "Shareholder Agreement" (the 1974 agreement). ⁴ The 1974 agreement states in pertinent part:

Article 2. Voluntary Transfer.

2.1 Notice.

If any Shareholder during his lifetime (the "Offeror") intends to transfer any Shares which he owns, he shall give written notice to the Corporation and the other Shareholders of his intention to do so. The notice shall state the number of Voting Shares and the number of Nonvoting Shares to be *804 transferred.

2.2 First Offer.

Within 60 days after the receipt by the Corporation of the foregoing notice, each of the other Shareholders shall have the option to purchase for a purchase price determined in accordance with Article 6 hereof, such portion of the Voting Shares and such portion of the Nonvoting Shares set forth in such notice (the "Offered Shares") as the number of Voting Shares and the number of Nonvoting Shares owned by him on the date of receipt of such notice shall bear to the total number of Voting Shares and the total number of Nonvoting Shares owned by the Shareholders, provided, however, that if any Shareholder does not purchase his full proportionate share of the Offered Shares, the unaccepted Shares may be purchased by the other Shareholders proportionately.

2.3 Second Offer.

If for any reason all the Offered Shares are not purchased by the Shareholders within 60 days after the Corporation's receipt of such notice, the Corporation shall have the option to purchase all of the Offered Shares not purchased by the Shareholders for a purchase price determined pursuant to Article 5 [6] hereof on a date to be mutually determined by the Shareholders, but *805 not later than 90 days after the Corporation's receipt of such notice. Notwithstanding anything herein contained to the contrary, if the Offeror at the time of giving notice owns more than fifty percent (50%) of the Voting Shares, the Corporation shall be required to purchase all of the Offered Shares which are Voting Shares and which are not purchased by the Shareholders for a purchase price determined pursuant to Article 6 hereof on a date to be mutually determined by the Shareholders but not later than 90 days after the Corporation's receipt of such notice. * * *

* * *

Article 3. Transfer Upon Death.

Upon the death of any Shareholder, all of the Shares then held in the estate of the deceased Shareholder shall be offered for purchase according to the terms of Paragraphs 2.2 and 2.3 of Article 2 hereof * * *.

* * *

Article 6. Purchase Price.

6.1 Determination of Value.

The purchase price of Shares to be purchased hereunder shall be the net per share book value of such shares (excluding any value for all intangible assets, such as goodwill * * *, etc.) as determined in the last audited annual statement of the Corporation preceding (a) the date the notice with *806 respect to such shares is received by the Corporation; (b) in the event of a transfer pursuant to Article 3 hereof, the date of death of the deceased Shareholder; or (c) in the event of a transfer pursuant to Article 4 hereof, the date of termination of employment (the "last Audited Statement Date"). The determination in such last audited annual statement shall be final and binding upon all parties.