Successfully Defending Valuations During Estate & Gift Tax Exams Carol Lewis, CPA, ABV Partner Forensics & Valuation Services clewis@bkd.com October 8, 2014 experience expertise // Elevate your understanding of key forensics concepts with guidance from BKD Forensics Institute. To Receive CPE Credit Individual Attendee o Participate in entire webinar o Answer polls when they are provided Group Attendees o Complete group attendance form with Title & date of live webinar Your company name Your printed name, signature & email address o All group attendance sheets must be submitted to training@bkd.com within 24 hours of live webinar o Answer polls when they are provided If all eligibility requirements are met, each participant will be emailed a CPE certificate within 15 business days of live webinar 2 1
What s the Risk? Worried about an IRS audit? Avoid what s called a red flag. That s something the IRS always looks for. For example, say you have some money left in your bank account after paying taxes. That s a red flag! Jay Leno 3 What Defines Success to the Taxpayer? Avoiding the exam in first place Expediting the process/settling at the agent level/ keeping professional fees in check A no change result, or as close to it as possible Minimizing exposure on subsequent returns 4 2
Goals Identify tactics to address IRS exam risk Discuss potentially vulnerable valuation issues Prepare key items to include in audit response Evaluate strategies for negotiating valuation discounts & other valuation issues under challenge 5 What s the Risk? Gift tax returns what s the chance for an IRS exam? Gift Tax Returns Filed & Audited From Sept. 2013 IRS Data Book 2012 Historically Approx total filed 260,000 100,000 Percentage audited a little over 1% about 1% 6 6 3
What s the Risk? Of 260,000 gift tax returns filed in 2012 Only 2,469 related to taxable gifts Only 1,755 of taxable gifts related to gifts over $1 million Of returns examined, only 38% resulted in no change 7 What s the Risk? As a result of gift tax exams $1,228,013,000 of additional tax was recommended by IRS examiners 8 4
What s the Risk? Estate returns what s the chance for an IRS exam? Estate Tax Returns Filed & Audited From Sept. 2013 IRS Data Book 2012 2011 Historically Approximate total filed 28,000 12,600 9,000 Percentage audited 11.6% 29.9% Estates under $5 million 19,000 9,500 Percentage audited 5.1% 14.5% Estates between $5 & $10 million 6,000 2,000 Percentage audited 5.1% 58.6% Estates over $10 million 2,700 900 Percentage audited 31% 100% 9 What s the Risk? If an estate tax return is selected for exam, what s the likelihood it will result in additional tax? 10 5
What s the Risk? If an estate tax return is selected for exam, what s the likelihood it will result in additional tax? Rule of thumb: 60% Additional tax 20% No change 20% Nominal overpayment 11 What s IRS Looking For to Back Up FMV? 1. Is there an appraisal report included to back up the value? 2. Is the appraiser with a recognized firm, does IRS have prior experience with the appraisal firm & does the appraiser have a credential? 3. Does the appraiser address limiting conditions? 4. Was a real estate appraisal obtained, & if not, was it explained in limiting conditions? 12 6
What s IRS Looking For to Back Up FMV? 5. Is an operating company in the mix? If so, were the valuation methods reconciled, & does it make sense? 6. Is there support for the discount for lack of control & lack of marketability? More than one method to determine the discounts? 13 What s IRS Looking For to Back Up FMV? Is an appraisal report included to back up the value? If the return lists noncash items that require an appraisal (land, investments in private companies), they ll be looking for an appraisal Appraisal should contain an opinion of value Entire appraisal report document needs to be included Possible exception: Small annual exclusion gift support in the form of calculation 14 7
What s IRS Looking For to Back Up FMV? Is the appraiser with a recognized firm, does IRS have prior experience with the appraisal firm & does the appraiser a have a credential? Returns from recognized firms are less likely to get scrutiny. In this instance, it is good to have a reputation The most recognized credentials held by business appraisers o ASA (American Society of Appraisers) o CPA/ABV (AICPA/Accredited in Business Valuation) o CVA (National Association of Certified Valuation Analysts/NACVA) 15 What s IRS Looking For to Back Up FMV? Does the appraiser address limiting conditions? Required by Uniform Standards of Professional Appraisal Practice Usually listed as an appendix to the report Contains information as to whether the appraiser requested certain information & didn t receive it 16 8
What s IRS Looking For to Back Up FMV? Was a real estate appraisal obtained, & if not, was it explained in assumptions & limiting conditions? Real estate appraisal in entirety should be included with the return & should be referenced in business appraiser s report If real estate appraisal was not obtained, it needs to be explained in business appraiser s report. Will likely need to be listed in the business valuation report s assumptions & limiting conditions. IRS will be looking for instances of inconsistency 17 What s IRS Looking For to Back Up FMV? Is an operating company in the mix? If so, were the valuation methods reconciled, & does it make sense? Three general approaches must be at least considered: assetbased, income-based, market-based Market approaches from transactions or public company data sometimes lead to very different conclusions from income approaches (reasons include stale data, insufficient amount of transactions, dissimilar companies, strategic acquisitions/ synergies anticipated in the transaction) If conclusions from various approaches don t support one another, appraiser shouldn t just rely on a simple average to arrive at a conclusion that may not be reasonable 18 9
What s IRS Looking For to Back Up FMV? Is there support for the discount for lack of control & lack of marketability? More than one method to determine discounts? 1. Restricted stock studies 2. IPO studies 3. FMV Restricted Stock Study 4. QMDM 5. Reference of general studies/court cases 6. Consideration of both qualitative & quantitative information 19 What Are the Hot Valuation Issues in Current Exams? 1. Issues with real estate appraisals in holding companies/agricultural real estate-based companies A. Yes, real estate appraisals actually are necessary. B. Sure, but can t we just use an estimate or county assessor s information? C. How current is current enough? D. A subsequent sale to support the value makes sense in certain situations. E. Particular risk due to escalating farm ground prices from 2011 through 2013. 20 10
Escalating farm ground prices have increased the popularity of gifting agriculture-based entities. IRS has scrutinized gifts of these entities, including reasonableness of the real estate appraiser s conclusion 21 What Are the Hot Valuation Issues in Current Exams? 2. Valuation discounts for lack of marketability & lack of control (the usual targets) A. Must IRS Job Aid really be considered, & what is IRS Job Aid? B. What are the sticking points with valuation of holding companies invested in marketable securities? C. Court cases cited by IRS experts/engineers 22 11
Get Familiar with Job Aid for IRS Professionals http://www.irs.gov/pub/irs-utl/dlom.pdf A must-read for any business valuation professional involved with valuations before IRS Pertains to discounts for lack of marketability/liquidity Only intended for IRS professionals in their work in challenging valuations, but not an official IRS position Intended for internal use only, but accidentally made available on the Internet/officially released in 2011 Often referenced by IRS engineers/valuation examiners Don t have to subscribe to their methodology, but must be familiar with their guide 23 IRS disclaimer on their internal guidance 24 12
Targeted Issues for Holding Companies Holding companies that hold cash rather than investments in securities Diversification of portfolio Anything other than a 10% discount for lack of marketability. (Does IRS think that 10% is the new safe harbor?) Layered entities Concept of willing buyer, willing seller. Don t forget to think about the willing seller! 25 Holding Co. Example Price to Net Asset Value Jones Family Holding Company, LLC Exhibit A Price to Net Asset Value (PNAV) Valuation Date, 2013 Applicable Lack of Fair Market Common PNAV Control Value Size Discount Discount Cash and receivables $ 5,000,000 25.0% x 7.8% = 2.0% Real estate 600,000 3.0% x 40.0% = 1.0% Municipal bonds 400,000 2.0% x 0.9% = 0.0% Diversified equities 1,000,000 5.0% x 13.7% = 1.0% Nondiversified equities 13,000,000 65.0% x 13.8% = 9.0% $ 20,000,000 100.0% 13.0% Selected Lack of Control Discount 13.0% PNAV Discount = (1 - PNAV ratio) Common size totals may not sum due to rounding. 26 13
Holding Co. Example Conclusions of Value Jones Family Holding Company, LLC Conclusions of Value Valuation Date, 2013 Exhibit B Member Units held by Mr. Jones Net asset value on a controlling, marketable basis $ 20,000,000 Total units outstanding 10,000 Voting Units Pro rata net asset value on controlling, marketable basis $ 2,000 Value of one voting unit (controlling, marketable basis) 2,000 Lack of control discount (13%) (260) Nonvoting Units Value of one nonvoting unit (controlling, marketable basis) $ 2,000 Noncontrolling marketable interest value 1,740 Lack of control discount (13%) (260) Lack of marketability discount (20%) (348) Noncontrolling marketable interest value 1,740 Noncontrolling, nonmarketable interest value $ 1,392 Lack of marketability discount (20%) (348) Add premium for voting rights (3%) 42 Indicated value of one voting unit Indicated value of one voting unit (noncontrolling, nonmarketable basis) 1,392 (noncontrolling, nonmarketable basis) 1,434 Nonvoting units held by Mr. Jones 5,000 Voting Class A units held by Mr. Jones 50 Conclusion of value of the nonvoting units held by Mr. Jones Conclusion of value of the voting units held by Mr. Jones (noncontrolling, nonmarketable basis) (rounded) $ 6,960,000 (noncontrolling, nonmarketable basis) (rounded) $ 72,000 27 Court Cases Mentioned During Recent Exams Trilogy of cases for discount for lack of control McCord, Lappo & Peracchio Holman v. Commissioner Astleford v. Commissioner 28 14
What Are the Hot Valuation Issues in Current Exams? 3. Adjustments (deductions) for built-in gains tax liability for C corporations A. Dollar-for-dollar deductions versus discounting a future event B. Deducting the built-in gains tax liability for S corporations that converted from C corporations C. Litchfield v. Commissioner 2009 U.S. Tax Court case that recognized built-in gains liability for S corporation 29 In Litchfield v. Commissioner, the Court found that hypothetical buyer & seller would agree to significant discounts for substantial built-in gains taxes & accepted taxpayer's expert's estimates. Assets consisted largely of farmland & marketable securities 30 15
Effective Response to IRS Regarding Proposed Valuation Adjustments 1. Have the response from valuation expert directed to legal counsel rather than taxpayer/client or IRS 2. Use references to court cases that have similar logic or set of facts (but only if the cases support the position) 3. Reconcile approaches/connect the dots for the examiner 31 Effective Response to IRS Regarding Proposed Valuation Adjustments 4. Valuation expert s response should be crystal clear on the issues on which they disagree with IRS examiner/engineer & explain why their own methods & analysis are superior/more applicable in specific case/result in a more reasonable conclusion of value 5. Keep it professional. No disparaging language about IRS expert, no overuse of professional jargon, & avoid using phrasing such as always, no expert would ever or anyone with experience 32 16
Tactics Do not include valuation expert in early meetings/ calls between examiner & legal counsel Deadlines are critical: make sure taxpayer s valuation expert has time to respond to an IRS engineer s report May be advantageous to hire an appraiser that was independent of the first appraiser to provide additional substantiation of the first appraiser s report 33 Practical Tips on Resolving Valuation Issues 1. Have someone else review correspondence/ reports/response to valuation adjustments (a cold read) 2. In responding to IRS, taxpayer s valuation experts should be advocates for their methods & analysis, not for their client 3. Valuation experts should rely on data & facts in their response, not just their professional judgment 34 17
Practical Tips on Resolving Valuation Issues 4. Keep taxpayer client informed about costs associated with defending the valuation 5. Don t take it personally 35 Taxpayers should have professional assistance addressing valuation issues in an IRS exam rather than going it alone! 36 18
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