All posts in Valuation

08 Apr

Don’t Get Penalized for Substantial Valuation Understatements

In Valuation by admin / April 8, 2013 / 0 Comments

Estate Planner Mar-Apr 1997

Many of the techniques currently used for estate planning rely on minimizing the value of transferred assets. Discounts are most commonly sought for lack of control, lack of marketability and minority interests. The Internal Revenue Service (IRS), however, imposes penalties for substantial estate and gift tax valuation understatements.

Outright gifts of parcels of real estate, marketable securities or stock in closely held businesses are often less than optimal. Instead, before gifts are made, it can be better to segment or combine assets and place them in family limited partnerships (FLPs) or limited liability companies (LLCs) and convert them to nonvoting or noncontrolling interests, or funnel them through grantor retained annuity trusts. The same type of planning is also used in anticipation of valuing an asset for estate tax purposes.

Reports circulate of cases where a combined 55%, 65% or even 85% discount from fair market value was allowed, or where everyone takes at least a 25% discount. Accordingly, you may be tempted to view discounting as less than an exact science. It is at this point, however, that you need to be mindful of the penalties for substantial estate and gift tax valuation understatements.

What Is an Understatement?

The valuation understatement can apply when the value of any property reported on a gift or estate tax return is 50% or less of what the court determines to be the current value of property. The IRS imposes a penalty of 20% of the amount of tax underpayment and increases the penalty to 40% for reported understatements of 25% or less of the current value.

For example, you place an interest in a closely held business into an FLP with an interest in real estate, at a combined value of $2 million. You make a gift of a 2.5% FLP interest. For gift tax purposes, you take a 60% minority-interest and lack-of-marketability discount, and value the gift at $20,000 ($50,000 x 40%). You and your spouse split the gift, each claiming a $10,000 annual exclusion gift.

The IRS contests the valuation, and the case goes to court. The court finds that the fair market value of interests that went into the FLP was actually $2.5 million and that the proper discount for the minority interest was 25%. This results in the gifted 2.5% interest being valued at $46,875, making the split gifts each about $23,438. The valuation understatement is by more than 50%, and the IRS could add a penalty of 20% of the tax underpayment.

Reasonable Cause

The penalty for valuation understatement is not imposed if there was reasonable cause and you acted in good faith. In several recent cases the courts have held that the IRS abused its discretion by refusing to grant a waiver of the valuation penalty for reasonable cause.

In one case, the taxpayer had relied on the advice of an accountant with valuation experience and on the opinion in a prior tax court case. In another case, the taxpayer had relied on an appraiser’s opinion, and, even though the court was critical of the appraisal, it held that the taxpayer had substantive support for its position and reasonable cause existed. In a third case, the taxpayer relied on the advice of the company’s long-time outside counsel and accountant, even though the taxpayer had agreed to higher valuations for the same property on prior gift tax audits. The court noted that the IRS audits did not bind either party as to valuation in future years.

Support Your Valuations

Gifts to family members or for valuing assets on an estate tax return are not required to be supported by a qualified appraiser. Nevertheless, a good appraisal can provide reasonable cause for the waiver of an undervaluation penalty. At minimum, the valuation process should involve the advice of an experienced and competent accountant or lawyer.

08 Apr

Is Fair Market Really Fair?

In Valuation by admin / April 8, 2013 / 0 Comments

Estate Planner Sept-Oct 1998

Have you made a gift today, one that you did not know you made? If so, you or your estate may be called upon years from now by the Internal Revenue Service (IRS) to account for gift taxes plus interest and penalties. The changes made in the tax law in 1997 affected the safety provided by the statute of limitations. Under current law, there is no statute of limitations for gifts made in connection with transactions that are not adequately disclosed to the IRS.

If you want to avoid making an unintentional gift, be sure you always obtain fair market value in exchange for anything you transfer to a family member (except for transfers to your spouse which qualify for the marital deduction).

Hypothetical Fair Market Value

What is the concept of fair market value, what does it involve and who determines it? The generally accepted definition of fair market value is “the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”

For federal tax purposes, the definition remains the same for income tax issues as well as estate, gift and generation-skipping transfer tax issues. The definition applies to transfers to charity as well as to transfers to family members. In order to understand and work within this definition of fair market value, the elements of the definition need to be considered.

The price at which property would change hands — This is the hypothetical sale price. Generally, the sale is presumed to be for cash. The hypothetical would insist that the buyer is able to borrow the requisite cash in order to pay the seller. For example, in a home sale, the seller receives cash because the buyer enters into a mortgage arrangement with a lender. Because the seller is deemed to receive cash, the price received by the seller will not need to be adjusted to reflect assumption of any risk or the time value of money and related interest rate.

Between a willing buyer and a willing seller — For purposes of valuation, it is irrelevant who are the actual seller and buyer since you must look to hypothetical persons. When you are dealing with unique property, this becomes the most difficult part of the hypothetical sale. Is there really a willing buyer for a 5% interest in a closely held family business or in a family limited partnership? And, is there really a willing seller when Dad ordinarily would not sell at any price? Nevertheless, we have to assume the existence of two states of mind, one that an imagined owner of the property is in fact a willing seller and second that an imagined holder of cash is a willing buyer.

Neither being under compulsion to buy nor sell — A foreclosure sale would not be indicative of fair market value as the price would generally be artificially low since the seller is under a compulsion to sell. Accordingly, we have to assume a situation where the seller wants to sell, but not too badly; and, the buyer wants to buy, but he really does not have to.

Both having reasonable knowledge of relevant facts of the applicable valuation date — It is important that you assume that both parties have reasonable knowledge of the property. The appropriate standard of reasonable knowledge is not what is actually known by the seller or by the buyer on the valuation date. Instead, you must consider the facts that are discernible through reasonable investigation on the valuation date.

After all, acquired information is not supposed to count, but hindsight is difficult to ignore. For example, assume that a painting which was being valued for gift purposes could be a forgery. The fact that the painting is later determined to be authentic is not a factor on the valuation date, but the possibility of it being a forgery is knowledge which both buyer and seller are assumed to have.

Know Your Facts

The hypothetical fair market value must take place in the marketplace. This generally will be where the property being valued is most likely to be offered for sale to the public. This usually will be the retail market and not the wholesale market.

Please call us if you need advice on ascertaining the fair market value of property. You need to document the considerations and the hypothetical negotiations that resulted in the final figure, since you may be called upon to justify your valuation.