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Valuation Planning Can Minimize Audit Risk on Your Estate or Gift Tax Return

Certain factors appear to increase the probability of an estate or gift tax return examination. Although some factors are unavoidable, such as related-party transactions, other red flags can be mitigated with proper planning ahead of time.

Discounts

Discounts are one of the most hotly contested items between the IRS and taxpayers. Excessive discounts, poorly supported discounts or the application of benchmark averages are a sure way to get the attention of the IRS. The reasonableness of valuation discounts used in estate and gift tax appraisals is still a primary focus for the IRS, which will often flag
discount conclusions that are not supported by the data or that apply study averages without sufficient explanation.

Standard of Value

Likewise, the IRS continues to receive valuation reports that apply the fair value standard instead of fair market value, or consider the perspective of only one person (either the hypothetical willing buyer or the seller) rather than both. (For a discussion of the difference between "fair value" and "fair market value"

Analytical Errors

The IRS is also finding appraisals that (a) lack a strong, consistent factual development, (b) are based on an income stream that is inadequately or inappropriately matched to any adjustments (discounts), and/or (c) feature an incomplete tax rate analysis. Appraisals that supply a good "analytical fit" to the facts of a case clearly show how the valuation conclusions were reached, what adjustments were made, what data were used, and what law was relied on.

Tax-Affecting

Valuation of S corporations is another problematic area, in which the courts, valuation experts and IRS examiners have not always been consistent. Rather than focus on the case law, attorneys and valuation professionals would be well-advised to carefully consider the particular facts and circumstances of any case.  Related issues include tax considerations in C to S corporation conversions and the valuation of embedded capital gains tax liability.

Formula valuations

Buy-sell agreements of closely-held businesses may use a formula to measure equity value, such as accounting book value. However, you should think twice before relying upon formulas to value a taxable estate. The IRS may consider the formula to be arbitrary. If the IRS determines a different value, backed up with a qualified appraisal, then the taxpayer may face a larger tax liability.

Likewise, a rule-of-thumb can be useful in a "quick and dirty" analysis but is not appropriate to value a gift or taxable estate. A rule-of-thumb does not provide a level of detail to assess the quality and quantity of information that is used to generate it, nor to assess the applicability to the subject interest.

Appraiser qualifications

Under Regulations Section 1.170A-13(c)(3), appraisals must meet requirements for certain charitable contributions. For other appraisals, such as for estate tax purposes, a qualified appraisal is not required but signals a certain level of quality.

Stale valuation reports

Out-of-date valuations can be problematic. One general rule is to use appraisals within three months of the property transfer date. However, it really must be determined on a case-by-case basis. If new information arises since the last appraisal, its impact on value must be considered. For instance, if new regulations are announced that are expected to have a major impact on the company's bottom line, then the value of the company may be different and the prior report rendered obsolete. On the other hand, if the earnings of the
company are stable and the marketplace is not experiencing much volatility, then a previous appraisal might still be relevant.

Inconsistency with past valuations

The value of a business should not fluctuate dramatically from year to year unless there is a dramatic change in the company's circumstances, the economy or the industry in which the company operates. A valuation analyst should consider any other recent valuation reports when preparing an appraisal. Any key differences in assumptions such as capitalization rate or significant changes in projections should be explored. Lack of a consistent valuation approach might welcome IRS scrutiny.

Inconsistency with other indications of value

Any documents with transaction provisions, such as buy-sell agreements, articles of incorporation or operating agreements, should be reviewed. Of course, any actual transactions should be reviewed as well. Transaction provisions or actual transactions provide additional indications of value that should be considered and addressed in a defensible valuation report.

Valuation Errors

Unfortunately, the IRS is still finding appraisals of business interests that purposefully include or exclude valuation approaches, ignore strong market evidence, or disregard professional standards. Many of these mistakes are made by individuals who lack appropriate training or experience and can be avoided by using qualified appraisers.

Factual Errors

Appraisal inaccuracies will also attract the IRS' attention. More than mere mathematical errors, they include presenting false information or assuming facts related to the appraisal that do not exist.

Report errors

A valuation report needs to be a stand-alone document. What good is a valuation expert's careful, thoughtful analysis if it is not documented in the report? The IRS is finding appraisals that have factual errors and shoddy documentation, which might increase the likelihood of IRS audit.

The Internal Revenue Service can be aggressive in valuation-related disputes, as evidenced by recent cases in the Tax Court. As the saying goes, an ounce of prevention is worth a pound of cure. When preparing a gift or estate tax return, proper valuation planning is helpful in reducing audit risk. An IRS examination may or may not end with a larger tax liability, interest and penalties, but it will almost definitely cause a big headache.

Consider discussing your needs with BARR CPA LLC' appraisal specialists who perform business valuations for various purposes, including gifting and estate tax, among others. Please contact Jacob Barr of the BARR CPA LLC Business Advisory Department at 201-445-8711 for assistance.