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 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.
Valuations of S-Corporations are another unsettled area. Case law is inconsistent in the application of tax-affecting S-Corporation earnings, and valuation experts must consider the particular facts and circumstances of each assignment.
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.
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Out-of-date valuations can be problematic.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.
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 Schneider Downs’ appraisal specialists who perform business valuations for various purposes, including gifting and estate tax, among others. Please contact Joel Rosenthal of the Schneider Downs Business Advisory Group at 412-697-5387 for assistance.
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