Picture this scenario: Your client, Mr. Enterprise, has asked for your help. His mother, Mrs. Enterprise, died two years ago. The IRS audited her Form 706 Estate Tax Return and raised a question on the valuation of her business, Signs of the Times, an outdoor advertising company with locations primarily in the Northeast and Midwest.

The estate had secured the services of an attorney and CPA to conduct the valuation. The gross sales, prior to her death were approximately $250 million. The net annual income for the 5 years preceding her death was $25 million. The estate tax return pegged the value of the business at $2 million. The IRS accessed a much higher value, $30 million, plus penalties and interest.

Mr. Enterprise’s question is, “Why is there such a disparity between the two values?”

A tool for the transition

Business valuations are used for a variety of purposes. An objective valuation provides the business owner with an important tool for planning an orderly transition. It is a benchmark against which to measure the owner’s personal, business and financial objectives. And it serves to identify viable transition options, including the timing of the liquidity event.

Business valuations are also important for banking, insurance, interfamily transfers, estate taxes and in instances of unexpected major events, such as the disability of an owner. In Mrs. Enterprise’s case, it was used to establish a value on the estate tax return.

In intra-family situations, a business valuation by a qualified appraiser can also help legitimize a transaction. If the value is considered to be less than fair market value, the transaction could thus be then considered a part gift and a part sale. This may cause unintended tax consequences and affect other planning.

Where there is a transfer among family members, for example, between parents and children or grandparents and grandchildren, the purchase price may come under close scrutiny by the IRS, even if an appraisal has been conducted that produced the valuation amount.

Thus, if a buyer and seller are related, the purchase price or valuation may not be viewed as indicative of fair market value. This is because the parties are not deemed to be “economically self-interested” to make a true arms-length transaction.

A lack of arm’s length dealing may have numerous other tax consequences that create unpleasant results. Many of these consequences result from the finding that the value of the property being questioned was different from the price actually paid due principally to the fact that the parties were related to each other. This includes, but is not limited to, increasing the value of the assets in the estate thus increasing the estate tax exposure, decreasing the amount of valuation discounts or changing the amount of marital and/or charitable deductions.

There are a number of key factors that impact the value of a business, such as the company’s strengths and weaknesses, profitability, competitive and geographic factors, unique aspects of its products or services, and “intangible” aspects of the enterprise. Past performance is reviewed and future potential is assessed. External factors such as the economy, industry trends, the mergers-and-acquisitions marketplace and current trends in the acquirer community are also examined.

A landmark case

A valuation should always be conducted by a qualified appraiser. A 1991 case established the framework when the U.S. Tax Court criticized the taxpayer’s experts in an estate tax case as not being qualified to perform valuations and failing to provide analysis of the appropriate discount. See Estate of Edgar A. Berg v. Commissioner (T.C. Memo 1991-279). In this landmark valuation case, the court observed that the estate’s appraisal consultants, both CPAs, made only general references to a prior court decision to justify their opinion of value. Additionally, the tax court observed that the CPAs were not in the business appraisal profession, did not have a formal education in business appraisals and were not members of any professional appraisal associations.

Mrs. Enterprises’ situation is loosely based on the Thompson v. Commissioner, 499 F. 3d 129 (2d Cir. 2007), cert. denied 128 S.Ct. 2932 (2008). In this case, Mrs. Thompson, a New York resident who owned a 20% interest in a family-owned printing company, passed away May 2, 1998. The estate secured the services of an Alaska attorney and CPA to conduct the valuation of the 20% interest in the business. The result of the estate’s appraisers was a value of the 20% interest at $1.75 million. An estate tax return was filed.

The IRS audited the return. The IRS appraiser’s composite value of three valuation methods produced an estate value for the shares of $46.3 million. With a 30% discount for lack of marketability, the IRS determined the share to have a value of $32 million. When a settlement could not be reached, the matter went to the tax court.

The tax court judge first stated that it was unusual to hire an Alaska attorney and CPA to value a New York corporation. Because there was such disparity between the estate value and the IRS value, the tax court determined the value itself at $22.7 million. With a 15% discount for minority interest and 30% for lack of marketability, the tax court determined the estate value to be $13.5 million.

The taxpayer appealed the judgment. The Second Circuit Court of Appeals generally supported the tax court calculation. However, since the tax court was found to have made a mathematical error, the Court of Appeals sent the case back to the tax court for further review. The final value arrived by the court was $12.3 million.

In addition to the change of value, the Second Circuit reinstated the Sec. 6602(a) 40% accuracy-related penalty. The court found that the estate’s valuation attorney did undertake “occasional valuations for small businesses” and had attended “limited appraisal courses.” It recognized that he had been appointed the Alaskan administrator for the estate.

The Alaskan accountant had done “occasional valuations for small businesses,” but was not a member of “professional organizations or associations relating” to appraisal work. In following the principals established in Berg, the Second Circuit concluded that the attorney and the accountant were barely qualified to value a well-established company based in New York City with high annual income.

Conclusion

If a court or the IRS determines that there is an undervaluation of assets, not only may there be additional tax due, but also penalties and interest. In addition, the IRS, as a result of the discounts being taken in valuations for estate and gift tax purposes, has been giving valuation reports increasing scrutiny.

In intra-family transfers of a business, especially when the transfers are made to the children or grandchildren, it is imperative that a professional appraisal be obtained by an independent firm that has had specific training in business appraisals, that holds the proper appraisal credentials and is experienced, preferably in the type of business that is being transferred.

The higher is the perceived value of the business, the stronger is the need to obtain a qualified appraisal for that business. Where an estate tax return is likely to be filed, either at the owner’s death or at the spouse’s death, it should be standard operating procedure. Failure to do this could result in a tremendous, perhaps unanticipated, financial burden for the estate’s heirs.

Elizabeth Lindsay-Ochoa, J.D., LL.M. is advanced market consultant at AXA Equitable, New York. Clay Bristow, J.D., LL.M, is AXA Equitable’s senior case design specialist. They can be reached at Elizabeth.Ochoa@axa-equitable.com and Clay.Bristow@axa-equitable.com