Business Valuation for Gift and Estate Tax

The Current Market Situation Creates an Opportunity for Business Owners to Gift Shares with Reduced Overall Tax Consequences

Many business owners who were considering gifting shares to family and employees are now moving ahead with those plans.  In gifting ownership shares, three regulations are important to the taxpayer and the advisor:

  • The 2006 Pension Protection Act defines the concepts of “Qualified Appraiser” and “Qualified Appraisal.”
  • The 1998 IRS Restructuring and Reform Act shifted the burden of proof from the tax payer to the IRS if the tax payer cooperated with the IRS, complied with the law, and provided “credible evidence” (the new standard from adequate disclosure).
  • The 1997 Tax Relief Act established a three-year statute of limitations that starts with the filing of a return if it includes “adequate disclosure.”
What Do These Three Regulations Mean for Taxpayers and Their Advisors?

If the taxpayer files a Qualified Appraisal prepared by a Qualified Appraiser, then the burden of proof may be shifted from the taxpayer to the IRS, and the three-year statute of limitations clock is started.  It also makes the taxpayer’s case much less desirable for the IRS to pursue.  This greatly reduces the risk of audit and potential liability for the taxpayer and their advisors.

2006 Business Valuation Guidelines

On July 27, 2006, the IRS issued business valuation standards (IRM 4.48.4 Engineering Program, Business Valuation Guidelines). While the guidelines do not specifically state that compliance with Uniform Standards of Professional Appraisal Practice (USPAP) is required, the IRS requirements are very similar to the requirements listed in USPAP. Compliance with USPAP is not stated because the IRS does not control USPAP.  However, the IRS has implied that a USPAP compliant appraisal will be considered a “Qualified Appraisal.”

2006 Pension Protection Act
Defines the concepts of “Qualified Appraiser” and “Qualified Appraisal.”

  • Focused on charitable gifts only.
  • Gives the IRS the authority to limit charitable contributions other than cash greater than $5,000 to their Fair Market Value as determined by a “Qualified Appraisal” prepared by a “Qualified Appraiser.”
  • This standard is expected to be extended to valuations for all IRS filings.
Qualified Appraiser:
  • Has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations prescribed by the Secretary [includes CBA (Certified Business Appraiser), ASA, ABV, and CVA].
  • Regularly performs appraisals for which the individual receives compensation, and
  • Meets such other requirements as may be prescribed by the Secretary in regulations or other guidance.
  • For returns filed after February 16, 2007:
    • Successfully completed college or professional-level coursework that is relevant to the property being valued.
    • Obtained at least two years of experience in the trade or business of buying, selling, or valuing the type of property being valued, and
    • Fully described in the appraisal the appraiser’s education and experience that qualify the appraiser to value the type of property being valued.
Qualified Appraisal:
  • Section 170(f)(11)(E)(i) provides that the term “qualified appraisal” means an appraisal that is (1) treated as a qualified appraisal under regulations or other guidance prescribed by the Secretary, and (2) conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed by the Secretary.
  • Qualified Appraisal – an appraisal will be treated as a qualified appraisal within the meaning of § 170(f)(11)(E) if the appraisal complies with all of the requirements of § 1.170A-13(c) of the existing regulations (except to the extent the regulations are inconsistent with § 170(f)(11), and is conducted by a qualified appraiser in accordance with generally accepted appraisal standards.
  • Generally accepted appraisal standards – an appraisal will be treated as having been conducted in accordance with generally accepted appraisal standards within the meaning of § 170(f)(11)(E)(i)(II) if, for example, the appraisal is consistent with the substance and principles of the Uniform Standards of Professional Appraisal Practice (“USPAP”), as developed by the Appraisal Standards Board of the Appraisal Foundation.

Provisions For Penalties
The Act includes provisions for penalties: the penalties include a fine of the lesser of 10% of the underpayment, $1000, or 125% of the appraisal fee; and being put on a blacklist of people who cannot submit work to the IRS. The qualified appraisal must contain the following language:

The appraiser understands that a substantial or gross valuation misstatement resulting from an appraisal of the value of property that the appraiser knows, or reasonably should have known, would be used in connection with a return or claim for refund, may subject the appraiser to a civil penalty under §6695A.

The IRS includes appraisers in the definition of both signing and non-signing preparers, with discretion to impose the section 6694 and 6695A penalties against an appraiser depending on the facts and circumstances.

1998 IRS Restructuring and Reform Act
Purpose is to simplify tax collection and administration, and protect the public from overzealous IRS agents.

It shifted the burden of proof from the taxpayer to the IRS in U.S. Tax Court, the federal district courts, and the Court of Federal Claims. Before 1998, the process was that the taxpayer file, IRS send Notice of Deficiency, taxpayer must pay tax & fine, then taxpayer can file for a rebate, IRS can negotiate a settlement.

The burden of proof is now shifted to the IRS if the taxpayer (IRC §7491):

  1. Cooperated with the IRS audit.
  2. Complied with the law, and
  3. Provided “Credible Evidence.” This is a new standard from “adequate disclosure,” but the elements were not defined.

Failure to meet the three requirements means the burden of proof reverts to the taxpayer:

  • The IRS can file a delinquency
  • Tax payer has to pay the tax, and then claim a rebate (guilty until proven innocent)
  • Prove that the IRS is wrong, and
  • The taxpayer has to pay for his own defense prosecution in court.

The IRS Has To Prove The Taxpayer Was Wrong
However, if the taxpayer does the three things, then the burden of proof is shifted to the IRS – the IRS has to prove that the taxpayer was wrong before collecting the tax.

Credible evidence is the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of the IRS correctness). Griffin v. Commissioner.

Providing Credible Evidence

A taxpayer has not produced credible evidence for these purposes if the taxpayer merely makes implausible factual assertions, frivolous claims, or tax protestor-type arguments. The introduction of evidence will not meet this standard if the court is not convinced that it is worthy of belief. If, after evidence from both sides, the court believes that the evidence is equally balanced, the court shall find that the Secretary has not sustained his burden of proof.

Credible Evidence means the IRS must prove in court that the actual additional tax due is at least 50% of the difference between the taxpayer filing and the IRS claim. If the IRS does not prove 50% of the difference as awarded by the court, the IRS has to pay the taxpayers’ legal costs for the defense (the taxpayer still has to pay the tax differential, but the IRS pays the legal fees (§ 7430)).

Taxpayer Relief Act of 1997 (TRA)
Established a statute of limitations on IRS actions for gift taxes (IRC §6501):

  • Previously, the IRS could go after the taxpayer at any time (not reported; 6 years if underreported 25%).
  • 1997 TRA, established a 3-year clock (statute of limitation) that starts with the filing of a return if it includes “adequate disclosure.” To start the clock, the taxpayer must provide “adequate disclosure.” However, adequate disclosure was not defined in the statute – how minimal the disclosure can be and still qualify as “adequate” was unknown.
  • Once the 3 years lapse, a taxpayer can usually use it as protection from an IRS assessment of the gift tax liability.

In 1997, an Appraiser was defined as anyone who claims to do appraisals. An Appraisal was defined as a detailed description with financial information. This applied to transfers other than just gift tax.

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