Navigating Business Valuation in Estate and Gift Taxation

Understanding Business Valuation

Valuations are subjective in nature so the expert’s report must be persuasive. It is critical to provide supporting information and documentation for every assumption, methodology, or process and make sure that it can be replicated by the reader. The IRS is going to read any valuation report attached to an estate tax return or a gift Tax Return. Any errors, no matter how small, will destroy the appraiser’s credibility. Objectivity and independence are critical to the role of the appraiser. 

Estate and gift taxes are based on the “fair market value of property.” Fair market value for estate tax and gift tax purposes is defined as follows:

“The fair market value is the price at which the property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.”

Fair market value is a complex determination framed by IRS regulations for tax liability and assessment, be it estate tax, gift tax, or income tax. 

Revenue Ruling 59-60 outlines the approach, methods, and factors to be considered in valuing shares of closely held corporations. The ruling applies to valuations performed for estate and gift tax purposes and to the valuation of stock on which market quotations are either unavailable or not reflective of fair market value. This revenue ruling has been made applicable to valuations for income and all other tax purposes and to partnerships and all other forms of business organizations. In part, Revenue Ruling 59-60 states that:

“.01 All valuations must be made in accordance with the applicable provisions of the Internal Revenue Code of 1954 and the Federal Estate Tax and Gift Tax Regulations. Sections 2031(a), 2032 and 2512(a) of the 1954 Code (sections 811 and 1005 of the 1939 Code) require that the property to be included in the gross estate, or made the subject of a gift, shall be taxed on the basis of the value of the property at the time of death of the decedent, the alternate date if so elected, or the date of gift”

The net value of a business interest is based on all relevant factors –

1. A fair appraisal as of the applicable valuation date of all the assets of the business, tangible and intangible, including good will.
2. The demonstrated earning capacity of the business; and
3. Other factors set forth in §20.2031-2 relating the valuation of corporate stock. 

The “other relevant factors” include:

1. The good will of the business
2. The economic outlook in the particular industry
3. The company’s position in the industry and its management
4. The degree of control of the business represented by the block of stock to be valued
5. The values of securities of corporations engaged in the same or similar lines of business
6. Nonoperating assets

Impact of Business Valuation on Estate Tax and Gift Tax

Current tax law allows individuals to gift $13.61 million per person or $27.22 million per married couple in gifts over the course of their lifetime without paying gift taxes. The lifetime exemption that applies to gift and estate transactions is set to “sunset” after 2025 making estate and gift tax planning at this point is critical.    

The IRS requires that assets included in an estate or conveyed as gifts be valued at their fair market value.  However, the IRS does not mandate a specific method for performing valuations. Some unique aspects of estate and gift tax valuations include the possibility of challenge, the IRS preference for guideline companies as the basis for value, and transactions between family members.

Possibility of Challenge

Estate tax returns have a high probability of IRS audit. The chances of audit increase as the size of the estate increases. Discounts require disclosure on Form 709, United States Gift Tax Return, increasing the probability of IRS audits for gifts. As previously mentioned, it is critical that the valuation consultant fully document their work and address specific valuation considerations raised by Rev. Rul 59-60 as well as other subsequent revenue rulings. An effective valuation report is intended to educate and inform the reader (i.e., the IRS examiner) as to what procedures were performed to address specific valuation considerations, why they were performed, and why the conclusion of value is reasonable. 

Preference for Guideline Companies As the Basis for Value

IRC Rev. Rul. 59-60 and tax court decisions clearly indicate the IRS and tax court’s preference based on guideline company data. If possible, the consultant should use the guideline company valuation methods.  Although ideal, guideline company data is not always available, especially when valuing a closely held company. Therefore, the selection of an alternative method becomes critical. There are three basic methods, income-based, market-based and asset based. Based upon their understanding of your business and the market, your consultant will decide which is the most appropriate for your company.

Transactions Between Family Members

A primary goal of estate planning is to reduce the amount of estate and gift taxes paid. Many strategies have been developed to lower the value such as family limited partnerships or buy-sell agreements that involve transactions among family  members. Transactions between family members are considered tainted by the IRS and intra-family agreements are quite often challenged. It will be necessary for your consultant to overcome the IRS presumption that transactions between family members are not arm’s length. 

Challenges and Controversies

The math is simple: the smaller the estate, the lower the estate tax. The valuation of closely held entities for gift and estate tax purposes has been hotly contested. A look at the court cases reveals that the valuation of closely held entities is a judgment call that relies upon the opinion of experts. The basic premise is that the value of a closely held business interest is usually less that the value of similar publicly traded interests for two reasons. Closely held entities are generally unable to quickly convert their property to cash at minimal cost (lack of marketability) and the inability of a minority interest to control managerial decisions (lack of control). 

Valuation discounts are commonly used for business appraisals for closely held companies like S corporations, private investment partnerships, minority interests in limited liability companies and family limited partnerships. Discounts can be immensely beneficial for gift and estate tax savings. Discounts can reduce valuations for estate tax purposes, and they allow you to gift to your children a larger percentage of the business at a reduced rate. 

A qualified business appraiser is needed to determine the appropriate discount based on the analysis of the assets held by the entity, the size of the interest being gifted, and restrictions outlined in the shareholders’ and operating agreements. 

Another hotly contested approach in valuation is “tax affecting.”  Tax affecting is a valuation approach that applies a hypothetical entity-level tax to a pass-through entity’s taxable income, which reduces the value of the business. Since the 1999 tax court decision in Gross v. Commissioner (TC Memo 1999-254), the IRS generally has taken the position that an entity-level tax should not be applied to S corporations.  However, a recent court case, Cecil v. Commissioner (TC Memo 2023-24), upheld the use of “tax affecting” to determine the value of S corporation shares for Federal gift tax purposes. 

To summarize, federal estate and gift tax court decisions generally emphasize the following:

1. Continued acceptance of discounts for trapped-in capital gains. 
2. Continued acceptance of discounts for fractional interests, although amounts varied.
3. Continued movement against tax affecting the earnings of an S Corporation, with some recent exceptions.
4. Continued movement toward requiring strong, supporting empirical evidence before accepting an expert’s discounted conclusion.

For more information, contact Paula Ellenberg via our online contact form.

Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.