Tips From the Pros: Focus on “Fair” Value, Discard “Discounts” From the Planner’s DictionaryTips From the Pros: Focus on “Fair” Value, Discard “Discounts” From the Planner’s Dictionary

As a long time reader of and author for Trusts & Estates, I appreciate the opportunity to join as a columnist for Tips From the Pros. I’ve always found these columns to be a tremendous resource in my practice, so hopefully the discussions in this and future contributions will be helpful to yours. There are several topics that I’m already looking forward to covering, but for the first one: a timely and at times controversial (with taxing authorities) topic—valuation discounts with closely held businesses. 

Reframing the Issue

As tax season approaches, practitioners are inevitably reviewing (hopefully re-reviewing) valuation reports prepared by professional appraisers determining the fair market value (FMV) of assets that were gifted in 2019. As part of the review of these reports, the determination of the value is just one number that’s relevant for transfer tax reporting purposes—the tax preparer needs to confirm whether there’s a valuation discount.¹ On the Form 709 (United States Gift (and Generation-Skipping Transfer) Tax Return), there’s the direct question, “Does the value of any item listed on Schedule A reflect any valuation discount? If ‘Yes,’ attach explanation.” For purposes of a gift tax return, the instruction’s term “valuation discount” is defined broadly, covering discounts for lack of marketability, a minority interest, blockage discounts and fractional interest discounts. The way the question is framed portrays discounts pejoratively and reflects the at-the-time hostile approach of taxing authorities. The Internal Revenue Service isn’t alone in its approach, as state taxing authorities can act similarly. For example, Connecticut’s Department of Revenue Service takes hostility towards discounts to a new level—it’s widely known that many of the gift and estate tax auditors reject all valuation discounts as “excessive” as a matter of course, revalue based on no discount and ask the taxpayer to respond with a different number.

What taxing authorities can often miss is that there’s more to life than taxes. The determined value of an asset can have an impact on the dispositive provisions of an estate plan. For example, an estate plan may leave a closely held business to a child who works at the company while leaving other assets of an equal amount to the owner’s other child, with the balance to be divided evenly. Both of these children have far more of an incentive (both emotionally and economically) than a taxing authority to dispute the valuation positions taken. As such, fiduciaries and planners can’t be deterred from the job of finding the FMV because the Taxman approaches the FMV with suspicion.  

As planners, we can’t fall into the trap of seeing “discounts” as a dirty word. Focusing on how high or low a discount is (that is, whether the number has that je ne sais quoi) isn’t a helpful exercise that deploys a practitioner’s knowledge of the law and the client. So, let’s not focus on the term “valuation discounts,” which brings negative connotations—but instead on FMV. After all, neither the Internal Revenue Code nor Treasury regulations use the term “discount” but instead focus on FMV, as that’s what the law sets as the basis for the transfer tax system. This shift in focus isn’t simply semantics, but better informs practitioners about what factors they, their clients and professional valuation experts should be looking at as they plan with an entity. 

Looking at Business Valuations

What taxing authorities describe as a “valuation discount” can apply to many asset classes. However, for purposes of this article, the focus will be on closely held businesses given that planning with these assets is fairly common, the voluminous amount of jurisprudence on the issue and important developments in the law in the past few years. Like any asset, FMV is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”² When it comes to non-publicly traded businesses, while there’s some regulatory guidance, it’s the IRS’ administrative pronouncement in Revenue Ruling 59-60 that’s remained the cornerstone for valuations.³ Rev. Rul. 59-60 doesn’t use the term “discount.” Instead, finding that valuation “is not an exact science,” it sets forward various facts and circumstances that should be considered.   

Two of the factors most often thought of when considering discounts of closely held businesses are for lack of control when it comes to transfers of minority interests and lack of marketability when there isn’t a readily available market.⁴ These concepts are self-evident. If someone purchases an interest in a business he’ll have no controlling interest over—a willing buyer would certainly consider that in determining an acquisition price. Further, if the purchaser won’t be able to freely sell the acquired interest in the future if there isn’t a ready market—this must be considered. What impact those considerations have (that is, the discount rate) is outside the scope of this article. Within the scope, however, is what other factors a purchaser considers when determining the price it would be willing to pay for an interest in a closely held business that the trusted advisor can help identify and ensure is included in the valuation.⁵

Factors to Review and Raise

While the number of factors that could be considered are near limitless, recent cases and developments in the law highlight some items advisors should focus on. As noted above, there’s more to life than taxes, but taxes are certainly part of life and business. Willing buyers and sellers consider the impact of an entity’s tax status and the impact it has on the economics of the entity. Valuation professionals refer to the exercise of determining the impact of taxation on a pass-through entity’s earnings as “tax-affecting.” Historically, the IRS has challenged tax-affecting and relied on the Tax Court’s 1999 decision in Gross v. Commissioner to value entities based on a fictional assumption that the earnings are effectively subject to a 0% tax rate.⁶ In 2019, taxpayers secured two victories—one from a federal district court in Kress v. United States⁷ and one from the Tax Court in the Estate of Jones v. Comm’r,⁸ which found in favor of the taxpayers that the valuations of their respective pass-through entities properly tax-affected the earnings. Given this important development, advisors should be reviewing appraisals of pass-through entities to ensure this issue was considered and raise the issue at the outset in future valuations.⁹ While 2019’s developments were with pass-through entities, this issue remains equally important for entities that are taxed as C corporations (C corps) because of the tax liability embedded in the entities’ gains, which a willing buyer would consider in acquiring an entity. An adjustment to the valuation of a C corp for this issue is typically referred to as a “built-in capital gain discount.”¹⁰

While an advisor’s knowledge of an entity’s tax status provides a valuable addition to the valuation discussion, so too does the advisor’s knowledge of the facts and circumstances surrounding the entity’s personnel and impending transactions. Rev. Rul. 59-60 recognizes that the potential loss of a key individual, whether a manager or someone who personally holds the goodwill on which an entity relies, could have a substantial negative effect on a company, but notes that facts could exist that would mitigate the economic impact on such a departure. This is especially relevant in entities in which the transferor or transferee is a “key man.” This issue has been quite active in cases recently that provide advisors with best practices to follow and issues to look for.¹¹ Finally, knowledge that an advisor has of potential impending transactions can have a bearing on valuations. As the IRS notes in a Chief Counsel Advice in 2019, the willing buyer’s “reasonable knowledge of relevant facts” that’s part of the FMV standard could include impending transactions, as such facts would come to light in the due diligence process.¹²

Review Carefully 

Simply looking to the overall discount percentage is selling the taxpayer short and potentially leaving the valuation high. By keeping current with developments on the IRS’ and the courts’ pronouncements on valuation issues and better familiarizing ourselves with what factors valuation professionals look to, other advisors become all the more valuable by raising key issues they know about the client and his assets. At the end of the day, it will be for the appraiser to compute the impact on valuation and how it’s factored in. But, by attempting to engage in the process by raising issues rather than simply trying to tinker with discount percentages, advisors can provide a value add.       

Endnotes

1. The federal estate tax return (Form 706) includes a similar question but limits it to business entities.

2. Treasury Regulations Sections 20.2031-1(b); 25.2512-1.

3. See Estate of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990). 

4. The International Glossary of Business Valuation Terms defines “marketability” as “the ability to quickly convert property to cash at minimal cost.” The discount for lack of marketability (DLOM) is “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.” See “Discount for Lack of Marketability Job Aid,” prepared by the Engineering/Valuation Program DLOM Team of the Internal Revenue Service (Sept. 25, 2009).

5. It should be noted that the purchaser’s factors are only half the equation, as the seller’s are equally important under the willing buyer/seller standard, but sellers certainly would be cognizant of these issues as well.

6. Gross v. Comm’r, T.C. Memo. 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001). See also “Valuation of Non-Controlling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes: A Job Aid for IRS Valuation Analysis,” prepared by the Engineering Program, Natural Resources and Construction Industry, Large Business and International Division (LB&I) and the Estate and Gift Tax Program, Small Business/Self-Employed Division (SB/SE), of the IRS (Oct. 29, 2014).

7. Kress v. United States, 372 F. Supp.3d 731 (E.D. Wis. 2019). 

8. Estate of Jones v. Comm’r, T.C. Memo. 2019-101.

9. For further in-depth discussions of the developments in tax-affecting entities, see Espen Robak, “Tax Court Takes First Step Towards Tax-Affecting,” Trusts & Estates (Oct. 24, 2019); James I. Dougherty, Todd G. Povlich and T. Sandra Fung, “Tax Court Accepts Tax-affecting, Taxpayer Prevails in Jones,” Bloomberg BNA Estates, Gifts, & Trusts Journal (January 2020); James I. Dougherty and Todd G. Povlich, “The Latest Development in Business Valuation: Burdens of Proof, Tax Affecting S Corporations, and Chapter 14 in Kress,” Bloomberg BNA Estates, Gifts, & Trusts Journal (July 2019).

10. See, e.g., Estate of Richmond v. Comm’r, T.C. Memo. 2014-26.  

11. Cavallaro v. Comm’r, T.C. Memo. 2019-144; Cavallaro v. Comm’r, T.C. Memo. 2014-189; Bross Trucking, Inc. v. Comm’r, T.C. Memo. 2014-17; Estate of Adell v. Comm’r, T.C. Memo. 2014-155.

12. Chief Counsel Advice 201939002 (Sept. 27, 2019).