Valuation Discounts for Estate and Gift Taxes: Recent Court Decisions Offer Guidance on Interests in Closely Held Businesses
EXECUTIVE SUMMARY * Unintended estate and gift tax consequences can arise from valuations of interests in closely held entities. Because these interests often lack any readily available market value, their values at transfer are usually determined under any of three methods: the market or comparable sales method; the income or discounted cash flow method; or the net asset value or balance sheet method. * The market or income method is most suitable for entities carrying on an active trade or business, while interests in entities that primarily hold investment assets such as real estate or securities most often are valued by the net asset value method. * Values of interests in closely held entities may also be discounted for lack of marketability where they are subject to restrictions, and lack of control where they constitute minority ownership interests. Discounts for a lack of marketability are usually based on studies of public companies' restricted stock or a comparison of share prices before and after an initial public offering. Discounts for lack of control for shares of a privately held business are usually based on comparisons of share prices to net asset value per share of publicly traded closed-end investment funds or, for real estate assets, real estate limited partnerships or investment trusts. * Another type of discount that has been increasingly recognized by courts in recent years is for projected built-in gains (BIG) tax liability upon liquidation of appreciated assets. Two appeals court decisions have allowed discounts for the full amount of estimated BIG tax when using the net asset valuation method. * With underpayment of gift or estate tax potentially at stake, such valuations will need to be competently performed by well-qualified experts. Sources of generally accepted appraisal standards include the Uniform Standards of Professional Appraisal Practice of The Appraisal Foundation and the AICPA's Statement on Standards for Valuation Services no. 1. Justin P. Ransome, CPA, is a partner in Private Wealth Services in Grant Thornton LLP's National Tax Office in Washington. Vinu Satchit, CPA, is a senior manager in Private Wealth Services, Grant Thornton LLP, in Charlotte, N.C. Their e-mail addresses are, respectively, justin.ransome@gt.com and vinny.satchit@gt.com. ********* [ILLUSTRATION OMITTED] One purpose of fixing a value on an interest in a closely held business is to determine gift and estate tax liability CPAs called upon to provide such valuations know that this can be a painstaking task. It is not an exact science but an educated estimate when, as often is the case, there is no identifiable market for the interest. This uncertainty can cause unintended gift or estate tax consequences for transfers between related parties during the transferor's life and at death. The difference between what a person transferring an interest in a business believes is its fair value and any higher amount the IRS determines is its fair value can result in a greater gift tax liability. Likewise, a redetermination by the IlLS of the value of such interests held in an estate can spell an underpayment of estate tax. Fortunately for CPA valuation analysts, there are methods that, while not always yielding uniformly accepted results, are recognized by taxing authorities and courts as providing a valid basis for those estimates. In applying those methods, however, CPAs must take stock of recent court decisions for guidance. This article gives an overview of valuation principles for gift and estate tax purposes, reviews some current trends in determining value for such purposes, and makes suggestions for seeking a qualified appraiser. WILLING-BUYER/ WILLING-SELLER TEST For gift and estate tax purposes, the value of property transferred to another party is measured on the date of the transfer as "the price at which the property would change hands between a [hypothetical] willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts" (the "willing-buyer, willing-seller test," Treas. …