Why a Business Valuation is Necessary for Estate Planning

The last few years were filled with uncertainty regarding the future of estate and gift taxes. There was a flurry of activity as people made gifts to take advantage of relatively favorable tax laws, which were due to revert to significantly less friendly provisions starting January 1, 2013.

The American Tax Relief Act of 2012, enacted January 2, 2013, made permanent several estate, gift and generation skipping transfer (GST) tax provisions. While the maximum estate tax rate increased to 40%, the exclusion for estate and gift taxes and GST remained at $5 million and is indexed for inflation going forward. The portability election for a deceased spouse’s unused exclusion also remains in place.  

Although the passage of this law was seen as largely positive and provides some stability, the increase in the maximum rate on transfers from 35% to 40% means taxpayers have even greater exposure should the IRS adjust the value of gifts or amounts included in a decedent’s estate. If there is no certainty that the amounts gifted over a number of years can truly be settled, this can be particularly problematic for an estate plan that takes time to implement.  

What to Consider If Your Estate Plan Includes the Transfer of a Business  

If your estate plan involves the transfer of a closely-held business interest or other complicated gifts, a sound business valuation performed by a qualified appraiser at the time of the transfer can be critical to achieving your goals.  

There generally exists a rebuttable presumption of correctness of tax deficiencies proposed by the IRS. The burden of proof can be shifted from the taxpayer to the IRS, however, if the “credible evidence” is provided by the taxpayer supporting a position.  

A contemporaneous appraisal can accomplish this and is the best evidence of the value of a business if it is challenged by the IRS. Although it is possible to go back and perform a valuation as of a date two or three years in the past, this can raise some difficulties, including leaving the burden of proof with the taxpayer. Valuations are performed as of a specific date (generally the date of death for estate tax returns or the date of the gift) based on information that is “known or knowable” as of that date.  

Just think how difficult it can be to remember what you had for dinner last week and then try to imagine how much harder it would be to try and recall the overall economic conditions, industry outlook and company prospects as they all existed in the past. Now let us assume the company experiences significant growth in revenues and profitability in the two years after the valuation date. While it is entirely possible these events were unforeseen and unknowable at the valuation date, in the absence of a contemporaneous valuation, you expose yourself to an IRS auditor utilizing hindsight and arguing that the conditions that resulted in the growth existed at the valuation date were knowable, and should have resulted in a much higher value.  

Beware of Penalties for Undervaluing Assets on Estate and Gift Tax Returns  

In addition to significant taxes that might be payable upon an IRS examination due to the 40% rate, Internal Revenue Code Section 6663 imposes penalties for taxpayers who undervalue assets on estate and gift tax returns.  

These penalties are based on a percentage of the difference between the final determined value and the value originally reported on the tax return. There is no penalty if the value per the tax return is more than 65% of the final determined value. However, a penalty of 20% is applicable if the value on the return is between 40% and 65% of the final determined value. A 40% penalty is applicable if the value original value is 40% or less of the final determined value.  

A Business Valuation Offers Peace of Mind and More  

A business valuation can also achieve some closure on the steps you have taken. While a business valuation will not guarantee that a transaction will go unaudited, if performed correctly it can be used to lock in a three-year statute of limitations for the IRS to act.  

The filing of a gift tax return will begin a three-year statute of limitations, but only if the return meets the adequate disclosure rules contained in IRS regulations. A business valuation performed properly by a qualified appraiser is an important part of satisfying these requirements. Note that the IRS defines a qualified appraiser as “an individual who has earned an appraisal designation from a recognized professional appraiser organization.” Certified Valuation Analysts, for example, are considered qualified appraisers.  

Three critical advantages to the running of the statute of limitations are:

1. The IRS cannot increase the amount of the initial gift

2. The IRS cannot increase the amount of a future gift based on an increase in the amount of the initial gift

3. The IRS cannot increase the amount of taxable gifts included in an estate tax return as a result of the gift

It is not too late if you have exposure for prior gifts that have not been adequately disclosed. You can start the statute of limitations by filing an amended return that meets the disclosure requirements.  

So while we now have some stability in the tax code regarding estate and gift taxes, the case law and regulations in this area continue to evolve. If you have a closely-held business interest to transfer it is just as important as it has ever been to have a business valuation prepared by a qualified professional as part of your estate planning.  

Need Help?  

A sound business valuation is an important component of effective estate planning. Our Certified Valuation Analysts have extensive knowledge of estate planning and use all available valuation and estate planning techniques and methods to help clients minimize their estate tax liability.  

Contact us online or call 800.899.4623.