Business Valuation Guidelines and the IRS

As a mediation and negotiation specialist I also address issues with the IRS associated with valuation. Have you ever wondered what the IRS Business Valuation Guidelines are? The are spelled out in Part 4 (Examining Process) of the IRS Internal Revenue Manual (IRM) in Chapter 48 (Engineering Program), Section 4 (Business Valuation Guidelines). The commentary that follows presents key elements from this section of the IRM to help you understand how the IRS looks at business valuations. Issues could arise with estate and gifts or with income-related issues.

Given my background of 28 years at the IRS and 11 years heading up business valuation at the IRS, and having been in the private sector for over 10 years serving hundreds of clients, I have found there is an interest in knowing the IRS business valuation guidelines. What follows summarizes key points and provides links for your reference.

 

 Overview and Background

 

 Internal Revenue Manual (IRM) 4.48.4 provides the manual transmittal, purpose, and background for “all IRS employees who provide valuation services or review the valuations and appraisals prepared by others.” This manual section is updated periodically and was last updated September 22, 2020. All sections of the IRM have a date associated with them so that everyone is clear as to the last date that section was updated.

The Engineering Program was initiated in 1914 a year after the 16th Amendment to the Constitution brought forth the first federal income tax return in 1913. The first federal income tax return covered the period from March 1, 1913 to December 31, 1913. The first audits took place in 1914.  Depreciation, depletion for oil and later for mining (1918) required additional expertise outside of an accountant, and so the first engineers were hired. Today the engineering program includes all types of engineers as well as real property appraisers, financial analysts, valuation specialists, business valuers, engineers trained in valuation, foresters, geologists, and others.

 

Technical approach

 

The IRM 4.48.4 section spells out how to approach business valuation issues by planning, identifying and analyzing issues, documenting workpapers, and reviewing business valuation reports. Employees are encouraged to work to resolve issues and where appropriate to apply penalties. Overall guidance is supplied regarding reports, but this is very flexible. Each written report has a required statement that is similar to professional standards of the major business valuation appraisal organizations (ASA, NACVA, AICPA). Planning is not provided in detail in this IRM section. Planning is further elaborated in other sections of the IRM. This is done to ensure coordination with revenue agents on these and other issues appropriately prioritized by management.

Identifying 4.48.4.2.2 (07-01-2006)

  1. In developing a valuation conclusion, appraisers should define the assignment and determine the scope of work necessary by identifying the followinProperty to be valued

          a, Property to be valued

          b. Interest to be valued

          c, Effective valuation date

         d, Purpose of valuation

         e. Use of valuation

         f. Statement of value

         g. Standard and definition of value

         h. Assumptions

         i. Limiting conditions

         j. Scope limitations

         k. Restrictions, agreements and other factors that may influence value

         l. Sources of information

Analyzing 4.48.4.2.3 (09-22-2020)

In the first of six parts states

  1. In developing a valuation conclusion, appraisers should analyze the relevant information necessary to accomplish the assignment including:
    • The nature of the business and the history of the enterprise from its inception
    • The economic outlook in general and the condition and outlook of the specific industry in particular
    • The book value of the stock or interest and the financial condition of the business
    • The earning capacity of the company
    • The dividend-paying capacity
    • Existence or non-existence of goodwill or other intangible value
    • Past sales of the subject stock or interest and the size of the block of stock to be valued
    • Subsequent sale of the subject stock or interest if it was reasonably foreseeable as of the valuation date
    • The market price of stocks or interests of corporations or entities engaged in the same or a similar line of business having their stocks or interests actively traded in a free and open market, either on an exchange or over-the-counter
    • Other relevant information

The parts that follow address the three generally accepted valuation methods, obtaining and adjusting financial statements, determining the appropriate income stream, determining the appropriate discount rate, and reconciling approaches then applying discounts and considering other factors.

Workpapers 4.48.4.2.4 (09-22-2020)

  1. Workpapers should document the steps taken, techniques used, and provide the evidence to support the facts and conclusions in the final report.
  2. Appraisers will maintain a detailed case activity record (Form 9984, Examining Officer's Activity Record) which is prepared consistent with IRM 4.48.1.4, Workpapers.
  3. The case activity record, along with the supporting workpapers, should justify that the time spent is commensurate with work performed.

 

Reviewing 4.48.4.2.5 (09-22-2020)

  • In reviewing a business valuation and reporting the results of that review, an appraiser should form an opinion as to the adequacy and appropriateness of the report being reviewed and should clearly disclose the scope of work of the review process undertaken.
  • In reviewing a business valuation, an appraiser should

          a. Identify the taxpayer and intended use of the opinions and conclusions, and the purpose of the review assignment.

          b. Identify the report under review, the property interest being valued, the effective date of the valuation, and the date of the review.

          c.. Identify the scope of the review process conducted.

          d. Determine the completeness of the report under review.

          e. Determine the apparent adequacy and relevance of the data and the propriety of any adjustments to the data.

          f.. Determine the appropriateness of the valuation methods and techniques used and develop the reasons for any disagreement.

          g. Determine whether the analyses, opinions, and conclusions in the report under review are appropriate and reasonable, and develop the reasons for any disagreement.

  •            In the event of a disagreement with the report’s factual representations, underlying assumptions, methodology, or conclusions, an appraiser should conduct additional fact-finding, research, and/or analyses necessary to arrive at a credible value conclusion.

 

Bringing it all together

 

After initiating a tentative conclusion, the IRS business valuer is encouraged to try and resolve the issue based on all the relevant facts (4.48.4.3.1 (09-22-2020)) and arrive at a conclusion of value (4.48.4.3.32 (09-22-2020)). A final report (4.48.4.4.2 (09-22-2020)) and a statement (4.48.4.4.3 (09-22-2020) similar to standards with the major appraisal organizations regarding the integrity of the report should be included.

The purpose of this commentary is to share with you the overall guidance IRS business valuers have to apply to issues associated with business valuations.

If you are interested in learning more about Business Valuations and the IRS regarding policies and procedures, resolving issues, or the three most audited business valuation issues and how to address them, check out this link.

About the author

Mike Gregory is a professional speaker, an author, and a mediator. You may contact Mike directly at mg@mikegreg.com and at (651) 633-5311. Mike has written 12 books (and co-authored two others) including his latest book, The Collaboration Effect: Overcoming Your Conflicts, and The Servant Manager, Business Valuations and the IRS, and Peaceful Resolutions that you may find helpful. [Michael Gregory, ASA, CVA, MBA, Qualified Mediator with the Minnesota Supreme Court]