Business valuers, the IRS, and conflict resolution – Part 2 - Top issues of disagreement

three hands pointing fingers at three other hands

This is part 2 of a 6 part series. Conflicts and disputes in the area of business valuation with the IRS may be expected given the subjective nature of this topic. Part 1 set the stage introducing the concepts of mediation, business valuer bias, steps to overcome bias, federal court rules, the likelihood of litigation, how most appraisers never know their appraisal is being audited by the IRS, and potential penalties on appraisers. This Part 2 commentary focuses on the most commonly adjusted areas by IRS valuers and what valuers can do to reduce the probability of an audit technically. 

 

What are the top issues of disagreement?

 

There is no one size fits all regarding the IRS and auditors are given broad discretion on deciding what to audit. Focusing on Estate and Gift (E&G) tax valuations as an example, after a national classification process followed by a local classification process an E&G attorney (agent) may be assigned a case. Depending on the facts in the case the E&G attorney may address valuation issues by themselves or bring on board an IRS valuer. Assuming an IRS valuer is assigned to the case as an examination[i] the most common areas of adjustment are associated with the following:

Discount for Lack of Marketability (DLOM)

Assumptions and Limiting Conditions

Subchapter S Tax Affecting

Reasonable Compensation

Cash Flow and Discount Rate

Math Errors

Discount for Lack of Marketability (DLOM)

The IRS has a dated Job Aid on DLOM. Although many of the comments are out of date, many still also hold true. For example, given U.S. Tax Court cases in the Job Aid and after publication, these cases indicate that Pre-IPO studies are only applicable if the subject entity is involved in or is likely to be involved in an initial public offering soon. With this precedent IRS valuers tend to agree with those cases and reject pre-IPO studies as a proxy for a DLOM in most cases. When business valuers include pre-IPO studies without these facts this tends to diminish the credibility of the valuer. By reading the pros and cons of various methods it is possible to see where the IRS is coming from with a given approach. It is best not to use an approach the IRS believes is not applicable to the facts in the case, or to make an extra effort to explain why it is with the facts in your case. See an elaboration on this topic in the next blog in Part 3 on October 3, 2022.

Assumptions and Limiting Conditions

If for example the business valuer believes that Fair Market Value (FMV) of assets should be determined by an appraisal, but the client does not want to pay for a real property appraisal, the valuer should protect themselves. This is accomplished in the Assumptions and Limiting Conditions section of the report when the business states that the book values were accepted for various assets as directed by the client. The business valuer is off the hook reducing their liability, but the IRS may or may not accept those book values. In particular if they are material. This is why an IRS auditor reviews the assumptions and limiting conditions. What might the business valuer point out to the auditor?

Subchapter S Tax Affecting

This is a controversial subject. Many valuers believe that all entities whether a C-corp or an S-corp should be valued as a taxable entity. Others believe there should be some form of adjustment for various reasons to the S-corp. The IRS won with the Gross case (Gross v. Commissioner T.C. Memo 1999-254, aff’d 272 F. 3d 333 (6th Cir. 2001cert denied, 537 U.S. 827 (2002) (Corp)) that was successfully appealed with the 6th circuit by the government, and the case was not accepted to be heard by the U.S. Supreme Court. That let the case stand. That case and 6 following cases upheld the position that tax affecting an S-corp that pays no federal taxes was not appropriate. One district court case where both the government’s expert and the taxpayer’s expert tax affected, tax affecting was accepted in U.S. District Court in Eastern Wisconsin (Kress v. Comm March 26, 2019 (Corp) and on another case where the taxpayer had an appraisal with tax affecting and the IRS did not have an appraisal, tax affecting was accepted with the Estate of Aaron U. Jones August 19, 2019. More recent cases including the famous Estate of Michael Jackson May 3, 2021  case have continued to rejected tax affecting. Some at the IRS believe incorrectly that the IRS position is to not tax affect in all instances. See an elaboration on this topic in the blog with Part 4 on November 7, 2022.

Reasonable Compensation

The IRS Reasonable Compensation Job Aid and associated Appendix spell out how the IRS addresses reasonable compensation. The IRS has done well on this issue in court too. See the blog dated June 27th on reasonable compensation for some updated information from that Job Aid.  

Cash Flow and Discount Rate

The determine of cash flow and discount rate are highly factual inputs for the discounted cash flow or capitalization of income approach. IRS business valuers review each for completeness, articulation of what was used, adjusted and how it was determined with clear documentation of the method. Unusual, non-recurring expenses, depreciation, working capital assumptions, and other considerations are examples of areas reviewed. The development of the discount rate with various components including subject entity risk can be areas of concern without proper development and clear articulation.

Math Errors

It was this authors experience that about 1/3 of appraisals submitted to the IRS have math errors. Having been in the private sector this has continued to be this authors experience with helping others with critiques before submitting reports to the IRS. Follow up with current IRS business valuers confirms that this continues to be an issue today. Having someone check spreadsheets and the report itself for math errors can overcome embarrassing issues raised by the IRS. They can be material.

Stay tuned to see future posts addressing DLOM’s, S-Corp Issues, Negotiating with the IRS, and comments on Revenue Ruling 59-60.

 

 

[i] An IRS valuer may assist an E&G attorney as an informal consultant (generally 2 hours or less with no time charged to the case), a formal consultation (in theory more than 2 to up to 8 hours or less, but there are examples of much greater time), an examination (more than 8 hours and focuses on most egregious areas of disagreement), or a full examination (development of a full appraisal by the IRS either internal or via an Outside Fee Appraiser – external hired consultant).  Note that no report is given to the taxpayer if the case is a consultation.

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]