Stakes are High in Business Valuations for Estate and Gift Tax Reporting

Thoughts from Experienced Litigation and Business Valuation Professionals Entering the Industry

In this article, seasoned BV and litigation support professionals John DelGrego and Heidi Walker share why litigation can be invaluable to a BV professional. The co-authors also expound on the professional perils and high expectations placed by the Tax Court on expert witnesses. Expert witnesses must be objective, current on the law, and persuasive.

Many business valuation (BV) practitioners have diverse practices, which may include valuations done for financial reporting, employee stock ownership plans (ESOP), financial forensic investigations, various types of litigation, including economic damages, marital dissolution, and shareholder disputes, and estate and gift tax planning and compliance.  We believe that experience and expertise in the litigation arena can be extremely beneficial when working on other valuation assignments, most notably valuations for tax compliance.  Although the purpose of each of these particular valuation engagements differs, the steps and procedures required in the valuation process are similar.

When performing a valuation for tax compliance purposes, the Internal Revenue Service requires the preparation of a “qualified appraisal,” which essentially means an appraisal that is conducted by a “qualified appraiser” in accordance with generally accepted appraisal standards.  A “qualified appraiser” is an individual who has earned an appraisal designation from a recognized professional appraisal organization and has education and experience in valuing the type of asset that is the subject of the appraisal.

Similarly, in civil litigation, to provide an opinion of value and be recognized as an expert witness for purposes of testimony, an appraiser must demonstrate specialized knowledge, skill, training, and experience that exceed the common knowledge of ordinary people.  This specialized knowledge and skill is acquired through advanced training and continuing professional education within the field of business valuation, and is typically evidenced by an appraisal designation.

Once an appraiser is “qualified” by the court as an expert witness, a valuation report is submitted as evidence or an “aid to the court,” but more importantly, the appraiser will provide direct testimony regarding his analysis, assumptions, approaches, and conclusions, as detailed in his report.  The rules in federal tax court are a bit different, as U.S. Tax Court Rule 143(g) provides that an appraiser’s valuation report received into evidence serves as the expert’s direct testimony and that additional testimony is only permitted, at the discretion of the court, to clarify or emphasize matters in the report. Therefore, the appraiser’s valuation report is a critical component of any valuation engagement.  Simply put, it needs to be persuasive.

This being the case, the ability to communicate effectively and present conclusions in a written valuation report or through live testimony at trial, if necessary, is critical to the successful resolution of tax valuation matters.  However, a review of recent tax court decisions will reveal that business valuation experts often fail to be persuasive.  It is not infrequent in these decisions to find quotes such as the following:

• “It is unclear how the interests were valued.”[1]
• “We lend little weight to his seemingly contradictory positions.”[2]
• “Because we fail to understand his adjustments, we shall disregard them.”[3]
• “The entire valuation process is a boundless subjective inquiry.”[4]

Most people would not think of valuation experts as storytellers, but that is exactly what we are.  As technical experts, we must be able to gather the relevant facts and connect all the dots, but also able to tell a story to which attorneys and judges can relate.  Persuasive experts are as valuable in an income tax context as they are in a litigation context.  In both cases, the bar for developing a clear, concise, and thorough valuation report is high.  After all, the valuation prepared for income tax purposes may well become the subject of litigation, and the appraiser may not have an opportunity to further explain or clarify his work.

Both the Internal Revenue Service and the Tax Court have become increasingly sophisticated with respect to their knowledge of business valuation concepts.  This has been demonstrated in numerous recent decisions, where the court addresses valuation methodology and concepts with a great deal of specificity.

The Tax Court has also demonstrated in Boltar, LLC v. Commissioner (2011) that it is not afraid to use its gatekeeper function when considering whether to admit valuation evidence.  Boltar appears to be the first Daubert exclusion of appraisal evidence to be handed down by the Tax Court.[5]  The taxpayer’s real estate expert was excluded on the basis that he failed to apply the correct legal standard when valuing a conservation easement for a charitable deduction.  In addition, the court called out the “cottage industry of experts who function primarily in the market for tax benefits,” stating that such practices “should be discouraged.”  The Tax Court continued, “Justice is frequently portrayed as blindfolded to symbolize impartiality, but we need not blindly admit absurd expert opinions.”  Boltar should serve as a warning to attorneys and appraisers that the Tax Court will exclude unreasonable, unreliable, and irrelevant expert testimony.

There is also a financial incentive for practitioners in the estate and gift tax arena to produce accurate, high-quality work.  With respect to our clients, taxpayers face potential financial penalties for undervaluation of assets on estate and gift tax returns under IRC §6662.  In addition, appraisers should be aware of the potential penalties they personally could face from the Internal Revenue Service for valuation misstatements.

The addition  IRC §6695A, under the 2006 Pension Protection Act, provides for a new penalty against any person who prepared an appraisal of the value of property and who knew, or reasonably should have known, the appraisal would be used in connection with a return or claim for refund and that appraisal results in a substantial valuation misstatement (within the meaning of IRC §6662(e)), a substantial estate or gift tax valuation understatement (within the meaning of IRC §6662(g)), or a gross valuation misstatement (within the meaning of IRC §6662(h)).  The penalty amount is the lesser of: (a) the greater of 10 percent of the amount of the underpayment (defined by IRC §6664(a)) attributable to the misstatement or $1,000; or (b) 125 percent of the gross income received from the preparation of the appraisal.

This is in addition to the existing $1,000 penalty under IRC §6701 for analysts whose valuations result in substantial understatements of tax.  Valuators may also be kept from testifying in future IRS tax proceedings without assessing a §6701 penalty.  As well, there are potential sanctions under Treasury Department Circular No. 230, which governs the right of CPAs and others to practice before the IRS.

Business valuation requires rigor, whether it is for high-stakes litigation or income tax appraisals that may well turn into high-stakes litigation.  Experts must be well-versed in myriad technical aspects impacting income tax appraisals, from the controversial issue of tax-affecting pass-through entities, to understanding the company’s legal agreements and how they impact value, to the wealth of empirical data appraisers rely on to support their valuation conclusions.  Also, they must also be convincing, objective, and persuasive storytellers with training and preferably experienced in working with attorneys and the courts.

[1] Estate of Liljestrand v. Commissioner, T.C. Memo 2011–259.

[2] Estate of Gallagher v. Commissioner, T.C. Memo. 2011–148.

[3] Ibid..

[4] Estate of Giustina v. Commissioner, T.C. Memo. 2011–141.

[5] Daubert v. Merrell Dow Pharmaceuticals, 509 U.S. 579 (1993) is a United States Supreme Court case determining the standard for admitting expert testimony in federal courts. The Daubert Court held that the enactment of the Federal Rules of Evidence implicitly overturned the Frye standard; the standard that the Court articulated is referred to as the Daubert standard.  Kumho Tire Co. v. Carmichael, 526 U.S. (1999), is a United States Supreme Court case that applied the Daubert standard to non-scientific expert testimony.

John DelGrego, CPA, ABV, ASA, is a managing director in the Business Valuation and Litigation Support Group at Meyers, Harrison & Pia, LLC, a firm specializing in business valuation, economic damages, and litigation support services. He is based in Connecticut. Mr. DelGrego has performed valuations of business interests for a variety of purposes, including but not limited to family law matters, business damages, buy-sell agreements, shareholder litigation, estate and gift tax matters, buying and selling businesses, intangible assets, and employee stock ownership plans. Mr. DelGrego can be contacted at jdelgrego@mhpcpa.com.

Heidi Walker, CPA, ABV, ASA, is a director in the Business Valuation and Litigation Support Group at Meyers, Harrison & Pia, LLC. Ms. Walker is based in Portland, Maine. She specializes in business valuations for litigation purposes, such as matrimonial dissolutions and shareholder disputes, and non-litigation purposes, such as estate and gift tax planning and filing. Ms. Walker can be contacted at (207) 775-5111.

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