Valuing a Pass-Through Entity for Gift and Estate Purposes
Tax Saving Tips for Small Business Owners
This article discusses the recently issued Rev. Proc. 2022-32. The revenue procedure also serves to remind every estate planner that the days of the high lifetime exemption will soon be ending starting in 2025, if not sooner with all the uncertainties in Congress and the economy. The author discusses the merits of gift-giving in light of the potential changes.
On July 8, 2022, the IRS released a revenue procedure that can be seen as a wake-up call about a tax-saving opportunity that may be overlooked by estates and their fiduciaries. Rev. Proc. 2022-32 calls attention to the popular tax-saving strategy known as “portability”. Portability makes it possible for a surviving spouse to preserve a deceased spouse’s lifetime exemption—an exemption that has reached historic highs while still hovering over $12 million (see “Portability Now Expanded” below).
Aside from providing an estate tax saving windfall for surviving spouses, however, the revenue procedure also serves to remind every estate planner that the days of the high lifetime exemption will soon be ending starting in 2025, if not sooner with all the uncertainties in Congress and the economy. Many family planners are finding it wise to step up their gift planning efforts with family members now. Why wait until later, they ask, and create a higher estate tax burden for the family? And, if they happen to be a business owner with a relatively successful business operation, chances are good that they will need an independent valuation of their business for gifting purposes.
Valuing a Business Interest for Gift/Estate Purposes Means Revenue Ruling 59-60 is on the Table
The IRS is aware of the increasing trend of estate planners to accelerate lifetime-gifting to avoid estate/transfer taxes. And, when business interests are the assets being transferred, it is likely that tax examiners will be called on to enforce the standards set by Revenue Ruling 59-60. Referred to as the gold standard for business valuations, Rev. Rul. 59-60 has long been applied by the IRS for its enforcement guidelines. However, it is not without shortcomings. For starters, the ruling seems to imply that a regular closely held corporation is the primary entity being valued. However, the ruling attempts to set valuation standards for all business entities, including S-corporations, LLCs, and partnerships.
Over the years, legal disputes have resulted from the shortcomings of Rev. Rul. 59-60 in determining the value of small businesses for estate and gift tax purposes. This has been followed by further clarifications from the IRS with other rulings and memoranda. These provide additional guidance with answers to critical questions about a business valuation, such as capitalization rates, formula methods, and minority discounts, etc.
In summary, Rev. Rul. 59-60 is still recognized as a living document and will likely be enforced with greater zeal with the surges in lifetime gifting by business owners to avoid taxes. The strict standards followed by “qualified” professionals in the valuation industry have generally proved to be successful when valuations are prepared for non-tax purposes, such as business mergers, acquisitions, family matters, etc. However, when dealing with gifts and estates with the IRS, lingering questions arise as to who is a “qualified appraiser”.
Who is a “Qualified Appraiser” for Gift and Estate Reporting
For decades, the IRS has provided guidance on who qualifies as an appraiser for IRS purposes. However, the references are usually in the context of paid professionals who set values for assets for charitable deductions under sec. 170, IRC. In 2018, the IRS attempted to finally broaden its scope under Sec. §1.170A-17. Here, it laid out certain requirements needed to qualify an individual as an appraiser for gift and estate tax reporting. As the ruling shows, these requirements may seem a bit arduous and overblown; however, it is expected that they will go a long way in satisfying the underlying requirements of Rev. Rul. 59-60 for business valuations.
Alternatively, one might refer to a less cumbersome source for defining a qualified appraiser for gift and estate purposes. It can be found in the instructions for the gift tax return. The instructions tell us about the importance of attaching to a return “adequate disclosure” in connection with (a) the assets being transferred and (b) the qualifications of appraisers.
Adequate disclosure is needed to gain assurance that the clock will start ticking immediately for a tax return for protection under the statute-of-limitations. If an appraiser is duly “qualified”, it can do much to eliminate fears about second-guessing by IRS about a business valuation, which may have been conducted over three years ago or longer.
The return instructions call attention to sec. § 301.6501(c)-1, which provides the details about disclosures needed for statutory protection. This includes the facts, observations, and assumptions about the valuation which are generally addressed by experienced professionals in the valuation industry. In addition, however, the regulation goes on to describe, concisely, the requirements that are needed for an individual to be deemed a “qualified appraiser”. In general terms, these requirements include the following:
- The appraiser holds himself or herself out to the public as an appraiser who performs appraisals on a regular basis.
- Details in the report must include reference to the appraiser’s background, experience, education, and membership, if any, in professional appraisal associations.
- The appraiser is not the donor or the donee of the property or a related party therein.
Transferring Business Interests to Family Members: Is Sooner Better than Later?
Family planners who feel that their estate will never be large enough to trigger a federal estate tax will often be advised  to refrain from lifetime gifting in general. Instead, they are shown how basis step-up, upon their death, could prove to be the welcomed tax-saver for their heirs.
On the other hand, as noted earlier, many successful business owners have good reason to adopt a use-it-or-lose-it mentality in their estate plans. For them, there is nothing gained (and much to be lost) if they wait too long to transfer some business interests while the lofty exemption for the estate tax still exists. This mindset has been supported with comforting assurances by the Service under its so-called “anti-clawback” regulations. Passed in 2019, these regulations were intended to assure family planners that their good faith effort to (legally) avoid gift/transfer taxes will not be upended later when the tax law changes.
Note: After further considerations by the IRS over potential abuse, additional “proposed” regulations were enacted in April 2022 to cover certain situations in which anti-clawback relief might not be available (sec. 20.2010-1(c)(3)). Generally, these involve cases where there are gifts with pass-through business interests in which the donor retains certain reversionary interests or powers. Provisions such as these should, of course, be discussed with the estate attorney.
Planning Alerts when Valuing Pass-Through Entities for Gift/Estate Purposes
In addition to being mindful of Rev. Rul. 59-60 and the benefits of having qualified appraisals, there are two other valuation issues that come to mind when valuing a business for gift/estate purposes. These issues include (a) timing and (b) “tax affecting”.
- Timing of the appraisal and historic valuations.
With Rev. Rul. 59-60, we are reminded that the IRS is especially focused on exactitude as to a precise date that had been set for determining the value of a business for gift or estate purposes. This could create an additional challenge since the valuation needs to be reflective of all the facts and circumstances that had been available as of a specific (perhaps much earlier) date. The IRS has little interest in what the value of an asset had been a month, or even a week, after a gift or estate transfer.Accordingly, during these uncertain times, historic valuations might be severely distorted because of global and political influences and events that occurred as of a specific valuation date—a date which has long passed. This, of course, is not to mention the foggy memories of small business owners who are given the task of locating older, archived records that are needed for the appraisal of their business.
And now, under with the new portability expansion rule (shown below), there could be additional challenges with research with historic valuations; especially for an appraiser who is trying to pinpoint a conclusion of value of a business enterprise back in an earlier time period (maybe as long as five years ago).
- Should tax-affecting be considered in the valuation of a pass-through entity?
This question has been generating much debate especially since 1999 when the Tax Court in Gross v. Commissioner responded with a no. Tax-affecting should be flat-out ignored when determining value of a business. The rationale was that S Corporations and partnerships do not need to factor in tax liability with a valuation because pass-through entities are not directly liable for the taxes on income. At the same time, adversaries continue to argue that a ”zero tax rate” is illogical since it will wind up inflating the value of a business unnecessarily. After all, they ask, won’t the owner(s) need to pick up the tax tab anyway?
Has the debate finally been resolved? After the Estate of Aaron U. Jones v. Commissioner in 2019, experts tend to agree that the playing field changed abruptly when the Tax Court sided with the taxpayer by rejecting the zero-tax rate approach. The decision was based on the theory that some tax liability must be acknowledged, notwithstanding the fact that a taxpayer decided to be treated as a pass-through entity, which is not taxed directly.
“Justification” is the key. Some justification is better than none. Although Jones has opened the door with a major win for taxpayers, it is not without caveats that need to be heeded. In Jones and other landmark cases, there appears to be agreement that tax-affecting, in general, will be permitted when it happens to be the best argument on the table. As in Jones, the Court has shown that tax-affecting (even if not exact) makes better sense than a flat-out zero-rate approach (by the IRS) that has no justification.
Scholarly articles are available providing (middle-of-the-road) models that show options for justifying tax liability attributable to S corporations or partnerships. These alternatives will often include sophisticated algorithms that could address a wide array of factors, such as (a) the tax rates of C corporations vs. individuals, (b) capital appreciation vs. cash distributions, and (c) dividend tax rates vs. ordinary rates, etc.
The takeaway: After Jones v. Commissioner, there is the realization that there are numerous, conflicting options to consider when trying to justify a projection of tax liability for a pass-through entity. Unfortunately, there is no clear-cut guidance from the IRS or the courts about which, if any, should be used based on the facts and circumstances at hand. However, this is a conundrum that the IRS will have to address as well.
Accordingly, when in doubt, “something is better than nothing”. As shown in Jones, it is often better to have your cards on the table with your calculations of tax liability rather than be the one with an empty hand. Having corroborating evidence, projections, testimonies, tax benefits etc. (even with open questions), can go a long way when the other side has nothing better.
Finally, Portability Now Expanded
As observed above, in June, 2022, the IRS provided a landmark tax-saving revenue procedure which calls attention to the general, changing dynamics in the tax law. Although the new ruling was directed to surviving-spouse taxpayers, it reminds many estate planners of the substantial tax-savings that could be achieved by making lifetime gifts now, while there is still time. And, if those gifts happen to be with an interest in a family business, the appraiser may need to take a few extra steps to determine value under a historic valuation that targets a specific, earlier date.
For several years, portability has been a valued benefit that allows a married taxpayer to preserve a deceased spouse’s (unused) lifetime exemption while it lasts (now over $12 million). To make this possible, the IRS has provided a simplified method to make an election to protect this carryover windfall for the surviving spouse. The surviving spouse simply needed to file a Form 706 estate tax return (even if a return is not required). And, the further good news was that the return did not need to be filed until two years after the first spouse’s death.
And now (under the new revenue procedure in 2022), even further relief is available for a surviving spouse. He or she can now look back even further and have up to five years from the anniversary of the decedent’s death to make the special election. Again, the election is made by simply filing an estate tax return even if it is not required.
Final Overview
Whether you are a business owner or not, all taxpayers are advised to take a snapshot view of the value of the assets that will be included in their gross estate. Unless Congress makes some more radical changes, it is expected that each person will have a lifetime estate exemption of about $6.4million in 2026. Thus, if you expect that the value of your estate will exceed this amount during your lifetime, you may want to discuss a gifting strategy with your attorney and tax adviser.
If you own a family business and your estate will be excess of the lifetime exemption, gifting some business interests to family members could have major tax-saving potential. In that case, however, you need to keep in mind, an independent (qualified) appraisal will likely be in your best interest.
Finally, if the small business that you own happens to be an S corporation, partnership, or an LLC, there are special new guidelines now available that could justify a lower (more favorable) valuation for tax reporting purposes.
Thomas J. Stemmy, CPA, CVA, EA, is a tax adviser and President of Stemmy, Tidler & Morris, P.A., a CPA firm based in Annapolis, Maryland. His practice has long been focused on general tax matters and tax planning. However, in recent years, his fascination has been captured by the wild swings with the estate tax rules under an uncertain Congress and an unpredictable economy. These changes have brought on increasing challenges to estate planners and their professional advisers as never seen before. Mr. Stemmy has attempted to address these concerns and offer valid estate-planning options for consideration in many of his published works. In addition to his earlier contributions on tax-related matters with newspaper columns and journals, his published works include peer-reviewed articles in the Journal of Accountancy, the MACPA Statement and the National Public Accountant. Recognition for prior authorship has been received from Prentice Hall/Simon & Schuster and from the National Society of Public Accountants, from which he was presented the Golden Quill Award.
Mr. Stemmy can be contacted at (410) 571-3195 or by e-mail to tstemmy@stmcpas.com.
