Pressures to Step-up Basis Leads to an Ethics Question

Ethical and Practical Implications

Too many appraisers omit the contingent BIGL in their appraisals. It certainly is easier to yield to the pressure of estate attorneys, CPAs, and the IRS on this point, but in light of the evidence for inclusion, is this the ethical path? The author discusses the merits and ethics of including the BIGL.

Too many appraisers omit the contingent built-in capital gain tax liability (BIGL) in their appraisals. It certainly is easier to yield to the pressure of estate attorneys, CPAs, and the IRS on this point, but in light of the evidence for inclusion, is this the ethical path?

While real estate appraisers may try, business valuation analysts are typically called upon to “value the wrapper” of a company that holds real estate and then apply minority interest discounts. The “discounts” are for the holding period until the controlling interest liquidates the investment and the investor captures the profit. This means that accredited valuers have an important role in promoting fairness and correct process for valuing equity of these companies.

As repeatedly decided for over 25 years, holding company valuation includes identification of the BIGL on the assets. Deducting this tax cost is key because, after all, it is the net cash provided to the investor over time that determines what they will pay for equity in the company. And with an equity transfer, this tax liability is not extinguished like it would be if the owner sold the property.

A big influence to omit the BIGL comes from stakeholders in marital estates. Married people get a special estate tax break because the full step-up in basis at the first death of a spouse is a free gift of untaxed capital gain by the U.S. government to the second spouse.

A second motivation to omit BIGL is that simplistic asset-based appraisals that are nothing more than a schedule of assets and liabilities are cheap. Talented appraisers are hurt because they do not get the work. Clients choose low price when offered an alternative of seemingly equal reports.

It does not help that the IRS is on the wrong side of the issue, and does not enforce, or that CPAs do not understand that the conditions at the date of value (DOV) control the valuation, not how the CPA plans to file a future tax return. In fact, the IRS continues to argue against BIGL. After losing on the question in Eisenberg v. Commissioner (1997), Davis v. Commissioner (1998), Dunn v. Commissioner (2002), Litchfield v. Commissioner (2009), Jelke v. Commissioner (2010), and Richmond v. Commissioner (2014), it is surprising that the Service continues this fight. I recently had the opportunity to defend a client against a new BIGL attack, simply because the interests were held in limited partnerships and the IRS sought to pierce the entity form. This latest attempt has also been resolved in favor of the taxpayer, but at unnecessary expense to the client.

Now look at the effect. Omitting the BIGL in a company appraisal clearly means that equity values for thousands of estates are overstated every year. The lost tax is likely to be more than 100 million tax dollars annually. One day, I expect the IRS to wake up to the lost tax opportunity and loopholes they have created. The tax question is close to a zero-sum game. The tax revenue exists on one side or the other. By stubbornly losing on one side for decades, billions in tax receipts have been lost on the other side.

There are maybe 2,500 taxable estate returns, and potentially thousands more if the estate exclusion falls. A sample scenario assumes that $1,000,000 of real property is held in the average taxable estate and 80 percent of appreciation is accrued by the first spouse’s death. Under these assumptions, $240,000 less step-up is allowed per estate and maybe $180,000 more taxable value exists at second death. That is $72,000 more tax, multiplied by say, 1,600 faulty appraisals. So, $115 million in additional annual tax revenue is uncollected.

In the worst case for the government, best case for the taxpayer, a taxpayer intentionally arbitrages the two valuation methods. At the death of the first spouse, the estate receives an overstated step-up by omitting BIGL. Then for the second death, they select an appraiser that properly deducts the BIGL. The taxable portion of the estate is then even less than it should be if the same method was used on both 706 returns. Consider that there may be 500 cases annually where the two appraisal methods were arbitraged, and the tax revenue opportunity likely totals over $175 million per year.

So, while this article serves as a roadmap to minimize estate tax via loopholes that the IRS has created, it is also a call to professional integrity and always allowing for BIGL in company equity. Raising awareness of the issue may help the IRS realize what it is missing. Not only is there legitimate, significant tax revenue to be collected, consistency will support good appraisers and taxpayer fairness. More tax revenue, support for good analysts, fairness, and less IRS conflict—four very positive, ethical outcomes.

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James A. Lisi, CVA, MBA, BSIE, CPIM, is owner of Santa Barbara Valuations Inc. and a representative of The Mentor Group’s cost segregation and investment banking services. His expertise spans valuation of businesses, real property partnerships, intellectual property, brands, cryptocurrency, and equipment. He has served clients across the U.S. since 2003 and has important advisory experience in business sales, acquisitions and angel investment, plus extensive practice in valuing start-ups and discounts; ERISA, IRC 409a, and ESOP compliance. He has enhanced clients’ due diligence efforts, negotiating key deal terms and favorable prices.

For litigation, Mr. Lisi has supported mediations and civil lawsuits for partner disputes, employee separations and divorce. He is a member of the National Association of Certified Valuators and Analysts (NACVA) and has presented at NACVA national conferences. Some of his technical solutions are published in the NACVA online library.

As a valuator, Mr. Lisi has valued over 300 business entities, intellectual properties, and equipment projects. The companies range from start-ups to low middle-market companies, and ‘main street’ business to manufacturing and SaaS companies.

Mr. Lisi can be contacted at (805) 797-1710 or by e-mail to jim@sbvaluations.com.