Important Lessons Regarding Valuation Issues

By Paige Goepfert, CPA, MST, CSEP, Chicago, IL

Editors: Mindy Tyson Cozewith, CPA, M. Tax., and Sean Fox, MPA

Estates, Trusts & Gifts

On April 28, 2011, the Tax Court held in Estate of Mitchell , T.C. Memo 2011-94, that an estate properly valued both real estate and artwork. The IRS had previously examined the estate’s federal estate tax return and claimed that the estate underreported the fair market values (FMVs) of paintings and interests in several real properties. In response, the executor of the estate filed a petition with the Tax Court to contest the entire deficiency. While the parties were able to resolve most valuation and other estate tax issues, they still disputed the FMV of fractional leased-fee interests in two real properties and of two paintings. Both parties agreed on discounts ranging between 19% and 40% for the real property interests.

Asked to determine the FMV of the real property interests and paintings, the court noted that valuing these types of assets “can be an ambitious task,” because they “are unique and infrequently exchange hands,” and the value of art “often lies in the proverbial ‘eye of the beholder.’” Both the estate and the IRS discarded the initial valuations used on the estate tax return and in the notice of deficiency and presented new valuations at trial. The court stated that this case illustrated the difficulty in ascertaining FMV, the “quintessential fact question.” The court held that the estate properly determined the FMV of the decedent’s real property interests and paintings.

Valuation Issues

Under Sec. 2031, the value of the gross estate of the decedent is determined by including the value of real, personal, tangible, and intangible property held by the decedent at the time of his or her death. Regs. Sec. 20.2031-1(b) indicates that the value discussed in Sec. 2031 equals the property’s FMV. The regulations define FMV as the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Furthermore, the value of tangible property must reflect its highest and best use as of the valuation date (Estate of Kahn, 125 T.C. 227 (2005)).

As indicated in Mitchell, ascertaining FMV is a question of fact that can cause controversy and litigation, particularly when the assets being valued are distinctive. If a decedent’s estate contains assets that have marked artistic or intrinsic value that totals more than $3,000, Regs. Sec. 20.2031-6(b) requires the appraisal of an expert, executed under oath, to be filed with the estate tax return. The regulations also require care to be taken to ensure that the expert appraisers are reputable and recognized as competent to appraise the assets involved.

Because of the frequency of disagreements regarding the valuation of artwork, Rev. Proc. 96-15 instituted a procedure by which a taxpayer may, after transferring artwork valued at $50,000 or more, obtain an IRS statement of value on which the taxpayer may rely in filing the income, gift, or estate tax return reporting the transfer. A taxpayer must attach to and file with his or her return a copy of the statement of value, regardless of whether the taxpayer agrees with it. If the taxpayer disagrees with the statement of value, the taxpayer may submit additional information with the tax return to support a different value.

When the taxpayer and the IRS do not agree on an asset’s value, both parties may obtain appraisals from valuation experts. The taxpayer technically has the burden of proving that the IRS’s valuation is wrong. However, in a valuation case, if the taxpayer submits an appraisal to support its valuation, the dispute becomes a battle of the experts. While a court may hesitate to decide the value, it will do so when required. Many times, a court will merely use the better of the appraisals. In other instances, the court may balance or even average the appraisals. It is obvious that the courts are requiring qualified experts to have a well-documented approach to their appraisals and to explain them thoroughly. The court will carefully consider all the facts, weigh all relevant evidence, and draw appropriate inferences and conclusions in determining FMV.

The Estate’s Assets

Mitchell’s estate reported a $17 million gross estate value. Its two largest assets were beachfront property and a ranch. The beachfront property was subject to a 20-year lease to an unrelated party, which accomplished the decedent’s goal of keeping the property in his family. The lease also transferred the cost of upkeep to the tenants and provided income to the decedent’s family. The ranch property was subject to a long-term lease to cattle ranchers. Leasing the ranch property accomplished the decedent’s goal of keeping the property maintained until it would be distributed to his two sons.

The decedent’s revocable trust held his assets, including the beachfront and ranch properties. The trust provided that, after the decedent’s death, both properties would be held for the benefit of his sons and distributed to them once the younger of them attained the age of 45. Shortly before the decedent’s death, he gifted a 5% interest in both properties to a separate children’s trust for the benefit of his sons.

The decedent’s estate also consisted of several paintings by well-known American Western artists. The two paintings subject to the Tax Court’s review were an oil painting, “Casuals on the Range,” by Frederic Remington, and a watercolor, “Creased,” by Charles M. Russell.

In valuing the real estate interests, the court noted that the parties had agreed that 19% and 32% fractional interest discounts applied to the 95% and 5% leased-fee interests, respectively, in the beachfront property. In addition, the parties had agreed to apply 35% and 40% fractional interest discounts to the 95% and 5% leased-fee interests, respectively, in the ranch. Therefore, the court had only to decide the value of a 100% interest in both properties to determine the discounted value of the interests in the estate.

The estate used an income-capitalization method to determine the property interest value, whereas the IRS used a lease-buyout method. The income capitalization method values income-producing property by estimating the present value of anticipated future cashflows. The IRS’s experts indicated that the lease-buyout method equals the property’s fee simple value less the amount necessary to buy out the tenant’s lease.

The IRS’s experts also indicated that appraisers generally use the income-capitalization method only with respect to commercial property leases, not residential leases. The court disagreed with this claim and stated that any property that generates income can be valued using the income-capitalization approach.

The decedent treated the beachfront property as an investment and leased it for a profit. Furthermore, the decedent did not intend to live in the property or use it as his residence. The court found that leasing the beachfront property was an income-producing activity that put the land to its best use. The ranch, which the decedent had been leasing for 25 years, provided the decedent with annual income and reallocated the normal maintenance cost to third-party caretakers. The court found the IRS’s lease buyout method to be “speculative at best,” stating that the method had not been accepted by any court or generally recognized by real property appraisers. Rejecting the IRS’s method, the court ruled that the estate’s income capitalization method was the best method for determining the value of the 100% leased-fee interest of both properties.

In valuing the artwork, the court noted that experts consider several different criteria or “art valuation factors,” including thematic appeal, period of work, style, overall quality, provenance, condition of artwork, and market conditions. The court received appraisals from the estate, the IRS, and the IRS Art Advisory Panel. The IRS’s experts did not have expertise or an extensive background in American Western art. All of the experts used the comparable-sales approach to valuing both paintings.

The court found that one IRS expert used poorly documented private sales to value one of the paintings, while the estate used public sale comparables. The court found that the public auction prices were a better indication of FMV. With respect to the second painting, the court found that the IRS experts had failed to adjust their valuation for the painting’s inferior status, poor paper quality, and poor “back boarding.” The court found that the estate’s expert’s reports were the better indicators of value, as they were more understandable, reasonable, and well supported.

Lessons Learned

Determination of value: As demonstrated in the Mitchell case, the determination of value in the Tax Court often operates like arbitration. The court will rule on which valuation best arrives at FMV. It is the taxpayer’s responsibility to conduct due diligence to arrive at an appropriate value. Otherwise, the court may determine that the taxpayer did not properly establish a value.

Valuation and the taxpayer’s and tax preparer’s responsibility: Under Sec. 6662, the taxpayer can be subject to substantial accuracy-related penalties that start at 20% of the understatement and can be higher with a substantial understatement of tax. In turn, the tax preparer can also be subject to understatement penalties under Sec. 6694. Therefore, the tax preparer must take due care that valuations disclosed on the return have appropriate support.

Determining the examination trigger of a valuation: Recently, the IRS has increased its scrutiny of high-income and high-net-worth taxpayers. According to the IRS’s Fiscal Year 2011 Enforcement and Service Results report, the IRS examined approximately 12% of taxpayers earning at least $1 million annually in 2011. That is an increase from 8% in 2010 and 6% in 2009. In comparison, approximately 1% of taxpayers earning less than $200,000 had their income tax returns examined in 2011. Clearly, returns with large reportable income, taxable gifts, or taxable estates face a heightened risk of IRS exams.

In the estate and gift tax arena, the number of experienced IRS agents has also increased. This investment in manpower has resulted in a heightened review of estate and gift tax returns, which in turn results in a greater number of IRS notices and examinations. In essence, a perfectly prepared return can still result in an examination for no other reason than that the taxable gift or bequest is large.

The IRS approach: As evidenced by the Mitchell case, the IRS has been aggressive regarding valuation challenges. Many of the IRS challenges assert estate valuations substantially larger than, and in some cases more than double, the taxpayer’s valuation. It is apparent that the Tax Court’s determinations center on which side presents the best data to support its values. In circumstances where the taxpayer fails to adequately substantiate an asset’s FMV, the additional tax costs can be substantial.

Valuation Red Flags

Several return disclosures can heighten the risk of an examination. Some are unavoidable, such as related-party transactions, while others can be avoided with proper planning.

Related-party transactions: Transactions between related parties (as defined under Sec. 267) have a heightened risk of examination due to perceived attempts to pass value to the younger generation by a discounted sale. If the IRS can prove that the transaction passed a disproportionate benefit to the younger generation, the IRS will assert that the younger generation received a value above the discounted sale and that the difference between the real value and the transacted value is a taxable gift.

In contrast, transactions between un-related parties have a rebuttable presumption of being negotiated fairly. Please note, however, that this presumption is not absolute. Some transactions between unrelated parties can result in IRS review, since there still can be “sweetheart” transactions similar to related-party transactions, such as those between common law partners.

Arbitrary value: Many buy-sell agreements use book value as the basis for an asset sale. When attached as exhibits to a taxpayer’s return, these agreements dramatically increase the risk of examination. Whether book value appropriately represents FMV is not relevant, since upon review, the IRS will assume that book value is arbitrary. Again, if the IRS challenges this valuation and, in turn, supports its valuation with appraisals and technical support, the taxpayer runs the risk of a larger tax liability.

Stale valuations: Reliance on old valuations or out-of-date information also creates problems. Timing is everything. Many taxpayers rely on a rule of thumb, such as appraisals within three months of the transaction; however, this rule can be problematic if the asset has wild swings in value that can make the appraisal’s assumptions obsolete.

Ways to Mitigate Examination Risk

The qualified appraisal: Although a qualified appraisal (one that meets the requirements under Regs. Sec. 1.170A-13(c)(3) for certain charitable contributions) is not required to substantiate the FMV of property for purposes of determining the size of the decedent’s taxable estate, a qualified appraisal provides a strong foundation to establish FMV. Keep in mind, however, that qualified appraisals do not completely protect the taxpayer from examination. The IRS challenges many taxpayers’ qualified appraisals, based on issues that estates can avoid.

  1. Is the appraiser qualified? Taxpayers should ensure the appraiser meets the definition of “qualified” under Regs. Sec. 1.170A-13(c)(5).

  2. Is the appraisal objective? Disclosing the reason for the appraisal in the report may provide the IRS reasons to challenge the report. For example, if the appraisal or the appraiser’s cover letter discloses that the appraisal relates to a related-party sale, the IRS may argue that the value is not objective, since the taxpayer’s goal is a lower value and not necessarily FMV.

  3. Are the appraisals consistent? If more than one appraiser provides a report, each appraiser may be using different assumptions to reach FMV. For example, differing discount rates used to calculate value under the capitalization-of-earnings method may create a red flag for the IRS. When using different appraisers, taxpayers should share information with them from prior appraisals to establish a consistent approach.

    Review the planning documents: Advisers should review documents related to buy-sell agreements, articles of incorporation, and voting trusts that have transaction provisions. Furthermore, prior transactions, whether related or unrelated, should also be reviewed. The key is to correct red flags that can lead the IRS to assume that the estate has used an arbitrary value or an inconsistent valuation. Transactions that consistently meet the qualified appraisal requirements provide the taxpayer with greater protection against examination.

    Conclusion

    The Mitchell case provides a reminder for taxpayers to assess and correct their appraisal processes. It is clear that proper valuation planning can supply the taxpayer with the ability to mitigate the examination risk and increase protection on future returns. Taxpayers with high income and high net worth should be diligent regarding the valuation process and ensure they have used thorough and well-documented appraisal methodologies. Otherwise, the taxpayer may end up triggering a large tax liability, along with interest and penalties.

    EditorNotes

    Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.

    For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or mindy.cozewith@mcgladrey.com.

    Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.

     

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