W ith the enactment of Sec. 6695A, the IRS was given new responsibilities to ensure the quality of appraisals and appraisers who provided information in support of a taxpayer’s federal tax filings. Before Sec. 6695A was enacted by the Pension Protection Act of 2006 (PPA), 1 appraisers might have been penalized and brought before the Office of Professional Responsibility (OPR) under Sec. 6701(a), if they were found to have aided and abetted a taxpayer in understating the taxpayer’s tax liability, or under Sec. 6700, if they were found to have promoted abusive tax shelters. However, actions under these sections were rare and penalties were small.
Sec. 6695A penalties can be substantial, which is why it has been a subject of much discussion and concern within the appraisal community since it was enacted. The original purpose of Sec. 6695A was to stop perceived abuse in real estate easement appraisals for charitable deductions. It was later explicitly extended to include business appraisals for estate and gift tax purposes. 2
In implementing this statute, the IRS initially focused on a noncredentialed cottage industry of individuals providing opinions of value without the understanding, training, or experience to apply accepted appraisal methodologies. Sec. 6695A provided a minimum threshold that all appraisers and appraisals had to meet. This allowed the IRS to better fulfill its responsibilities and also helped protect the appraisal profession from competition by unqualified providers offering desired valuations at low prices.
Appraisers and Appraisals Defined
Sec. 170(f)(11)(E)(ii) provides that a “qualified appraiser” is an individual who:
- Has earned an appraisal designation from a recognized professional appraiser organization or has other-wise met minimum education and experience requirements set forth in regulations prescribed by the IRS;
- Regularly performs appraisals for which the individual receives compensation; and
- Meets such other requirements as may be prescribed by the IRS in regulations or other guidance.
Sec. 170(f)(11)(E)(iii) further provides that with respect to a specific appraisal, an individual will not be treated as a qualified appraiser unless that individual:
- Demonstrates verifiable education and experience in valuing the type of property subject to the appraisal; and
- Has not been prohibited from practicing before the IRS by the IRS at any time during the three-year period ending on the date of the appraisal.
Sec. 170(f)(11)(E)(i) defines a qualified appraisal as an appraisal that is (1) treated as a qualified appraisal under regulations or other guidance the IRS prescribed, and (2) conducted by a qualified appraiser “in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed” by the IRS (emphasis added). The IRS provided guidance on the meaning of these terms in Notice 2006-96 and proposed regulations. 3
Generally Accepted Appraisal Standards
The AICPA finalized and issued Statement on Standards for Valuation Services No. 1 (SSVS1), Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, soon after the enactment of Sec. 6695A. SSVS1 applies to all AICPA members, whether or not they hold an Accredited in Business Valuation (ABV) credential:
This Statement establishes standards for AICPA members (hereinafter referred to in this Statement as members) who are engaged to, or, as part of another engagement, estimate the value of a business, business ownership interest, security, or intangible asset (hereinafter collectively referred to in this Statement as subject interest). For purposes of this Statement, the definition of a business includes not-for-profit entities or activities. 4
SSVS1 itself acknowledged it would allow CPAs to be considered qualified appraisers under Sec. 6695A. 5
The AICPA and three other major business appraiser organizations are recognized by the IRS as having generally accepted business appraisal standards. The other organizations are the American Society of Appraisers, the National Association of Certified Valuators and Analysts, and the Institute of Business Appraisers. From a client’s perspective, any CPA offering to provide valuation services may be seen as a “qualified appraiser” under Notice 2006-96, and clients may assume any advice is being given “in accordance with generally accepted appraisal standards.” If a client files a tax return using indications of value a CPA provided, even if those indications were provided orally and whether or not they were used with the CPA’s permission or knowledge, that client’s actions may expose the CPA to the IRS’s appraisal review process.
IRS Appraisal Review Process
The Sec. 6695A appraisal review process was developed after open forum discussions in 2010 with representatives from appraisal organizations, including representatives of the AICPA. 6
Under the Sec. 6695A review process, all estate and gift valuations are sent to one of two central locations where estate and gift tax attorneys and IRS engineer 7 specialists perform an initial national classification process. 8 Both tax returns with and without attached appraisals may be referred to estate and gift tax attorney groups at local IRS offices for further classification. After classification of the case at the local level, an estate and gift tax attorney may open the return for an examination. After the return and any valuation on the return have been analyzed, the IRS may impose a Sec. 6695A penalty.
An appraisal examination can also be initiated by an IRS revenue agent. While the revenue agent’s primary focus will be the taxpayer and a potential tax deficiency, rather than the appraiser, the revenue agent may decide to initiate a Sec. 6695A process. At this point, the process also should involve an IRS engineer.
Practice tip: The authors strongly suggest that the taxpayer and/or appraiser request the involvement of an IRS engineer to assure matters of professional judgment can be fully addressed.
The Sec. 6695A process has a three-year statute of limitation from the later of the return’s due date or filing date. This process is independent of any tax deficiency negotiations with the taxpayer or any litigation. Accordingly, it is possible that a Tax Court decision on the appropriate valuation may occur after a Sec. 6695A determination. It is also possible that the two processes could come to different conclusions.
IRS engineers responsible for reviewing business valuations begin with a review of the appraisal. If there are apparent issues, the IRS engineer will likely compare the contents of the appraiser’s report against a checklist of the standards that apply to that particular appraiser, depending on the credential(s) the appraiser holds.
If the IRS engineer believes that the “correct value” of the interest being appraised differs from the appraised value and that the appraiser has not complied with his or her organization’s standards, the review process may proceed and may ultimately lead to appraisal penalties under Sec. 6695A and a possible referral to the OPR, which is charged with ensuring that practitioners adhere to professional standards and follow the law.
Appraiser Penalties Under Sec. 6695A
The penalty under Sec. 6695A addresses two essential questions: First, is the value reported on the income tax return greater than 150% of the correct value for the property? 9 (Or, in the case of an estate and gift tax return, is the value reported on the return less than 65% of the correct value?) If so, then the IRS would ask this second question: Is there a greater than 50% likelihood that the appraiser would prevail in court? 10
To gather the facts in support of this question, Internal Revenue Manual (IRM) Section 20.1.12 directs the examiner to schedule an audit appointment with the appraiser. If the examiner is unable to reach the appraiser after two attempts, an Appraiser Appointment Letter No. 4477 is sent to schedule the audit appointment. The purpose of this meeting is to gather sufficient facts to determine whether the appraiser can establish that the value in the appraisal meets the “more likely than not” exception as provided in Sec. 6695A(c). If not, then the penalty would apply to the appraiser.
Example: The IRS determines that the correct value of an estate is $6 million. The original value a CPA determined and entered on the estate return (or perhaps entered by the taxpayer after discussions with a CPA) was $2 million. Because this is less than 65% of the correct value, it is a substantial understatement. The additional $4 million resulted in additional tax of $1,600,000 (assuming a 40% tax bracket and no estate tax exemption). The amount of the penalty to the CPA who provided the valuation is the lesser of:
- The greater of $1,000 or 10% of the tax, which, in this case, is $160,000, or
- 125% of the appraisal fee. If the appraisal fee in this case had been $16,000, 125% of the appraisal fee would be $20,000.
In this example, the penalty would be $20,000.
If the facts were such that there had been no direct appraisal fee, the IRS would look to other indications of compensation. For example, if there had been a $10,000 fee for various services over the course of the year, and the valuation appraisal was determined to have included oral discussions or a back-of-the-envelope analysis by the CPA or feedback from a partner that totaled $1,000, the penalty might be as low as $1,250 (125% of $1,000). While this penalty may seem light, it is best not to be a test case for an alternative methodology.
While penalties have the potential to be substantial, the appraiser may be more concerned about referral to the OPR and potential ramifications for non-IRS-related work. As to the latter, because penalties assessed against an appraiser become part of a public record, 11 a CPA questioned in court during the qualification process may expect the opposing side to ask about this penalty. This might result in the appraiser’s being excluded as an expert. A Daubert/Kumho Tire 12 challenge in federal court (or a Frye 13 challenge in state court), which requires a preponderance of proof that an expert is qualified, is a means by which a judge can be a gatekeeper to prevent a jury from hearing an expert’s opinion. An appraisal penalty and/or a related IRS sanction could be used as a basis for excluding the appraiser’s testimony and could seriously disadvantage the party who hired him or her.
For the CPA who does not have appraisal knowledge and experience, but who has offered a valuation opinion or advice to a client that resulted in a penalty, this, too, could have professional liability implications for the firm, and AICPA and the relevant state’s accountancy board ethics compliance implications for the CPA.
The OPR and Circular 230
Following the determination of a penalty, the IRS may refer a matter to the OPR. The OPR works with the U.S. Department of Justice (DOJ) to present an appraiser penalty case to an administrative law judge. Per IRM Section 20.1.12, “[d]iscretionary referrals to OPR should be based on a pattern of conduct that is subject to IRC 6695A penalty. However, where there is a willful violation of IRC 6695A, a referral to OPR is mandatory.” 14
The OPR applies Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10). Its August 2011 revision added specific language related to appraisers. 15 Circular 230 spells out the rules governing authority to practice, the duties and restrictions relating to practice before the IRS, the sanctions for violating the regulations, and the rules for disciplinary proceedings.
Potential sanctions on appraisers under Circular 230 range from censure, suspension, or disqualifying individuals from practice before the IRS. Penalties may be imposed against the individual and the individual’s firm. Circular 230 presents the rules governing the authority to practice before the IRS as well as duties and restrictions relating to this practice. The sanctions are explained, as well as the rules applicable to disciplinary proceedings.
While the OPR processes are still in development and not publicly disclosed, some public evidence is available. For example, a search with keywords such as “appraiser penalty” or “business valuation penalty,” etc., at the broader Department of Justice OPR website results in hundreds of hits, many referring to discussions of court cases involving appraiser penalties. 16
From a review of the information brought up by these searches, it is clear far more penalties have been imposed on real property appraisers than any other type of appraiser, but this number includes only cases that have been finished. It does not provide information about what is in process or current trends. As such, all CPAs providing valuation opinions should be aware that this is an area of increased IRS scrutiny.
Practice tip: As a matter of policy, a CPA firm may want to propose that only those with ABV credentials do business valuations or offer opinions about value. Partners who offer oral advice or back-of-the-envelope advice to clients need to understand SSVS1 and be educated as to the potential ramifications to the individual and to the firm. Any practitioner doing a valuation who does not follow his or her credentialing organization’s standards poses a real danger to the individual and the firm. Certified members of the other three business valuation groups should know, remain updated about, and follow their organization’s standards.
Caution: The same standards apply not only to holders of the ABV credential, but to all members of the AICPA providing a valuation in any form. Any non-ABV CPAs doing business valuation work must be very careful. They should make sure that they know what the AICPA’s standards are, ensure they are met, and avoid any of the pitfalls presented here.
All CPAs, whether or not they are ABVs, should know and meet all standards related to SSVS1. They should also assume their clients do not know or understand these standards and do not distinguish between discussions about valuation issues in an open environment, back-of-the-envelope analyses, preliminary analyses, calculation engagement reports, or complete valuation reports.
Because of most clients’ lack of sophistication, CPAs should not offer off-the-cuff oral commentary, back-of-the-envelope advice, or preliminary analysis to their clients. CPAs should be conscious of the SSVS1 standards and follow them and should have a clear understanding with clients of the scope of engagements that potentially involve valuation issues. This is good for the CPA, the client, and the profession.
Authors’ note: Michael Gregory’s comments offered here are his own. He does not represent the IRS.
1 The Pension Protection Act of 2006, P.L. 109-280.
2 Per the Tax Technical Corrections Act of 2007, P.L. 110-172, §3(e), the application of appraisal penalties under Sec. 6695A(a) of the PPA was amended to include instances of “substantial estate or gift tax valuation understatement[s].”
3 Notice 2006-96, 2006-2 C.B. 902; REG-140029-07. Taxpayers can rely on Notice 2006-96 until the proposed regulations are finalized.
4 SSVS No. 1, p. 7 (footnote omitted).
5 Several Journal of Accountancy articles have emphasized and clarified when SSVS No. 1 applies and encouraged CPAs to obtain the ABV credential. These articles are relevant to helping CPAs avoid Sec. 6695A penalties. See Gilbert, “ 50 Examples of When to Apply SSVS1,” 204 Journal of Accountancy 33 (September 2007), where Gilbert points out 19 examples where SSVS1 compliance is required that specifically relate to federal tax. Parker, “ Breaking Into Business Valuation: Steps for Small Firms to Consider When Entering the Valuation Market,” 209 Journal of Accountancy 43 (March 2010), is helpful in explaining why CPAs who conduct valuations are encouraged to obtain the ABV credential.
7 IRS engineer is a broad job classification that includes engineers, real property appraisers, and business appraisers.
8 Classification takes place as often as once every two weeks to once every two months depending on the quantity of returns filed at the Cincinnati or Ogden, Utah, service centers.
9 See, e.g., Crain, “Pension Protection Act Changes Valuations for Tax Purposes,” 204 Journal of Accountancy 40 (September 2007).
10 IRM §18.104.22.168.
11 According to the IRS website, OPR has a business objective: “To increase the percentage of tax professionals who do adhere to professional standards and follow the law by: . . . Publicizing actions taken to promote the integrity of the system and deter further non-compliance.”
12 From Daubert v. Merrell Dow Pharmaceuticals, Inc. , 509 U.S. 579 (1993), and Kumho Tire Co. v. Carmichael , 526 U.S. 137 (1999).
13 From Frye , 293 F. 1013 (D.C. Cir. 1923), which established the rule that expert testimony must be based on scientific principles that are “sufficiently established to have gained general acceptance.”
Michael Gregory is the founder of Michael Gregory Consulting LLC in Roseville, Minn., and is a former IRS territory manager who focused on business valuation issues. Renée Marino is a business appraiser and expert witness with Cupitor Consulting LLC in Arden Hills, Minn., as well as a member of the Board of Governors for the American Society of Appraisers . For more information about this article, contact Mr. Gregory at email@example.com or Ms. Marino at firstname.lastname@example.org .