Tax Talk: When Reporting Gifts at Discounted Values, a Qualified Appraisal is Crucial
Monday, January 18, 2016
A common method for transferring wealth from one generation to the next involves contributing assets to a partnership or limited liability company, then transferring minority interests in the partnership or LLC to descendants or other family members. Done correctly, the technique allows donors to reduce their taxable estates by making gifts at reduced values, because of discounts for lack of control and lack of marketability. In so doing, the donor also effectively shifts the tax on any appreciation of the underlying assets to the younger generation.
In order to benefit from this estate planning technique, however, it is crucial that the gift is adequately disclosed on a gift tax return and its value backed by a qualified appraisal or a detailed description of the method used to determine the fair market value of the transferred partnership or LLC interest. Unfortunately, we have encountered situations recently in which a gift was not supported by a qualified appraisal, leading the Internal Revenue Service to challenge the value claimed by the donor and to propose additional gift tax, penalties and interest. Such challenges can lead to significant uncertainty, stress and legal expense—even if the donor’s valuation ultimately is sustained.
This article describes what constitutes a qualified appraisal and the information that is necessary if no appraisal is provided, and offers some practical advice for donors based on our recent experiences dealing with the IRS in audits and administrative appeals involving disputed gift tax valuations.
IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, requires donors to disclose whether the value of any gift reflects a valuation discount and, if so, to attach an explanation. If the discount is for “lack of marketability, a minority interest, a fractional interest in real estate, blockage, market absorption, or for any other reason,” the explanation must show the amount of, and the basis for, the claimed discounts. Moreover, in order for the statute of limitations to begin running with respect to a gift, the gift must be adequately disclosed on a return or statement for the year of the gift that includes all of the following:
A complete Form 709;
A description of the transferred property and the consideration, if any, received by the donor;
The identify of, and relationship between, the donor and each donee;
If the property is transferred in trust, the employer identification number of the trust and a brief description of its terms (or a copy of the trust);
A statement describing any position taken on the gift tax return that is contrary to any proposed, temporary or final Treasury regulations or IRS revenue rulings; and
Either a qualified appraisal or a detailed description of the method used to determine the fair market value of the gift.
While most of these requirements are straightforward, the last generally requires the donor to provide a more complete explanation. Fortunately, the IRS has published regulations that describe what constitutes a qualified appraisal and what information must be provided in lieu of an appraisal.
With respect to the latter, the description of the method used to determine fair market value must include the financial data used to determine the value of the interest, any restrictions on the transferred property that were considered in determining its value, and a description of any discounts claimed in valuing the property. If the transfer involves an interest in a non-publicly traded partnership (including an LLC), a description must be provided of any discount claimed in valuing the entity or any assets owned by the entity. Further, if the value of the entity is based on the net value of its assets, a statement must be provided regarding the fair market value of 100% of the entity (determined without regard to any discounts in valuing the entity or any assets owned by the entity), the portion of the entity subject to the transfer, and the fair market value of the transferred interest as reported on the return.
Donors and their counsel will rarely have the expertise needed to provide such a description. While it may be relatively simple to provide some of the factual information, determining the appropriate actuarial factors and discount rates is a highly complex and specialized field. Moreover, even if a donor or his or her counsel happened to have the relevant expertise, a description that is not prepared by an independent expert may be viewed suspiciously by the IRS because of a lack of impartiality. Moreover, if the description (or the appraisal, for that matter) is prepared by the donor’s counsel, it may negate the attorney-client privilege, at least with respect to any work papers prepared by the attorney in connection with the description or appraisal.
For these reasons and others, we strongly recommend that donors obtain an appraisal from an independent, reputable valuation firm before claiming discounts with respect to a gift of a partnership or LLC interest. The applicable Treasury regulations provide that the requirement described above will be satisfied if, in lieu of submitting a detailed description of the method used to determine the fair market value of the transferred interest, the donor submits an appraisal of the transferred property prepared by an appraiser who meets all of the following requirements:
The appraiser holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis;
Because of the appraiser's qualifications, as described in the appraisal that details the appraiser's background, experience, education, and membership, if any, in professional appraisal associations, the appraiser is qualified to make appraisals of the type of property being valued; and
The appraiser is not the donor or the donee of the property or a member of the family of the donor or donee or any person employed by the donor, the donee or a member of the family of either.
Further, the appraisal itself must contain all of the following:
The date of the transfer, the date on which the transferred property was appraised, and the purpose of the appraisal;
A description of the property;
A description of the appraisal process employed;
A description of the assumptions, hypothetical conditions, and any limiting conditions and restrictions on the transferred property that affect the analyses, opinions and conclusions;
The information considered in determining the appraised value, including, in the case of an ownership interest in a business, all financial data used in determining the value of the interest that is sufficiently detailed to allow another person to replicate the process and arrive at the appraised value;
The appraisal procedures followed, and the reasoning that supports the analyses, opinions, and conclusions;
The valuation method used, the rationale for the valuation method and the procedure used in determining the fair market value of the asset transferred; and
The specific basis for the valuation, such as specific comparable sales or transactions, sales of similar interests, asset-based approaches, merger-acquisition transactions and the like.
While there is no firm rule on when or how often appraisals must be obtained, appraisals that are more than a year old may be less reliable—particularly if there is good reason to believe that the value of the underlying assets has changed—and thus more vulnerable to challenge.
An appraisal that meets all of the requirements described above is not unassailable, of course, but if the IRS does choose to challenge a gift tax valuation that is supported by such an appraisal, the donor will be in a significantly stronger position in the resulting examination or proceeding than a donor who failed to obtain a qualified appraisal or opted to rely on a stale appraisal.
In sum, obtaining a qualified appraisal is a crucial step in any estate planning or gifting strategy that involves making gifts of assets valued at a discount. Although donors may occasionally balk at the time and expense of preparing a reliable appraisal, it is almost certainly less time-consuming and costly than battling the IRS in an examination, administrative appeal or in litigation and should give donors confidence that their gifts are unlikely to be successfully challenged by the IRS.
Virtually no business or investment activity is free from federal and state tax considerations and pitfalls. Schiff Hardin's tax attorneys advise clients on the tax aspects of the formation, financing, operation and termination of their business activities, and in the structuring of their investments.