Over the past few years, U.S. judges have substantially increased their knowledge of valuation methodology and application. More frequently, Tax Court judges are applying their valuation knowledge to better scrutinize taxpayer testimony for lack of a professionally prepared appraisal, misapplication of valuation theory, lack of a credible expert witness and lack of expert independence.

Upon the death of a taxpayer, taxes may be imposed on the decedent’s taxable estate. The audit determines if the estate tax return undervalues the decedent’s property, which includes ownership of a business and results in an underpayment of taxes due. If the Service determines an underpayment exists and a resolution with the taxpayer cannot be reached, the Commissioner of the IRS issues a “Notice of Deficiency.” If a notice is issued, it means the Commissioner intends to proceed to court and the taxpayer bears the burden of proving the IRS is wrong. In Tax Court, the Commissioner is always the defendant.

The Internal Revenue Code is the primary source of tax law and contains code sections that are created by Congress. Although there are approximately 240 sections within the Code that require a determination of fair market value to assess tax liability, it does not define it. Fair market value is defined within the Treasury Regulations, which have the full force of the law. Regulation section 20.2031-1(b) defines fair market value as:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

The Treasury issues Revenue Rulings and Revenue Procedures, which are announced positions of the IRS. Revenue Ruling 59-60 is a widely recognized ruling and provides eight “rules” on valuing stock or ownership of a closely-held business. However, rulings do not carry the full force of the law although experienced valuators and related professionals take heed of their application for valuation purposes.

Over the past decade, fair market value determination based on a buy-sell agreement among owners of a closely-held business has become a heavily contested topic of case law.

Consider the Tax Court case of the Estate of H.A. True, Jr. and Jean D. True v. Commissioner, issued July 6, 2001 (T.C. Memo 2001-167). In this case, the IRS determined the estate had almost $76 million in unpaid tax and assessed more than $30 million in undervaluation penalties. The Tax Court’s position regarding True’s buy-sell agreement incorporated several factors. The Court applied the “price control” test.

If a buy-sell agreement meets the four factors of the “price control” test, it is admissible for estate tax purposes:

  1. The price is determinable from the agreement;
  2. The terms of the agreement are binding throughout life and death;
  3. The agreement is legally binding and enforceable; and
  4. The agreement was entered into for bona fide business reasons, and is not a testamentary substitute intended to pass on the decedent’s interests for less than full and adequate consideration.

In True, the Tax Court found: 1) the buy-sell agreement did not pass the arm’s-length dealings test, 2) the buy-sell agreement set terms without negotiation, 3) the buy-sell agreement excluded significant assets; and 4) the agreement did not provide for periodic reviews or adjustments. Most importantly, the Tax Court ruled the decedent failed to rely on the advice of a professional business valuator in selecting the business interest price.

In the Estate of Mildred Green v. CIR, T.C. Memo. 2003-348, the Tax Court ruled on a minority interest of a closely-held commercial bank. The decedent’s estate did not have the business interest appraised by a professional business valuator when preparing the estate tax return. Green’s estate valued her 5.09% interest, or 3,276 shares, at $50 per share. The IRS audited the estate tax return and determined Green’s stock was undervalued. The IRS’ valuation was accepted by the Tax Court, and ultimately, after valuation discounts were applied for lack of marketability and minority ownership, the Tax Court concluded Green’s interest had a fair market value of $220.18 per share, to total $721,300. This far exceeds the estate’s value of $163,800. In total, a $1.2 million federal estate tax deficiency was determined.

These cases demonstrate the importance of hiring an experienced, credentialed business appraiser who understands and performs valuations compliant with Treasury Regulations and IRS standards, as well as one who is knowledgeable of relevant case law. Taxpayers involved in transactions that necessitate a business valuation must be appropriately prepared. When challenged by the IRS, the burden of proof is on the taxpayer as the Service is presumed to be correct.

About the Author

Erin Hollis, AVA, is the Business Valuation Manager for Accountancy Associates, LLC, a related company of International Profit Associates, Inc. (IPA-IBA), the largest privately-held business development company for small to medium size businesses in North America, and a leading authority on small business.