Transfer tax valuations are the most scrutinized work in the profession. The taxpayer has an incentive toward a lower number, the government has an incentive toward a higher one, and the resolution mechanism is examination and, if necessary, Tax Court. A report prepared for this purpose has to be built to be read by a hostile, technically competent reader.
This article covers the authority that governs the work, what a qualified appraisal requires, how discounts are supported, and the documentation practices that reduce examination risk.
This is general information about valuation practice, not tax or legal advice. Work with your attorney and tax advisor on your specific facts.
The governing framework
Revenue Ruling 59-60
Still the foundational authority for valuing closely held stock. It sets out the factors that must be considered:
- The nature and history of the business
- The economic outlook generally and for the specific industry
- Book value and financial condition
- Earning capacity
- Dividend-paying capacity
- Goodwill and other intangible value
- Prior sales of stock and the size of the block being valued
- Market prices of comparable publicly traded companies
A report that does not visibly address each factor invites the argument that the analysis was incomplete. Good practice is to address them explicitly rather than implicitly.
Related guidance
Subsequent rulings and IRS materials address specific issues, including the treatment of restrictive agreements, the valuation of interests in entities holding marketable securities, and the treatment of built-in gains. The IRS also publishes internal valuation guidance used by its examiners; understanding how the other side is trained to read a report is genuinely useful.
Chapter 14 and IRC §2703
Section 2703 provides that, for transfer tax purposes, certain restrictions and buy-sell arrangements are disregarded unless they meet specific tests, including being a bona fide business arrangement, not a device to transfer value to family members for less than full consideration, and comparable to arms-length arrangements. A buy-sell price is not automatically the estate tax value.
What makes an appraisal “qualified”
For gift tax adequate disclosure and for charitable and other purposes, regulations specify what an appraisal and an appraiser must satisfy. In practice this means:
- The appraiser holds appropriate credentials and regularly performs appraisals for compensation
- The appraisal is prepared no earlier than 60 days before the transfer date and is signed and dated
- The report describes the property, the valuation date, the terms of any agreement affecting the interest, the qualifications of the appraiser, the standard of value applied, and the methods and specific bases used
- The report includes sufficient detail to allow a reviewer to reproduce the analysis
Adequate disclosure and the statute of limitations
This is the practical point most often missed. A completed gift that is adequately disclosed on a timely filed gift tax return generally starts the statute of limitations running. Without adequate disclosure, the IRS can revisit the valuation of that gift many years later, including at the donor’s death, when the facts are colder and the witnesses may be gone.
Adequate disclosure requires more than a number on a form. It typically requires a description of the transferred property and the relationship of the parties, the entity’s financial data, a description of the valuation method, and either the qualified appraisal or a detailed description of the appraisal analysis.
Spending money on a defensible appraisal and then failing to disclose it properly wastes the expenditure.
Valuation discounts, and how they are actually supported
Discounts are legitimate and well established. They are also the most frequently challenged element of a transfer tax valuation, because they are where the largest dollars sit.
Discount for lack of control
A non-controlling holder cannot compel distributions, set compensation, sell assets, or force a liquidity event. The magnitude is informed by control premium data observed in public markets, converted to an implied minority discount, and adjusted for the subject’s governance facts. A minority holder with contractual protective rights warrants a smaller discount than one with none.
Discount for lack of marketability
A privately held interest cannot be sold quickly at low cost. Support is drawn from restricted stock studies, pre-IPO studies, and quantitative models including option-based approaches. The report should explain why the selected magnitude fits the subject: transfer restrictions in the operating agreement, distribution history, holding period expectations, and the likelihood of a liquidity event all bear on it.
Family limited partnerships and LLCs
Entities holding marketable securities or real estate remain a common planning structure, and discounts on non-controlling interests in them remain available. They also attract attention. The cases that go badly for taxpayers tend to share features: the entity was formed on the eve of death, formalities were ignored, the donor retained the use and enjoyment of the contributed assets, personal expenses were paid from entity accounts, and there was no articulable non-tax business purpose.
The valuation is rarely what fails in these cases. The operation of the entity is.
Special situations
Built-in gains. For a C corporation holding appreciated assets, the embedded tax liability is a real economic burden to a hypothetical buyer. Courts have accepted dollar-for-dollar and present-value approaches in different circumstances; the treatment should be reasoned rather than asserted.
Key person discounts. Where the business depends heavily on a decedent whose death is the valuation event, an adjustment may be appropriate, applied either through the discount rate or as a separate adjustment, not both.
Alternate valuation date. An estate may be able to elect a date six months after death. That is an election with consequences beyond valuation and belongs to the tax advisor, but the appraiser needs to know which date governs.
Blockage. Where the interest is large relative to the trading market for the security, an additional discount may be supportable.
Documentation practices that reduce examination risk
- Value at the right date. Date of gift, date of death, or alternate date. Not year-end for convenience.
- Address every Rev. Rul. 59-60 factor explicitly. Make it easy for the reviewer to check the box.
- Show the discount derivation. Cite the studies, show the reasoning that connects study data to the subject’s facts, and address why a lower or higher figure was rejected.
- Reconcile with the entity documents. If the operating agreement restricts transfers, the marketability analysis should say so and reflect it.
- Keep the file. Workpapers, the document request, the management interview notes, and source data should survive as long as the statute could remain open.
- Avoid inconsistency across filings. A low value for gift purposes and a high value in a loan application relating to the same period is an obvious vulnerability.
Timing
Appraisals for transfer tax purposes should be commissioned before the transfer where possible, not after. A pre-transaction appraisal informs how much can be transferred within an exemption amount, allows for defined value clause drafting with counsel, and avoids the awkwardness of a gift that turns out larger than intended.
FAQ
Do I need an appraisal for every gift of business interests? Not every transfer requires one, but adequate disclosure on a gift tax return generally requires either a qualified appraisal or a detailed description of the valuation analysis. Discuss the threshold with your tax advisor.
How large are typical valuation discounts? There is no typical figure, and any appraiser who quotes one before looking at your documents should be treated with caution. Magnitude depends on governance rights, transfer restrictions, distribution history, asset composition, and expected holding period.
Can the buy-sell price in our shareholder agreement be used as the estate tax value? Only if the arrangement meets the requirements of §2703 and related authority. Many agreements do not.
What if the IRS disagrees with my appraiser? Examination may lead to negotiation, appeals, or litigation. The strength of the original report, the credentials of the appraiser, and the completeness of the workpapers materially affect how that process goes.
