The facts and circumstances surrounding an appraisal are a critical input to both financial reporting and tax valuations. Valuations are performed as of a specific date. Thus, it is imperative to consider all the relevant facts that were known or knowable as of that specific date. While using foresight may not be appropriate in certain situations, documentation and diligence can avoid future legal probes. A recent IRS Memorandum (#202152018) issued on December 30 th of 2021 suggests that ignoring pending transactions or other events – despite uncertainty existing around these events – is unacceptable. This ruling was recently applied to a Grantor Retained Annuity Trust (GRAT) in which the facts were as follows:
- The trust donor and owner of the company shares in question had used external advisors to explore the possibility of a sale
- Meetings were held with potential buyers, and the topic of a partial/full sale was discussed prior to the contribution of shares into a trust
- Based on these meetings, there was a reasonable expectation that a bid for at least a minority stake would be received and that the offer would include a call option on the entire business
- Several offers were presented to the donor/owner 3 days ahead of the trust contribution (trust annuity was based on a percentage of the fair value of the property contributed)
- Fair value of the shares was established using a valuation performed 7 months prior to the trust funding (most recent appraisal performed)
- After the contribution, additional and final offers for an equity stake in the corporation owning the donated shares were received, with some offers higher than the initial offers received prior to the contribution
- At a more recent date, the donor gifted shares to an additional charitable organization at the price of the tender offer, which was 10% higher than the original offer at the time of the trust funding. This value was 3x the fair value used for the trust funding (which represented the value from several months prior to the funding).
The key issue rests on the fact that despite no changes occurring in the operations of the company over the 6 months following the original fair value assessment, a new fact, namely the potential sale of company shares reasonably, changes the value of those shares. This introduces an additional variable that needs to be considered in the fair market value assessment at the time of the contribution. The lesson from this ruling is that triggering events, even uncertain ones, have the potential to change the value of a business, despite no real change in operations. The reason is that markets are rapidly evolving spaces, in which investors can, directly and indirectly, affect the values of assets through offers and transactions on similar assets and especially on the assets themselves. Appraisals are likely to be considered outdated when new facts and circumstances are present as of subsequent valuation dates. Two key statutes stand out from the ruling that reiterate the importance of frequent qualified appraisals.
- “For the charitable gifts, under the rules for Form 8283, in order to substantiate a charitable deduction greater than $5,000, a qualified appraisal must be completed.”
- “Fair market value (FMV) is the price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.”
Using an appropriate value as of the date of a transfer that effectively considers the points noted above is key to avoiding challenges from tax authorities or auditors. Appraisals should always incorporate future events despite uncertainty being present. It is not uncommon to quantify the uncertainty of a future event, and valuation professionals use several techniques when dealing with uncertain information. The value of a property for Federal tax transfers must weigh all relevant facts and circumstances as of the date in question. This also applies to financial reporting concerning fair value. A final lesson is that the willing buyer and seller mentioned in the fair market value definition, represent hypothetical actors and not necessarily the specific actors at play. Therefore, many valuations are done under market participant assumptions, and despite certain valuations accepting the use of company- specific assumptions, the fair market value definition cannot be ignored.
Generally, a valuation does not consider unknowable future events. However, a reasonable probe can be made by the IRS as to whether those events were truly not foreseeable. Probes can still be made in situations in which value-driving events happen near a valuation date, which suggests that appraisals should make reasonable efforts to document and diligence all relevant facts and circumstances, even those with a low probability of occurring.
Tax court cases as early as 1974 have shown the importance of considering future events when establishing fair market value conclusions, for example, a pending IPO. Further, the Court of Appeals reiterated decisions made by the circuit courts in the late 1990s suggesting high certainty events such as mergers need to be incorporated into fair market value opinions.
In situations in which there is a bias to depress the value of an asset, which is relevant to a situation in which a trust’s annuity relies on the fair market value of the assets in question, we can reasonably expect the IRS to probe when near-future events drastically change the value of those assets. Thus, it is highly recommended to take into consideration both high certainty and low certainty events and to accurately document their impact on the fair value of an asset or liability as of its valuation date. While this can lead to additional time spent up front, it can significantly lower the risk of future litigation.
For inquiries into gift and estate valuations, as well as other tax-related appraisals, do not hesitate to contact our valuation professionals at Objective, Investment Banking and Valuation.
About the Author:
Jordi Pujol, CFA
Director, Objective Valuation, LLC
10+ Years of Experience
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