After several relatively quiet years, the Internal Revenue Service (IRS) is seemingly ready to increase the frequency and intensity of valuation-related challenges. In the 4th quarter of 2022, the IRS posted 14 open positions across the United States for experienced valuation professionals. The job description describes some of the key duties, including (a) reviewing, scrutinizing, and challenging valuations and (b) potentially serving as an expert witness for the IRS in the U.S. Tax Court or District Court.
With the likelihood of IRS challenges increasing, it is important to understand the most common situations where a valuation may have tax implications and, therefore, may be challenged by the IRS:
- Family Transfers & Gifting: Transactions that occur between family members, whether a gift or a sale (perhaps using trusts or other estate planning vehicles), should be supported by a comprehensive valuation analysis and report prepared by an experienced valuation professional. Further, for the statute of limitations to begin on such a transfer, the fair market value of any transferred interest must be supported by a valuation that meets the IRS’ “Adequate Disclosure” documentation requirements. Valuations that fail to meet these requirements are susceptible to challenge indefinitely, including at the time of the donor’s death. Estate and gift-related valuations have historically been some of the IRS’ most frequent targets to challenge.
- Date-of-Death Estate: Taxpayers must report the fair market value of any assets (including ownership interests in privately-held businesses) as of the date of death (or as of the alternate date six months later) for purposes of measuring potential estate tax due. Valuations for this purpose are often attached to estate tax returns as support for the taxpayer’s position.
- Issuing Stock-Based Compensation to Management/Employees: To avoid negative tax consequences, any transfer of equity-based compensation to management or employees (i.e., stock, stock options, management incentive units, phantom stock, stock appreciation rights, restricted stock units, profits interests, etc.), should be supported by a valuation to confirm whether such a transfer results in taxable compensation to the recipient. Note that certain valuations should be compliant with the requirements of IRC 409(A).
- Shareholder Transactions: When buying out a shareholder or admitting a new owner, a valuation is often advisable to ensure that the transaction does not result in compensation or a gift.
- Reorganizations, Spinoffs, Mergers/Exchanges: Certain corporate transactions may trigger income tax, including reorganizations, spinoffs, mergers, exchanges, debt-for-equity swaps, etc. A valuation is often advisable to measure the amount of any associated tax, if any.
- Charitable Donations of Closely-Held Stock: If a taxpayer donates stock (or LLC interests or other forms of equity) to a charitable organization, a “qualified appraisal” is required to support the deduction. Further, the valuation should follow the requirements outlined in IRS Publication 561, Determining the Value of Donated Property.
- C-to-S Elections: Taxpayers should establish the fair market value of all assets (including intangible assets, going concern value, and goodwill) at the time of a conversion from a C corporation to an S corporation for purposes of establishing a basis for built-in-gains in the event of a sale of the company.
- ESOPs: Although the Department of Labor is the primary government agency that challenges ESOP transactions and valuations, the IRS may also challenge these valuations since the ESOP stock value can affect the magnitude of tax deductions associated with contributions to ESOPs.
An accurate, well-supported, and well-documented valuation has always been a centerpiece of any transaction with potential tax implications, but with the prospect of greater IRS resources to challenge and scrutinize transactions, the importance of valuations has never been higher. GBQ has extensive experience in each of the situations discussed above, so please contact a member of GBQ’s Valuation Advisory team if you have any questions related to valuation.
About GBQ’s Valuation Advisory Practice
GBQ is a nationally-recognized authority on valuations, with our professionals performing 300+ valuations annually and having completed thousands of valuations throughout our careers. GBQ’s valuations are designed to withstand regulatory scrutiny, and we have a 20+ year track record of successful valuations on many high-profile transactions, estates, etc. Frequent thought leaders on topics related to valuations and ESOPs, GBQ specializes in valuations of all types, including ESOPs, estate & gift, stock-based compensation, shareholder transactions, mergers and acquisitions, financial reporting, and various other purposes.
Article written by:
Director of GBQ Capital Advisors