The value of an asset at the time of a transfer is the key component to the United States’ transfer tax system. Gratuitous transfers during lifetime are considered gifts, while transfers as a result of the death of the owner are included in the value of the decedent’s estate. Some assets are easy to value: marketable securities have a value based on the mean of the high and low on the public exchange on the applicable date where they are listed, while the value of cash is equal to the total amount transferred. Valuing an interest in a closely held business is much more complex. When an estate planner has initial discussions with a client and invariably asks how much their business is worth, the client may give you a number based entirely on speculation, or perhaps they are using “book value,” a multiple of the business’ EBITDA (i.e., earnings before interest, taxes, depreciation, and amortization), a value used in a recent loan application, or even the value used for equity as compensation (a “409A” value). None of these values are “adequate” for purposes of determining the value of the business at the time of a transfer for estate planning purposes, and none of these “values” can be used to substantiate the value of a transfer on a Federal Gift or Estate Tax Return.

Some additional background: Generally speaking, any gratuitous transfer over smaller annual gifts must be reported to the Internal Revenue Service (“IRS”) on a Federal Gift Tax Return for the year of the gift. This is how the IRS keeps track of the amount of lifetime gifting an individual has made. Each individual has a lifetime gift tax exemption that is used first before any gift tax is due. That exemption amount changes annually. As part of that return, the taxpayer must provide information sufficient for the IRS to review and determine whether the value of the asset gifted is accurate. This is the concept of “adequate disclosure.” By providing adequate disclosure, the IRS generally has three years to challenge the valuation of the asset (by auditing the return) otherwise the value is set, and the IRS cannot revisit the transfer. And if the IRS does audit the return, the main focus of that audit will likely be the methodology and sufficiency of the valuation of the business. If the taxpayer fails to adequately disclose the gift and the valuation on the return, the assessment period for the IRS to audit the return will not begin, and the IRS will be free to challenge the valuation at a later time, such as in connection with a subsequent audit of the return or following the decedent’s death in connection with the decedent’s estate tax return.

Since the transfer tax system is cumulative, such that the available lifetime gift tax exemption in any year is reduced by the amount of lifetime gift tax exemption used in prior years, and the amount of estate tax exemption available at a person’s death is generally reduced by the amount of lifetime gift tax exemption used, having finality on any lifetime transfer is critical to effective estate planning going forward.

All of this background is intended to emphasize the importance of the business valuation. The IRS provides key details that must be included for the value of a business interest to be adequately disclosed. While these details are somewhat technical in nature, the key takeaway is that a business valuation for transfer tax purposes should be performed by an independent third party, who is a qualified business appraiser, and who will issue a qualified appraisal report to be attached to the gift tax return to substantiate the value reported. The preparation of this report, generally, involves engaging a consultant to review the financial and tax details of the business, review key business documents, and interview key personnel. The engagement should be between the consultant and the estate planning attorney, rather than the business or the business owner, so that arguments can be made that the report (or earlier drafts thereof) is protected from disclosure to anyone other than the IRS (such as subsequent potential buyers as part of the due diligence process).

There is a wide range in the costs of valuation reports, often dictated by the complexity of the business and its ownership structure. By spending money on the right valuation expert to generate a defensible report, the business owner is absolutely saving money in the long run.

When is the right time to engage the valuation expert? If there is uncertainty over the business value, then the valuation expert should be engaged prior to the transfer to provide guidance on the anticipated value of the gift. Conversely, if there is a comfort level with the general value of the business, the valuation expert can be engaged after the transfer is made in order to provide the valuation report in advance of the filing of the Federal Gift Tax return, generally by April 15 of the year following the year of the gift. However, if a valuation report is not obtained prior to making the gift and the business owner assumption regarding the general value of the business is incorrect, the business owner may end up using more gift tax exemption than anticipated or the transfer may result in the imposition of a gift tax liability if the business owner exceeds his or her remaining exemption in making the transfer.

A valuation report will not only provide the value of 100 percent of the business, but will also apply discounts depending on the interests being transferred. For example, a minority interest in a closely held business would receive discounts for lack of control as well as lack of marketability. Those discounts may result in a reduction of 25–40 percent of the value of the interests transferred. We will look at an example using real numbers in the next part in this series.