Estate tax valuations and subsequent events
When appraised values seem to contradict real-life transactions

Estate tax issues can be tricky. Suppose a business owner dies or gifts shares of his or her company to family members. So far, so good. But what if six months or a year later, the company sells for significantly more than its previously appraised value? If the IRS catches wind of this apparent discrepancy, the family members may receive a deficiency notice.

It’s important to keep in mind, however, that a discrepancy between a previous appraisal and a subsequent event doesn’t guarantee an IRS win. You can protect your gift and estate returns with a strong defensive strategy. A valuator can protect your gift and estate returns by preparing a comprehensive rebuttal memo supported by facts and empirical evidence.

Management’s intentions - The IRS requires appraisers to address only those facts and circumstances that are known or reasonably foreseeable on the valuation date. As soon as a sale is imminent, minority interests suddenly become more liquid and appealing to investors. The proposed transaction price also provides a clear-cut indicator of the company’s value.

The IRS may contend that the subsequent sale price should override the appraised value. It may also try to reduce or eliminate minority interest and marketability discounts.

The first step in supporting a gift or estate tax return is to ascertain whether management intended to sell the business on the valuation date. The valuator can compile a timeline based on management interviews, business calendars and meeting notes as well as answers to the following questions:

On the valuation date, was management entertaining any serious offers for the sale of the company? - If so, and the valuation report didn’t disclose or address pending offers, how did those offers compare to the subsequent sale price? An offer that occurred closer to the valuation date may better indicate the company’s value than its subsequent sale price.

Before the valuation date, had management met with investment bankers or business brokers to discuss selling the business? - Notes from these meetings may provide evidence of the company’s probable sale price around the valuation date. If revised throughout the negotiation process, these preliminary estimates may provide insight into changes in the outlook of the business from the valuation date to the closing date.

How active was the merger and acquisition (M&A) climate within the subject company’s industry on the valuation date? - The IRS may argue that an active M&A market suggests that a subsequent sale of the business was foreseeable on the valuation date.

Viable explanations - Management’s intentions may be moot if the valuator can legitimately explain why the appraised value should differ from a subsequent sale. Here are some possible explanations an appraiser might suggest for this apparent contradiction:

Unforeseeable changes in business performance or economic conditions - In some cases, the company’s outlook might change significantly from the valuation date to the closing date. For instance, new technology within the industry may render a business more (or less) competitive.

Or a catastrophic event — such as a terrorist attack or a tornado — may impair future profits. Conversely, a disaster may reduce the number of competitors in the company’s industry. As long as these events were unforeseeable at the valuation date, they may support a change in the business value over time.

Noncash transactions - Transactions often involve complex terms and conditions, such as earn outs, non-compete agreements, employment contracts or stock in the acquiring company. By contrast, fair market value is a cash-equivalent price. If a transaction involved noncash or non-present value terms, the valuator must convert that transaction to a cash-equivalent value. Otherwise, the comparison is invalid.

Control transactions - Gift and estate tax appraisals typically estimate a business value on a minority, nonmarketable basis. Conversely, a sale of the entire company provides a value estimate on a controlling basis. After the appraiser applies reasonable valuation discounts to a subsequent sale price, the apparent discrepancy often shrinks dramatically.

Manageable discrepancies - A discrepancy may arise between a valuator’s estimate and the subsequent sale price for many reasons, and it’s true that the Tax Court has been somewhat inconsistent in its treatment of subsequent events and value. But well-supported valuations — accompanied by thorough rebuttal reports — are likely to withstand IRS scrutiny.

Sidebar: Fair market value vs. strategic value

Fair market value and strategic value are two different concepts. The former, which is the required standard of value for estate tax valuations, is the price that the universe of well-informed “hypothetical” buyers and sellers would settle on for the subject company. The latter is unique to one specific buyer. Strategic value may incorporate certain synergies that aren’t available to the “hypothetical” buyer.

Prospective buyers possess differing value perceptions. A competitor seeking to obtain a specific competitive advantage or boost market share may be willing to pay a premium for the subject company. Similarly, a participant up or down the subject company’s value stream may pay more to become vertically integrated.

To defend an appraisal that is lower than the sale price, a valuator can demonstrate how the actual buyer differed from other potential (hypothetical) buyers. In other words, he or she can show what motivated the purchaser to pay a premium above fair market value.