Issue: Are formal valuations really necessary for estate and gift tax purposes? Does the code require formal valuations, and if so, exactly what is required? These questions are often asked, particularly by the taxpayer or his heirs, but also by some advisors who are not fully aware of the requirements of the code and the technical issues that must be addressed in order to properly value a business entity for estate tax purposes. Too many valuations are prepared in a less than professional manner, by practitioners who are not qualified valuators.

IRC SEC. 2031 – Some Key Requirements

The code is very specific about the valuation of securities for estate tax purposes (most of the following criteria is also required for gift tax valuation). To begin with, a basic tenant of IRC 2031 is the valuation guidance given in Revenue Ruling 59-60. This revenue ruling requires eight specific areas of investigation for the valuation of the common stock of closely-held companies. They are:

  1. The nature of the business and its history since inception.
  2. The economic outlook in general and the outlook for the specific industry.
  3. The book value of the business and its overall financial condition.
  4. The earning capacity of the business.
  5. The dividend paying capacity of the business.
  6. Goodwill and other intangible assets.
  7. The sale of stock and the size of the block being valued.
  8. The sale of securities of corporations in the same or similar line of business, whose stocks are actively traded on a major exchange or over-the-counter.

The standard of value required for estate tax valuations is Fair Market Value, defined as the price at which a transaction would be consummated between an independent third-party buyer, who is under no obligation to buy, and a seller, who is under no obligation to sell, both being adequately informed of all relevant facts. This standard has been upheld by the courts, the IRS and the Department of Labor (regarding ESOP and other qualified plan valuations). This is the highest possible standard of value and assumes a great deal of sophistication, investigation and expertise.

Another critical issue with regard to estate tax valuations is the date of the valuation. IRC 2031 requires that the valuation is made as of the date of death, or the alternate valuation date, which is six months following the date of death. Events subsequent to the valuation date will not be considered. The relevant issue is the value of the asset as of the date of the valuation. The decedent’s attorney or CPA should instruct the valuator as to the valuation date. It will then be necessary for the valuator to develop an evaluation report at some reasonable point in time within 90 days of the date of death (or alternate valuation date). A good point in time to pick would be the most recent quarter end and, of course, financial statements must be available. Working from this point, the valuator will review the company’s financial condition from the date of the report to the valuation date and will opine as to the value on the actual valuation date chosen. An update letter will be required, dated on the date of death (or alternate valuation date).

IRC 2031 and Revenue Ruling 59-60 also make it clear that formula valuations are not acceptable. Such attempts to make the valuation process simple and quick lack of reasoning and financial sophistication. The courts have also rejected sophomoric attempts to standardize the valuation process.

An often overlooked position held by the service is that the Commissioner’s valuation opinion is “prima facie” correct. The taxpayer must present his arguments and evidence in an acceptable report format in order to support his opinion as to value. Upon presentation of the taxpayer’s report and arguments, the assumption of the Commissioner’s opinion being “prima facie” correct is dropped and the value of the asset will be decided based on the evidence presented. This is an extremely important point to ponder as one decides how to proceed with an estate valuation.

As a final point to consider, IRC 2031 requires that “Complete financial and other data upon which the valuation is based should be submitted with the return, including copies of reports of any examinations of the company made by accountants, engineers, or any technical experts as of the applicable valuation date”. Be careful here! Giving the IRS too much too soon can bolster their position and diminish yours.

Clearly a technically correct valuation report is required for estate and gift tax purposes. This report must be in writing and it must comply with case law, various revenue rulings and with applicable code.