Why would families destroy estate value, Judge Mark Holmes asks appraisers

"Why would a wealthy elderly lady willingly destroy half of the value of her estate," Judge Mark Holmes of the US Tax Court just asked 200 appraisers at the LA Chapter of the Appraisal Institute's IRS Valuation Summit last month.  "That's the question you have to ask yourself when you're trying to explain the transfer of hard assets" to legal structures like limited partnerships and more.  "You had better have a good story to describe why a discount is valid," he concluded.

He humorously recalled hearing testimony from an expert who said the reason for the destruction of family value was that the wealthy individual preferred that her kids came up short rather than "having a penny go to the IRS."  Holmes commended the fact that at least this tells a story that makes sense--whatever the outcome of the case.

In BVU’s opinion, Judge Holmes may be oversimplifying to make his point.   As Rick Warner, the editor of the ASA’s BV E-letter comments, “the seller is a willing participant in any FMV deal, but the buyer gets a vote here also. If I have an opportunity to purchase an interest in a non-diversified investment that may not pay dividends or make distributions, in which I have little or no control, and no idea as to when I might be able to liquidate my position, I think the level of risk, and return, and holding period are all reasons why a discount may be warranted.”

Ron Cerruti (IRS) agreed with the Judge--with a major point of emphasis.  "You need to write well," he demanded.   While not reflecting the position of the IRS as a whole, he said that reading poorly written reports (he offered five examples of valuation report language that literally made no sense) "starts to piss us off after awhile."

"We have lots of time," Cerruti says.  "And if you get past us, you don't have to worry about Tax Court.   So put in the effort to make a good argument for your position," he advises.

One tax attorney in the audience commented that "after Boltar v. Commissioner, you need to be an advocate for your valuation report, not for the taxpayer.   As long as [Judge Mary Ann] Cohen is on the bench, you can't be stubborn or ignore a relevant principle."

Paul Frederic Marx (Rutan & Tucker), one of the leading trust and estate lawyers in the country, says he's particularly wary of appraisers that "cherry pick methods to get desired results."  What's his solution?  "Fire the appraiser and hire a new one.   There's a higher standard of professionalism here," he warned.  "Advocate and explain why you choose the methods that work in each particular case."  He cited the standard of care that's necessary to determine highest and best use in real estate as a prime example where appraisal reports frequently become obviously slanted.

Lance Hall (FMV Opinions), who moderated this session, commented on some particular risks that the Tax Court has commented on recently:

  • Shortening your reports due to cost constraints—brevity make your report look flimsy
  • Exaggerating your credentials--Hall mentions one Tax Court opinion where the judge commented on a false claim that the appraiser was an ASA.
  • Failing to represent that your report meets USPAP or SSVS1 standards

"A small mistake can create a situation where a judge is reluctant to accept other subjective judgments in your report," Hall summarized.

Another appraiser who does a lot of report reviewing agreed with the panelists.   "If I'm reviewing your report and can't understand the logic or the writing, I start to get angry, and the sloppy work gets looked at even harder," he said.  "My marking pencil comes out, and my 12C comes out to check your calculations.   I'm more than happy to rework your assumptions or discounted cashflow once I sense there's sloppiness."

His summary: "if it's logically written and well supported, we don't have a dog in the fight."

Advocacy seems to be the biggest red flag in tax valuations. “I’m afraid I’ve found that for every valuation there’s an equal and opposite valuation,” David Elbaz (Kopple & Klinger), another attorney panelist at the AI meeting, said.  “We tell our appraisers to give us an objective response that’s defensible, but we also tell them what we want. “

In this environment, Elbaz says that the first thing his law firm looks at when hiring business appraisal experts is the reputation of the appraisal firm.   We then look for expertise, particularly if it’s a unique asset,” he says.  “We ask about the right credentials and whether they understand the IRS standards.”

Katharine Davidson (Holland & Knight) looks toward the type of valuation report they need.   “It will be attached to the tax returns so it’s an admission of value.” As Judge David Laro predicted at the BVR/San Diego Tax and Valuation Summit two years ago, Daubert challenges are now occurring in Tax Court. Davidson agrees that current cases, particularly the Mitchell and Bolter case from Judge Cohen, show that, now that the floodgates are open, the Tax Court will continue to consider valuation expert Daubert challenges.  “Lawyers must vet their appraisers or they risk the chance of having their report thrown out.”

Elbaz comments that appraisal reports that get thrown out usually do so “because of death by a thousand cuts.”  So he feels that he needs to look carefully at all assumptions,.  And, of course, look to the “wisdom of decisions from [Judge David Laro] and other judges,” Davidson recommends.

Appraiser conflict of interest is becoming a bigger issue too.  “If your CPA partners have been receiving big audit fees for years, it won’t look great to the judge if you’re the appraiser,” Davidson says.

“We used to learn this by doing,” commented Espen Robak (Pluris).  “But now we’re in a different environment influenced by Daubert and Kumho Tire.”

Better DLOM benchmarks are still elusive.   Besides the obvious databases (FMV, Valuation Advisors, or Pluris for example) appraisers can focus on business agreements.  “Buy-sell and corporate divorce provisions not created for estate tax purposes can offer a guideline for discounts,” said Robak.  “But there still aren’t great benchmarks for discounts appropriate to some of the extreme terms that show up in these agreements.”  The result, says Robak, is that these provisions offer less guidance that most lawyers or appraisers might wish.

Phil Schwab (FMV Opinions) offers one exception; when the agreements in place delimits the terms of control and influence—“who can remove a partner, who can vote in certain circumstances, that kind of thing,” he says.   These can be more helpful than a standard general partner agreement.  “You need to be familiar with the agreements and the rights and restrictions granted in every case, “ he agreed.

Sid Luckenbach (WTAS) points out that the various studies help but “none of them can be blindly applied.   You need to get behind the numbers to make sure you’re dealing with comparables,” whether you’re using restricted stock, pre-IPO studies, undivided interests, or other data source.