Estate Tax Valuations and Appraisal Update


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Estate Tax Valuations and Appraisal Update

  1. 1. Estate Tax Valuations and Appraisal Update <ul><li>30Th Annual Inland Empire Estate Planning Seminar </li></ul><ul><li>John Glenn </li></ul><ul><li>President </li></ul><ul><li>The Mentor Group, Inc. </li></ul><ul><li>Direct - 760-325-6411 </li></ul><ul><li>Brad M. Cashion, CFA </li></ul><ul><li>Managing Director </li></ul><ul><li>The Mentor Group, Inc. </li></ul><ul><li>Direct - 760-898-3334 </li></ul><ul><li>November 4, 2009 </li></ul>
  2. 2. Agenda <ul><li>IRS Statistics </li></ul><ul><li>4 main estate tax reform bills </li></ul><ul><li>Valuation in the Distressed Economy </li></ul><ul><li>Types of Discounts </li></ul><ul><li>IRS Issues – Common errors the service sees in valuation reports </li></ul><ul><li>Valuation for Charitable Gifts </li></ul><ul><li>Valuation of Life Insurance Policies </li></ul>
  3. 3. IRS Statistics <ul><li>In year 2008, the IRS spent an average of 41 ¢ to collect $100 of tax revenue </li></ul><ul><li>2007 40 ¢ </li></ul><ul><li>2006 42¢ </li></ul><ul><li>2005 46 ¢ </li></ul>
  4. 4. IRS Statistics – Estate Tax <ul><li>(in thousands) </li></ul><ul><li>Year Total Estate Examined % Returns Returns % Not </li></ul><ul><li>Tax Returns Returns Examined Not Agreed Agreed </li></ul><ul><li> 46,251 NA NA NA NA </li></ul><ul><li>47,298 3,852 8.1% 217 5.6% </li></ul><ul><li>54,851 5,299 9.7% 301 5.7% </li></ul><ul><li>71,172 6,081 8.2% 351 5.8% </li></ul><ul><li>Source: IRS Data Book </li></ul>
  5. 5. IRS Statistics – Gift Tax <ul><li>(in thousands) </li></ul><ul><li>Year Total Gift Examined % Returns Returns % Not </li></ul><ul><li>Tax Returns Returns Examined Not Agreed Agreed </li></ul><ul><li> 252,286 NA NA NA NA </li></ul><ul><li>255,123 1,071 .04% 143 13.4% </li></ul><ul><li>265,455 2,051 .77% 410 20% </li></ul><ul><li>262,164 2,125 .81% 510 24% </li></ul><ul><li>Source: IRS Data Book </li></ul>
  6. 6. IRS Statistics – California Tax <ul><li>(in thousands) 2008 2008 </li></ul><ul><li>Estate Tax Gift Tax </li></ul><ul><li>Filed Returns 8,528 24,784 </li></ul><ul><li>% of US Total Returns 18.5% 9.8% </li></ul><ul><li>Gross Collections $5,339,566 $461,170 </li></ul><ul><li>% of US Collections 20.1% 14.1% </li></ul><ul><li>Source: IRS Data Book </li></ul>
  7. 7. 4 Main Federal Estate Tax Reform Bills <ul><li>The Pomeroy Bill (H.R. 436) - $3.5m exemption, max. rate = 45%, with a 5% surtax over $10m. Eliminate discounts for entities holding non-business assets </li></ul><ul><li>The Mitchell Bill (H.R. 498) – 15% Cap. Gains < $25m, 30% Cap. Gains > $25m, gradually increasing tax exemption up to $5m, then indexed to inflation </li></ul><ul><li>The Baucus Bill (S. 722) – Permanent AMT relief indexed for inflation, 15% cap. gains tax, shifting individual tax rates with max. individual tax rate at 35%, marriage penalty relief permanent </li></ul><ul><li>The McDermott Bill (H.R. 2023) - $2.0m exemption indexed for inflation, graduated estate tax rate based on estate value starting at 45% </li></ul><ul><li>The Pomeroy Bill is the only bill to propose restricting valuation discounts </li></ul><ul><li>It is doubtful that the estate tax and discounts will disappear in 2010. It is our belief that congress will pass legislation to continue the current estate tax exemption of $3.5m and a 45% rate for 1 more year </li></ul><ul><li>Source: </li></ul>
  8. 8. Planning During Economic Turmoil <ul><li>Economic downturns are an ideal time to transfer assets. </li></ul><ul><li>The increased volatility in the markets has increased discounts </li></ul><ul><li>Alternative valuation date is most often used </li></ul><ul><li>Appraisals must be completed using what is known or reasonably should be known at the valuation date </li></ul><ul><li>Monte Carlo simulation is used in valuations to capture uncertainty in projections </li></ul>
  9. 9. The Economic Downturn has Affected Valuation Inputs <ul><li>Equity risk premiums used to compute discount rates have increased </li></ul><ul><li>Revenues have declined faster than expenses </li></ul><ul><li>What income statement measure should be used? </li></ul><ul><li>Businesses cannot borrow money like they could so their debt to equity ratios have changed </li></ul><ul><li>Marketability and liquidity of businesses have gone down and it takes longer to sell a business </li></ul><ul><li>Discounts for lack of marketability have increased </li></ul><ul><li>Valuation multiples have gone down less than expected </li></ul>
  10. 10. The Current Economic Downturn Requires Us to Revisit What “Fair Market Value” Means… <ul><li>Willing buyer & willing seller </li></ul><ul><li>Neither under any compulsion to buy or sell </li></ul><ul><li>Both buyer & seller are hypothetical </li></ul><ul><li>Both are aware of all facts & circumstances </li></ul><ul><li>The asset is valued in its “highest & best use” regardless of its current use </li></ul><ul><li>Is valued without regard to events occurring after the valuation date, unless reasonably foreseeable </li></ul>
  11. 11. Valuation Issues Relating to First vs. Second to Die <ul><li>First To Die: Taxpayer usually desires high value for new basis </li></ul><ul><li>Second To Die: Taxpayer usually desires low value to minimize tax </li></ul><ul><li>Discounts should be taken on the first and the second to die </li></ul>
  12. 12. Entity Level Discounts <ul><li>Built-In Capital Gains Discounts - There are 3 thoughts on how to deal with Built-In Gains </li></ul><ul><li>1. Assume the assets will not be sold and no discount for the tax should be taken </li></ul><ul><li>2. Assume the assets will be sold over time and the time value of the tax should be deducted </li></ul><ul><li> 3. Assume the assets will be sold as of the date of valuation and take 100% of the tax due as a discount. (Jelke vs. CIR, No. 05-15549 case) </li></ul><ul><li>The 5 th and 11 th circuits have rejected the idea that the tax will be realized over time stating that 100% of the tax should be taken into account </li></ul>
  13. 13. Entity Level Discounts <ul><li>Key Person Discount – Rev. Rul. 59-60, section 4.02 This relates to unique relationships, technology & product capability, leadership skills & financial strength (“Steve Jobs affect”) </li></ul><ul><li>Portfolio – (Non-Homogenous Assets) – Companies that hold disparate or non-homogeneous assets/operations. We see that break up values are often greater. </li></ul><ul><li>Contingent Liabilities – Can be deducted as a percentage of value or as an exact dollar amount </li></ul>
  14. 14. Subject Interest Discounts <ul><li>Discount for lack of control </li></ul><ul><li>Discount for lack of marketability </li></ul><ul><li>Voting vs. Non-voting – Empirical evidence from public markets have shown a range of 2% to 7% </li></ul><ul><li>Blockage Discount – computes the depressing effect on the market rather than lack of marketability on sale. In Adams vs. Commissioner, the court allowed both a marketability discount and a blockage discount on a restricted block of stock. </li></ul><ul><li>Auker vs. Commissioner computed a 6.189% blockage discount for real estate held in a trust </li></ul>
  15. 15. The New World We Work In…. Application of Discounts <ul><li>Benchmarking – using empirical market data for studies </li></ul><ul><li>Quantitative Methods </li></ul><ul><li>Guideline Transaction Methods </li></ul><ul><li>Discounts must be supported through qualitative and quantitative analysis </li></ul><ul><li>Discounts must be supported by a “sanity check” using an internal rate of return calculation </li></ul>
  16. 16. Discounts for Lack of Control <ul><li>Must match source of market data with the type of asset held by the entity </li></ul><ul><li>Closed End Funds – Must use specific CEFs that match type of assets owned </li></ul><ul><li>RELP – good for entities that own real estate </li></ul><ul><li>Income Method – Discounted cash flow and capitalization of earnings </li></ul>
  17. 17. Discounts for Lack of Marketability <ul><li>Benchmarking – using market studies and apply the “Mandelbaum factors” </li></ul><ul><li>Quantitative Methods </li></ul><ul><ul><li>Put Option Calculation </li></ul></ul><ul><ul><li>LEAPs </li></ul></ul><ul><ul><li>QMDM </li></ul></ul><ul><ul><li>Guideline Transactions – 2 step process </li></ul></ul>
  18. 18. Discount for Lack of Marketability vs. Lack of Liquidity – Degree of Marketability <ul><li>Public Stock Liquid </li></ul><ul><li>A large block of Public Stock Marketable illiquid </li></ul><ul><li>2. Controlling Interest Marketable illiquid </li></ul><ul><li>in Private Company </li></ul><ul><li>Minority Interest Non-Marketable </li></ul><ul><li>in a Private Company </li></ul><ul><li>Real Estate Marketable illiquid </li></ul><ul><li>Machinery & Equipment Marketable illiquid </li></ul><ul><li>The term non-marketable does not assume that the interest cannot be sold, only that it is usually difficult to do so under normal circumstances </li></ul><ul><li>These distinctions are very important in computing the size of the marketability discount </li></ul>
  19. 19. Judge Laro’s Mandelbaum Factors that Affect Marketability Discounts – used in the benchmarking analysis <ul><li>Private vs. Public Sales Comparables </li></ul><ul><li>Financial Statement Analysis – Financial Strength </li></ul><ul><li>The Entity’s Dividend or Distribution Policy </li></ul><ul><li>The Entity’s Position in the Industry and its Economic Outlook </li></ul><ul><li>Management Strength of the Entity </li></ul><ul><li>Amount of Control being Transferred </li></ul><ul><li>Restriction on Transferability </li></ul><ul><li>Expected Holding Period of the Investment </li></ul><ul><li>The Entity’s Redemption Policy </li></ul><ul><li>Costs Associated with Selling the Interest Being Valued </li></ul>
  20. 20. Computation of Discounts for Multi-Level Entities <ul><li>These are entities that own fractional LP or LLC interests in other entities. </li></ul><ul><li>Care must be given to not double count the discounts. Discounts can only be taken at each entity level after analysis of the specific facts. </li></ul><ul><li>Facts that drive multi-level discounts </li></ul><ul><li>a. Asset Allocation – are the same assets included at each entity level </li></ul><ul><li>b. Entity Management – are the managers the same or different at each entity level </li></ul><ul><li>c. Governance – does the interest have the same voting and ownership rights at each entity level </li></ul>
  21. 21. Computation of Discounts for Undivided Fractional Interests <ul><li>Use of Comparable sales – very few sales are available in most markets. </li></ul><ul><li>Partition Analysis – a DCF model that computes the value of the cash flows at the end of the partition period where it is assumed that the property is sold. </li></ul><ul><li>The length of time before the partition is completed must be considered </li></ul><ul><li>The net cash flows for each year during the partition must be estimated </li></ul><ul><li>A required rate of return (discount rate) must be computed based on the risks and uncertainties of the estimated cash flows and the time of the cash flows </li></ul>
  22. 22. Comments From Honorable David Laro (U.S. Tax Court) <ul><li>The Top 5 Elements That Every Valuation Report Should Have…. </li></ul><ul><li>Transparency – Can the court replicate what the appraiser has done? </li></ul><ul><li>Credibility – Is the expert evidence reliable, “peer reviewed,” believable? Judges have become more sophisticated in valuation matters. </li></ul><ul><li>Intellectual Honesty – The appraiser’s job is to help the court with an unbiased point of view. Not a “hired gun.” </li></ul><ul><li>Complete – The report is the direct testimony. The appraiser giving testimony must be the one who prepared the report. </li></ul><ul><li>Credentialed – “The days of uncredentialed BV experts is gone.” Congress and the IRS have “raised the stakes” for appraisers. </li></ul><ul><li>Source: NACVA / IBA 2009 Conference </li></ul>
  23. 23. Comments From Mike Gregory… IRS Territory Manager, St. Paul “Common Errors in Valuation – Bullet Proof Valuations” <ul><li>The math does not add up correctly </li></ul><ul><li>Were the discounts applied properly </li></ul><ul><li>Did the appraiser reconcile and explain what method or why weights were applied to compute the conclusion </li></ul><ul><li>Is the appraiser acting as an obvious advocate </li></ul><ul><li>Was selective data used without justification – using data after the valuation date </li></ul><ul><li>Was professional judgment relied upon to the exclusion of the facts </li></ul><ul><li>Are the guideline companies truly comparable </li></ul><ul><li>Is the future ignored in favor of the past </li></ul><ul><li>Were the income statements properly adjusted – Non-business expenses, salaries at market </li></ul><ul><li>Was the tax status considered properly – S Corp vs. C Corp </li></ul><ul><li>Was the wrong premise of value used – Liquidation vs. going concern </li></ul><ul><li>Source: AICPA BV Conference </li></ul>
  24. 24. Valuations for Charitable Giving <ul><li>Reg§1.170A-13(c)(3)(A) Need for a Qualified Appraisal: </li></ul><ul><li>No earlier than 60 days before contribution and no later than due date of return </li></ul><ul><li>Content: Description of asset Date of Contribution </li></ul><ul><li>Name & Qualifications of Appraiser </li></ul><ul><li>Appraised Value </li></ul><ul><li>Methods to Determine Value </li></ul><ul><li>Form 8283 Completed </li></ul><ul><li>To reduce the chance of an audit, it is highly recommended to attach the appraisal to the return. </li></ul>
  25. 25. Valuation of Life Insurance Policies <ul><li>New Calculations to support Fair Market Value </li></ul><ul><li>“ PERC” Calculation outlined in Rev. Proc. 2005-25 as the safe harbor calculation does not consider fair market value </li></ul><ul><li>The Mentor Group Approach – use of scenario analysis assuming varying life expectancies </li></ul><ul><li>There are new mortality tables issued as of May 2009 </li></ul>
  26. 26. What To Remember From This Presentation <ul><li>The Downturn in the economy has the affect of increasing discount rates, increasing DLOM and reducing multiples of private companies less than expected </li></ul><ul><li>There are entity level discounts as compared to subject interest level discounts </li></ul><ul><li>Discounts must be computed using the correct market data and a quantitative method to support the final discount. </li></ul><ul><li>There are several factors that must be evaluated for each entity that affect the size of the discounts. </li></ul><ul><li>Multi-Level entity structures must be analyzed carefully so there is no double counting of discounts. </li></ul><ul><li>There are 3 different viewpoints on how “built-in” capital gains are to be computed, but the trend is towards taking the full discount. </li></ul><ul><li>Once the total discounts have been computed, an “internal rate of return (IRR)” calculation must be computed to support the size of the discounts. </li></ul><ul><li>Valuations for charitable giving are on the top of the IRS list to audit, and a full report to support the value of the gift is needed </li></ul>