For the third year, the Los Angeles Chapter of the American Society of Appraisers presented its National IRS Symposium in Los Angeles. This is a program designed by IRS and supported as part of their outreach program.
Such programs are offered in tandem with the onset of §6695A appraiser penalties, signaling that IRS is intent on reducing audits and improving compliance results from two directions: increased awareness and rather intense enforcement provisions – perhaps a classic carrot and stick approach. The underlying message for appraisers as well as lawyers using appraisals is that we want your work to be acceptable, and will tell you what we need, and the extreme
and unsupported valuations will stop.
This year’s program also featured Judge James S. Halpern of the USTC, and several valuer panelists who were included to provide additional insight into valuation issues.
Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS.
Brenda Woolbert, Team Manager Engineers and Appraisers, opened with a few comments on IRS cooperation with LA-ASA since 2005 and directed the audience to the appraisal links at irs.gov which describe appraisal expectations. She emphasized the idea of “talk first, write reports second” when working with taxpayers’ valuation issues. These practices are consistent with LB&I Core Emphasis areas of identifying our highest compliance risk work, working cases more efficiently and effectively and resolving casework as soon in the process as possible.
Rob Schlegel, ASA International President, stressed the importance of chapters and these sorts of events, engaging the ASA and IRS.
I provided a short overview of the day, and of the underlying situation with IRS. It was definitely the elephant in the room; namely, that IRS has had ongoing problems with valuations, they have been accumulating tools to go after tax dodges since 1982. The fact that problems have not gone away is emphasized by their asking for and getting new powers to deal with appraisers from Congress, now codified at §6695A. How bad does it have to get? If we keep doing what we’re doing, we will continue to get the same result we’ve been getting…nothing will change…and clearly something needs to change.
According to Albert Einstein, “The significant problems we face… cannot be solved … at the same level of thinking we were at when we created them.” I think it’s fair to say that, if we stay at the same level, audits will continue, appraisers will be sanctioned, and IRS will prevail.
Personally, I would hate to see what the sequel to the Pension Protection Act might look like. I care about the valuation profession and what it has to offer to the public, but I would be surprised if Congress wants to hear about this any further. And my worry is that parts of the profession will be crushed out of existence if this continues. It is time for us to change our thinking.
I’ve practiced discount valuation for 15 years, and during that time I have had very successful dealings with the IRS, as have many of my colleagues. I have written and taught quite a lot on the subject. And time and time again, I’ve observed that tax benefits don’t have to be sacrificed for the system to work.
The sort of thinking got us here might be related to some kind of taxpayer v IRS opposition, or egregious claims for undeserved benefits, or simply issuing tax-dodge valuations. From the point of view of the ASA, I would like to think not, but maybe we are tempted to think in these ways. There are certainly a few bad actors, but this is too big to be their fault alone.
What if we changed our thinking – what would it look like? It might look like understanding what IRS valuers want to see. It might look like regarding IRS and the Court as appraisal users and more due diligence on the part of appraisers. It might even look like lawyers stepping in when they read the appraisal and it doesn’t make any sense. Changing our thinking would certainly require a cooperative approach across the board. And clearly, it would not occur at the level that created the problem.
Valuation in the United States Tax Court
Judge James S. Halpern, U.S. Tax Court, opened the Symposium with comments on Ludwick. Was his a taxpayer-unfriendly decision? In the Judge’s view, no, because he must be persuaded in each case. In looking over his time on the bench for this talk, he noted that he has heard expert testimony in 32 cases over the past 21 years.
Concerning expert witness, he referenced the Tax Court Rules of Procedure (not the federal rules of civil procedure), rule 143(g), which provides for written reports including qualifications, and states briefly other requirements for evidence (the Rules are available on the USTC website).
He used his decision in Peracchio to address a number of issues with expert opinions as well as very interesting statistical inferences (below). In particular: The Supreme Court has said the Court is not bound by expert opinions; it may accept or reject testimony based on whether it is sound. The Court may also select portions of expert testimony from either or both sides; We can pick and choose (see also Trout Ranch).
In Peracchio, Judge Halpern objected to the minority discount analysis due to the method being imprecise; not supported by statistical analysis. He thought the appraiser should have looked at the different components (types of assets). The Government used 2% as an estimate without explanation, but the petitioner did not meet burden of proof. He noted that the judge is not an investigating magistrate; thus, in this case the side with the burden of proof loses.
When asked about whether the Court established a “benchmark” discount of 35% in Mandelbaum, Judge Halpern stated that he believes the Mandelbaum argument did not set a legal standard, as the example does not resemble a family partnership. (A “Mandelbaum Approach” is used by some appraisers in applying the process that Judge Laro applied in Mandelbaum [essentially Revenue Ruling 59-60] to determine discounts for lack of marketability. It involved minority shares of Big M, a C Corporation.)
Q. Do you believe your opinion in Ludwick stands for the proposition that cost of partition analysis is the only proper method for valuing undivided interests in real property? A. The cost of partition analysis is what’s left when experts fail to support anything else.
Q. In a case with a valid partition waiver executed, would that be respected, and change the proper valuation method away from the cost of partition analysis? A. Would need to hear arguments. The judge said he is not an expert in valuation, he merely decides on what is in front of him. He gives no advisory opinions.
Q. Have you even thrown out an opinion based on obvious bias? A. No he has not.
Current Status of the Estate and Gift Tax Statute
The current state of the Estate and Gift tax statute was discussed by Chuck Morris, JD, former IRS Western States E&G Territory Manager, who is now in private practice in Irvine, California. This was mostly an overview of methods used to leverage the current $5million exemption, including defective trusts, transferring assets to annuities and the like. He did not see the estate tax being abolished, and noted that the current administration wants to go back to a 45% rate and permanent portability.
His presentation included commentary on several cases: Noble which involved post-death facts and the notion of strategic buyers, and Mitchell, concerning business purpose of late-in-life transfers (§2036) and (amazingly) stipulated discounts.
Chuck is involved in quite a few examinations (on behalf of the taxpayer). He discussed Judge Halpern’s decision in Ludwick and that IRS examiners are indeed throwing the concluded 17% at him. For a detailed analysis of Ludwick and one way to respond to such challenges, see Case Study 1. Chuck also noted that valuation issues still account for the majority of the work in Estate and Gift.
For guidance in preparing expert reports, especially Federal Rules of Evidence §703, Chuck made reference to Noble, where having only one of three appraisers preparing a report was reason for exclusion, and where facts never made it into evidence. The case also includes a detailed treatment of the implications of sales of other shares in the company for fair market value of the shares being valued.
Recent Court Decisions – Valuation
A panel on recent court decisions featured Miles Friedman, SBSE Associate Area Counsel, Guy Glaser, JD, Area Counsel LB&I, and The Honorable James S. Halpern, Judge U.S. Tax Court, and Mel H. Abraham, CPA, ASA. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS.
Miles Friedman introduced the panel’s discussion of the Boltar case, which is citeable and rumbles the ground regarding rules of evidence and expert reports. Some valuations can’t even get out the gate. Taxpayer expert report had significant [actually, mind-boggling] errors that affected reliability (relevant and reliable). The Court applied Daubert and established the court’s role as gatekeeper to keep out “junk science,” i.e., any expert testimony that is not relevant and reliable. Thus, petitioner’s report did not even get considered.
Miles questioning Mel Abraham: What if appraiser writes report and other side files a motion in limine to exclude report? Mel answered that the motion would be rebutted simply because reliability is part of our Standards. We as appraisers create the relevancy. Get it in and let it be determined at trial. However, there is a difference between reliable vs. Errors. Miles then asked Judge Halpern: Who bears the risk of failure if the report is excluded? The Judge answered: The taxpayer attorney. With a 30-day limit, the party will not have enough time for a new report and there will be no grounds for continuance. The attorney needs to review report to have confidence that it will not be subject to a motion in limine.
Miles’ advice to appraisers: Make sure you know what counsel wants you to do. It should be in the contract. Get all the facts; you need to talk, decide if you need formal discovery to get all the facts and information you need. We will see more motions in limine, and should expect the quality of reports to increase as a result. Guy Glaser added that when he gets a report, the first thing he does is review it to see if it can be excluded via a motion in limine for not complying with the principlesset forth in Daubert.
Audience question: How much weight is put on credentials alone? Judge Halpern answered that experience alone can qualify an expert without formal training or credentials. He commented that USPAP compliance is not a condition precedent to acceptance of an appraisal report; appeals have affirmed that USPAP isn’t a precondition to acceptance, but its adherence does go to the weight given to the appraiser’s opinion.
Audience question: What about “more likely than not” standard of proof? Judge Halpern described the burden of proof as a particular “measure of persuasion.” In fraud cases in tax court, the measure of persuasion is “clear and convincing evidence.” If fraud is not an issue, the measure is a “preponderance of evidence,” which is the case if there is a scintilla over 50% likelihood, depending on constituent facts; is it an ultimate fact (i.e., value of property), or a subsidiary fact (i.e., cost to dispose, commissions, etc.)? And is one party’s evidence more likely to be true (more persuasive)?
When asked about the Court’s role in establishing evidence, Judge Halpern likened his job to “holding coats” (while the parties duke it out). It is the obligation of counsel to bring evidence and object to evidence. It the case of reports, they are either excluded or are in evidence.
Guy Glaser began a new discussion of U.S. vs. Richey [9th Circuit 1/2011]. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS. In Richey, the district court quashed a summons issued by the IRS to an appraiser seeking his workfiles in connection with an appraisalhe had prepared at the request of an attorney and whichwas attached to afiled return to substantiatea donation of a conservation easement. The district court concluded theappraiser’s work file was protected by both the attorney-client privilege as well asthe work product doctrine. The IRS filed an appeal to the Ninth Circuit, where the court held that attorney client privilege did not apply to an appraiser’s work files, since an appraisal is valuation advice and not legal advice. His observation is that an appraiser’s work filesmay be summoned by the IRS and are not protected by the attorney-client privilegeif the appraiser’s report isattached to a filed return even if the report wasprepared at the request of an attorney. The work product argument was also reversed since the report was not strictly in preparation for litigation. (Since the report was attached to a tax return, a dual purpose existed.)
According to Miles Friedman, if the appraisal had to be attached to a tax return, it was out there for a third party, and privilege would not exist.
Built-in capital gains was addressed in context of Davis. The case says that the taxpayer should not get a dollar-for-dollar reduction, but issues of value (and gain) growth over time, the realization event and discounting back to present value remain unclear. This remains a heavily technical, fact-dependent situation with inconclusive case guidance.
Tax-affecting S-Corporations was addressed, but again it’s a heavily technical issue, this time with extensive works by prominent valuers to contend with (as Chris Treharne addressed in a later panel). Miles Friedman didn’t have a big problem with the subject, though: “I can answer this in a second. The cases say no, the IRS says no.”
Issues with appeals and tips for successful ones were provided by John Schooler, JD, Appeals Team Manager. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS. Most importantly, he noted that appraisers should make sure report/case is fully factually developed before going to appeal. Act with judicial attitude. Appeals officers are not developing and investigating cases, only dealing with what is brought before them (which is impossible anyway, since each officer has about 48 cases at any given time). Most important to John is a failure to identify appraiser credentials, and common-sense aspects of the appraisal report, such as relevancy of comparables.
Appeals has been emphasizing Fast Track Mediation rather than going to trial since 2002 for non-docketed cases. Fast Track Settlement should also be considered. Appeals Settlement Guidelines (“ASG”) for Family Limited Partnerships (“FLP”) should be issued soon.
Professional Responsibility – Pension Protection Act
The latest action in the Service’s enforcement of appraiser penalties were discussed by Peter S. Crane, AVA, IRS Senior Appraiser. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS. Peter provided a brief history of appraiser penalties; in general, appraisers have been subject to penalties since 1982 under §6700 and §6701. With the Pension Protection Act of 2006, there is now §6695A, which provides penalties for returns or submissions filed after 8/17/2006 (facade easement donation returnsfiled after 7/25/2006). Penaltiescan be applied toanyone who prepared an appraisal of the value of property and who knew, or reasonably should have known, the appraisal would be used in connection with a return or claim for refundand the claimed value of the propertyresults in a substantial or gross valuation misstatement.
For substantial and gross misstatements of value in income tax and estate/gift tax reporting,the threshold is 150%/200% more than the amount to be determined to be correct. For gift and estate tax returns the threshold is 65%/40% less than the amount determined to be correct. In the event that a 6695A penalty is asserted, the appraiser has post-assessment pre-payment rights of appeal.
He noted that applicability of the penalty is not solely mechanical, though. The threshold just alerts IRS to a problem, and that they are looking for egregious behavior. “Are there significant errors, omissions, departures from professional standards, or presenting incorrect information?” They would want to know circumstances (qualitative factors) to take into account before opening penalty case. He stressed early resolution, and commented that “if you just do your due diligence it won’t happen to you.”
He then discussed professional standards and certifying organizations, with an emphasis on ethics rules and non-advocacy. “Be an advocate for your value, not for your client.” In response to a question from the audience, why doesn’t IRS adopt USPAP?, Brenda Woolbert answered that IRS has never adopted any particular standards but that its own valuation staff must comply with the valuation standards found in the Internal Revenue Manual. Peter indicated that as a state licensed appraiser and an associate member of the AI, he follows USPAP. He also emphasized that he has experience no internal effort to influence his opinion, and said he was genuinely pleased with the freedom he was given to form his own opinion of value.
In answer to another question, is the taxpayer alerted to a §6695A penalty? Brenda Woolbert answered that a section 6695A penalty will only be discussed with the appraiser, never with the taxpayer.There is a question of due process to protect appraisers. The appraiser will be contacted prior to a 6695A case being opened, but only after the examination case is closed. The appraiser will be invited to a meetingtodiscuss the report and demonstrate thatthe opinion of value is more likely than not correct. If the appraiser can convince the IRS Valuation Specialist that the appraiser’s value could be more likely than not correct, then the penalty will not be pursued. The appraiser should bring their entire work file, engagement letter, and limiting conditions on the engagement to the meeting for review.Penalties being considered against an appraiser are not discussed with the taxpayer. The examination of the appraiser is separate from examination of the taxpayer.
Peter’s take was that, in his opinion “If you follow your professional standards, do you due diligence, follow the commonly accepted methods of your peers, you will never have to worry about penalties.” Issue guidance on §6695A penalties is currently being developed. When this guidance is completed, it will be shared with the public.
Concurrent Session 3 – Business Valuation
The business valuation breakout featured a panel including Neil Mills-Mazer, AVA, JD, IRS Engineer Team Manager, Judge Halpern, and appraiser-panelists Dennis Webb, ASA, MAI, FRICS, and Chris Treharne, ASA, MCBA, BVAL. The panel was moderated by Steve Grubic, ASA.
Fractional Interest Valuation
Neil Mazer’s presentation began with an overview of methods he has seen for valuing fractional interests in real property, and some of the more significant problems. Please note that the views and opinions expressed are those of the presenters and do not necessarily reflect the views and opinions of the IRS. For actual transactions of fractional interests, issues are that the appraiser uses comparisons with wildly different types of property, the data is very old, comparable transactions are too complex, facts are incomplete, and parties are related. Partnership transaction data is a problem because the interests don’t carry the same rights as tenant in common; management is not shared, and there is no right to partition. Cost to partition has issues with growth rate assumptions, years to partition, underestimated cash flows during the partition period, and the discount rate used to bring the cash flows and eventual sale proceeds back to present value. However, the partition method is a favorite, because “it represents the reality of what the present interest holder would receive.”
His presentation then continued with one of his pet peeves, the idea of a minority premium. What happens when a very large interest holder, say 99%, could acquire a 100% interest (thereby eliminating control and marketability impairments) by simply buying out the smaller interest holder. An example was given showing that claiming even a 5% discount for the 99% interest would be the same thing as the 99% holder buying out the 1% holder for a 495% premium over its pro rata share of the whole. Of course, that is extreme, but taking a more typical percentage and discount, say 90/10 and a 20% discount, the amount of the discount would imply 180% premium for the 10% holder. Neil would consider the 20% discount unrealistic on this basis; this method would cap the discount between 5% to 10%, which would produce a premium between 45% and 90% for a 100% buyout for the 10% holder. Extending this logic further, if the relationship were 50/50, then the maximum discount to consider would be 30%.
Of course, there were multiple audience objections: Why is there empirical market data that suggests fractional interests trade at discounts of 30% and higher? Aren’t the facts and circumstances of many such holdings much more complicated than the IRS model suggests?
When Judge Halpern was asked for his thoughts on the model, he recommended reading his decision in Holman (in which partnership buyout provisions placed an effective cap on marketability discounts). He asked whether a 99% holder would ever be willing to sell at a large (say 30%) discount? Not if he can buy out the 1% owner at what would amount to a 1%-2% discount.
The idea of such a premium, and an implied cap on the discount, is an interesting one, but there was not nearly enough time to explore the subject fully. We look forward to more dialogue from IRS on this one.
A Statistical Wake-Up
Judge Halpern made a presentation based on Peracchio that should alert appraisers (and counsel) to the implications of common but unsupported references to the use of means and medians when applying data to (in this case) a partnership that holds securities. The Judge takes representations of statistical inferences seriously (to the point that he has audited a number of classes in higher mathematics), and commissioned his presentation from Theodore S. Sims, Professor of Law at Boston University School of Law.
The presentation involved the closed-end investment fund data that was submitted to the Court in Peracchio. The appraisers had selected between median and mean discount indications in their analysis of the partnership. He was not happy with their inability to explain why they selected one or another, and with their lack of understanding of statistical measures. He asked “how can we characterize the data, and what can we infer from it?” He demonstrated how the appraisers might have used such measures as “confidence interval” to communicate a meaningful understanding of the data and their use of it in their analysis. The takeaway for appraisers (and for lawyers reading appraisal documents) is that use of statistical terms and analysis in valuation had better be accompanied by an understanding of what the data mean, and why the appraiser is relying on it. Casual use of means and medians in Judge Halpern’s courtroom can be a hazardous activity for an expert.
Question: How much description of statistical method is necessary to insert in report if using statistical analysis? Judge Halpern’s answer: Talk to counsel, ask who is the judge, and what does he or she think is important. The lawyer should be studying the judge’s cases. Prepare your report for the judge. Talk to the other attorneys involved in the cases, look at other expert witness reports, and look at trial transcripts (if it’s a big enough case).
One of the Symposium attendees was Jay Abrams, who commented on the presentation. Mr. Abrams is the author of a comprehensive book on statistical methods for business valuation, titled “Quantitative Business Valuation” (2nd Edition).
So we know that IRS has ongoing problems with valuations, and we also know IRS is the intended user of all the stuff we (appraisers and practitioners) generate. Therefore, knowing how the IRS system works is vital. What if the appraisals sent to IRS all made sense? What if attorneys and accountants were able to count on values being accepted as their clients are led to expect? What if, when it comes to it, the Court gets to work with nice clear, persuasive evidence from both sides?
The Symposium offered a chance to become more aware of what IRS is looking for. They were there to tell us. They didn’t have to be there, but they were. This is a very good sign…
It will take many steps to move to a different level of thinking than the one that created the problem. IRS included.