ORANGE COUNTY BAR ASSOCIATION

TAX LAW SECTION WEBINAR

Getting the Most Out of Your IRS Business Valuation

Thursday, November 12, 2020

Getting the most out of

your IRS Business

Valuation

LaVonne Lawson, JD, MBALAWSONTAXll@lawsontax.com310.231.1040

Adam Minow, CPAMinowCPA Corporationadam@minowcpa.com714.900.9853

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IRS Circular 230 Disclosure:

To comply with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained herein (including any attachments), unless specifically stated otherwise, is not intended or written to be used, and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter herein.

No legal advice stated herein.

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LaVonne Lawson, JD, MBA• Law Office of LaVonne Lawson

- LAWSONTAX• Tax Controversy & Litigation• Outside Counsel to Businesses

& Business Owners

Contact Info:ll@lawsontax.comLaw Office of LaVonne LawsonOffice: 310.231.1040

Adam Minow, CPA, CVA, CFF, MBA• President, MinowCPA Corporation• CFO & CPA to closely-held

corporations and LLCs• University of Chicago Booth MBA• E&Y, Bank of America, KB Home,

PaineWebber, Genentech• Expert witness on topics including

business damages

Contact Info:adam@minowcpa.comMinowCPA CorporationOffice: 949.333.1625

Presenters

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Why a business valuation? What for…

● Tax Return Preparation○ Charitable contributions○ Built-in gains tax○ Gifting○ Estate tax return preparation

● Tax Controversary Work● Financial Planning, Estate Planning● Preparer penalties

○ IRC 6662 – Substantial valuation misstatement penalties○ 20% Accuracy related penalty○ 40% Gross valuation misstatements

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Preparer Penalties

● Form 706 – Instructions stipulates that an IRC Section 6662 20% penalty for the underpayment of estate tax that exceeds $5,000 when the underpayment is attributable to valuation understatements

● Valuation Understatement: Property value reported on Form 706 is 65% or less than the actual value of the property.

● Gross Valuation Understatement: Penalty increased to 40% if property value reported on Form 706 is 40% or less than the correct value.

● Preparer Penalties: Greater of $1,000 or 50% of the income earned for tax return preparation

● Willful or reckless conduct are subject to a penalty of $5,000 or 75% of the income earned for tax return preparation (IRC Sec 6694(a) & (b). https://www.irs.gov/pub/irs-irbs/irb09-11.pdf

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IRS Business Valuation Guidelines

● https://www.irs.gov/irm/part4/irm_04-048-004● Identification of the following elements of a business valuation

○ Property, interest, date, purpose, use, definition, assumptions, limiting conditions, scope limitations, restrictions, agreements, source of information

● Planning, identifying, analyzing○ Consideration of three generally accepted valuation methods (asset, income, market)○ Analysis of historical financial statements and benefit streams○ Nature of the business, the industry, and the economy○ Analysis of marketability of the business ownership interest

● Workpapers○ Document steps taken, techniques used, evidence to support facts and conclusions○ Detailed case activity records (Form 9984)• Concluding and Reporting○ Appraiser must use professional judgment, sufficient information, and objectivity○ Report / conclusion of value documented in writing

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Revenue Ruling 59-60

● Gold standard of business valuation for more than 60 years.

● https://www.irs.gov/businesses/valuation-of-assets

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Revenue Ruling 59-60

● Factors to consider○ Nature and history of the business○ Economic outlook, generally and industry-specific○ Earning capacity of the company○ Dividend paying capacity○ Goodwill or intangible value○ Sales of the stock, and the size of the block being valued○ Market price of similar stocks traded on an open market

● Elements to Consider in Valuation○ Current and prospective economic conditions○ Internal conditions in the company, including the management team○ Balance sheets, End of month, and for 2+ years preceding the date of valuation○ Detailed profit-and-loss statements, representative period preferably five or more years○ Goodwill○ Capitalization rates 8

Revenue Ruling 59-60

● Broad guidelines for comprehensive data analysis

○ “All other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate and gift tax purposes.

● Key language to allow appraisers subjectivity in their valuation engagements

○ Valuation of securities is, in essence, a prophesy as to the future and must be based on facts available at the required date of appraisal.

○ The value of shares of stock of a company with very uncertain future prospects is highly speculative.

○ No general formula may be given that is applicable to the many different valuation situations arising from the value of such stock

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Valuation Discounts – Lack of Control

● Minority interest discount due to lack of control. Little or no voice in company affairs, including:○ Elect directors and appoint management○ Determine management compensation and perquisites○ Set policy and change the course of business○ Acquire or liquidate assets○ Select people with whom to do business and award contracts○ Liquidate, dissolve, sell, recapitalize, acquire, IPO

● Evidence of minority interest discounts○ Mergerstat studies○ Closed-end mutual funds

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Valuation Discounts - Marketability

● IRS Auditor Perspective on Marketability Discounts

Start with the basic question as it relates to DLOM:Under the prevailing facts and circumstances and considering the nature of the interest to be valued, why is the DLOM not zero? By enumerating the factors that would lead to a conclusion that some DLOM at all is appropriate you will be building a framework as to how substantial a discount for lack of marketability might be reasonable.

● Mandelbaum v Comm., T.C. Memo. 1995-255, affd. 91 F. 3d 124 (3rd Cir. 1996)

Court relied on neither expert and computed marketability discount of 30%Established a framework for analyzing marketability discounts, including: private versus public sales of the stock, financial statement analysis, the company’s dividend policy, the nature of the company (history position, and economic outlook), the company’s management, the amount of control in transferred shares, restrictions on transferability of stock, the holding period for stock, the company’s redemption policy, and transaction costs.

Restricted stock studies and Pre-IPO studies11

Reasonable Compensation

● Valuations should consider whether compensation paid to owners / officers / related parties is “reasonable”.

● Reasonable compensation is an income normalization adjustment in the process of analyzing the financial statements during the valuation process

● IRS provides guidance for analyzing reasonable compensation:● Multiple hats● Hypothetical independent investor theory

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Case Law

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IRS Procedures

● Tax Court Rules of Practice and Procedure

○ Rule 71

○ Rule 74

○ Rule 143

● Sunoco, Inc. v. Commissioner, 118 T.C. 181 (2002)

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Thank you!

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