Poor Business Appraisals Contribute to 2704(d) Change

By Carl L. Sheeler, PhD, ASA, CBA, CVA

About a quarter century ago, when I first started in the valuation profession, there was a common “freeze and squeeze” approach used by affluent taxpayers and their advisors.

By forming a partnership, an asset like real property or a businesscould be placed inside and equity in partnership interests would be held.  Because most equity holders had no direct control or access to the assets and there was a limited market, discounts for lack of control (“DLOC”) and lack of marketability (“DLOM”) were applied. This lowers the applicable gift and estate tax.


$5 million in real estate placed inside a Family Limited Partnership (“FLP”).  Two general partners (husband and wife) each held a 1% GP interest and a 49% LP interest.  They gift a 20% LP interest to each of their three children.  20% of $5 million is $1 million.  However, since they have a noncontrolling interest a combined DLOM/DLOC discount of 40% is opined bringing down the value of their interests to $600,000 each.  If the combined tax was 40% and the “lost value” was $400,000 ($1,000,000 - $600,000), then the tax savings would be .40($400,000) or $160,000 x the three gifts for $480,000. 

So, the IRS fought and frequently lost the argument for these discounts and administratively changed the valuation rules under Internal Revenue Code Chapter 14:  Sections 2701 – 2704 making it harder for such transfers to be made if a legitimate business purpose wasn’t provided.

But the real issue, which gets lost in the noise of legal wrangling, was that many of the discounts reflecting impairments associated with holding equity interests in closely held entities were often poorly supported by the business appraisers retained.  Before the internet to deepen the intellectual rigor required to provide empirical support for such discounts various academic studies were cited.  Most had some failings.  I should know.  I wrote my doctoral dissertation on what seemed to best reflect the level and presence of these discounts.  The California Bar 2010 Business Succession Planning Manual and the 2003 AICPA’s Team Approach to Tax, Financial and Estate Planning had valuation and discounting chapters written by me.

While certainly not all encompassing, here are examples of some of the common oversights in most valuation reports:

Ø  The influence of interest rates and availability of capital differs from period to period.  If the transfer/transaction occurred on March 2009 (the worse decline in stock market since the depression), then it stands to reason that March 2006 (a period of heavy leverage and availability of capital) would have a different result.  These studies don’t reflect these real world changes.  And legal practitioners pushed for 30% to 40% discounts which may have been too high in 2006 and too low in 2009.

Ø  Discount studies have to look at BOTH growth and income.  Basic finance indicates that total return (what and investor seeks) is a combination of appreciation of an asset (buy at $10 and sell at $15 for a 50% increase).

And the dividends paid (2% on the $10 would be 20 cents or a nickel a quarter).  So, if total return was assumed to be 12% per annum would it matter if it was 6% growth and 6% income; 9% growth and 3% income or 0% income and 12% growth?  It would!  If I have no control on the frequency and amount paid and I am receiving half of the 12% in distributions I have some liquidity right now and if that liquidity is greater than alternative investments or within the asset class I am investing, then the “impairment” of having less liquidity and control would be lower.  The discounts would be lower as well.  Conversely, if all 12% is in growth and no income is being received and the period when 100% of the interests would be sold and distributed is unknown, there is no economic benefit until a distribution is made.  So issues like market volatility and decline in asset values could have a dramatic impact on the level of discounts. 

Ø  Asset class and alternative investment historic performance and holding period matters.  If the class is commercial real estate and holding periods are from 5 to 10 years with total return between 12% and 15% per annum, then assets performing above or below these levels matters.  This is true when such assets have been held through both up and down cycles with nominal change is what is held and what is sold.  Paper gains are not the same as real increases and when decreases occur in the asset class held, what has been done by management to mitigate these losses?  Adjustments reflects investor behavior given alternative assets or size interests they could hold.

Ø  Size of equity interest can matter.  How valuable is a 2% interest if the other two shareholders each hold 49%?  Let’s say that that the underlying asset is valued at $100 million.  Would it be more preferable to hold a 2% interest with a pro rata value of $2 million, but with negligible control other than a potential swing vote (2% + 49% = 51%) if a simple majority is all that is needed?  Or would having 100% at $2 million be more preferred.  What influence could the amount of leverage the unit holder have by using debt?  What is the 2% interest had a value of $10 million?  First, how many investors have $10 million to make the investment and what percentage of them would want to concentrate their risk into a single holding?  It is obvious the pool of potential investors drops considerably from $1 million to $100 million, but studies don’t examine these real world issues that would influence the discounts.

Never mind the facts.  Let’s return to what is.  Remember 2012 when nobody really knew when the gift and estate tax levels would sunset under Bush and return to $1 million?  Everyone who could was transferring wealth before the year end to avoid future taxes.  I wrote a white paper in Valuation Strategies (peer reviewed article) cautioning that the sheer number would inundate the IRS and the blowback could be revisiting Chapter 14.  It would be comparable to the S&L defaults in the late 1980’s, when the real estate appraisers, not the bankers, were faulted for the poor quality of loans and collateral.  Congress stepped in and mandated state licensing.  What 2704(d) would do is simply disallow many of the discounts families have received.  One way to devise a work around is to simply indicate a size interest to be gifted versus the dollar amount.

Given the billions of dollars at stake, embrace the fiduciary duty of ensuring the work product has adequate support and the appraiser is truly qualified – not primarily how much is charged.

Dr. Sheeler can be reached at csheeler@thinkbrg.com or 619.453.3015. 


Carl Sheeler, PhD, ASA brings wisdom gained from his 25 years of strategic planning, governance, business
operations, finance and advanced analytics experiences to bring clarity to complex risk identification, measurement, management, and mitigation issues faced by family offices and businesses.  
He is the author of the John Wiley & Sons book titled Equity Valuation Enhancement, a treatise which addresses scaling 8- to 10-figure companies and has presented or published 200+ times for entities such as the American Institute of Certified Public Accountants, the American Bar Association, the Federal Bar Association and other organizations on value, strategy and governance.  He can be reached at carl@carlsheeler.com or 424-253-0110