Proposed 2704 Modification:  Where’s there’s smoke there’s fire?

Let’s get to it.  Any trusted advisor working with affluent families with concentrated wealth in real estate and business ownership knows there are those in their profession whose skill level warrants improvement.  This is as true for accountants and attorneys as it is for appraisers.

Since the 1970’s, there were many taking advantage of putting valuable assets such as highly appreciated real property into “wrappers” such as partnerships.  Then limited partner interests were transferred.  So, if the asset was $10 million and a 25% LP interest is transferred, the pro rata value is $2.5 million.  However, since the LP interest is privately held and has little to no control, the argument goes that it’s worth less than the $2.5 million.  So, let’s say -40% or reduce the $2.5 million by $1 million (40% of $2.5 million) leaving $1.5 million.  That makes the $1 million “disappear” as well as its associated taxes.  Let’s say 35% is the tax rate.  That provides a $350,000 reduction in taxes on $1 millionGiven legal and appraisal fees that are likely to be only about a 10th or less, it’s a great decision.

Because the fair market value standard requires reflecting what a notional pool of investors would do, one would look at what their expectations are.  Most would likely seek a concession for the impairments associated with that lack of control and limited market.  These concessions are widely referred to as “discounts”.  Because these discounts were not always well supported and transfers were solely for tax minimization, about 25 years ago, the Treasury argued for limitations to include “tax reduction” could not be the sole or primary purpose for a transfer.  The Internal Revenue Code Chapter 14: Section 2701 – 2704 was born.

This led to more sophisticated planning.  Keep in mind the lifetime exclusion was below $1 million, so even families with an upper middle income home and savings could exceed this threshold.  A blessing for the professionals and planning services. 

But, in all the “noise” and because the third check paid by most families is to appraisers to quantify value, one might successfully argue their work product was commoditized.  The number one and two checks were for legal and tax services to design the plan.  So, to justify their services, they were more than willing to “save” their prospect/client on appraisal fees.

We come fast forward to technology and availability of information on the Internet and planning using software driven products that provide options and even print out trust instruments and agreements.  So, differentiation from mass production requires differentiation.  This differentiation takes two paths:  (1) Highly bespoke work product; or (2) High touch services.

Both have strengths and weaknesses.  If the plan is elegant, not understood or simply fails to address what the founder and family needs, there’s no execution or following the plan.  Makes no difference the technical mastery.  If the services are high touch, but overly simplistic, the family and founder might feel good about the deliverable, but may not receive the assistance they truly need.  So, a blend of purposeful planning that is holistic requires engagement by more than just the accountant and attorney and should not minimize the role of the appraiser.

Trusted advisors are not order takers.  Their practices are not just technical, tactical or transactional as plans are fluid and dynamic.  Why is this so important?  Because if fee drives the selection of an appraiser, then the veracity of their work product becomes suspect.

Underpinning the past and proposed future of 2704 is the issue of the application of these valuation discounts. The losers are the taxpayers and those who have not demonstrated the fiduciary duty to ensure the work product defends these financial opinions.  It’s simply not enough to suggest that’s the appraiser’s job. 

In 2013, Valuation Strategies released a peer reviewed article I wrote that expressed concern over the mad rush of equity transfers to beat the clock before December 31, 2012.  Why?  A legitimate concern that the lifetime exclusion sunsets and reverts to $1 million.  Let’s call it for what it was.  Business reasons be damned, use the exclusion or stand a chance of losing it.

But that brings us back to the discounts that are behind much of these issues.  It’s not an issue of whether they are warranted.  It is an issue is what are their levels and how supported.

A couple decades plus ago, Tax Court Judge David Laro made an important decision in the Estate of Mandelbaum that took much of Revenue Ruling 59-60 (factors to consider when valuing a business) and opined that the issue wasn’t whether a discount was applicable, but it’s level.  He suggested that a starting place for business equity interests was -30% to -35% adjustment and was higher and lower based upon the unique circumstances of the specific matter.  Guess what?  Following that almost all the various studies reflected discounts in or around that range. Most appraisals then opined discounts in that range as well. 

As it concerned direct ownership interests in real property, the court case Propstra opined an accepted -15% discount.  Following that most discounts were +/-5% of this level. 

Nonsense.  Reread my statements above.  The role of the appraiser is to examine what notional investors would consider and do.  This is a risk/reward assessment.  Take a public company’s share price at $10 on March 9, 2009.  It was the same company two years earlier and two years after.  Would you expect the share price to be the same?  Only by accident.  The performance of the business and what was occurring in the marketplace drives the share price as does its level of debt and its growth rate.

A fundamental role of finance is determine level of risk and economic benefit.  Risk exists at the company level and at the equity level.  Economic benefit is the growth and income of the investment.  This tends to be referred to as appreciation and yield.

Here’s a simple example.  Two identical companies.  The first company pays no dividends and its growth is at or near the rate of inflation.  The second company pays 2% dividend and has a 6% year-over-year growth rate, which is greater than the industry norm.  If this differentiation has been consistent for five years, it should be reasonably evident the second company makes for a better investment. 

So, the bad news, there has been inadequate review of valuation and discount work products, which then make their way to state and federal tax authorities. 

This leaves these examiners to review these work products and often find them wanting.  This ranges from absent of any substantiation to nominal empirical support.  Seldom or ever do these results examine whether the level of the adjustments are reasonable. 

Consider the share volume of these reports and the staff size to review and pursue.  While I categorically reject the notion of changing the fair market value standard and applying family attribution when examining transfers, I can understand the regulatory over-reach by unilaterally challenging the presence of discounts.  This means that non-family transfers would still have adjustments for impairments to reflect investor concessions, but not families.  Unconstitutional, but it could happen just as it did with Chapter 14.

So, let’s examine the issue a bit closer.  My understanding is that business and economic reasons for the adjustments are permissible.  Our work products have always performed this step.  This may explain after thousands of reports we have had no unfavorable audits.  Then again, we lose millions of dollars in appraisal fees, because we’re unwilling to dilute the intellectual rigor and due diligence needed to substantiate our conclusions for low fees.

Below is an example of a real estate partnership interest discount having adequate support:

Lucky 6 Partnership has no debt.  The property was appraised at $5 million and there are no other assets. The real estate generates and distributes 5% of its value in yield each year.  Its growth has averaged 4% per annum for the past 20 years.  It’s the only asset held.  There are three tenants and one is on its last 3-year option.  The second has two more three-year options and is paying below market rent.  The third is recently signed tenant and paying market rents.  The property is titled in John and Jane Smith’s name.  They collect the rents and have been active in the property’s management.  They’re in their 80’s.  They want to transfer 10% each to their three grand-children’s trusts.

So, what’s going through the notional investor’s mind?  If they’ve held the asset for 20 years, will they for another 20?  Who else would replace them?  Was the real property valued assuming a mix of debt to equity?  Was it valued assuming market rents?  Does the real estate appraiser consider ownership structure and performance?  What could a similar holding bring in the way of return?  Would it be wiser to hold an investment in a smaller direct ownership of $500,000 where they maintain control or a noncontrolling interest that on a pro rata basis is worth $500,000?  What if the market suggests that a total return for a 7- to 10-year buy-and-hold is 15% (15% of $500,000 or $75,000)?  This suggests that holding the 5% + 4% offered (9% of $500,000 or $45,000) by the Lucky 6 LP interest is less than the 15%.  The ratio would be 9/15 or 3/5 or 60% or simply put a $30,000 difference.  The 10% LP interest of $500,000 would have to be “discounted” by at least 40% to $300,000 to achieve 15% ($45,000/$300,000). 

The above example has nothing to do with benefitting the family, but reflects the business and economic reality.  A 30% discount would be too low and a 50% would be too high if one is looking to reflect the central tendency (the distinct area of where the majority of transactions are occurring.  Picture a scattering of points along a “Y” and “X” axis.  Where the majority migrate is the central tendency. 

The mistake many make is they examine the specific transaction versus what the pool of notional investors would do.  Needless to say, the analytics and research needed to substantiate the impairments of private equity is even a higher bar.

The good news is trusted advisors and their clients have options.  They learn a little bit more about what a “good” appraisal ought to look like and their cost.  Plus, they examine ways how drafting trust instruments’, buy-sell, shareholder and operating agreements’ provisions ought to include this business and financial perspective.

By doing so, the issue of risk management and mitigation brings the discussion to the forefront of what our clients are most concerned about.  By examining assets through this shared lens the conversation can also extend to how not only to reduce taxes, but how to enhance value of these assets.  By doing this, the tax tail ceases to wag the dog.  Isn’t this worth the investment?

If the above commentary hasn’t moved you to change your behavior; then the presidential elections should.  There is a real chance that needing to weigh and understand income, capital gains, estate and gift taxes will bring an even more engagement with clients.  This is especially true if both the 2704 proposed change is made and the level of permitted gifts are lowered to $3.5 million from north of $11 million.  This gives advisors and clients a bite of the apple – twice.

The first are issues of enterprise level risk.  Most private businesses have a myriad of risks they depress the price multiple the market would pay.  This reduces the value of the company.  It’s a good time to effect some transfers then as the equity level discounts will also be greater due to the entity level’s underperformance.  Then by addressing these risks and increasing the value of the business additional options are available from ESOPs to Private Equity making minority investments or obtaining cheap debt capital.  This brings liquidity and additional capital (financial and human) to improve and scale the controlling interest remaining in the business.  Thus a business worth $10 million could be scaled to $25 million or more in a relatively short period of time with the right engineering and holistic team.  Don’t forget life insurance when the premiums are lower due to age and health of key officers and shareholders…

So, the smoke came from ignoring the smoldering embers of an unsupervised process that can often be mechanical and the fire arrived when decisions and actions poured water in other than the root cause that created the smoke in the first place.  Clearly, we can develop considered results that up the game of advisors and enhance our value to our clients.  What’s not to love?


Carl L. Sheeler, PhD, ASA has been conducting 8- to 10-figure valuations and discount engagements for 25+ years.  He was the 2015 Middle Market Merger & Acquisition Thought Leader of the Year and the Amazon Best Selling Author of the Wiley Book “Equity Value Enhancement”.  His doctoral dissertation addresses Support of Illiquidity Discounts of Private Companies.  In addition he is the contributing author of both an AICPA and California Bar manuals on Business and Succession Planning where he addresses the issue of valuations and discounts.  He has also been a speaker at numerous Estate Planning Council, Wealth Counsel and American Bar Association events applying his significant IRS/Court qualified testimony experiences.  He may be reached to review appraisals,; assist in drafting/review of plans/trusts/agreement provisions and conduct business appraisals and equity discounts of both asset holding and operating companies at or 1-800-286-6635.