Often, a significant portion of an individual’s net worth is derived from an ownership interest in a closely held business, partnership, or LLC. Therefore, an important element of estate planning is the valuation of that interest. If the estate plan includes a transfer of such interests, it is critical that a qualified business appraisal be performed by a qualified professional.
The purpose of an appraisal is to determine and present an opinion of fair market value, which is defined as the price at which an asset would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well-informed about the asset and the market for such asset.
Techniques available to reduce estate taxes include the gifting of minority interests in private entities to other family members. Such non-controlling and illiquid interests can be discounted for both lack of control and lack of marketability. Transfers of these discounted interests reduce taxable estates and shift future appreciation to the recipients of the gift; i.e., the next generations. A gift tax return should be backed by a qualified appraisal and if it satisfies adequate disclosure rules, filing of the return begins a three-year statute of limitations. Using a qualified independent appraiser should help in satisfying these rules and in avoiding penalties for underpayment of estate or gift taxes because of a valuation understatement.
A qualified appraisal is prepared by a qualified appraiser in accordance with generally accepted appraisal standards. The IRS regulations generally define a qualified appraiser as an individual who has earned an appraisal designation from a recognized professional organization or who has met certain minimum educational and experience requirements. In both cases, the individual must regularly prepare appraisals for compensation.
Generally accepted appraisal standards mean that the valuation has been prepared in accordance with the substance and principles of the Uniform Standards of Professional Appraisal Practice (“USPAP”), as developed by the Appraisal Standards Board of the Appraisal Foundation. USPAP, one of the more important developments in the valuation world over the past few decades, was promulgated “to promote and maintain a high level of public trust” in the profession. Prior to USPAP, both full-time appraisers and part-time novices often would refer to “generally accepted valuation standards.” The trouble is, there were none. Today, USPAP is a fact of life for appraisers of every discipline, and attorneys and others who retain them should have a solid awareness of what that means. Here’s a thumbnail sketch of USPAP:
- USPAP’s detailed set of standards, statements and advisory opinions affect the development and communication of real estate, machinery and equipment, personal property and business appraisals.
- Each of these four primary disciplines has at least two standards dealing with how a valuation should be developed and then reported.
- Rather than specifying particular methods, USPAP requires that the appraiser be familiar with all applicable methods and apply those that are appropriate to the valuation at hand.
- To comply with USPAP, a valuation report should be error-free and self-contained, enabling the user of the report to replicate all of the steps taken in the appraisal process. Even though the reader may disagree with the judgment calls that are an inevitable component of every appraisal, he/she should have access to the data necessary to recreate the valuation.
- All extraordinary assumptions and hypothetical conditions should be clearly delineated, and there are workpaper retention requirements and ethics provisions that must be adhered to.
Adherence to USPAP is perhaps the best of the best practices in the valuation world, so expect nothing less than full compliance from the appraisers you retain.
Business valuation therefore plays a key role in the estate planning process. An incorrect valuation of a business interest can not only result in missed opportunities to employ tax-savings strategies during the development of an estate or succession plan, but can also lead to unforeseen tax obligations and possible penalties should the IRS challenge the valuation (which it may do even several years after a transfer has been made). Obtaining a qualified appraisal from a qualified business appraiser can help to mitigate these risks and provide peace of mind for both the taxpayer and his or her counsel during any stage of the estate planning process.