IRS internal memo: any agent can now assess penalties against you under 6695A
In a troubling glimpse into its procedures, the Internal Revenue Service issued an internal memorandum to examiners, estate and gift attorneys, and appellate officers regarding “Procedures for Implementing the Penalty for the Substantial and Gross Valuation Misstatements Attributable to Incorrect Appraisals Under IRC Section 6695A.” The memo—written in August 2009—only recently came to light after requests under Freedom of Information Act, according to Jay Fishman, who moderated a tax update at the 2009 ASA Advanced BV Conference in Boston this week. Among its provisions, the memo permits IRS agents and examiners—even those lacking BV accreditation or appraisal experience—to issue a penalty citation without consulting the appraiser or Field Specialist Engineer:
If the claimed value of the property on the return or claim for refund, which is based on an appraisal, results in a substantial valuation misstatement, substantial estate or gift tax valuation understatement, or gross valuation misstatement with respect to such property, the examiner should open an IRC section 6695A penalty case to determine if sanctions against the appraiser are warranted.
“I’m very troubled by this,” said Howard Lewis, former IRS Engineering Program Manager and ASA panelist. An appraiser would only become aware of the pending assessment after receiving a “Penalty Appointment Information Letter” (“4477 Letter”). “It’s a dangerous situation,” he added, that may lack due process safeguards (an attendee in the session noted that, whether or not a penalty is assessed, an appraiser who receives a notice will never have a clean record again when asked “have you ever been cited by the IRS”). Penalties do not apply if it is "more likely than not" that the appraisal value is correct—but even the IRS admits that “the statute does not define ‘more likely than not’” and “forthcoming regulations will provide further guidance on this standard.”
The ASA has requested an emergency meeting with the IRS to discuss the ramifications of the memo, said Fishman, also a member of the IRS Standing Advisory Council. “But that doesn’t guarantee they’ll listen.” Until further developments, Lewis encouraged all BV appraisers to read the memo. And should they ever receive a 4477 Letter, “do not go alone.”
Another big taxpayer victory: Federal court accepts appraiser’s 35% combined discounts for 94% family
The Murphy Oil Corp. grew from a small, family owned business into a multinational conglomerate, with over $2 billion in market cap. During the 1990s, the CEO and son of the founder set out to preserve his holdings and his investment philosophy for the benefit of his children. He formed a family limited partnership (FLP with an LLC as general partner, in which he retained a 49% interest and two of his kids took a 51% interest, leaving them in charge. When all was formed and funded, the father owned a 96.75% LP interest in the FLP. He also retained $1.3M in assets, sufficient to pay his living expenses and estate taxes after death.
Five years later, the father died unexpectedly. After his estate paid over $46M in taxes, the IRS cited an additional $34M in deficiencies, including those related to the FLP transfers. Not surprisingly, the estate lacked sufficient liquidity to pay the assessment, because its only remaining assets were tied up in the FLP’s non-controlling, non-marketable interests. It borrowed from the children’s trusts and sued the IRS for a refund. At trial, both parties’ experts asserted minority and marketability discounts, plus Rule 144 discounts for large blocks of stock.
Held: In each determination, the federal district court (W.D. Ark) found the taxpayer’s appraiser (Donald Barker, HFBE) more credible than the IRS’s expert, and adopted his 32.5% combined discounts versus the government’s 10%. (Notably, the IRS’s “option collar approach” to valuing the Rule 144 blocks failed just as it did in Litman v. U.S.; see BVWire™ #60-1). The 50-page decision in Murphy v. U.S., issued October 9, 2009, makes fascinating reading: As with every other major FLP case, an abstract of Murphy will appear in Business Valuation Update™ and the full-text court opinion at BVLaw™.
Implied minority discount lacks theoretical, financial basis
In a poll of ASA BV Conference attendees, at least half raised their hands when speaker and Lawrence Hamermesh (Univ. of Penn.) asked if they used an implied minority discount when adjusting data from comparable public companies to value a non-marketable, minority share in a private entity. When asked how many would continue to do so after his presentation with Gil Matthews (Sutter Securities)—only a couple of stalwarts kept their hands in the air.
“We’re all working toward a convergence of thought and shared conceptualization on fair value appraisals,” said Matthews. “Part of our job is to overcome a failure in terms,” Hamermesh agreed. He attributed the courts’ continued application of the IMD to “a gap in communication between folks who make the legal standards regarding fair value and folks like you who actually do it.” His solution? In his current article, he and co-author Michael Wachter argue that:
Where a [controlling shareholder] fails to present a valid discounted cash flow analysis and relies instead on a comparable company analysis that is based solely on historical data, the minority shareholders and the court are deprived of access to projections of future free cash flows of the firm. We therefore advocate that the courts adopt a penalty default in the form of a presumption that fair value includes the value of control as reflected in comparable company acquisitions.
To access “Rationalizing Appraisal Standards in Compulsory Buy-outs,” click here.
Nearly half of BV marketers are ‘flying by their seats’
Although nearly one-half (41%) of respondents to last week’s online survey said that they are focus on business development during the downturn, just about the same number (42.9%) admitted that they are working “from the seat of their pants.” The vast majority (71.4%) are encouraging their professionals to publish, present, and participate in BV professional activities and also to review current referral lists for reconnection potential (64.3%). Nearly half (42%) are taking clients out and updating their print/web materials. Only a few (14%) are launching (or re-launching) a client newsletter or similar electronic or mail campaign.
“On the whole, I would say the results reflect the ‘feast or famine’ nature of business valuation,” comments John Borrowman (Borrowman Baker LLP), who helped create the survey. “When you’re busy, you’re usually too busy to market. When the phone stops ringing there’s a tendency to get like the proverbial ‘deer-in-the-headlights.’”
Borrowman says. “When times get good again (and they will!), finding time for public presentations may become a lower priority, while on-going marketing efforts like a newsletter or e-alert will continue to reach a larger audience on a regular basis.” And, some of these marketing tasks can be delegated even when your practice becomes too busy.
As one respondent said, “You have to treat marketing like a client. Some one at your firm must keep paying attention to it. Not just in bad times but all of the time.” Given the candid comments and discussion, the survey is still open: To participate, click here.
Good questions to ask when using restricted stock studies
Of all the “small bombs” dropped at DLOM Summit II (the 2nd Annual Business Valuation and Tax Conference, held at the University of San Diego Law School on October 9th), one that drew the most comments related to the observation that marketability discounts don’t always correlate to size (revenues), earnings, or other performance measures (see last week’s BVWire™).
Why might that be? “For the most part, the buyers in the restricted stock studies have been institutional investors, who had the opportunity to purchase public shares in the marketplace but chose to acquire restricted shares of the same public companies,” comments
Z. Christopher Mercer (who did not attend the Summit). The institutional investors required compensation for the risks related to the restrictions, including:
- Having to hold the shares during the applicable Rule 144 period;
- Being subject to “dribble-out” provisions after Rule 144 requirements elapsed;
- Earning no or few dividends during the period of illiquidity; and
- Not knowing how long it would take to achieve liquidity.
“With all these uncertainties being baked into the pricing recipe, it’s not surprising that there may be little correlation to revenue or earnings,” Mercer says. Not to mention that the benchmarking studies and others are aged. “One has to question what relevance guideline company pricing [in 1997, e.g.], regardless of how comparable, would have to transactions occurring in 2009?”
Bottom line. “Real life investors make decisions based on the expected risks of the investment, expected cash flows (including interim distributions and ultimate liquidity), and expected holding periods (or a possible range),” Mercer says. Thus analysts may want to assess how actual investors reach their pricing (i.e., discount) decisions. For example, what expected returns were available from publicly traded shares? What incremental return did investors require in restricted shares? What expected return? “That’s a lot of questions,” Mercer admits, but like all the good discussion that came out of DLOM II, they may lead to more support for defensible discounts.
Are you prepared to provide distressed business values in today’s economy?
Until credit markets thaw and current financial conditions improve, the challenge for business appraisers is to assess the options for distressed and impaired entities, says bankruptcy expert Jim Alerding CPA/ABV, ASA, CVA (Clifton Gunderson LLP), with particular attention to capital procurement, management forecasts, industry of operation—and the all-important premise of value: liquidation or going concern?
How to deal with these specialized issues? Join Alerding along with James Ewart (Dixon Hughes PLLC) and investment banker Robert Shortle (Periculum Capital Co.) for “Companies in Distress: Valuing the Impaired and Currently Unprofitable,” BVR’s next teleconference on Thursday, November 5, 2009. The experts will discuss the classic methods of appraising troubled entities as well as the current challenges of providing fair market value in bankruptcy and work-out contexts. Attendees will earn 2 CPE credits; to learn more or to register, click here.
New study shows business litigation about to swell
The latest results from Fulbright & Jaworski LLP's sixth annual Litigation Trends Survey have arrived—and 42% of corporate counsel polled say they expect litigation to swell in the coming year. This represents a significant leap over last year’s survey, when only a third (34%) of in-house attorneys predicted an increase. Moreover, the majority of U.S. respondents (83%) reported that they’ve already fielded new litigation during the past year, up from 79% last year.
The main dispute-driver is the economic downturn, of course, which has spawned big increases in bankruptcy, contract, and labor disputes. Only the healthcare industry appears relatively unscathed, with only 6% of healthcare respondents reporting a rise in bankruptcy and reorganization litigation. Corporate budgets will track the areas of concern: 18% of respondents plan to increase funds for labor/employment litigation; 15% will spend more on bankruptcy; and 14% will lay out more for contract disputes. Meanwhile, 11% will spend more for regulatory and investigations work, and 16% will spend on e-discovery. For the complete survey, click here.
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