Estate Tax Valuations and Appraisal Update

30Th Annual Inland Empire Estate Planning Seminar

John GlennPresident

The Mentor Group, Inc.Direct - 760-325-6411

Brad M. Cashion, CFAManaging Director

The Mentor Group, Inc.Direct - 760-898-3334

November 4, 2009

Agenda

• IRS Statistics• 4 main estate tax reform bills• Valuation in the Distressed Economy• Types of Discounts• IRS Issues – Common errors the service sees in

valuation reports

• Valuation for Charitable Gifts• Valuation of Life Insurance Policies

IRS Statistics

In year 2008, the IRS spent an average of 41¢ to collect $100 of tax revenue

2007 40¢

2006 42¢

2005 46¢

IRS Statistics – Estate Tax(in thousands)

Year Total Estate Examined % Returns Returns % NotTax Returns Returns Examined Not Agreed

Agreed

2008 46,251 NA NA NA NA

2007 47,298 3,852 8.1% 217 5.6%

2008 54,851 5,299 9.7% 301 5.7%

2009 71,172 6,081 8.2% 351 5.8%

Source: IRS Data Book

IRS Statistics – Gift Tax(in thousands)

Year Total Gift Examined % Returns Returns % NotTax Returns Returns Examined Not Agreed

Agreed

2008 252,286 NA NA NA NA

2007 255,123 1,071 .04% 143 13.4%

2008 265,455 2,051 .77% 410 20%

2009 262,164 2,125 .81% 510 24%

Source: IRS Data Book

IRS Statistics – California Tax

(in thousands) 2008 2008

Estate Tax Gift Tax

Filed Returns 8,528 24,784% of US Total Returns 18.5% 9.8%

Gross Collections $5,339,566 $461,170% of US Collections 20.1% 14.1%

Source: IRS Data Book

4 Main Federal Estate Tax Reform Bills

1. The Pomeroy Bill (H.R. 436) - $3.5m exemption, max. rate = 45%, with a 5% surtax over $10m. Eliminate discounts for entities holding non-business assets

2. The Mitchell Bill (H.R. 498) – 15% Cap. Gains < $25m, 30% Cap. Gains > $25m, gradually increasing tax exemption up to $5m, then indexed to inflation

3. The Baucus Bill (S. 722) – Permanent AMT relief indexed for inflation, 15% cap. gains tax, shifting individual tax rates with max. individual tax rate at 35%, marriage penalty relief permanent

4. The McDermott Bill (H.R. 2023) - $2.0m exemption indexed for inflation, graduated estate tax rate based on estate value starting at 45%

The Pomeroy Bill is the only bill to propose restricting valuation discounts

It is doubtful that the estate tax and discounts will disappear in 2010. It is our belief that congress will pass legislation to continue the current estate tax exemption of $3.5m and a 45% rate for 1 more year

Source: Gibbonslaw.com/news

Planning During Economic Turmoil

1. Economic downturns are an ideal time to transfer assets.

2. The increased volatility in the markets has increased discounts

3. Alternative valuation date is most often used

4. Appraisals must be completed using what is known or reasonably should be known at the valuation date

5. Monte Carlo simulation is used in valuations to capture uncertainty in projections

The Economic Downturn has Affected Valuation Inputs

• Equity risk premiums used to compute discount rates have increased

• Revenues have declined faster than expenses• What income statement measure should be used?• Businesses cannot borrow money like they could

so their debt to equity ratios have changed• Marketability and liquidity of businesses have gone

down and it takes longer to sell a business• Discounts for lack of marketability have increased• Valuation multiples have gone down less than

expected

The Current Economic Downturn Requires Us to Revisit What “Fair Market Value” Means…

1. Willing buyer & willing seller2. Neither under any compulsion to buy or sell3. Both buyer & seller are hypothetical4. Both are aware of all facts & circumstances5. The asset is valued in its “highest & best

use” regardless of its current use6. Is valued without regard to events occurring

after the valuation date, unless reasonably foreseeable

Valuation Issues Relating to First vs. Second to Die

First To Die: Taxpayer usually desires high value for new basis

Second To Die: Taxpayer usually desires low value to minimize tax

Discounts should be taken on the first and the second to die

Entity Level Discounts

• Built-In Capital Gains Discounts - There are 3 thoughts on how to deal with Built-In Gains

1. Assume the assets will not be sold and no discount for the tax should be taken

2. Assume the assets will be sold over time and the time value of the tax should be

deducted

3. Assume the assets will be sold as of the date of valuation and take 100% of the tax

due as a discount. (Jelke vs. CIR, No. 05-15549 case)

The 5th and 11th circuits have rejected the idea that the tax will be realized over time stating that 100% of the tax should be taken into account

Entity Level Discounts

• Key Person Discount – Rev. Rul. 59-60, section 4.02 This relates to unique relationships, technology & product capability, leadership skills & financial strength (“Steve Jobs affect”)

• Portfolio – (Non-Homogenous Assets) – Companies that hold disparate or non-homogeneous assets/operations. We see that break up values are often greater.

• Contingent Liabilities – Can be deducted as a percentage of value or as an exact dollar amount

Subject Interest Discounts

• Discount for lack of control• Discount for lack of marketability• Voting vs. Non-voting – Empirical evidence from public

markets have shown a range of 2% to 7%

• Blockage Discount – computes the depressing effect on the market rather than lack of marketability on sale. In Adams vs. Commissioner, the court allowed both a marketability discount and a blockage discount on a restricted block of stock.

Auker vs. Commissioner computed a 6.189% blockage discount for real estate held in a trust

The New World We Work In….Application of Discounts

• Benchmarking – using empirical market data for studies

• Quantitative Methods

• Guideline Transaction Methods

• Discounts must be supported through qualitative and quantitative analysis

• Discounts must be supported by a “sanity check” using an internal rate of return calculation

Discounts for Lack of Control

• Must match source of market data with the type of asset held by the entity

• Closed End Funds – Must use specific CEFs that match type of assets owned

• RELP – good for entities that own real estate

• Income Method – Discounted cash flow and capitalization of earnings

Discounts for Lack of Marketability

• Benchmarking – using market studies and apply the “Mandelbaum factors”

• Quantitative Methods– Put Option Calculation– LEAPs– QMDM– Guideline Transactions – 2 step process

Discount for Lack of Marketability vs. Lack of Liquidity – Degree of Marketability

1. Public Stock LiquidA large block of Public Stock Marketable illiquid

2. Controlling Interest Marketable illiquidin Private Company

3. Minority Interest Non-Marketablein a Private Company

4. Real Estate Marketable illiquid

5. Machinery & Equipment Marketable illiquid

The term non-marketable does not assume that the interest cannot be sold, only that it is usually difficult to do so under normal circumstances

These distinctions are very important in computing the size of the marketability discount

Judge Laro’s Mandelbaum Factors that Affect Marketability Discounts – used in the benchmarking analysis

1. Private vs. Public Sales Comparables

2. Financial Statement Analysis – Financial Strength

3. The Entity’s Dividend or Distribution Policy

4. The Entity’s Position in the Industry and its Economic Outlook

5. Management Strength of the Entity

6. Amount of Control being Transferred

7. Restriction on Transferability

8. Expected Holding Period of the Investment

9. The Entity’s Redemption Policy

10. Costs Associated with Selling the Interest Being Valued

Computation of Discounts for Multi-Level Entities• These are entities that own fractional LP or LLC interests in

other entities.

• Care must be given to not double count the discounts. Discounts can only be taken at each entity level after analysis of the specific facts.

• Facts that drive multi-level discounts

a. Asset Allocation – are the same assets included at each entity level

b. Entity Management – are the managers the same or different at each entity level

c. Governance – does the interest have the same voting and ownership rights at each entity level

Computation of Discounts for Undivided Fractional Interests

• Use of Comparable sales – very few sales are available in most markets.

• Partition Analysis – a DCF model that computes the value of the cash flows at the end of the partition period where it is assumed that the property is sold.

The length of time before the partition is completed must be considered

The net cash flows for each year during the partition must be estimated

A required rate of return (discount rate) must be computed based on the risks and uncertainties of the estimated cash flows and the time of the cash flows

Comments From Honorable David Laro (U.S. Tax Court)

The Top 5 Elements That Every Valuation Report Should Have….

1. Transparency – Can the court replicate what the appraiser has done?

2. Credibility – Is the expert evidence reliable, “peer reviewed,” believable? Judges have become more sophisticated in valuation matters.

3. Intellectual Honesty – The appraiser’s job is to help the court with an unbiased point of view. Not a “hired gun.”

4. Complete – The report is the direct testimony. The appraiser giving testimony must be the one who prepared the report.

5. Credentialed – “The days of uncredentialed BV experts is gone.” Congress and the IRS have “raised the stakes” for appraisers.

Source: NACVA / IBA 2009 Conference

Comments From Mike Gregory… IRS Territory Manager, St. Paul

“Common Errors in Valuation – Bullet Proof Valuations”

1. The math does not add up correctly2. Were the discounts applied properly3. Did the appraiser reconcile and explain what method or why

weights were applied to compute the conclusion4. Is the appraiser acting as an obvious advocate5. Was selective data used without justification – using data after the

valuation date6. Was professional judgment relied upon to the exclusion of the

facts7. Are the guideline companies truly comparable8. Is the future ignored in favor of the past9. Were the income statements properly adjusted – Non-business

expenses, salaries at market10. Was the tax status considered properly – S Corp vs. C Corp11. Was the wrong premise of value used – Liquidation vs. going

concern

Source: AICPA BV Conference

Valuations for Charitable Giving

Reg§1.170A-13(c)(3)(A) Need for a Qualified Appraisal:

1. No earlier than 60 days before contribution and no later than due date of return

2. Content: Description of assetDate of Contribution

Name & Qualifications of AppraiserAppraised ValueMethods to Determine ValueForm 8283 Completed

To reduce the chance of an audit, it is highly recommended to attach the appraisal to the return.

Valuation of Life Insurance Policies

New Calculations to support Fair Market Value

“PERC” Calculation outlined in Rev. Proc. 2005-25 as the safe harbor calculation does not consider fair market value

The Mentor Group Approach – use of scenario analysis assuming varying life expectancies

There are new mortality tables issued as of May 2009

What To Remember From This Presentation

• The Downturn in the economy has the affect of increasing discount rates, increasing DLOM and reducing multiples of private companies less than expected

• There are entity level discounts as compared to subject interest level discounts

• Discounts must be computed using the correct market data and a quantitative method to support the final discount.

• There are several factors that must be evaluated for each entity that affect the size of the discounts.

• Multi-Level entity structures must be analyzed carefully so there is no double counting of discounts.

• There are 3 different viewpoints on how “built-in” capital gains are to be computed, but the trend is towards taking the full discount.

• Once the total discounts have been computed, an “internal rate of return (IRR)” calculation must be computed to support the size of the discounts.

• Valuations for charitable giving are on the top of the IRS list to audit, and a full report to support the value of the gift is needed