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Yo Your Presen esenters

Sheri Fiske Schultz

CPA/ABV/CFF

Katie Gilden

CPA/ABV/CFF, CFE, CVA

About About Fisk Fiske & Com Compan any

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• Business Valuation
• Forensic Accounting
• Litigation Support
• Tax & Accounting
• Consulting Services

Fiske & Company is an independent member of the BDO Alliance USA, a nationwide association of independently owned local and regional accounting, consulting and service firms with similar client service goals. The BDO Alliance USA presents an opportunity for firms to expand services to clients without jeopardizing our existing relationships or our autonomy by accessing the resources of BDO USA, LLP and other Alliance members.

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• Why Get an Estate/Gift Tax Valuation?
• Terms of Engagement
• Defining FMV
• Documentation
• Valuation Methodology
• Determining Discounts
• IRS Considerations
• Court Case Examples and Case Study
• Questions and Wrap‐up

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Why Get an Estate/Gift Tax Valuation

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• Investment Holding Companies (FLP, LLC, etc.)
• Real Estate
• Securities
• Art
• Fractional Interest Discount
• Establish Basis

Terms of Engagement

Why should a potential client hire you? There is no requirement that a taxpayer engage the services of a professional appraiser ‐ BUT – IRC Sec. 6662 imposes penalties for undervaluation of estate and gift assets

• Penalties computed as a percentage of tax

underpayment

• Penalties may not apply if the value reported

was made in good faith and had a reasonable basis

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Terms of Engagement

Hiring a valuation analyst can help establish a “reasonable basis”

• Note: Estate that relied upon an unsigned draft

appraisal, performed by a practitioner who had valuation experience and had previously testified several times, but had no valuation/appraisal credentials was considered not to have been a “reasonable basis” and was still assessed penalty (see Estate of Richmond)

• Beware – IRS Sec. 6701 imposes penalties on

valuation analysts for “aiding and abetting an understatement of tax liability”

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Tax Rate & Exemptions

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Item Current Law Annual gift exclusion 15K per person Exemption Amount (2020) $11,580,000 per person Basis of Assets Gift = Carryover Basis Inheritance = FMV on Date of Death or Alternate Valuation Date Tax Rates – Gift Tax 40% Effective Dates On or after 1/1/2018 & on or before 12/31/2025

Defining Fair Market Value

Fair Market Value (FMV) is used for:

• Gift Tax Purposes ‐

Treasury Regulation 25.2512‐1

• Estate Tax Purposes –

Treasury Regulation 20.2031‐1(b)

• Revenue Ruling 59‐60
• FMV defined as:

“The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge of relevant facts”.

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“The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge of relevant facts”.

Documents

What do you need from the client?

• Partnership Agreement/Operating Agreement
• Copy of Certificate of Limited Partnership filed with state or

Private Organization

• Valuations of real estate or other assets held by the FLP as of

the valuation date (if the FLP owns interests in other closely held businesses, these must be separately valued before the value of the FLP interest can be determined)

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Documents

What else do you need from the client?

• Financial statements and/or tax returns for the FLP

(Generally 3 to 5 years – or since inception if more recently formed).

• Copies of bank account, brokerage account and

mortgage statements as of the valuation date and closest month end.

• List of owners as of date of formation and as of

Valuation Date. Details respecting any ownership changes in the last five years.

• Minutes of meetings of partners.
• History of distributions made to partners, if any.
• A balance sheet as of the valuation date.

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Factors to Consider

Factors to Consider in the Partnership Agreement:

• Term provision (i.e., how long will the FLP

exist?)

• No guarantee of return of capital

contributions or distributions

• Capital call provision
• Limitation on transferability (voluntary or

involuntary) of GP and LP interests and/or limitation on rights of GP/LPs to withdraw from partnership

• Right of first refusal
• Approval rights of LPs for major decisions –

exclusion of LPs from participating in management otherwise

• Method for electing new managing GP
• Provision distancing the LPs from the assets of

the FLP

• Whether GP is required to make an IRC

Section 754 Election

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Va Valuation Methodol thodology

• gy
• Asset Approach
• Income Approach
• Market Approach

Asset Approach (Net Asset Value)

• Determination of the FMV of all assets
• wned by the FLP (less value of the FLP’s

liabilities) to arrive at net asset value (NAV) and then application of appropriate discounts for lack of control (DLOC) and marketability (DLOM)

• Normally used where the FLP holds passive

type assets like real estate, publicly traded securities, etc.

• What’s wrong with the NAV method?
• Ignores income-generating ability
• Doesn’t quantify future benefits
• Often relies on overall averages from

studies for discounts

• May be inappropriate for non-

controlling interests (A minority owner cannot force the sale of the underlying assets, and although you would apply a DLOC to account for this, does the DLOC truly account for the inability to obtain the value of the underlying assets?)

Income Approach

Income Approach (Net income/cash flow generated by the assets of the FLP)

• May consider current earnings and

cash flow of the FLP as well as projected future earnings and cash flow over a period of time and application of appropriate discount (DLOM) (No DLOC is necessary since CF capitalized or discounted is the amount available to the minority

• wner, and result is already a

minority value)

• Normally used where the FLP activity is

an active, operating business

• Discount rate developed based upon

risk attributes of assets owned in the FLP and the required return on assets relative to comparable investments

Issues with Income Approach

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Often, investment earnings or rental income may be low, but growth in asset values is high

• Unless there is a plan to sell the assets at a certain point in future, the

return to a minority owner is a low level of income that does not truly reflect the value of the assets

Selection of discount/capitalization rate Be careful with number of years you are discounting/capitalizing

• Many practitioners look to capitalize dividends, assuming an infinite life
• Although many FLPs have 20‐30 year terms, many FLPs owning only real

estate do not make it that long

• Perhaps use a 5‐year scenario and a 10‐year scenario

Tax Affecting

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ZERO TAX RATE BLENDED FULL CORPORATE C TAX RATE

Market Approach

• Compares attributes of FLP to

partnerships with similar attributes – determine appropriate valuation multiple (e.g., price to NAV), adjusted for risks specific to subject company, and apply appropriate discount (DLOM

• nly)

(Data is based on trades of minority interest. Therefore the result is a minority value)

Determining Discounts

Discount – Lack of Control Factors that may influence the discount (where applicable):

• Types of assets held in the FLP
• Professional management

(marketable securities)

• Diversification and size
• Investment objective
• Performance
• Maturity of bonds
• Amount of FLP’s debt (if any)
• History of distributions (affects

DLOM also)

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Sources for DLOC

• Closed‐end Funds
• Partnership Profile Data

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Determining Discounts

A Closer Look at the Databases

Closed End Funds A closed‐end fund is a publicly traded investment company that invests in a variety of securities, like stocks and bonds. The fund raises capital primarily through an initial public offering (IPO). CEF shares and the proceeds are invested according to the fund's investment objectives. "Closed" refers to the fact that, once the capital is raised, there are typically no more shares available from the fund sponsor and the issuance of new shares is closed to investors.

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Determining Discounts

Closed End Funds Table

Determining Discounts

A Closer Look at the Databases Partnership Profiles Data

• Data available at www.partnershipprofiles.com and PPI Annual

Executive Summary Report

• Partnership Profiles keeps track of resale transactions involving non‐

controlling interests in non‐traded publicly held limited partnerships and REITS

• Price‐to‐NAV discounts ranged from around 18% to 56%
• Discount depends most on type of assets owned by partnership, on

degree of cash distributions, and on amount of debt financing utilized by the partnership

• According to PPI, most of this discount is due to lack of

control

• 10% discount is due to lack of marketability

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Determining Discounts

Limited Partnership Discounts (PPI Annual Studies):

Determining Discounts

Discounts – Lack of Marketability

• May apply regardless of

whether or not the LP interest transferred is a minority interest

• Premise is that transfer

restrictions attributable to the LP interest make it less attractive than comparative publicly‐traded assets

• Determined by comparable

sales of stock of publicly traded companies (similar to other valuation engagements)

• Restricted Stock

Studies

• IPO / Private

Placement Studies

• Previous Court Cases

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Determining Discounts

Discounts – Lack of Marketability

• Partnership Profiles studies indicate

investors require 30% to 45% increase in rate of return for a nonmarketable interest versus a marketable interest

• Average Incremental Returns in

three studies:

• Private Equity vs. Public

Equity Returns – 45.2%

• Restricted Stock

Transactions – 29.5%

• LT vs. ST Bond Horizon Risk

– 34.3%

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Determining Discounts

Discounts – Lack of Marketability Factors that may influence the discount:

• Volatility in value of

underlying assets

• Future yield and growth

expectations

• Earnings and distributions

history (note: i.e., a willing buyer might be more inclined to ignore transfer restrictions in exchange for a stream of cash)

• Capital call requirements

Determining Discounts

Discounts – Lack of Marketability Factors that may influence the discount:

• Restriction provisions in partnership

agreement

• Transfer restrictions indicating a partner

may not transfer an interest without prior written consent of other partners

• Transfer restrictions indicating

transferee will only have rights of an assignee unless other partners consent

• Withdrawal restrictions not allowing

partners to withdraw before FLP’s dissolution/liquidation and/or not allowing partners to reduce capital account without consent

• Section 754 election

(note: partnership can adjust its books to show that a new partner paid a higher price for assets that are worth more at the time of purchase/transfer – does not affect existing partners, but has a positive tax effect on new partner)

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Determining Discounts

Tiered Valuations

• Frequently FLP’s hold interests in other closely

held businesses, which can be limited partnerships, limited liability companies or C corporations

• The underlying entity must be valued first
• Must determine whether or not to apply two

layers of DLOC and DLOM

• Tax court decisions are split based upon the

nature and size of the interest

• Two layers of discounts were allowed where the

subject interest being valued was a minority interest in an entity which held a minority interest in another entity (Estate of Piper, Janda, Gow, Gallun).

• Two layers of discounts were not allowed where

the lower level interest constituted a significant portion of the parent entity’s assets or where the lower level interest was the parent entity’s “principal operating subsidiary” (Martin, Estate

• f O’Connell).

IRS Code Considerations

• The value of the gross estate shall include the value of

all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—

• the possession or enjoyment of, or the right

to the income from, the property, or

• the right, either alone or in conjunction

with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

• If the formation and operational matters of the FLP

are not followed, then there may be dispute over whether or not a bona fide sale has occurred.

Internal Revenue Code Section 2036(a)

IRS Code Considerations

Internal Revenue Code Section 2036(a)

Factors the IRS may look at are:

• Personal assets contributed to the FLP
• Contribution of substantially all of the decedent’s assets to the FLP
• Creation of the FLP utilizing a POA of decedent or just prior to date of death
• Minimal contributions by other partners
• Commingling of decedent’s personal assets with FLP assets
• Decedent’s personal expenses or gifts paid out of FLP bank accounts
• Limited documentation regarding non‐tax business purpose of the FLP
• Decedent’s estate receiving a distribution from FLP or borrowing from FLP to pay estate

taxes

• Not following outlined purposes for forming FLP (i.e., if you say you are forming the FLP

to diversify assets or obtain outside 3rd party managers but continue the same investment structure and management that was there prior to formation of the FLP)

Navigating Chapter 14

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• Outlines valuation rules for valuing interests in closely held companies and partnerships
• Generally provides that when valuing interests that are transferred between family

members, restrictions that would not exist if the transfer was between unrelated third parties should be ignored

• If Chapter 14 provisions are not adhered to, the IRS may determine that the

partnership does not exist for tax purposes and then the IRS would value the underlying assets in calculating the applicable gift/estate tax.

Case Examples

Estate of Richmond (Feb. 2014) Facts:

• Assets in PHC consist primarily of publicly traded

stock; both sides agree to NAV of $52.1M

• Built‐in capital gains tax of approximately $18M

(agreed to by both sides) Methods:

• Estate expert:
• Used capitalization of dividends method (draft

report, not finalized shows value of $3.1M – used on 706)

• Testifying expert used 6% DLOC and 36% DLOM

(includes adjustment for BICG tax) – value adjusted to $5M

• IRS expert:
• Used NAV method (value of $9.2M determined

by IRS auditor – IRS expert testified value was $7.33M)

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Case Examples

Estate of Richmond (Feb. 2014) Court Ruling:

• BICG
• Says that a potential tax liability, which can be

postponed indefinitely, is not the same as a debt that immediately reduces the value dollar for dollar

• Most reasonable discount is the PV of the cost of

paying off that liability in the future (using 20‐30 year holding period)

• Accounts for BICG tax by reducing NAV by $7.8M

(15% of NAV)

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Case Examples

Estate of Richmond (Feb. 2014) Court Ruling:

• Agrees with IRS criticism of estate’s expert because

expected rate of return from Ibbotson of 10.25% (1926‐2004) was from different time period than dividend growth rate (1970‐2004)

• Court corrects rate of return using PHC’s historic data
• nly (9.414%), and shows that just by changing the

rate slightly, the PV of future dividends increases by about $1M – court says this makes the methodology less reliable

• Court also notes that the value arrived using its

corrected rate of return is much closer to the value using the NAV method

• Allowed 7.75% DLOC and 32.1% DLOM

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Case Examples

Estate of Stone / Estate of Kelly (Feb 2012 / Mar 2012) Stone Facts:

• Only asset was forestland that required no

management

• Land sat idle for years between set up of FLP

and decedent’s death

• Parents paid property taxes on land out of

their own pockets Kelly Facts:

• Decedent was incompetent at formation of FLP
• Mother’s estate plan called for unequal

distributions among kids

• Four children used FLP to equalize bequests ‐

valid nontax motive per Court

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Case Examples

Estate of Stone / Estate of Kelly (Feb 2012 / Mar 2012)

Court Ruling:

• Tax Court judges found that setup of each

FLP was a “bona fide sale”

• Not subject to Section 2036(a)
• DLOC and DLOMs allowed

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Case Examples

Estate of Turner II (Mar 2012)

• FLP fails Section 2036(a):
• Nothing in the FLP that required

management

• Decedent’s relationship with assets

didn’t change

• Children were not involved in setting up

the entity

• Inconsistent with Stone, which also had bad

facts

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Case Case Study Study

Facts:

• Lebron / Wade

Properties, Ltd.

• Net Asset Value =

$200,000

• Discount using

REIT data = 13%

• Discount using

RELP data = 17%

• Partnership

Profiles takes an average – uses 15% discount rate.

• Long‐term growth

rate = 2%

• Value is a 1%

interest

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Scenario #1

Scenario #1 – Income Approach (Assumes Property Held into Perpetuity)

• Note: for simplification

we are ignoring mid‐ year discounting in example

• NPV = $150,252
• Since NAV is $200,000,

this represents a DLOC

• f $49,748, or 24.9%

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Case Study

Scenario #2

Income Approach (Assumes Property sold and FLP liquidated Year 5)

• NPV = $175,493
• Since NAV is $200,000,

this represents a DLOC

• f $24,507, or 12.3%

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Case Study

Scenario #3

Scenario #3 – Income Approach (Assumes Property sold at FLP liquidated Year 10)

• NPV = $181,473
• Since NAV is $200,000,

this represents a DLOC

• f $18,527, or 9.3%

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Case Study

Summary

Income Approach Summary Assuming each scenario has an equal chance of taking place, the average DLOC would be 15.5% (average of 24.9%, 12.3% and 9.3%)

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Case Study

Katie Gilden

CPA/ABV/CFF, CFE, CVA T 954 236 8600 Ext. 107 E katie@fiskeco.com

Sheri Fiske Schultz

CPA/ABV/CFF T 954 236 8600 Ext. 124 E sheri@fiskeco.com

Fiske & Company – Certified Public Accountants & Consultants 1000 S. Pine Island Road | Suite 440 Plantation, Florida 33324

FORT LAUDERDALE | KENDALL | MIAMI | BOCA RATON

www.fiskeco.com

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