Many taxpayers believe that their reporting obligations are complete once they file a return involving the transfer of a business interest. Some attach a valuation prepared for another purpose, and others omit the valuation entirely. However, if the IRS determines the disclosure is inadequate, the statute of limitations does not begin. The return can remain open indefinitely, and if the reported value is later challenged, interest and penalties may apply from the original date of the transfer.
In one published IRS memo, the agency concluded that a taxpayer’s disclosure was insufficient because the valuation addressed the wrong asset and lacked key identifying details. As a result, the return remained open to audit with no deadline.
The Role of Valuation in Tax Compliance
As this memo demonstrates, valuation is critical to ensure compliance with U.S. tax laws when transferring ownership of a privately held business. However, a private company’s value is often difficult to measure. Transactions are infrequent; most owners will only sell their business once, and not likely in the near future. This causes a dilemma for those seeking estate planning or charitable contributions with privately held business interests. In the absence of actual transactions, how is an owner to know what their stock is worth?
The answer is that for tax purposes, a private company’s value is determined by what federal regulations and IRS guidance call a “qualified appraisal”, which is a formal way of saying a business valuation done by a professional that meets specific legal standards. The precise definition of a qualified appraisal is found in Title 26 of the Code of Federal Regulations and IRS Publication 561 .
Relying on a valuation prepared for another purpose is not enough, and not every appraisal will qualify. In Hoensheid v. Commissioner, the taxpayer donated closely held stock and attached a valuation prepared by an investment banker. The court found that the appraisal did not meet the qualified appraisal requirements, disallowed the deduction, and imposed additional tax.
In practice, we see many clients unsure if they need a qualified appraisal for their situation, or if they can rely on a prior valuation prepared for a different purpose. To clarify, we prepared this guide to explain the most common conditions that require a qualified appraisal and to help remove any confusion about whether you need one.
“Adequate Disclosure” for Gift Taxes, Estate Taxes, and Charitable Contributions
Some of the most common reasons for a qualified appraisal are gift taxes, estate taxes, and charitable donations. When a business interest is transferred, it may be a taxable event (you transfer shares to your children or their trusts) or a tax-reducing event (you donate shares). The IRS requires “adequate disclosure” of the transferred business interest in both cases. Adequate disclosure requires that the donated interest be clearly reported on the relevant tax return to start the statute of limitations for IRS review, which is typically three years. Without adequate disclosure, the IRS can audit the transfer indefinitely, potentially leading to future tax liabilities more than three years in the future. Notably, interest and penalties accruing from the transfer date may be applicable in addition to the taxes owed.
In the cases that led to the IRS memorandum and Tax Court ruling mentioned above, the taxpayers could have avoided substantial interest, penalties, legal expenses, and the considerable burden of extended negotiations or litigation simply by obtaining a qualified appraisal at the outset.
Why a 409A Valuation Is Not Good Enough
A 409A valuation is an appraisal of the fair market value of a private company’s common stock, used to set stock options’ strike prices for compliance with Internal Revenue Code Section 409A. Importantly, the purpose of a 409A valuation is for income taxes on employee compensation (stock options), and not for taxes on the transfer of shares by a shareholder. A 409A valuation’s conclusion is always of the fair market value of the common stock; it does not conclude on the value of other share classes, which are often the subject of the transfer at issue. For these reasons and others, a 409A valuation will not meet the IRS adequate disclosure requirements for gift taxes, estate taxes, and charitable contributions.
In practice, 409A valuations tend to be highly automated, template-driven products that are not intended to stand up to scrutiny. In contrast, qualified appraisals meeting adequate disclosure requirements are thoroughly developed considering facts and circumstances unique to the asset being transferred. They are intended to be supportable in the face of IRS review. While it’s possible to get away with using a 409A valuation instead of a qualified appraisal, when such returns are audited, the consequences can be higher taxes, penalties, and headaches for the taxpayer .
Don’t Discount the Value of a Good Discount
A qualified appraisal is often viewed as a compliance requirement but can also be a powerful estate planning tool. Involving valuation professionals early allows business owners and advisors to identify opportunities for estate tax optimization before transactions occur. Strategic use of discounts, ownership structure, and share classes can materially affect the outcome of a gift or estate plan. When valuation is treated as part of the planning process rather than a final step, it can support both defensibility and tax efficiency.
For gift and estate tax purposes in particular, the real value of a qualified appraisal to the taxpayer lies in the discounts for lack of control and lack of marketability. The IRS understands that these discounts are appropriate because a non-controlling interest in a business has a limited ability to affect key decisions, and because privately held business interests are inherently illiquid assets. For those reasons, the fair market value of privately held business interests can be discounted by as much as 20%-30% or more for gift and estate tax purposes. However, the catch is that such discounts must be supported by real-world facts and circumstances specific to the asset being transferred. Slapping a 25% discount on the value of your shares unquestioningly and filing a gift tax return based on that number can be a great way to create more taxes and penalties for yourself in the future. In contrast, a qualified appraiser can reach a value conclusion incorporating supportable discounts to withstand IRS scrutiny. The result should be tax savings realized without compromising peace of mind.
Key Takeaways
When transferring interests in a privately held business, relying on a qualified appraisal is not just best practice; it’s essential for protecting your financial interests and ensuring IRS compliance. A well-supported valuation with appropriate discounts for lack of control and marketability can reduce your tax burden while standing up to scrutiny. Using shortcuts like 409A valuations may seem convenient but can lead to costly consequences. At Withum, we specialize in preparing defensible, IRS-compliant appraisals tailored to your situation. Contact us to ensure that your business interests are valued accurately.
Author: Morgan Sansbury, CVA | [email protected]
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For more information on this topic, please contact a member of Withum’s Forensic and Valuation Services Team.
