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Appraising Actions That Speak Louder Than Words

It’s a question that should be considered more often than it is. How do buy/sell agreements, buyouts of departing employees’ stock, appraisals, divorce settlements, initial public offerings and other events in the capital structure “life” of your company affect the share value for estate and gift planning purposes? And, vice versa. The tax law states that “fair market value” (of which the IRS gets up to 55% in a gift or estate setting) is the price that a willing buyer would pay a willing seller, both having reasonable knowledge of relevant facts, and neither being under compulsion to buy or to sell. Despite this scholarly perspective, the real world definition is the price that is agreed to by an unwilling IRS agent and taxpayer representative, neither having first-hand knowledge of the facts, neither having ever bought or sold anything of substantial value, and both being under compulsion to settle the case! With this backdrop, both sides look for facts to use against their adversary. The taxpayer often fires the first salvo by obtaining an appraisal with glossy pictures and a startlingly low value. But, the IRS isn’t stupid. The agent responds with a counter appraisal at an incredibly high value. Two can play that game, but the game can turn ugly. One of the first questions that an IRS agent asks when examining a gift or estate tax return is, “Were there any stock transactions, appraisals or other stock-related events within a couple of years on either side of the date of gift (or death)?” The agent knows that transactions that have no gift or estate tax motivation ca better reflect actual value than an appraisal that has been crafted with the transfer tax in mind. Your customer-friendly IRS agent will assume that a high-price event is proof-positive of gift/estate tax value. Of course, you will have the burden of proving that low-price events should be anything more than a historical footnote in the tax deficiency assessment. The fact is that unrelated transactions can be relevant to determining gift/estate tax value and they can cut both ways. They can be used against you, help you or lull you into a false sense of security. Suppose you routinely sell stock to key managers at book value. You buy the stock back at book value when they quit or retire. As a result, you conclude that book value is the magic number for gift/estate tax purposes. However, the facts surrounding these transactions must be considered. For example, a book value sale price might not be evidence fair market value if it there is a buy/sell agreement that allows the company to repurchase employees’ stock at book value. Book value might be the value to the employees, but not the value of shares given to family members who are not subject to the same buy/sell agreement. A sale of stock to an employee also might understate the actual value if the cheap price is a disguised way to reward the employee for services, meaning there is a compensation element to the sale. Speaking of considering all of the facts, one clever advisor counseled a client to sell a few shares of stock at a cheap price to an unrelated individual and then give a large number of shares to his children. He valued the gifts at the same low price and argued that the IRS must respect that price for purposes of calculating the gift tax. The agent interviewed the unrelated person, who stated that he bought the shares as an accommodation for his friend and was willing to sell them back at the same price at any time. IRS one, taxpayer nothing, advisor one to three years. Consultants often recommend that family shareholders be allowed to sell their stock to the company or other family members on relatively generous terms to avoid conflict and preserve family relationships. These generous terms may be built into buy/sell agreements or may simply be determined on a case-by-case basis. However, one important consequence is that the IRS will use these agreements or actual transactions as evidence when you are trying to assert a lower value for estate or gift tax purposes. One fourth-generation family I know is struggling with this issue. They want to buyout a family line at a price that will be negotiated on a friendly basis, probably at a rather high price. However, some of the remaining shareholders are approaching 80 years old. The buyout likely will be used against the 80-year olds’ estates. Another family faced this issue, but with a buyout that was on unfriendly terms. The price was high because the company felt compelled to buyout dissident family members who were disrupting business operations. We may succeed in disregarding this buyout for transfer tax purposes because fair market value is determined based upon an assumption that neither party is under compulsion to buy or sell. I once saw a divorce settlement that awarded the family business stock to one spouse (a son) and an “equal” value of cash and marketable securities to the daughter-in- law. Within about three months of the divorce, the father died. The IRS agent asserted that the divorce settlement was a clear indication of the value of the father’s stock for estate tax purposes even though the estate tax appraisal came in at a much lower value. The resulting struggle could have been avoided if the divorce attorney had simply written the settlement agreement without the statement that the property division was based upon value. Focusing upon fact changes between the time of gift and the unrelated transaction also can help to fend off a zealous agent. I often counsel clients prior to an initial public offering of their company’s stock. A gift occurring a reasonable time period before a public offering justifies a lower-than-IPO value because pre-IPO stock lacks marketability. Similarly, estate tax value may be lower than pre-death transaction values because a leader’s death often warrants a “key-man” discount. On the other hand, one business owner commissioned an appraisal to determine the possible sale value of his company. The appraisal was inflated because the investment banker who performed it was trying to excite the owner about how much dough he could get in a sale. The owner decided against the sale and then proceeded to make stock gifts to his kids. The gifts were valued based upon a second appraisal that came in at a much lower price. The IRS agent got her hands on the first appraisal and used it to beat the owner over the head in a gift tax assessment. The point is that you should at least be aware of and consider the gift and estate tax implications of various equity-related actions and events that might indicate stock value. Think about what the IRS might say if it becomes aware of the action or event. You might be able to mitigate the IRS’ use of that information, or at least take steps to muddy up the water.




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