Virginia State Bar

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Trusts and Estates

A Section of the Virginia State Bar.

Spring 2015 Newsletter

Newsletter - Trusts and Estates

Volume 22, No. 12

Maximizing the Basis of Difficult-to-Value Assets in Non-Taxable Estates without Getting into Trouble1

By Thomas D. Yates and Alvi Aggarwal

1. The Changing Picture (Purpose & Scope)

The tax picture associated with the administration of a decedent’s estate has changed. In most cases, the focus now is away from minimizing estate taxes and toward obtaining the highest defensible step-up in the tax basis of capital assets owned by the decedent at death.2

Because of the increased federal estate tax exemption (currently $5.43M), which is indexed for inflation3 and the new portability rules (which, if elected, permit aggregation of the decedent’s exemption with that of the decedent’s surviving spouse),4 most estates now escape the imposition of estate tax altogether.

In this new environment, increases in the value of an estate asset may be available at little or no estate tax cost. Because the tax basis of a decedent’s capital asset is equivalent to its estate tax value, and any valuation is not exact but generally accurate within a range of numbers, there is a premium on obtaining a higher-side value which is defensible from an audit point-of-view and protectable from penalties. This premium is enhanced by the current income tax climate where capital gains bear higher income taxes. This article will briefly review certain elementary concepts of basis and valuation, provide an overview of potential penalties, and then address how a fiduciary may obtain the highest defensible value.5

2. Valuation & Basis

An estate’s (or beneficiary’s) basis in property acquired from a decedent is generally the “fair market value of the property at the date of the decedent’s death,” or, at the alternate valuation date, if applicable.6 The fair market value is deemed to be the value as finally determined for federal estate tax purposes or as determined for state death taxes if no federal estate tax return is required.7 If no federal or state estate tax return is required to be filed, fair market value would, of course, not be reported initially, but would still be ascertained using federal estate tax valuation principles.

For estate tax purposes, the fair market value of an asset is “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 reasonable knowledge of relevant facts.”8 This is the “willing buyer/willing seller” test, which is the cornerstone of the valuation process. The Treasury Regulations (the “Regulations”) provide some fairly specific guidance as to certain types of assets, including promissory notes and closely held business interests.9 The valuation of real estate is not addressed in-depth in the relevant Regulations.

The fair market value of an interest in a business “is the net amount which a willing purchaser whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”10 This is just a slight variation on the general test for determining fair market value. Relevant facts may include an appraisal of the business’s assets, the business’s earning capacity, and the additional factors set forth in the Regulations.11 The instructions to Form 706 require that the decedent’s estate include “complete financial and other data used to determine value, including balance sheets (particularly the one nearest to the valuation date) and statements of the net earnings or operating results and dividends paid for each of the 5 years immediately before the valuation date” with the estate tax return. Generally, business valuations may be based on asset values, earnings, or a combination of both.

The fair market value of real estate is determined under the general willing buyer/willing seller test.12 Appraisals typically reflect closed sales of comparable properties and may be inaccurate in an improving market. By way of circular reasoning, the Regulations assert that “[p]roperty shall not be returned at the value at which it is assessed for local tax purposes unless that value represents the fair market value as of the applicable valuation date.”13 Case law provides additional guidance, including “highest and best use” where the real estate is reasonably subject to development.14

3. The Risk of Over enthusiasm: Penalties

The most significant risks in maximizing basis are potential penalties to the taxpayer, return preparer, and appraiser.

3.1 Taxpayer Penalties: IRC § 6662

The Internal Revenue Code of 1986, as amended, (the “Code”) imposes an accuracy-related penalty on taxpayers for the underpayment of tax.15 An underpayment might result from an overstatement of an asset’s basis, from the reporting of improper depreciation deductions, or from an incorrect calculation of gain or loss upon the asset’s sale. The accuracy-related penalty is typically 20% of any underpayment.16 The penalty may be imposed if the underpayment is attributable to one or more of the following acts of misconduct: (i) “[n]egligence or disregard of [the] rules or regulations”; (ii) “substantial understatement of income tax”; or (iii) “substantial valuation misstatement under chapter 1 [of the Code].”17 This penalty does not apply if a taxpayer has “reasonable cause” and acts in “good faith,” or meets the criteria for any additional exceptions.18

3.1.1 Negligence or Disregard

The imposition of penalties for negligence19 or disregard20 require analysis of the taxpayer’s conduct, such as whether the taxpayer made a reasonable attempt to comply with the provisions of the Code and exercised ordinary and reasonable care in the preparation of the tax return.

There is a special exception to the negligence and disregard penalties: if a position contrary to a rule or regulation is adequately disclosed on a return21 and represents a good faith challenge to the validity of the Regulation, the position will not give rise to a negligence or disregard penalty.22

3.1.2 Substantial Understatement

Another activity that can trigger an accuracy-related penalty for an individual taxpayer is the taxpayer’s overstatement of basis in an asset which results in the “substantial understatement” of income tax.23 For individuals, an understatement is not substantial unless it “exceeds the greater of (i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $5,000.”24 The amount of the understatement is the amount of tax that should have been reported reduced by the tax that was shown. The understatement calculation effectively excludes any item for which: (i) the taxpayer had “substantial authority” for its tax treatment; or (ii) “the relevant facts affecting the item’s tax treatment are adequately disclosed in the return or in a statement attached to the return” and the taxpayer had a “reasonable basis for the tax treatment of such item.”25

3.1.3 Misstatement

Finally, a “substantial valuation misstatement” can trigger an accuracy-related penalty for a taxpayer in this context. Similar to the substantial understatement penalty, the substantial valuation misstatement penalty has a threshold for individuals: the penalty does not apply “unless the portion of the underpayment for the taxable year attributable to substantial valuation misstatements under chapter 1 [of the Code] exceeds $5,000.”26 Also, an underpayment of income tax is attributable to a “substantial valuation misstatement” only if “the value of any property (or the adjusted basis of any property) claimed on any return of tax imposed by chapter 1 [of the Code] is 150 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis.”27 The determination of whether a misstatement has occurred is made on a property-by-property analysis, not on the basis of the entire return.28 Unlike the other accuracy–related penalties to which taxpayers can be subject, a valuation misstatement can be “gross” and the penalty increased to 40% of the deficiency amount if the asset’s value or adjusted basis is 200% or more of the correct amount.29

3.1.4 Exception: Reasonable Cause and Good Faith

There is an exception that applies to the penalties for “negligence or disregard,” “substantial understatement of income tax,” and “substantial valuation misstatement”: “[n]o penalty shall be imposed under section 6662…with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”30 The relevant Regulations, which are fairly extensive but somewhat uninformative, impose a “facts and circumstances” test for whether a taxpayer acted in good faith and with reasonable cause.31

Although the Regulations state that “[r]easonable cause and good faith ordinarily is not indicated by the mere fact that there is an appraisal of the value of property,” it is clear that an independent professional appraisal provides a measure of protection as an important part of the facts and circumstances.32 In considering an appraisal, the Regulations indicate the court or the Internal Revenue Service should look at “the methodology and assumptions underlying the appraisal, the appraised value, the relationship between appraised value and purchase price, the circumstances under which the appraisal was obtained, and the appraiser’s relationship to the taxpayer or to the activity in which the property is used.”33 Case law suggests that a reasonable reliance on an appraiser with proper qualifications is generally very helpful in determining reasonable cause and good faith.34

As to whether a taxpayer relied in good faith on professional advice, certain threshold requirements must be met:35 (i) “[t]he advice must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances”;36 (ii) “[t]he advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person”;37 and (iii) “[a] taxpayer may not rely on an opinion or advice that a regulation is invalid to establish that the taxpayer acted with reasonable cause and good faith unless the taxpayer adequately disclosed, in accordance with Section 1.6662-3(c)(2), the position that the regulation in question is invalid.”38 Even if these threshold requirements are met, it is not necessarily established that a taxpayer acted with reasonable cause and a good faith.39

3.2 Preparer Penalties

Code Section 6694 imposes certain penalties on a tax return preparer who prepares a return or claims a refund involving an understatement of tax. One penalty is imposed if the underpayment is attributable to an unreasonable position, and the preparer “knew (or reasonably should have known) of the position.”40 The penalty in that case is “the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.”41 Another penalty is imposed if the understatement is attributable to “(A) a willful attempt in any manner to understate the liability for tax on the return or claim, or (B) a reckless or intentional disregard of rules or regulations.”42 In those cases, the penalty is higher: the greater of “(A) $5,000, or (B) 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.”43 This potentially higher penalty amount is reduced by any penalty attributable to an unreasonable position of which the preparer knew or should have known.44 It is possible that an attorney could be considered a nonsigning tax return preparer under certain circumstances.45 Practitioners are also subject to Circular 230 requirements under certain circumstances.46

3.3 Appraiser Penalties

Code Section 6695A imposes certain penalties on “a person [who] prepares an appraisal of the value of property” and “knows, or reasonably should have known, that the appraisal would be used in connection with a return…[if the valuation] results in a substantial [or gross] valuation misstatement.”47 The term “appraisal” is not defined in the relevant Code Section, and its meaning may be broad enough to reach a return preparer’s estimate of an asset’s value reported on the return. Substantial and gross valuation misstatements have the same meanings as in Code Section 6662.48 The amount of the penalty is the lesser of: (i) 125% of the gross income received by the appraisal preparer for the preparation of the appraisal; and (ii) the greater of $1,000 or 10% of the amount of the underpayment attributable to the misstatement. 49

Code Section 6695A provides one exception to the appraiser penalty: no penalties are imposed if the person who prepares the appraisal establishes that the appraisal value “was more likely than not the proper value.”50

4. How Do We Value Assets to Maximize Value/ Basis?

4.1 Working with Appraisers

Valuation of hard-to-value assets (such as real estate and closely-held business interests) is more art than science, and most hard-to-value assets will reasonably fit into a range of values.

In spite of our objective of maximizing basis, we should interact with the appraiser just as we would in situations where estate tax would have been due. So, although we give information and input, it is with the understanding that the final appraisal is peculiarly the professional, independent work product of the appraiser. Within that framework, we should consider taking the following steps:

1. Notifying the appraiser of the purpose of the appraisal, including a description of estate tax exposure or lack thereof;

2. Reviewing the draft report prior to finalization in order to correct factual inaccuracies and provide proper input; and

3. Providing the appraiser with true facts and attributes which point to a higher valuation or to lower valuation discounts:

a. For lack of control discounts, we can bring to the appraiser’s attention attributes which could limit the scope of the discount, i.e., the power to direct the management and policies of a business enterprise. Factors generally could include positive characteristics relating to business governance in terms of the interest to be valued, history of cash distributions, history of strong cash flow, history of or anticipation of sales of assets, ease of dissolution/liquidation of entity, day to day management, and history of and ability to refinance/leverage assets.

b. Likewise, for lack of marketability discounts, we should emphasize attributes which limit the extent of the discount, i.e., the potential to quickly convert an asset to cash with an emphasis upon the liquidity of the asset. Factors generally could include cash flow distributions, historical cash flow from the underlying assets, relative size of investment, lack of restrictions on transferability in governing instruments, low loan to value ratios, existence of diversification, lack of prepayment penalties, lack of phantom income, lack of a portfolio discount, favorable debt or debt terms, lack of market absorption issues, low vacancy rates, lack of loans to related parties, lack of title problems, lack of litigation, limited extent of potential capital improvements, limited historical or potential capital calls, limited liability risks, lack of development risks, and existence of multiple tiers of entities. The key factors appear to be cash flow and cash distributions.

c. For fractional interest in land, we should focus on attributes which limit the potential discount, including, but not limited to, history of cooperative decision-making by co-owners, history of undivided use and possession, historical and potential cash flow, lack of debt, small size of investment, and impending sale of the property.

4. Emphasize with the appraiser, as the Internal Revenue Service does in transfer tax cases, the lower end of valuation discounts from reported case law where relevant and appropriate, including (i) Knight v. Comm’r, 115 T.C. 506 (2000), involving a partnership with securities and real estate, and a combined effective discount of 15%; (ii) Holman v. Comm’r, 130 T.C. 12 (2008), dealing with a partnership with a concentrate stock position, and a discount of 22.5%; (iii) Ludwick v. Comm’r, 99 T.C.M. (CCH) 1424 (2010), regarding a fractional interest in land, and a discount of 17.5%; (iv) Astleford v. Comm’r, 95 T.C.M. (CCH) 1497 (2008), involving a real estate limited partnership, and discounts of 15% and 22%; and (v) Estate of Heck v. Comm’r, 83 T.C.M. (CCH) 1181 (2002), involving an S Corporation that produced champagne and owned land, and a discount of 25%.

5. For real estate, we may want to stress lease terms favorable to the lessor, strong sales of comparable properties, upward trends in the marketplace, and the good condition and convenient location of the property. In addition, because estate planning objectives may be to foster higher values, entity documents in the future should be drafted (or amended) with lower discounts in mind.

4.2 Working Without Appraisers

In some cases, obtaining professional appraisals might not make economic sense or might not seem worthwhile to the client.

For federal estate tax purposes, an appraisal is required for “household and personal effects articles having marked artistic or intrinsic value of a total value in excess of $3,000.”51 No other requirement for an appraisal appears in the Regulations, although the federal estate tax return instructions require an explanation of how the values of certain types of assets were determined. As noted previously, an appraisal can help avoid imposition of penalties described above. Accordingly an attempt at estimating values may trigger penalties, including possibly the Code Section 6695A penalty. Real estate tax assessments may not be sufficient for estate tax purposes.52 Traditionally, tax assessments are periodic, not immediate, and thus lag behind value in markets trending up and could exceed value in markets trending down. Some assessments are not done yearly. Generally, a Realtor’s letter or a Zillow valuation will not excuse or avoid the imposition of penalties.

4.3 Not Bound by Probate Values, Unless Duty of Consistency Applies

Nothing in the Code requires a taxpayer to use “probate” values as the taxpayer’s basis. The estate probate inventory form may require a listing of the “fair market value” of each asset and permit the use of tax assessments for real estate. Probate documents, if sworn, might be unfavorable evidence and should be amended if the taxpayer wishes to take a later valuation position different from what was reported in the probate documents.

5. Conclusion

For years the government has been taking positions to increase the value of taxpayer’s assets for federal estate tax purposes. In this new climate, taxpayers will be taking positions consistent with that approach.

Thomas D. Yates is a partner at Yates, Campbell & Hoeg, LLP, in Fairfax, VA. His practice focuses on estate planning and the administration of complex estates and trusts. He formerly was on the Board of the Trusts & Estates Section of the Virginia State Bar and he is currently a member of the Legislative Committee of the Virginia Bar Association Trusts & Estates Section.

He has a J.D. from George Mason University, 1995, and B.A. from the University of Virginia, 1991.

Alvi Aggarwal is an associate at Yates, Campbell & Hoeg, LLP, in Fairfax, VA. Her practice focuses on estate planning, probate, estate and trust administration, and business planning.

She has an LL.M. in Estate Planning from University of Miami School of Law, 2010, a J.D. from The George Washington University Law School, 2009, and a B.A. from Georgetown University, 2005.

(Endnotes)

1. The authors thank Munford R. Yates, Jr. (Yates, Campbell & Hoeg, LLP) and Craig Stephanson (Valuation Services, Inc.) for their valuable contributions to this article. For other sources, the authors recommend consulting the following: JOHN A. BOGDANSKI, FEDERAL TAX VALUATION (Thomson Reuters 2015) (1996); Howard M. Zaritsky & Lester B. Law, Fundamentals Program: Basis – Banal? Basic? Benign? Bewildering? (Focus Series), 49 INST. ON EST. PLAN. CH. 1 (2015); COMMERCE CLEARINGHOUSE, IRS VALUATION GUIDE FOR INCOME, ESTATE AND GIFT TAXES: VALUATION TRAINING FOR APPEALS OFFICERS (CCH 1994).

2. There is an analogous concern in estate planning for clients whose assets do not exceed their available exemption(s). See Paul S. Lee, Run the Basis and Catch Maximum Tax Savings—Part 1, EST. PLAN., Jan. 2015, at 1; Paul S. Lee, Run the Basis and Catch Maximum Tax Savings—Part 2, EST. PLAN., Feb. 2015, at 2; Michael A. Yuhas & Carl C. Radom, New Estate Planning Frontier: Increasing Basis, 122 J. TAX’N 4 (2015).

3. I.R.C. § 2010(c)(3)(B).

4. Id. §§ 2010(c)(2)(B), 2010(c)(4).

5. The consideration of any additional limitations arising from fiduciary duties under state law is beyond the scope of this article.

6. I.R.C. § 1014(a).

7. Treas. Reg. § 1.1014-3(a).

8. Id. § 20.2031-1(b).

9. See, e.g., Trea. Reg. §§ 20.2031-4 (regarding valuation of promissory notes), § 20.2031-3 (regarding valuation of interests in businesses).

10. Treas. Reg. § 20.2031-3.

11. Id. §§ 20.2031-2(f), (h), 20.2031-3.

12. Id. § 20.2031-9.

13. Id. § 20.2031-1(b).

14. The appropriate method for valuing real estate depends on the type of real estate (undeveloped land, commercial, residential, etc.). See Estate of Pattison v. Comm’r, 60 T.C.M. (CCH) 471 (1990); Estate of Necastro v. Comm’r, 68 T.C.M. (CCH) 227 (1994); Rev. Proc. 79-24, 1979-1 C.B. 565.

15. I.R.C. § 6662.

16. Id. § 6662(a).

17. Id. § 6662(b). There are additional circumstances, listed in Code Section 6662(b), under which the Code Section 6662(a) penalty can be triggered.

18. See I.R.C. § 6664(c).

19. “Negligence” is not precisely defined in the Code or the Regulations. The Code provides “the term ‘negligence’ includes any failure to make a reasonable attempt to comply with the provisions of this title.” I.R.C. § 6662(c). The Regulations clarify that “[n]egligence is strongly indicated where—(i) [a] taxpayer fails to include on an income tax return an amount of income shown on an information return, as defined in [I.R.C. §] 6724(d)(1); or (ii) [a] taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances.” Treas. Reg. § 1.6662-3(b)(1). The negligence standard has a special exception: “A return position that has a reasonable basis…is not attributable to negligence.” Id. There are other circumstances that “strongly indicate” negligence described in the Regulations, though they generally apply in the corporate and partnership contexts. Id. A “reasonable basis” is a “high standard,” though it is not as high as the “substantial authority” required to avoid certain other penalties. Id. § 1.6662-3(b)(3).

20. “Disregard” refers to disregard of “rules or regulations,” which encompass the “provisions of the Internal Revenue Code, temporary or final Treasury regulations issued under the Code, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin.” Treas. Reg. § 1.6662-3(b)(2).

21. In accordance with the requirements of Treas. Reg. § 1.6662-4(f).

22. See Treas. Reg. § 1.6662-3(c). Importantly, the adequate disclosure exception to these penalties will not apply if the taxpayer “fails to keep adequate books and records or to substantiate items properly.” Id. § 1.6662-3(c)(1).

23. I.R.C. § 6662(b)(2).

24. Id. § 6662(d)(1)(A).

25. Id. § 6662(d)(2)(B).

26.Id. § 6662(e)(2).

27. Id. § 6662(e)(1)(A).

28. Treas. Reg. § 1.6662-5(f)(1).

29. I.R.C. § 6662(h).

30. Id. § 6664(c)(1).

31. See Treas. Reg. § 1.6664-4(b)(1).

32.See Id.

33. Id.

34.See, e.g., Estate of Thompson v. Comm’r, 499 F.3d 129 (2nd Cir. 2007); Bergquist v. Comm’r, 131 T.C. 8 (2008). Reliance on an accountant (or perhaps a lawyer) who is not a “certified appraiser” or without an assessment of the appraiser’s approach, on the other hand, may not be sufficient. See, e.g., Estate of Richmond v. Comm’r, T.C. Memo 2014-26.

35.See Treas. Reg. § 1.6664-4(c)(1).

36. Id. § 1.6664-4(c)(1)(i).

37.Id. § 1.6664-4(c)(1)(ii).

38. Id. § 1.6664-4(c)(1)(iii).

39. Id. § 1.6664-4(c)(1). There is a notable exception to the availability of the reasonable cause and good faith defense: reasonable cause and good faith will not prevent the application of Code Section 6662 penalties in a case where the underpayment is attributable to a “disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.” I.R.C. §§ 6662(b)(6), 6664(c)(2).

40.See I.R.C. § 6694(a).

41. Id. § 6694(a)(1)(B).

42.Id. § 6694(b)(2).

43.Id. § 6694(b).

44.Id. § 6694(b)(3).

45.See Treas. Reg. § 301.7701-15(b).

46. 31 C.F.R. Subtitle A, Part 10 (Rev. 6-2014).

47. I.R.C. § 6695A(a). Additional conditions can trigger this penalty, but only the valuation misstatement trigger is relevant in this context.

48.Id. § 6695A(a)(2).

49.Id. § 6695A(b).

50.Id. § 6695A(c).

51. Treas. Reg. § 20.2031-6(b).

52. Id. § 20.2031-1(b).