While this applies to appraisers for income tax purposes, the courts have held that the same attributes are necessary in business valuation cases. CPAs should already be qualified under these criteria, with perhaps the exception of training in appraisal methods.

It is generally accepted by the courts that a taxpayer may avoid any negligence penalty if the party relied on professional advice. But the courts have gone on to say "the taxpayer must show that such professional had the expertise and knowledge of the pertinent facts to provide informed advice on the subject matter" [David V. Goldman v. Comm'r, 39 F.3d 402 (2nd Cir. 1994)]. It is not clear that the requisite knowledge exists if an appraiser has not had advanced training in this area.

The Courts' View

Business valuations are often challenged in the courts. Judges recognize they do not have the training or expertise to handle such situations, so they often rely on qualified appraisers as expert witnesses to give them guidance. A number of recent court cases illustrate the importance judges place on an understanding of
those issues.

Merely indicating that a person is an expert is not binding on the courts. For example, in Estate of Cloutier v. C.I.R., (T.C. Memo 1996-4), the court stated, "While expert testimony can sometimes aid the court in evaluating a claim, we need not follow an expert's opinion when it is contrary to our judgment. We may reject an expert's opinion in its entirety whenever we believe it is appropriate to do so." [Helvering v. National Grocery Co., supra at 294-95; Estate of Kries v. Comm'r, 227 F.2d, 753, 755 (6th Cir. 1955), affg. T.C. Memo 1954-139].

Estate of Berg v. C.I.R. To the contrary, when the court believes the expert witnesses to be experienced and have training in valuation procedures, the party with the most qualified expert often prevails. In Estate of Berg v. C.I.R. (T.C. Memo 1991-279), the court found for the IRS due to the credentials of its expert witnesses. The case dealt with the appropriate discounts on stock owned by the decedent due to his minority interest and the lack of marketability of his stock. The petitioner claimed a 60% discount and the respondent a 30% discount for the two factors.

In ruling for the respondent, the court noted that the petitioner's expert, a CPA, had provided advisory services related to the valuation of equity interests, mergers, acquisitions, leveraged buy-outs, employee stock ownership plans, and litigation, but had no formal training as an appraiser. The court also recounted that petitioner's expert relied on an unidentified study of minority discounts allowed in the industry and an unidentified SEC study to support a 40% discount for lack of marketability. In a post-trial brief the petitioner cited several court cases that supported its position, but the court held that the facts in those cases were distinguishable from the current case and therefore irrelevant.

In contrast, defendant's expert witnesses were each in the business of real estate and/or business valuations. The fact that the witnesses had taken business valuation courses evidently impressed the court. The court noted that one appraiser "has completed courses sponsored by the American Society of Appraisers in research and analysis of business valuations, advanced valuation, and closely held business valuation. He is an associate member of the American Society of Appraisers, Business Valuation Section." A second appraiser "has completed an advanced business valuation seminar, a closely held corporations valuation seminar, four business valuation courses, and a business valuation strategy seminar. He is a member of the American Society of Appraisers, Business Valuation Section, and a member of the Institute of Business Appraisers." The third expert witness "has completed courses in eminent domain valuation, going concern valuation, and two courses in valuation of businesses and professional practices. He is a member of the American Institute of Real Estate Appraisers, an associate member in the American Society of Appraisers, Business Valuation Enterprise Section, and a member of the Institute of Business Appraisers." The court's inclusion in its decision of the credentials of the expert witnesses was unusual but suggests that those involved in business appraisals should carefully document their experiences, memberships, and training to improve their chances of succeeding when challenged in court.

Lehman v. Comm'r. Discounted cash flow methods are often accepted by the courts as an appropriate method to value business property. In a 1997 case, Lehman v. Comm'r (74 T.C.M. 415), the court held that the expert witness for the IRS did not explain how he came up with a "typical" discount, therefore the court did not rely upon the testimony of the IRS's witness. The taxpayer's expert witness used a discount rate based upon current Treasury bond rates adjusted for additional risk. The court accepted his risk approach but rejected his projections on future revenue, operating costs, and trends. Additionally, the court found that the expert witness had made a number of calculation errors. For example, the present value of future rents had been calculated as if received at the end of each year, while the rents were actually paid at the beginning of each month. In calculating projected expenses, the expert witness failed to explain the amounts used. In conclusion the court held, "Finally, the taxpayer's witness estimated the liquidation costs at the end of the lease term in 2062. We find these amounts to be too speculative, conjectural, and remote."

While the court noted that the defendant's expert witness made several valid conclusions, it estimated the value of the property by modifying his analysis. The IRS's expert witness determined a value of $1,154,043 on the property, the defense determined a value of $399,000, and the court settled on a value of $699,853. While the defense's approach was in some aspects found faulty by the court, the fact that his approach utilized a preferred appraisal approach with reasoned documentation led the court to set a value approximately 40% less than the IRS's expert witness.

Using the Arbitrage Pricing Model

Since most valuation problems arise with firms that are not publicly traded, an approach is needed that attempts to bring various risk factors into the determination of a firm's value. One approach which has been gaining popularity is the arbitrage pricing model, which is formula-driven and based on various risk relationships.

Highly recognized appraisers use this approach, and judges find it helpful, for it addresses the issue of risk in a mathematically logical manner. With smaller companies, the risk factor may be the most important issue in valuation, and the model applies a reasoned approach to that problem. There are published risk factors for companies of different sizes in different industries, so the application of the model can be based on verifiable information. With small, closely held firms, the business appraiser must still estimate an element of the risk factor, but with the balance of factors derived from published sources, the court may find the method objective and acceptable. As noted above, the taxpayer's appraiser in Lehman utilized the discounted cash flow approach, which is a less sophisticated model than the arbitrage pricing model. Therefore if two opposing appraisers were presenting their positions, one using a discounted cash flow approach and the other utilizing the arbitrage pricing model, the court might rely more on the more rigorous methodology.

Available Training

For a number of years, the American Society of Appraisers (ASA) and the Institute of Business Appraisers (IBA) have offered course work in business appraisals. In the last few years, the AICPA has established a certificate program in business valuation (BV CEA) and has recently instituted additional training with the advanced business valuation program, which builds on the BV CEA studies. More advanced topics dealing with such issues as rates of return, discounts and premiums, advanced research and analysis, and use of the market approach are covered. These formal programs prepare a CPA to advise clients in the business valuation area, as does membership in and course work through the ASA and IBA. An advantage of the AICPA program is the number of locations at which these courses are offered. Since many ASA instructors also teach in the AICPA program, the quality is comparable. The ASA and IBA programs have operated for over 20 years, so adversaries, clients, and the courts may better recognize designations from these organizations. But CPAs now have another choice in obtaining instruction in business appraisal methods. *

Robert D. Swanson, PhD, CPA, is a professor of accounting at Iowa State University.

Editor:
John F. Burke, CPA
The CPA Journal

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.