February 2002

Federal Taxation Uniform Standards for Business Valuations

By Louis J. Cercone, Jr.

The days when almost anything could pass as a business valuation report are gone forever, primarily because of quality education and business valuation standards promulgated by several appraisal organizations. The American Society of Appraisers (ASA), the Institute of Business Appraisers (IBA), and the National Association of Certified Valuation Analysts (NACVA) have each developed and issued a comprehensive set of business valuation standards (the AICPA is developing a set as well). Only members of these organizations must adhere to these standards. There are no legal requirements set forth by the IRS, which establishes specific appraiser qualifications and minimum standards for the development and communication of business valuation opinions.

The results of a study conducted by the ASA indicated that the IRS receives more than 15 million tax returns, forms, and schedules annually on which taxpayers report a tax-related event requiring an estimate of value, including personal and real property as well as closely held business interests. Obviously, the IRS has a tremendous impact on the practice of business valuation. To ensure the integrity of taxpayer fair market value estimates, the IRS should adopt and require conformity with a uniform set of valuation standards, and better define the requirements of a qualified appraiser.

Revenue Rulings

Most of the IRS's valuation guidance has come through its revenue rulings. Revenue rulings illustrate the treatment of certain issues not clearly addressed in IRS regulations. The following are the most important rulings on business valuation:

• Revenue Ruling 59-60: well-written guidance on valuation of closely held stock for estate and gift tax
• Revenue Ruling 68-609: the "formula" or excess earnings method
• Revenue Ruling 77-287: relevance of restricted stock studies in quantifying discounts for lack of marketability
• Revenue Ruling 83-120: valuation of preferred stock
• Revenue Ruling 93-12: allows discounts for lack of control in the valuation of minority interests even when those interests are part of a family-owned controlling interest.

Many of the issues raised in the revenue rulings have been resolved in the courts and have become case law precedent. However, the revenue rulings are not standards, and many professionals feel that the IRS's low expectations for business valuations ignore the protocols of the valuation profession.

Recent IRS Reform

In response to criticism of its valuation policies, the IRS established a valuation review team. In January 2000, the review team recommended the following changes to the IRS appraisal policies and procedures:

• An IRS valuation policy council to set direction for valuation policy
• An issue/industry specialist for valuation
• An update to Revenue Ruling 59-60 n Additional requirements for taxpayer substantiation of valuation estimates, for all tax purposes
• A single-source document for taxpayers that would reconcile and incorporate all IRS valuation requirements for all tax purposes
• A form (similar to Form 8283, now used for non-cash charitable contributions), to be attached to all tax returns containing fair market value estimates of property. The form would describe the appraisal methodology used and the qualifications of the appraiser.
• Clear and concise guidelines for appraisal reports prepared by IRS personnel
• Revised estate and gift tax regulations from the IRS tax counsel that would update and remove obsolete valuation materials.

The policy changes recommended by the Review Team suggest that IRS requirements may be drastically enhanced to include reliance on credentialed appraisers and conformity with uniform standards for all significant tax valuations.

As further evidence of its reform, the IRS is hoping to have one-third of their personnel accredited by one of the major appraisal organizations by the end of 2002. Also, in May 2001, the IRS released a draft of its own set of business valuation guidelines, using standards from the USPAP (Uniform Standards of Professional Approval Practice) and the ASA, IBA, and NACVA.

IRS Business Valuation Guidelines

The IRS business valuation standards were submitted for comment to the various appraisal organizations in May 2001. According to IRS Engineering Program Manager Howard Lewis, the comments prompted some minor revisions to the original draft. The revised IRS Business Valuation Guidelines will guide IRS valuators in the development and communication of valuations, as well as the resolution of valuation issues. Lewis hopes the IRS Business Valuation Guidelines will improve the quality and consistency of the IRS valuation program and increase the acceptability of IRS conclusions to taxpayers and the courts (see Shannon Pratt's Business Valuation Update, November 2001).

The IRS Business Valuation Guidelines include development, resolution, and reporting guidelines. The Development Guidelines include procedures for planning a business valuation engagement, identifying the subject interest, and preparing workpaper documentation, as well as reviewing another professional's report. The Resolution Guidelines contain procedures to resolve valuation disputes, and the Reporting Guidelines contain requirements for all written reports prepared by IRS personnel. In addition, there is an "international glossary of business valuation terms" and a "valuation report checklist" that cites various authoritative references and standards in the preparation of a comprehensive business valuation report. Copies of the IRS Business Valuation Guidelines can be found at the websites of most appraisal organizations.

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