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Navigating Company Valuation Amidst Sales & Mergers: IRS Insight - Pat Soldano

By Todd G. Povlich, CFA, ASA, Mark E. Lingerfield, ASA, and Tadd A. Lindsay

 

Appraising A Company That Is Subject To A Potential Sale/Merger Event: Chief Counsel Advice Memorandum 202152018

 

We are often asked in the gift tax context about our approach towards appraising a company that is subject to a potential sale or merger.

 

The underlying question is whether we would consider the potential sale as a part of our analysis – to which the short answer is yes. Under the fair market value standard, the hypothetical willing buyer and a willing seller would take into account what is known and knowable as of the date of valuation, including the potential for a major liquidity event, such as an outright sale. A recent Chief Counsel Advice (“CCA”) memorandum provides some additional guidance, which is outlined below.

Chief Counsel Advice Memorandum 202152018

The IRS provided some guidance on this issue in Memorandum 202152018,1 which was released at the end of 2021. A CCA memo is a document issued by any national office division of the Office of the Chief Counsel of the IRS to employees of the IRS and conveys: (1) any legal interpretation of a revenue provision; (2) any IRS or Office of Chief Counsel position or policy concerning a revenue position; or (3) any legal interpretation of State law, foreign law, or other Federal law, relating to the assessment or collection of any liability under a revenue provision. It is important to note that CCA memos are usually issued in response to field-level service employees requesting guidance on a particular issue or topic.

CCA Memorandum 202152018 was written to respond to two issues related to a taxpayer case.

The issues were:

  • Whether, under the particular taxpayer case circumstances, a hypothetical willing buyer and willing seller of shares in a company would consider a pending merger for purposes of valuing stock for gift tax purposes.
  • Whether the taxpayer retained a qualified annuity interest in trust when the taxpayer used an outdated appraisal that did not take into account all the facts and circumstances of a pending merger.

The conclusions were:

  • Yes. Under the fair market valued standard, the hypothetical willing buyer and willing seller of a company would consider a pending merger when valuing stock for gift tax purposes.
  • No. The retained interest is not a qualified annuity interest under Section 2702 of the IRS Code because the taxpayer used an outdated appraisal that did not take into account all the facts and circumstances of a pending merger. This resulted in treating the gift that the taxpayer made to a grantor retained annuity trust (“GRAT”) as being equal to the full value of the assets contributed to the GRAT with no offset for the value of the retained annuity payment rights.

Timeline of Events

Time Zero: Business owner contacted investment bankers to find buyer for the business. Time Zero plus 6 months: Owner presented with five offers for the company.

Time Zero plus 6 months and 3 days: Owner funds a GRAT using a 409a appraisal dated 7 months earlier.

Time Zero plus 9 months: Four of the five offers raised their offers while one withdrew.

Time Zero plus 10 months (approx.): Owner gifted some company shares to a charitable remainder trust using a qualified appraisal which equated the final offer value.

Time Zero plus 11 months (approx.): Owner accepted one of the four offers via a cash tender offer that equated to a value that was nearly three times greater than the value of the appraisal value used to fund the GRATs.

Summary of Facts

At “time zero,” the business owner (taxpayer) contacted a number of investment bankers to initiate the process of selling the business. Six months after hiring the investment bankers, the owner was presented with five offers for the company. Three days later, the owner funded a two-year GRAT with shares of the company. Annuity payments were to be based on the appraised fair market value of the shares as of the date of funding.

The owner, however, used an appraisal contemporaneous with “time zero” (more than 6 months old) and not the date of the GRAT funding. This appraisal did not include any language or analysis pertaining to the potential sale/merger or even the hiring of investment bankers, and this appraisal was prepared for 409a purposes and not gift tax purposes.

At a later date, the company received final offers from four different bidders. The owner then made a contribution of some shares to a charitable remainder trust using a qualified appraisal of the company that opined to a value consistent with the offering price ultimately accepted by the company. The offer that was accepted was approximately 3 times greater than the value as was contained in the 409a appraisal used to fund the GRAT. When asked by the IRS why the taxpayer used a 409a valuation that was “stale,” as compared to the GRAT funding several days after the Company had received bids, the taxpayer stated that business operations had not materially changed.

What Went Wrong?

  • Using a 409a appraisal for a transfer tax matter (for purposes of funding the GRAT). Using a 409a appraisal for gift, estate and charitable purposes is problematic. Although 409a valuations are done under the same “fair market value” standard, they can be influenced by “fair value” (financial reporting) standards and methods. 409a appraisals are often used in the context of equity-based compensation programs which can lead to biases that can cause the value to diverge from what a qualified appraiser determines in an appraisal used for transfer tax purposes.
  • Using a six-month-old appraisal in a case where the company value was clearly changing due to the sale/merger process.
  • Ignoring the facts and circumstances that existed on the gift date, i.e. the potential sale/merger.
  • Approaching the valuation for purposes of the charitable contribution in a completely different manner than that used for the GRAT funding with the appearance of doing so to obtain a much higher value and tax deduction.
  • For the charitable donation of the company stock, it appears aggressive to use the finally accepted offer price one month prior to the actual acceptance date of that offer.

Some Final Thoughts

The IRS has been aggressive in pursuing GRATs that it believes have been formed improperly and/or not administered correctly. Consequences can be severe – the entire amount contributed to a GRAT can be treated as a gift, and there could be a 40% undervaluation penalty.

As with any gift, including GRATs, properly appraising the value of the gift on the gift date will reduce the chance of an audit. Relying on an improper appraisal, stale appraisal, or not considering what is known and knowable (e.g., a potential sale/merger) as of the date of the gift can trigger an audit. The CCA memo points to many U.S. Tax Court cases that state that an appraisal needs to consider all relevant facts and circumstances as of the valuation date, including a potential/sale merger.

If you are interested in learning more, please reach out to MPI.

Disclaimer

The information provided herein has been prepared without consideration of any specific objectives, financial circumstances or needs. Accordingly, MPI disclaims any and all guarantees, undertakings, and warranties, expressed or implied, and shall not be liable for any loss or damage whatsoever (including human or computer error, negligent or otherwise, or actual, incidental, consequential or any other loss or damage) arising out of or in connection with any use or reliance upon the information or advice contained within this publication. The viewer must accept sole responsibility associated with the use of the material in this publication, irrespective of the purpose for which such use or results are applied. This material should not be viewed as advice or recommendations. This information is not intended to, and should not, form a primary basis for any investment, valuation, or other decisions. MPI is not acting as a fiduciary, an expert or advisor in any capacity whatsoever in providing the information set forth herein. The information set forth herein may not be relied upon and is not a substitute for competent legal and financial advice.

About MPI
MPI (Management Planning Inc.) is a business valuation, litigation support, forensic accounting and M&A advisory firm providing valuations for a variety of tax, financial reporting, litigation and other business applications, as well as corporate advisory services to business owners and their representatives.

MPI has over 80 years of experience preparing Business Valuations for estate and gift tax planning and estate tax administration matters. MPI’s work product is used as the foundation for succession planning strategies implemented by advisors for numerous types of businesses and assets. MPI has decades of experience presenting and defending its work product to IRS agents and engineers at the initial audit and appellate levels. Our valuation conclusions have withstood scrutiny under audit and been accepted as filed at a high rate, which has the effect of helping clients avoid the perils and costs of tax court or ongoing tax disputes with the IRS.

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