Valuation Penalties under the Pension Protection Act
Update of the original published in the Dec. 2008 issue of National Litigation Consultants’ Review
Since the passage of the Pension Protection Act, it is much more likely to see large underpayment and negligence penalties imposed on taxpayers than in the past. A 20% to 40% underpayment penalty is now applicable in income, estate and gift tax returns that are filed without qualified valuations or claim unsubstantiated valuation discounts.
Most Common Errors
A study published by the IRS – “Audit Revaluation of Federal Tax Returns”, found that the second most frequently revalued asset among audited estates was closely held stock. 37% of those estates with closely held stock sustained an average stock revaluation by the IRS of $387,000, or 29% above the market value claimed on the return. Mortgages and notes receivable accounted for the largest revaluations, averaging $501,000, or 170% above the market value claimed. (SOI Bulletin, Volume 20, Number 3).
The PPA gives the IRS authority to impose underpayment penalties of up to 40% against the taxpayer and civil money penalties of 10% against the appraiser based on “substantial” or “gross” valuation misstatements. Further, the substantial and gross misstatement thresholds have been lowered (i.e. the margin for error has been reduced) and also now apply to estate and gift tax appraisals.
If there is an underpayment of income tax of more than $5,000:
- A substantial valuation misstatement is defined as a value claimed for a deduction that is 50%-100% higher than what the IRS determines to be the “correct” value, and the 20% underpayment penalty applies.
- A gross valuation misstatement is defined as a value claimed for a deduction that is more than 100% higher than what the IRS determines to be the “correct” value, and the 40% underpayment penalty applies.
If there is an underpayment of estate and gift tax of more than $5,000:
- A substantial valuation misstatement is defined as a value claimed that is 35%-60% lower than what the IRS determines to be the “correct” value, and there is a penalty of 20% of the underpayment of estate or gift tax attributable to the undervaluation.
- A gross valuation misstatement is defined as a value claimed that is more than 60% lower than what the IRS determines to be the “correct” value, and there is a penalty of 40% of the underpayment of estate or gift tax attributable to the undervaluation.
For example, assume that the business appraiser applies total discounts of 45% to an underlying business value of $10 million, for an estate/gift tax valuation of $5.5 million. If the IRS or court determines that total discounts should have only been 15%, the “correct” value would be $8.5 million. Because the appraised value is only 64.7% of the “correct” value (i.e. 5.5/8.5 = 0.647, more than 35% lower), the 20% underpayment penalty would apply.
If the IRS were to prevail in this example, the $3 million valuation misstatement and a marginal estate tax rate of 45% would result in an additional tax liability of $1,350,000, plus a 20% penalty of $270,000. The appraisal firm could be assessed a penalty of 125% of its valuation fee, up to $135,000.
The potential magnitude and frequency of such penalties is significant, due to the fact that one out of four estate tax returns filed in 2005 included private equity or debt investments. In that year alone, 45,070 estates reported over $26 billion in closely held business and partnership interests, representing up to 42% of total value in the largest estates.
Avoiding Penalties
Although the IRS regularly attempts to assess accuracy-related penalties in valuation cases, the Tax Court has in the past disallowed these assessments when the taxpayer has acted “reasonably” by engaging a valuation professional who demonstrates verifiable education, valuation training and experience in valuing the type of property subject to the appraisal.
However, since reasonable cause is no longer a defense to a gross valuation misstatement penalty for income, estate, or gift tax purposes, the appraiser’s ability to substantiate and defend the valuation before the IRS and court will be essential. In addition, IRS Notice 2006-96 specifies the IRS minimum qualifications for a valuation report and appraiser, which include the use of an experienced professional having specialized valuation training and credentials.
The licensed professionals at New Value, LLC are experienced in the valuation of hard-to-value assets including early stage companies, partnership interests, undivided real estate, restricted stock, debt instruments, options, contracts, patents, trademarks and other intangible assets.
For a free consultation with a CPA business valuation expert contact us at info@NewValueLLC.com or call 215-850-1403.
