I can remember worrying about getting audited by the Internal Revenue Service (IRS) on the first gift tax appraisal I conducted 27 years ago when I first started as a full-time business appraiser. Over the next several years, I learned that if an appraiser followed the best practices in business valuation, complied with IRS regulations and documented all inputs and assumptions, there was no real need to be concerned about an appraisal being challenged. The context for this article is centered on gift and estate tax appraisals as that has been the primary focus of my practice. As it turned out, over the years I've been involved in two landmark Tax Court cases and several IRS audits in business valuation. Based on these experiences, I want to share how the audit to Tax Court process works, what I've learned about the business appraisals over the years, and tips on how to avoid IRS scrutiny and build a stronger appraisal report.

Importance of a Business Appraisal

First, we need to talk about the importance of submitting a business appraisal when filing a federal tax return for a gift. Internal Revenue Code Section 6501(c)(9) sets a statute of limitations for reporting gifts. The statute of limitations is three years on the revaluation of gifts as long as the IRS adequate disclosure rules are met. There are two ways to start the statute of limitations when a business interest is being transferred.

1. The taxpayer can attach with her tax return the schedules of information that is requested in Internal Revenue Code §301.6501-1(f)(2), or
2.  The taxpayer can include a business appraisal report conducted by an independent appraiser with their tax return.

For the IRS to accept a business appraisal, the appraiser must meet the following criteria to be considered a qualified appraiser:

• Earns an appraisal designation from a recognized professional appraisal organization or has met certain minimum education and experience requirements.
• Regularly prepares appraisals for which the individual is paid.
• Demonstrates verifiable education and experience in valuing the type of property being appraised.
• Is not prohibited from practicing before the IRS under Title 31, Section 330(c) of the United States Code at any time during the three-year period ending on the date of the appraisal.
• Is not an excluded individual (someone who is the donor or recipient of the property).

The IRS also has a definition for a qualified appraisal that requires the report to be prepared, signed and dated by the appraiser and prepared in accordance with generally accepted appraisal standards. The report must meet the relevant requirements of IRS Regulations Section 1.170A-13(c)(3) and Notice 2006-96, 2006-46 I.R.B. 902. The appraisal is to be made not earlier than 60 days before the date of the contribution of the appraised property. The appraisal must include certain information such as the property description, terms of the sale agreement, appraisal identification information, date of the valuation and valuation methods employed.

A worthy tax case to examine to see the importance of a business appraisal is Estate of Harvey Evenchik, Gregory V. Gadarian, Personal Representative, and Deanna C. Evenchik, Petitioners v. Commissioner of Internal Revenue, Respondent. In this case, the petitioner lost a significant tax deduction because they failed to have a proper business appraisal conducted.

In 2005, the petitioner donated 15,534.67 shares of common stock in Chateau Apartments, Inc. to a charity to create an endowment fund to assist low-to-moderate–income individuals in obtaining affordable housing. The company’s primary assets were two apartment complexes located in Arizona. The petitioner’s donation equaled 72% of the company’s stock and the value was claimed to be $1,045,289. As supporting back-up documentation, the petitioner submitted two real estate appraisals of the underlying assets in the corporation, but neither appraisal addressed the individual shares or the petitioner’s 72% interest in those shares; this should have been done with a business appraisal. In addition, the real estate appraisals did not include a statement that the appraisals were prepared for income tax purposes.

The petitioner claimed the deductions across two tax years. In the second tax year, the return was audited, and the entire deduction (across both years) was disallowed, and a notice of deficiency was issued. Most of the issues at hand were settled, except one question—did the petitioner obtain a qualified appraisal on the donation, which in this case amounted to shares in a company?

IRS regulations govern the deductibility of charitable donations. Section 170 of the Internal Revenue Code requires a taxpayer claiming a deduction for the donation of property worth more than $5,000 to “obtain a qualified appraisal for the property contributed.” Income tax regulations say that no deduction under Section 170 shall be allowed with respect to a charitable contribution unless the donor obtains a qualified appraisal for the property contributed. If the contributed property is a partial business interest, a business appraisal of the subject interest is necessary.

The first problem for the estate of Harvey Evenchik was that the appraisals presented were not appraisals of the interest donated. They were real estate appraisals of the underlying assets held by the company. The court recognized that the status of a partial interest may have an effect on total value that should be assessed. The Tax Court concluded that the proper appraisal was not conducted, and the real estate appraisals of the underlying assets were not a qualified appraisal of the subject interest for purposes of valuing a charitable income tax deduction for a contribution of the corporation’s stock. Consequently, the Evenchik estate  was denied all deductions taken from the donation. It is helpful to not only understand the need for a business appraisal; one should be knowledgeable of how an IRS audit process works when writing a business appraisal report to withstand scrutiny in Tax Court.

IRS Audit Process

All parties should be familiar with the process whereby the IRS can initiate an audit of a gift or estate tax return. After a gift or estate tax filing has been filed along with a qualified business appraisal, the IRS will review the tax return and place it into one of three groups:

• Group A – No audit recommended
• Group B – Audit recommended dependent on available time
• Group C – Audit required^[1]

There are several factors that the IRS considers, including the thoroughness of the business appraisal, the qualifications of the business appraiser and whether the report adequately discloses the necessary information for a reader to be able to understand the methodology employed. At a minimum, the business appraisal report should meet Standards 9 & 10 of the Uniform Standards of Professional Appraisal Practice (USPAP).

If the tax filing is selected for audit, the IRS will contact the taxpayer or their representative and request additional information. The initial audit process can take several years to run its course. If the concerns are not resolved at the audit level, the taxpayer can appeal the matter to the Independent Office of Appeals of the IRS. At the appeals level, if the IRS and the taxpayer cannot agree, then the taxpayer has the option to go to U.S. Tax Court or can pay the tax and penalties and have the matter heard in U.S. Federal Court. The following diagram shows how the process works:

IRS Audit
Office of Appeals
U.S. Tax Court		U.S. Federal Court

It should be noted that the IRS can pull up past returns and conduct ratio comparisons with a current return. This is contrary to what some practitioners believe in that each filing or return stands on its own. The IRS is capable of reviewing the past five years of tax returns to look for inconsistencies.^[2] Therefore, it is important to be consistent in valuation methodology and follow industry best practices.

Within the IRS, the group that conducts the technical review of a business appraisal is called the IRS Engineering Program. The engineering program provides technical expertise to field agents for audits and appeals purposes. The program includes a national program manager, territory managers and teams composed of engineers, geologists, foresters, accountants, real estate appraisers and business appraisers.

As mentioned above, if a case cannot be resolved at the audit level, the taxpayer may petition that the issue be considered by the IRS Appeals Division. The IRS Appeals Division goal is to avoid costly litigation and time by resolving the matter equitably. If the issue is not resolved at the appeals level, the taxpayer has the option to litigate the case in either Tax Court or Federal Court. It is estimated that 90% of disputes go to Tax Court where the IRS attorneys represent the US Government and the remaining 10% of disputes select Federal Court where the Department of Justice represents the U.S. Government.

In summary, the audit process is an equitable structure and allows the taxpayer’s issues to be considered by multiple government parties. The process can be expensive, and many cases often do not warrant the high cost of following through to litigation. This is one reason why many cases are resolved early in the audit process.

Suggestions for a Supportable Appraisal

The following list is a set of guidelines that may help identify issues to avoid an audit when reviewing a business appraisal.

• All appraisals should be self-contained reports that meet IRS regulations for adequate disclosure and USPAP Standards 9 and 10. A five-page calculation report does not meet the legal requirement.
• An appraisal report should cite authoritative sources and footnote all assumptions. For example, growth rates for revenue and asset appreciation rates in the appraisal forecasts should be based on a respected source.
• An appraisal signed by an appraiser with training and experience from a major accreditation (ASA or ABV) has greater credibility than a non-accredited individual.
• The appraisal report should be logical and walk the reader through a thought process that is easy to understand and builds the knowledge of a reader as it progresses. The report should be well organized and summarize major points in the text. It should include schedules and tables in the report reflecting the pertinent issues, so the reader does not have to flip back to the exhibits and should be clear and concise so as to not raise unwarranted questions.
• It is recommended that the appraiser use two of the three approaches to value in the report (Income, Market and Asset-Based Approaches).
• The appraiser should calculate a final rate of return using the ending value and the income projections in the report to see if the final value is reasonable. Most business interests should fall within a 15%– 30% rate of return.

In all assignments, business appraisers should work with all parties as an independent appraiser but should also gather as much information as possible so that the important matters and unique characteristics of the business are disclosed and understood. When it comes down to it, value is based on an analysis of risk and return. A report should tell a story, albeit a technical story, that a reader can follow and build an understanding of the issues that must be considered to properly arrive at a conclusion of market value.

Bruce A. Johnson, ASA is a partner in the business valuation firm of Munroe, Park & Johnson, Inc. based in San Antonio, Texas. He holds a degree in Engineering and an MBA from Texas A&M University. Johnson is an Accredited Senior Appraiser, Course Developer/Instructor and Member of the Board of Governors of the American Society of Appraisers. He was the taxpayer expert in the first Family Limited Partnership court case, and has been published on a wide range of valuation topics.