Is the IRS Increasing the Value of Family Businesses in Divorce?

taxable transactions

Is the IRS Increasing the Value of Family Businesses in Divorce?

Could a change in tax law increase the value of family businesses in divorce? A new IRS regulation that was proposed in the fall of 2016 might have that effect.  So far, the stiff resistance of forensic accountants and lawyers has prevented the new rule from going into effect.  Whether that will continue remains to be seen.

You might wonder: does the IRS set the value of family businesses in divorce?  Technically, the answer is no.  Yet, the IRS regulates business valuation in many taxable transactions, such as gifts, sales and inheritance where business interests are transferred from owners to family members or purchasers. The IRS regulations applicable to those transactions may affect the valuation standards that are applied in other kinds of transactions, such as divorce and shareholder disputes. Forensic accountants try to be consistent, because (arguably) a business should have the same value in these different contexts.  Thus, an IRS change in business valuation standards for gift and estate tax purposes might affect family businesses in divorce cases – if the controversial IRS proposal is implemented.

The current controversy arose from the Tax Court decision in Kerr vs. Commissioner, 113 T.C. 449 (1999).  Mr. Kerr, who was a successful lawyer representing Pennzoil, earned a $10 million dollar bonus for his work and invested it into a family limited partnership for the benefit of his children and grandchildren.  Mr. Kerr and his wife made a donation to the University of Texas, and using trusts, transferred some limited partnership interests to their children.

As most people know, gifts can be taxable transactions when the value of the gift exceeds the annual exclusion amount (currently $14,000 in 2017). The person who gives the gift is responsible for paying the tax; the IRS provides more information here. So, Mr. and Mrs. Kerr were responsible for paying federal gift tax when they gave partnership interests to their children, if the value of the transferred partnership interests were greater than the annual exclusion amount.

When a forensic accountant determines the fair market value of a business partnership, there are some valuation discounts that may be applied.  A private company or partnership is very different from a publicly-traded company like Apple or ExxonMobil. Public companies must report their financial performance to investors. Public companies trade freely on the stock exchange; anyone with money can buy and sell through a stockbroker, for a small fee.  A private company does not report its financial performance or trade freely in the stock market, so buying a private company is more risky, and buyers pay a discounted price.

To account for the risk of buying a private company, forensic accountants may apply discounts, known as “marketability” discounts, that can range from 25% to 50% of a company’s value. And, if a buyer is not buying a controlling interest in the company (usually 51% or more), then forensic accountants may apply an additional discount for the lack of control.

In Kerr, a forensic accountant had to report the fair market value of the fractional interests in a private partnership that Mr. and Mrs. Kerr gave to their kids as gifts. The accountant applied valuation discounts ranging from 25% to 42.5% on the gift tax returns.  The IRS objected by sending a deficiency notice, demanding additional taxes to be paid on the gifts.  The Tax Court sided with the Kerrs, excusing them from paying additional taxes. More specifically, the Tax Court allowed the Kerrs to take advantage of a loophole in IRC § 2704, which was enacted to regulate the valuation of certain family-controlled businesses. The valuation discounts, according to the Tax Court, were valid to reduce the fair market value of the partnership interests that the Kerrs gave to their children.

For many years, the IRS has tried to get around the Kerr decision in subsequent Tax Court cases involving family-controlled businesses. Having no success in the courts, the IRS decided in 2016 to change the federal regulations associated with IRC § 2704.  All of the major organizations for forensic accountants, such as the American Society of Appraisers (ASA), the American Institute of CPAs (AICPA) and the National Association of Certified Valuation Analysts (NACVA), wrote strong letters to the IRS objecting to the proposed regulations.  Hearings held in December 2016 were inconclusive.

If the proposed regulations to IRC § 2704 are enacted, then the taxable value of many businesses may increase by 25% to 50% for federal estate and gift tax purposes.  This might have a collateral effect on family businesses in divorce cases.  Currently, most states apply the “fair market value” standard for determining the value of a business in equitable distribution and community property division.  A small handful of states have recently adopted the “fair value” standard, in which valuation discounts are ignored.  If the IRS eliminates valuation discounts for family-controlled businesses in federal estate and gift tax cases, it might build momentum for the “fair value” standard in divorce cases.  The value of businesses might increase for divorce cases by eliminating valuation discounts.

The owners of family businesses in divorce need skilled guidance when settling or litigating their equitable distribution case in divorce.  Brian C. Vertz is an active member of NACVA, one of the business valuation organizations that has advised the IRS in these matters.  For top legal representation in Western Pennsylvania, call Brian C. Vertz and his law firm, Pollock Begg, at 412-471-9000 or use the contact form.