Making transfers of interests in family limited partnerships
or shares of a family corporation are key elements in protecting your family
assets from future lawsuits. Gifts to a charitable trust, family foundation
or an irrevocable trust or even outright gifts of property to various family
members are also widely used methods of asset protection for family property.
All of these inter-family and charitable transfers have one critical
problem that is seldom discussed in articles or books on asset protection.
There are transfer tax valuation implications. The gifted property needs
to be properly valued to avoid future penalties. The estate and gift taxes
are generally based on the value of the property at the date of the transfer.
With cash or publicly traded stock or bonds, valuation is not much of a
problem. With every other asset it can become a huge problem in the future.
Contributions of property to a charity require a "qualified appraisal"
by a "qualified appraiser" as defined in tax code section 170. Gifts of
property to family members are to be valued at the "fair market value",
which is the theoretical amount at which the property would change hands
between a willing seller and a willing buyer, where both parties have reasonable
knowledge of the relevant facts. Applying this theory to the valuation
of real estate or a family owned business is more of an art than a science.
Penalties for undervaluing any part of an estate can be severe, but
won't usually be incurred until the estate tax return is audited by the
IRS. The most significant penalty provisions are spelled out in tax code
sections 6662 through 6664, dealing with penalties relating to accuracy
or to fraud. These sections impose a 20% penalty on any understatements
of value if the value of the property claimed on any return is 50% or less
of the "correct" value (as determined by the IRS). Where the reported value
is 25% or less of the "correct" value, the penalty is increased to 40%
of the difference in the tax.
How can you avoid the penalty? The key is to show that you relied
in good faith on a well qualified expert - an appraiser. The better qualified
the expert, the less the chance of a penalty. Be sure the appraiser is
also well informed on any related tax laws.
A Tip On Choosing An Appraiser
When you are making a transfer of property that can't be valued by
reference to an auction market, the most critical element is the valuation
appraisal. A well qualified appraisal will protect you from substantial
penalties down the road and will make it hard for the IRS to dispute the
value placed on your property. On behalf of a client, I recently spent
quite a bit of time helping the client to select an appraiser. About two
months before that, I wrote an article for a technical journal about business
valuation software. As a result of the research I did on the subject of
valuations, I concluded that the reputation of the appraiser is far more
important than the software.
With the software I still have, I could compute the value of a business
at least 20 different ways. But I won't and if I would, it would be a mistake
for anyone to hire me for that purpose. Why? Because I have no experience
or relevant credentials. Being a CPA doesn't mean that I'm fully qualified
to put a value on a business. The reason I'm not fully qualified is because
I don't choose to specialize in this field. Anyone who doesn't devote at
least 60% of their work time to valuation issues isn't a genuine specialist
- in my opinion. And anyone who hasn't been doing business valuations almost
full time for at least three years isn't going to be presumed to be an
expert.
The "secret" in getting an appraisal is to get someone with a reputation
that will make it impossible for the IRS to convince a judge that your
appraiser wasn't qualified and didn't know what he or she was doing. You
want your appraiser to be so well qualified that it will make their appraiser
look like an amateur by comparison.
How did I make the choice for my client? I called about a dozen estate
planning lawyers in the area and asked for recommendations. Then I called
the five who were mentioned the most and asked for a professional bio and
a sample appraisal report. Then we interviewed three of the five. Then
I suggested the client hire the one with the largest firm that did the
most appraisals. And, the appraiser we selected wasn't any more expensive
than the others.
How much did it cost? The fee was about $7,000 to prepare a valuation
analysis for a business with about ten employees and with annual sales
of about $3 million. Based on the valuation provided by the appraiser,
the taxpayer was able to immediately remove more than $1.2 million in assets
from his estate and to be able to remove an additional $80,000 per year,
thereafter. The estimated estate tax savings will be far in excess of the
appraisal fee - and I believe that an appraisal by an experienced specialist
with a good reputation is a bargain when you are planning to make transfers
of assets for asset protection and/or estate planning.
By the way. The Taxpayer's Relief Act of 1997 included a provision
that will take much of the uncertainty out of the question of how the IRS
will value prior gifts when they do an estate tax audit. Previously, it
was their practice to not value a gift until they looked at the estate
tax return. Even though the three year statute of limitations had run on
a gift tax return, the IRS contended that they could still value the gifted
property as part of the estate tax audit. The 1997 law put an end to this
little bit of senseless duplicity on the part of the IRS. Now, they only
get "on bite at the valuation apple". If they don't audit the gift tax
return within the three year statute of limitations, they can't come back
years later and argue about that value when they examine the estate tax
return.
Further details about protecting your assets from future lawsuits
are available in our subscriber's web
site. Changes in the tax laws and various federal and state laws
affecting various asset protection devices are provided in our monthly
newsletter on Asset Protection Strategies.
