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Using a Form 409A Valuation Report for a Gift or Estate Tax Filing

It may cause trouble down the line If your client is audited.

Some clients and their advisors may think it’s okay to use a 409A Valuation Report for a gift or estate filing. While they may get away with it if there’s no audit, it’s not advisable. Section 409A valuations establish a “safe harbor,” which the IRS recognizes as a reasonable method to ensure the exercise price is at FMV. However, 409A Valuation Reports aren’t filed with the IRS.

Value of Equity Compensation

Internal Revenue Code Section 409A states that deferrals of compensation under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. Compensation is deferrable on stock options that are issued at an exercise price (that is, the price at which an underlying security can be purchased or sold when trading a call or put option) greater than or equal to the stock’s fair market value (FMV) on the grant date.

A privately held company should hire a qualified independent valuation professional to determine the FMV of equity compensation. Valuation professionals are typically engaged to value a client company’s common stock, and the client then uses this value to establish an exercise price of options being granted and to determine the FMV (or fair value when also done in compliance with Accounting Standards Codification Topic 718) of the options.

Estate and Gift Tax Valuations

Valuations of businesses or business interests are often needed for estate-planning purposes, such as in determining the probable amount of estate or gift taxes to aid in planning before the owner’s death. In the case of the estate of a deceased individual, a valuation of a business interest owned by the estate is frequently necessary for the preparation and filing of an estate tax return (IRS Form 706).

In the case of a gift, a valuation report determines how much lifetime exclusion the taxpayer uses and establishes a statute of limitations for audit (and sometimes to pay a gift tax). It’s filed with the gift tax return (IRS Form 709). Unlike the 409A Valuation Report, the valuation report for gift and estate purposes is attached to the applicable tax return and filed with the IRS.

Five Risks

Valuations are very purpose-specific. How the client will use the valuation dictates the applicable standard of value, the valuation methods used, the report’s content, the depth of due diligence, the effective date of valuation and the equity interest being valued, among other factors. The standard of value – FMV – is the same for the 409A Valuation Report and gift and estate valuations. But then things diverge. There are at least five reasons (and other more subtle reasons) why there’s risk and possible liability in using a 409A Valuation Report for a gift or estate tax filing:

  1. Foundation.  409A valuations are conducted under the guidance of the AICPA’s Practice Aid – Valuation of Privately-Held-Company Equity Securities Issued as Compensation – published in 2013. Gift and estate valuations are subject to various IRS revenue rulings (for example, 59-60, 77-287 and 93-12), the Internal Revenue Code (for example, Chapter 14, Sections 2701-2704) and Tax Court precedence. These can have a material impact on how valuations prepared for these different purposes are completed.
  2. Audit risk. Because valuation reports prepared for 409A purposes aren’t filed with the IRS, they’re subject to virtually no audit risk if prepared by an independent third-party valuation professional. On the other hand, since gift and estate valuation reports are attached to the taxpayer’s return and an actual tax is often payable or, in the case of many gift tax returns, a record of the amount of a taxpayer’s lifetime exclusion from tax is being made, gift and estate valuation reports have significantly higher audit risk than 409A valuation reports. In the event of an audit, using a 409A valuation for gift and estate purposes exposes a client to additional risk.
  3. IRS Adequate Disclosure. The current standard for the disclosure of valuations under the federal gift tax filing is outlined in the IRS’ “Adequate Disclosure Rules.”  The 3-year statute of limitations on gift taxes begins on the date the Form 709 is filed only if the gift is “adequately disclosed. The submission of a valuation report prepared by a qualified appraiser will meet the adequate disclosure requirements concerning the valuation of any gift transfer if the report meets the requirements of Treasury Regulations Section 301.6501(c)-1(f)(3). Because no such rules exist for 409A valuations, 409A Valuation Reports aren’t written to meet the IRS Adequate Disclosure Rules. As a result, using a 409A valuation report for a gift tax filing runs the risk of an audit indefinitely into the future.
  4. Underlying interest. The underlying equity interest valued in a 409A Valuation Report may differ from the one gifted or includible in the estate. For example, in an estate tax situation, the various classes of shares the decedent holds are aggregated for valuation purposes.
  5. Attorney/client privilege. A client’s estate-planning attorney often hires the valuation professional on behalf of the client so that the valuation report is covered by attorney-client privilege and work product protection in case of an audit. A 409A report isn’t covered.

While there are several reasons not to use a 409A Valuation Report for a gift or estate tax filing, referencing one can be very helpful. If a 409A valuation report has recently been completed, it helps save time (and, therefore, fees) in completing a gift tax valuation. Ultimately, it will depend on the quality of the 409A report.

Chris Mellen, ASA, MCBA, CVA, ICVS, CM&AA, is a Senior Managing Director with VRC

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