THE IRS AND DISCOUNT VALUATIONS

The IRS is ramping up enforcement with increased audits of discount valuations. The Mentor Group has an excellent reputation with the IRS. Our valuations are almost always accepted without changes. Our discount valuations are well-documented, consistent, and reasonable to withstand any audit. Following are some common issues that arise in audits of discount valuations.

1. Disagreement with Assumptions: The IRS may challenge the assumptions used to calculate the discount valuation. For example, if the discount valuation is based on projections of future earnings, which seems unreasonably low, the IRS may argue that the projections are too pessimistic.

2. Comparability Analysis: The IRS may conduct a comparability analysis to determine whether the discount valuation is consistent with similar transactions in the same industry.

3. Lack of Support: The IRS may challenge the discount valuation if it is not supported by sufficient documentation or evidence. For example, if the discount valuation is based on a separate appraisal (e.g. real estate), the IRS may challenge the methodology used in the appraisal or the qualifications of the appraiser.

4. Control Premium: The IRS may challenge the inclusion of a control premium in the valuation. The IRS may argue that the control premium is not justified in the particular circumstances.

5. Reasonable Factors: Elements affecting value should have reasonable probability of occurrence.

6. Family Participants: The IRS often attacks transactions based on family member participants, as they believe that family members tend to collude with each other. However, the courts generally reject the notion that family is more cohesive than non-family. They do not like valuators “imagining the ultimate purchaser.”

7. Agreement Terms: The specific language in the LLC or entity agreements, re control of operating functions versus distributions/exit strategies, is paramount to supporting various discounts.

8. Rate of Return: To combat the IRS, the valuator should justify the rate of return (RoR) for the specific investment. This RoR should fall within a narrow band, depending on the investment profile and risk.