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1. Core Valuation Principles
- Fair Market Value (FMV): Defined as the price between a willing buyer and seller, neither under compulsion, both informed. It’s a snapshot in time, similar to a balance sheet.
- Three Approaches:
- Income approach (e.g., discounted cash flow).
- Market approach (e.g., EBITDA multiples).
- Asset approach (e.g., real estate or holding companies).
- Advisors should be aware that if two approaches yield drastically different results, something is likely misstated.
📖 Reference: IRS Treasury Regulations on FMV
2. Known vs. Knowable: Hindsight vs. Foreseeability
- Hindsight not allowed: Courts reject valuations based on events after the valuation date (e.g., Gallagher v. Commissioner, 2011).
- Foreseeability allowed: Reasonably predictable risks may be factored in (Pierce v. Commissioner, 2025). Advisors should ensure experts evaluate forecasts critically and adjust for risks, not blindly accept client projections.
📖 Reference: Journal of Accountancy – Valuation Standards
3. Company-Owned Life Insurance (COLI) – A Major Red Flag
- Connelly v. United States (2024): Court included life insurance proceeds in company valuation, doubling estate tax liability.
- Proper practice: COLI is valued at cash surrender value unless death is imminent/known.
- Risk: Life insurance for buy-sell agreements may artificially inflate estate values if not structured properly. Alternatives include cross-purchase agreements or irrevocable life insurance trusts (ILITs).
📖 Reference: Thomson Reuters – Connelly Case
4. Discounts: Control & Marketability
- Discount for Lack of Control (DLOC): Typically 8–15%, reflecting inability of minority owners to direct operations.
- Discount for Lack of Marketability (DLOM): Typically 25–35%, reflecting illiquidity of private company interests.
- Courts heavily scrutinize both; unsupported or generic studies can be rejected (Estate of McCord v. Commissioner, 2006).
- Advisors can use these strategically in estate planning by gifting minority interests in stages to reduce taxable value.
📖 Reference: WealthManagement – Marketability Discounts
5. Pass-Through Entities & Tax Affecting
- Pass-throughs don’t pay entity-level tax, but owners do. Valuations should tax-effect cash flows for consistency.
- Courts increasingly accept tax affecting when aligned with economic reality (Kress v. United States, 2019; Cecil v. Commissioner, 2023).
- Advisors should confirm that valuations match after-tax cash flows with after-tax discount rates.
📖 Reference: Bloomberg Tax – Tax Affecting Valuations
6. Built-in Gains (BIG) Tax in Real Estate
- Real estate holding companies often have embedded gains from depreciation deductions.
- Depreciation recapture taxed up to 25% under IRC §1250, creating real embedded liabilities that reduce FMV.
- Courts split: some allow full reductions (Estate of Jelke III v. Commissioner, 2007), others require timing-based adjustments (Estate of Litchfield v. Commissioner, 2009).
- Advisors should assess whether a client’s estate is taxable vs. non-taxable to decide whether to recognize BIG adjustments.
📖 Reference: IRS – Depreciation Recapture
7. Advisor Takeaways
- Spot Red Flags: Unrealistic projections, poorly supported discounts, and misapplied COLI valuations.
- Estate Planning: Break gifts into minority interests to leverage DLOC/DLOM.
- Succession & Buy-Sell: Ensure operating agreements are structured to avoid liquidity and control issues.
- Audit Awareness: IRS often pulls valuations with combined discounts >40% or those signed by non-credentialed professionals.
📖 Reference: NACVA – Business Valuation Red Flags
✅ Bottom Line for Financial Advisors:
Valuations are not just compliance exercises; they’re strategic tools. By understanding FMV basics, recognizing how courts treat foreseeability, insurance, discounts, and taxes, advisors can anticipate IRS challenges, reduce estate tax exposure, and safeguard clients in high-stakes transitions like succession, gifting, or business sales.
