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Valuations (IRS 2704 Rule Changes)

During the waning months of the Obama Administration, the IRS proposed changes to section 2704(b) that would remove legitimate valuation discounts for estate, gift and generation skipping taxes. In a significant victory for family forest owners, the Treasury Department, in response to President Trump’s Executive Order, announced on October 2 that the Section 2407 proposed regulations would be withdrawn. The proposed changes would have effectively doubled the estate tax valuations for timberland by removing legitimate valuation discounts for estate, gift and generation skipping taxes (read more).

For nearly 20 years, these discounts have been used to protect family business from over taxation at the time of a transfer of shares via death or gift. If implemented, the proposed valuation requirement will approximately double estate tax valuations for timberland.

The Forest Landowners Association has been engaged in this issue since it first developed. On April 27, 2017, FLA submitted comments to Secretary Mnuchin urging him to withdraw the regulations, and we continue to monitor the issue as it progresses. 

Why Does this Matter?

Many families organize their real estate assets in a family owned company, which serves multiple purposes, including: gifting shares in a company, providing a means of involving second or third generation family members in the business, and facilitating orderly day to day management.

Company valuations (or appraisals) are often needed to provide shareholders with values for a financial statement, loans, property sales or exchanges, or transferring to the next generation by gift or inheritance. The object of these valuations is to determine fair market value. Determining fair market value for real estate is developed by three approaches: comparable sales, income (discounted cash flow analysis) and summation approach or sometimes called “sum of the parts”.

If assets are in a company, fair market value is determined by the value of the company’s stock or shares. The appraiser must first consider the nature and value of all assets in the company before attempting to value the fair market value of all company shares. Typically, the fair market value of shares held in closely held company, like many family forest landowners, will sell at a price less than the simple prorate percentage of ownership that someone might hold. This ratio has evolved to be expressed as a “discount”. While the term “discount” is a misnomer, it’s a convenient way for appraisers to illustrate the relationship between share price and the sum of the assets.

Historically, stock/share prices for timberland companies, whether public traded or closely held companies, typically sell at something less than the sum of values for the land and crop (i.e. shares sells at a “discount”). Nevertheless, the appraisal process leads the appraiser to a fair market value conclusion.

In the 2704 proposed rule changes, the appraiser will be forced to value based on a prorate share of the value established by “sum of the parts” or the income approach, but excludes the comparable sales approach. Requiring such valuation/appraisal, is totally contrary to long held appraisal principles and will result in imposing a value that may have no relationship to “fair market value”, a willing buyer-willing seller approach to value. “Fair market value” will be deemed to be “sum the parts” without consideration for the fact that it is actually stock or shares being valued. Abandoning such long-held principles will create an artificial value not in relationship to the marketplace.

Example

Let's examine the following scenario within the context of forestland: 

  • 4000 Acres (Land Valued @ $1000/acre) = $4,000,000
  • 4000 Acres (Timber Valued @ 1500/acre) = $6,000,000
  • Sum of Values = $10,000,000 

Assume this asset is held in a closely held family company with 100,000 shares of outstanding stock issued, meaning that:

  • $10,000,000 / 100,000 shares issued = $100 per share

Now, let's split the land up by shares:

  • Owner A - 30,000 shares x $100/share = $ 3,000,000
  • Owner B -  20,000 shares x $100/share = $ 2,000,000
  • Owner C - 50,000 shares x $100/share = $ 5,000,000

While the sum of the parts (for the assets) indicates a value of $5 million for owner C, the 50,000 shares of stock will have a market value at something less than $5 million. Why?

Because of illiquidity and lack of control, there is no quick and ready public market for these shares. A typical buyer with $5 million in hand would typically prefer to buy his own land and have complete control. But, there is a price that would make the purchase attractive. Let’s assume that he is willing to pay $2.5 million. This can be translated to a 50 percent discount to the “sum of the parts value”.

In reality, buyer discounts for such purchases reflect a 30 percent to a 70 percent “discount”. If the IRS 2704 proposed changes can be implemented, fair market value ($50/share), a long-held principle in all trade and in all appraisals, must be abandoned in favor of summing the parts ($100/share).

This proposed valuation requirement will approximately double estate tax valuations for timberland owned by closely held companies, a devastating effect on timberland owners across the country.

Related Articles

October 4, 2017
Forest Landowners Applaud Treasury Department Decision to Withdraw Section 2407 Proposed Regulations
In a significant victory for family forest owners, the Treasury Department, in response to President Trump’s Executive Order, announced on Monday that the Section 2407 proposed regulations would be withdrawn (view the full release). The proposed changes would have effectively doubled the estate tax valuations for timberland by removing legitimate valuation discounts for estate, gift and generation skipping taxes.

August 2, 2017
Congress Presses Forward on Tax Reform; Latest push by Republican leaders mirrors FLA agenda
A joint statement released in late July makes it clear that Republican leadership in the White House, Senate and the House of Representatives will craft, introduce and work to build support for a comprehensive tax reform package this fall.

August 23, 2016
Treasury Department Proposes Changes in Family Business Valuation Approach
Earlier this month, the Internal Revenue Service proposed changes to section 2704(b) that would remove what family business advocates consider legitimate valuation discounts for estate, gift and generation skipping taxes. These discounts have been used for nearly twenty years to protect family business from over taxation at the time of a transfer of shares via death or gift.

November 8, 2016
FLA Comments on Proposed 2704 Rule Change
On August 2 the US Department of Treasury proposed changes to the way estates are valued in what is known as section 2704(b). Public comment is being sought through November and a public hearing will take place in December 1 in Washington, DC.

 

 

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