Determining the fair market value for a closely-held business for various tax purposes depends upon valuations assuming a willing buyer and willing seller aware of all relevant facts. In CCA 202152018[1] the IRS finds that the valuation used by a taxpayer in attempting to set up a grantor retained annuity trust (GRAT) did not consider the fact that there was a high likelihood the entity being valued would be likely involved in a lucrative merger in the near future.

IRC §2702 governs the values of certain interests transferred in trust:

Solely for purposes of determining whether a transfer of an interest in trust to (or for the benefit of) a member of the transferor’s family is a gift (and the value of such transfer), the value of any interest in such trust retained by the transferor or any applicable family member (as defined in section 2701(e)(2)) shall be determined as provided in paragraph (2).[2]

Under IRC §2702(a)(2)(A), the value of any interest retained by the donor in a trust is set at zero. Thus, the entire value will be deemed as being transferred to the remainder interest holders, so if $1,000,000 of assets are put in trust for a member of the donor’s family as the remainder beneficiary and the donor retains an interest that would normally be valued at $500,000, the value of the beneficiary’s interest would be the full $1,000,000 for gift tax purposes and not the $500,000 that represents the economic value of that interest.

The law does provide an option where the donor’s interest will not be considered to have a zero value, found at IRC §2702(a)(2)(B), where a qualified interest will be valued under IRC §7520 (the IRS valuation tables). This is a GRAT. To be a qualified interest, the following three conditions must be met:

Any interest which consists of the right to receive fixed amounts payable not less frequently than annually,
Any interest which consists of the right to receive amounts which are payable not less frequently than annually and are a fixed percentage of the fair market value of the property in the trust (determined annually), and
Any noncontingent remainder interest if all of the other interests in the trust consist of interests described in the prior two bullets.[3]

If an interest does not strictly meet the requirements above, then its value will be set to zero under the default treatment of IRC §2702(a)(2)(A). In this case the question will be whether the annuity payment was actually being determined based on the fair market value of the property in the trust.

The memorandum begins by discussing the donor’s commencement of an attempt to find an outside buyer for his very successful company:

Donor is the founder of a very successful company, Company. At the end of Year 1, Donor contacted two Investment Advisors to explore the possibility of finding an outside buyer. The facts indicate that, “[T]he Company was marketed through outreach by investment bankers to potential strategic buyers, some of which had previously expressed an interest in partnering with [Company]. Meetings were then scheduled to introduce [Company] and determine if there was additional interest.” Potential buyers were expected to purchase a minority stake of Company with a call option after several years to acquire the remainder of Company at a formula valuation.

In Year 2, approximately six months later and within a two-week period concluding on Date 1, the Investment Advisors presented Donor with an offer from each of Corporation A, Corporation B, Corporation C, Corporation D, and Corporation E (collectively, the Corporations).[4]

At this point, the Donor made a transfer to a trust that was intended to qualify as a GRAT under IRC §2702:

Three days later, on Date 2, Donor created Trust, a two-year grantor retained annuity trust (GRAT), the terms of which appeared to satisfy the requirements for a qualified interest under § 2702 and the corresponding regulations. Under the terms of Trust, the trustee was to base the amount of the annuity payment on a fixed percentage of the initial fair market value of the trust property. Donor funded Trust with a shares of Company. The value of the shares of Company was determined based on an appraisal of Company on December 31, Year 1, a date approximately seven months prior to the transfer to Trust. The appraisal, which was obtained in order to satisfy the reporting requirements for nonqualified deferred compensation plans under § 409A of the Code, valued the shares of Company at $w per share.[5]

Note the use here of a valuation that was performed just after the Donor began having advisers contact third parties to determine interest in the Company, but well before the Donor had five offers to buy on the table. As well, the purpose of that valuation was for reporting for the IRC §409A plans.

The process of completing a merger then moved forward.

Additional time was granted to the Corporations to submit final offers. The last offer was received on Date 3, almost three months after the initial offers. Corporations A through D raised their offers, while Corporation E withdrew from the bidding, expressing no further interest.[6]

Now the Donor establishes and funds a charitable remainder trust (CRT), this time obtaining a new valuation for this purpose:

On Date 4, Donor gifted Company shares to a separate charitable remainder trust and valued those shares at $x per share pursuant to a qualified appraisal. This per share value was equal to the tender offer value described below.[7]

Following the formation of the CRT, the sale process continued and concluded:

Three months after the new offers were received and several weeks after the transfer to his charitable remainder trust, Donor accepted Corporation A’s offer, which represented a 10 percent increase over its initial offer. Per the final offer, an initial cash tender offer was made of $x per share, an amount that was nearly three times greater than $w (the value determined as of December 31, Year 1). During the tender period, Donor tendered b shares, while Donor’s charitable remainder trust also took advantage of the tender offer.

On December 31, Year 2, Donor again had Company appraised for purposes of § 409A and the new appraised value was $y per share, which was almost twice the previous year's value of $w per share.2 These steps were repeated for a December 31, Year 3 appraisal with similar results. The December 31, Year 2 and Year 3 appraisals both included the following language: “[a]ccording to management, there have been no other recent offers or closed transactions in Company shares as of the Valuation Date.” There was no such declaration in the December 31, Year 1 appraisal.

In Year 4, approximately six months after the end of Trust's two-year GRAT term, Corporation A purchased the balance of the Company shares for $z per share, a price almost double the value of $y.[8]

The CCA notes that while, generally, events occurring after the date of a donation are not considered as of the valuation date, what was known about such events, including how likely the events are to take place, do have an impact:

Generally, a valuation of property for Federal transfer tax purposes is made as of the valuation date without regard to events happening after that date. Ithaca Trust Co. v. United States, 279 U.S. 151 (1929). Subsequent events may be considered, however, if they are relevant to the question of value. Estate of Noble v. Commissioner, T.C. Memo. 2005-2 n.3. Federal law favors the admission of probative evidence, and the test of relevancy under the Federal Rules of Evidence is designed to achieve that end. Id. Thus, a post-valuation date event may be considered if the event was reasonably foreseeable as of the valuation date. Trust Services of America, Inc. v. U.S., 885 F.2d 561, 569 (9th Cir. 1989); Bank One Corp., 120 T.C. 174, 306. [9]

But even if the event is not reasonably foreseeable, a sale shortly after the event in a sale where we have truly willing buyers and sellers does provide evidence of value.

Furthermore, a post-valuation date event, even if unforeseeable as of the valuation date, also may be probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date. See Estate of Gilford v. Commissioner, 88 T.C. 38, 52-55 (1987).[10]

If a taxpayer or the IRS wants to ignore that sale, generally the party pushing to ignore that value will want to explain what changed that renders this later arms-length sale not representative of the value at the date the value is important from a tax perspective.

The key issue is what information would have been available to the willing buyer and willing seller at the date in question, as the memorandum discusses:

The principle that the hypothetical willing buyer and willing seller are presumed to have “reasonable knowledge of relevant facts” affecting the value of property at issue applies even if the relevant facts at issue were unknown to the actual owner of the property. Estate of Kollsman v. Commissioner, T.C. Memo. 2017-40, aff’d, 777 Fed. Appx. 870 (9th Cir. 2019). In addition, both parties are presumed to have made a reasonable investigation of the relevant facts. Id. Thus, in addition to facts that are publicly available, reasonable knowledge includes those facts that a reasonable buyer or seller would uncover during negotiations over the purchase price of the property. Id. Moreover, a hypothetical willing buyer is presumed to be “reasonably informed” and “prudent” and to have asked the hypothetical willing seller for information that is not publicly available. Id.[11]

The CCA outlines the taxpayers’ explanation for the use of the seven month old valuation for the GRAT contribution and annuity amount and the use of a new valuation for the CRT funding shortly thereafter:

When asked to explain the use of the outdated appraisal (as of December 31, Year 1) to value the transfer to the GRAT, as well as the use of a new appraisal to value the transfers to charity, the company that conducted the appraisal stated only that “[t]he appraisal used for the GRAT transfer was only six months old, and business operations had not materially changed during the 6‐month period . . . For the charitable gifts, under the rules for Form 8283, in order to substantiate a charitable deduction greater than $5,000, a qualified appraisal must be completed. Because of this requirement an appraisal was completed for the donations of [Company] stock to various charities on [Date 4].”[12]

In analyzing this situation, the CCA finds one court case especially helpful. The CCA discusses the facts and rulings in the Ferguson case:

In Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999), aff’g 108 T.C. 244 (1997), the appellate court considered the issue of whether the Tax Court correctly held that taxpayers were liable for gain in appreciated stock under the anticipatory assignment of income doctrine. In Ferguson, taxpayers owned 18 percent of AHC and served as officers and on the board of directors. In late 1987 and early 1988, the AHC board of directors contacted and eventually authorized Goldman, Sachs & Co. to find a purchaser of AHC and to assist in the negotiations. By July 1988, Goldman, Sachs had found four prospective purchasers. Shortly thereafter, AHC entered into a merger agreement with DCI Holdings, Inc. With the taxpayers abstaining from the vote, the AHC board unanimously approved the merger agreement. On August 3, 1988, the tender offer was started. On August 15, the taxpayers, with the help of their broker, executed a donation-in-kind record with respect to their intention to donate stock to a charity and two foundations. On September 9, 1988, the charity and the foundations tendered their stock. On September 12, 1988, the final shares were tendered and on or about October 14, 1988, the merger was completed.

The Court of Appeals affirmed the Tax Court’s conclusion that the transfers to charity and the foundations occurred after the shares in AHC had ripened from an interest in a viable corporation into a fixed right to receive cash and the merger was “practically certain” to go through. In particular, the 9th Circuit noted that “[t]he Tax Court really only needed to ascertain that as of [the valuation] date, the surrounding circumstances were sufficient to indicate that the tender offer and the merger were practically certain to proceed by the time of their actual deadlines — several days in the future.” Ferguson, 174 F.3d at 1004. Consequently, the assignment of income doctrine applied and the taxpayers realized gain when the shares were disposed of by the charity and foundations.[13]

The memorandum finds that this situation was very similar to the Ferguson situation:

The current case shares many factual similarities with Ferguson, supra, for example, the targeted search by Donor to find merger candidates, the exclusive negotiations with Corporation A immediately before the final agreement, the generous terms of the merger, and an agreement that was “practically certain” to go through. While the Ferguson opinion deals exclusively with the assignment of income doctrine, it also relies upon the proposition that the facts and circumstances surrounding a transaction are relevant to the determination that a merger is likely to go through. See Bank One and Kollsman, supra.

Further, the current case presents an analogous issue, that is, whether the fair market value of the stock should take into consideration the likelihood of the merger as of the date of the transfer of the shares to Trust. The Ferguson and Silverman opinions, as considered by the Tax Court and the Ninth Circuit and Second Courts of Appeal, respectively, support the conclusion that the value of the stock in Company must take into consideration the pending merger. Accordingly, the value determined in the December 31, Year 1 appraisal does not represent the fair market value of the shares as of the valuation date. Under the fair market value standard as articulated in § 25.2512-1, the hypothetical willing buyer and willing seller, as of Date 2, would be reasonably informed during the course of negotiations over the purchase and sale of the shares and would have knowledge of all relevant facts, including the pending merger. Indeed, to ignore the facts and circumstances of the pending merger undermines the basic tenets of fair market value and yields a baseless valuation, and thereby casts more than just doubt upon the bona fides of the transfer to the GRAT.[14]

The memorandum goes on to find that this dooms the entire GRAT structure:

In addition, although the governing instrument of Trust appears to meet the requirements in § 2702 and the corresponding regulations, intentionally basing the fixed amount required by § 2702(b)(1) and § 25.2702-3(b)(1)(i) on an undervalued appraisal causes the retained interest to fail to function exclusively as a qualified interest from the creation of the trust. The trustee’s failure to satisfy the “fixed amount” requirement under § 2702 and § 25.2702-3(b)(1)(ii)(B) is an operational failure because the trustee paid an amount that had no relation to the initial fair market value of the property transferred to the trust; instead, the amount was based on an outdated and misleading appraisal of Company, at a time when Company had received offers in the multi-billion dollar range. When asked about the use of the outdated appraisal, the company that conducted the appraisal stated only that business operations had not materially changed during the 6‐month period. In contrast, in valuing the transfer to the charitable trust, the company that conducted the appraisal focused only on the tender offer, and accordingly gave little weight to the business operations for valuation purposes.

The operational effect of deliberately using an undervalued appraisal is to artificially depress the required annual annuity. Thus, in the present case, the artificial annuity to be paid was less than 34 cents on the dollar instead of the required amount, allowing the trustee to hold back tens of millions of dollars. The cascading effect produced a windfall to the remaindermen. Accordingly, because of this operational failure, Donor did not retain a qualified annuity interest under § 2702. See Atkinson.[15]

Of course, this document is merely a memorandum from the IRS Chief Counsel’s office, and there’s no guarantee that a court would agree with the entirety of this analysis or find any shortcomings are totally fatal to the GRAT.

But certainly, it appears the facts of this case present the IRS with opportunities it would have been better had the taxpayer avoided. While it’s very likely the IRS would have complained about using the valuation from the prior December for the GRAT regardless, the creation of the CRT triggered a significantly higher valuation that was much closer in time to the funding of the GRAT. The higher valuation conceded that, at least by the date of the CRT funding, the taxpayer’s position was that the merger negotiations greatly increased the fair market value of the operation.

Certainly, the taxpayer and advisers should have recognized that using the appraisal prepared months earlier to value the contribution to the GRAT was going to lead to questions in the event of an IRS challenge due to events related to the eventual sale that took place between the date of the valuation and the date the GRAT was funded. A preparation of a valuation at the GRAT funding date and basing the annuity payments on that amount would have greatly reduced this risk.

Similarly, when it was decided to fund a charitable remainder trust, the fact that a new, much higher appraisal would be prepared should have raised concerns about both the risk and potential for success of an IRS attack against the GRAT which relied upon a much older valuation before the merger talks got serious.

Obviously, we are not privy to how the taxpayer and advisers addressed these issues, or what facts they may believe would serve to blunt the impact of the IRS’s arguments since this is purely an IRS document. But the memorandum should serve to remind advisers of the need to consider issues that arise when the taxpayer decides against getting an updated valuation prepared before any major gift tax or income tax transaction.

At the very least, a valuation prepared as of the date of the transaction allows the appraiser to outline the facts being relied upon as well as a justification at the time regarding any arguments to limit the impact of such negotiations in process. While clients may balk at paying for “yet another” valuation, a valuation prepared right at the time of a gift transaction before the final results of negotiations to sell the business are known will be a lot easier to defend than an attempt to argue, after all parties know what ultimately happened, that that result was not easy to spot at the valuation date.

[1] CCA 202152018, December 30, 2021, https://www.taxnotes.com/research/federal/irs-private-rulings/legal-memorandums/anticipated-merger-affects-grat-appraisal-valuation/7cr6d (retrieved December 31, 2021)

[2] IRC §2702(a)

[3] IRC §2702(b)

[4] CCA 202152018, December 30, 2021

[5] CCA 202152018, December 30, 2021

[6] CCA 202152018, December 30, 2021

[7] CCA 202152018, December 30, 2021

[8] CCA 202152018, December 30, 2021

[9] CCA 202152018, December 30, 2021

[10] CCA 202152018, December 30, 2021

[11] CCA 202152018, December 30, 2021

[12] CCA 202152018, December 30, 2021

[13] CCA 202152018, December 30, 2021

[14] CCA 202152018, December 30, 2021

[15] CCA 202152018, December 30, 2021