Fair market value (FMV) is the cornerstone of accurate business valuations, especially when it comes to managing assets within trusts or estates. For banks and trust companies, understanding FMV is essential to fulfilling fiduciary responsibilities and ensuring compliance with IRS regulations. Relying on business owners or CPAs for valuations may lead to inaccurate figures, putting trustees at risk of breaching their duties and clients at risk of paying more taxes than necessary. By obtaining a reliable FMV through independent appraisers, trust companies can protect their clients’ interests while upholding regulatory standards. This blog explores the importance of FMV and why it matters in the trust and estate world.
What is fair market value?
In business valuation terms, fair market value (FMV) is a “standard of value.” Since the meaning of “value” can depend on the person and context, the standard of value defines the type of value being sought by addressing: “value to whom?” and “under what circumstances?” (Pratt, Valuing a Business. 5th ed.) While there are other standards of value (e.g., fair value, investment value, intrinsic value), fair market value is considered the most widely recognized and accepted standard of value related to business valuations. It is the standard that applies to virtually all federal and state tax matters such as federal estate taxes (Form 706), gift taxes (Form 709) and even inheritance and income taxes. As such, fair market value is the standard of value required by the IRS. The International Glossary of Business Valuation Terms provides the following definition of “fair market value”:
“The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
Where can I obtain a fair market value indication?
Prior to now, you’ve likely been receiving a value for your private business interests from your client, the business owner or even the company’s CPA. Although these seem like logical sources for obtaining “a value,” they are not logical for obtaining a “fair market value.” For example, if you were the client and your trust officer simply asked you for the value of your interest, knowing that there may be tax implications would you understate the value in order to pay a smaller tax? Regardless of your morals, the IRS has witnessed this abuse firsthand, hence has enhanced reporting standards and oversight.
How about going straight to the company and getting the value from the business owner? Who could possibly know the business better than the owner?
True, but when it comes to value, the owner may have an unrealistic opinion as to what the business is really worth. As trustee/custodian you now run the risk of being in breach of your fiduciary duty because you assumed the owner’s value to reflect FMV when in reality it was greater than FMV. For example, more money can be forced out of an IRA account annually and your client pays more in taxes each year for having to report excess taxable income.
How about the company’s CPA? They do the taxes and certainly understand the finances of the business. There’s no incentive for the CPA to provide a biased opinion, right?
Not always. In some instances, the CPA may have an underlying incentive to do what’s best for their client. After all, ‘the CPA has been the company’s accountant for over 10 years, considers them a good client and certainly doesn’t want to lose them.’ This introduces a potential “conflict of interest.” Conflicts of interest can arise when firms that offer a variety of services are hired to perform business valuations for current or prospective clients. CPAs often face an inherent conflict of interest by offering services that require advocacy (such as tax accounting) in addition to business valuation services, which require independence.
An attractive alternative for receiving an accurate fair market value while avoiding a conflict of interest is to hire an independent, “qualified appraiser”. Independent professional appraisers are legally and ethically prohibited from entering into arrangements where the appraiser’s fee is contingent on a certain settlement amount or the outcome of a court decision. According to §170(f)(11)(E) of the Internal Revenue Code, a qualified appraiser is one who:
- Has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements in IRS regulations;
- Regularly performs appraisals for which the individual receives compensation;
- Meets other requirements of IRS regulations or other guidance;
- With respect to any specific appraisal, demonstrates verifiable education and experience in valuing the type of property subject to the appraisal and has not been prohibited from practicing before the IRS at any time during the three-year period ending on the date of the appraisal
How is fair market value derived?
Since there is no public market where we can readily price these assets, we essentially need to create one. In 1959 the IRS issued Revenue Ruling #60 as guidance on how to credibly value a closely held business. This Ruling, more commonly known as Revenue Ruling 59-60, suggests a review of the following:
- The nature of the business and the history of the enterprise from its inception
- The economic outlook and the conditions and outlook of the specific industry in particular
- The book value of the stock and the financial condition of the business
- The earning capacity of the business
- The dividend-paying capacity
- Whether or not the enterprise had goodwill or other intangible value
- Prior sales of the stock and the size of the block of stock to be valued
- The market price of stocks and the sizes of companies engaged in the same or a similar line of business having their stocks actively traded on an exchange or over-the-counter market
The above factors form the basis for developing a fair market value indication based on the utilization of three basic approaches to value: the Market, Income, and Cost approaches, briefly defined as follows:
Market Approach: Based upon the valuation principle of substitution, as it develops value measures from prices investors are paying for stocks of similar publicly traded companies.
Income Approach: Based upon the valuation principles of anticipation and substitution, as the approach considers expected returns on an investment, which are either discounted or capitalized at an appropriate rate of return to reflect investor risks and hazards.
Cost Approach: This approach uses balance sheet data at or near the valuation date adjusted to reflect the estimated market values of the assets and liabilities. A net asset value is then derived by subtracting the recorded liabilities from the estimated fair market values of the underlying assets.
Learn More: The Three Methods of Valuing a Closely Held Business
Shareholder-level discounts
Finally, sticking with the “hypothetical willing buyer/hypothetical willing seller” FMV mentality, it is important to note that the buyer and seller are hypothetical as opposed to any one specific, identified buyer or seller. This qualification is intended to eliminate the influence of any underlying motivations (as referenced above with the client, owner and CPA). As a result, under the standard of fair market value the focus must be on the specific ownership interest on an “as is” basis. Therefore, a discount or premium may be applicable that adjusts the value of the subject interest relative to the base value to which it is compared. (American Society of Appraisers Business Valuation Standard VII, Valuation Discounts and Premiums).
Since minority interest positions are generally void of control factors (viz. right to vote, acquire/sell assets, determine dividend policy, control day-to-day operations, etc.), it stands to reason that the value of a minority interest is less than the pro-rata portion of a controlling interest value. Likewise, if there are withdrawal and transfer restrictions and relative difficulty with liquidating your ownership in the company, you would expect to pay less to reflect the inherent illiquidity of the investment. There are a number of factors and elements that can be covered here, but essentially, when analyzing the value of a partial interest in a closely held business, discounts for lack of control (DLOC) and lack of marketability (DLOM) may be applied to account for the lack of these valuable rights and benefits, as demonstrated in the chart below:
Why fair market value?
When taxable events occur in transactions involving privately held businesses, and the IRS wants to make sure that the proper amount of tax is being collected. Essentially, reporting requirements were implemented to prevent abuse by reporting too low of values with the intent to pay less in taxes. By codifying these assets, the IRS can easily identify the existence of hard-to-value assets and scrutinize the value if it appears understated. There have been multiple tax court cases where taxable events were not supported with accurate values (Berks v. Commissioner of Revenue; Gist v. Commissioner of Internal Revenue), and in each case the taxpayers incurred huge taxes and penalties.
Accurate FMVs don’t necessarily translate to higher taxes. Instead, they can often prove beneficial to the account owner. For example, if the FMV of a hard-to-value asset shows that the value has actually declined since the original investment, then that translates to a lower tax bill for the owner when distributions are taken. Oftentimes, a trustee/custodian will continue to report the original price of the investment even though the value has declined. The only way to support a decline in value is by obtaining a fair market value.
Conclusion
Obtaining an accurate fair market value is crucial for banks and trust companies in managing privately held business interests within trusts. Relying on owners or CPAs for valuations can lead to conflicts of interest, inflated taxes, or even breaches of fiduciary duty. By working with independent, qualified appraisers, you can ensure compliance with IRS standards while protecting your clients’ assets.
To dive deeper into the topic and learn best practices for navigating business valuations in trusts, join us for our upcoming webinar, Privately Held Business Valuations for Trusts. ITM’s valuation team will be joined by Life Insurance Trust Company to discuss the nuances of business valuations and how they impact trusts. Don’t miss this opportunity to get expert insights and practical strategies.
