High Growth Client – How do you Protect their Legacy?

As a trusted advisor, you’re determined to help your high-growth clients plan for the future, especially when they own a company that is growing rapidly. Often this includes helping them gift a portion of their company to the next generation—which means you’ll want to carefully examine their gift tax returns and any related appraisals before the IRS does.

When your client’s team picks discounts for a gift tax valuation, a careful review of The Discount for Lack of Marketability: Job Aid for IRS Valuation Professionals (otherwise known as the Job Aid) will help you avoid several common mistakes—like the pitfalls described below.

Mistake #1: Overlooking a “Dividend Bump”

The Job Aid is the internal handbook used by IRS agents to evaluate gift tax returns and valuation reports, specifically related to discounts for lack of marketability (DLOMs) and discounts for lack of control (DLOCs). Released in 2009, it offers critical insights into how the government assesses discounts, what the IRS considers a red flag and best practices for selecting and supporting discounts used by appraisers in gift tax valuation work.

One key determinant of a DLOM is the level of anticipated dividends or distributions that will be paid out. The Job Aid references both historical and expected future dividend yields (the ratio of how much the company pays out relative to its share price) in several restricted stock studies. If distributions were to increase significantly after the date of the gift, then the IRS may rely on this fact to argue that the DLOM used in the gift tax return was too high.

How can you avoid this common mistake? Confirm that your appraisal team has considered future distribution levels when picking a DLOM and advise your client not to make sudden changes to their dividend policy.

Mistake #2: Double-Counting

Some in the valuation community may rely on certain market data to pick their DLOC without realizing that their chosen number also includes a DLOM. For example, the Job Aid discusses (on page 67) implied discounts associated with secondary market trading of real estate limited partnerships (RELPs), with this study also referred to as “Partnership Profiles” or the “Partnership Spectrum”:

The RELP resale market is so small (i.e., “thinly-traded”) that the Partnership Profiles data arguably reflect some additional consideration for lack of marketability [i.e., a DLOM].

Practically speaking, even an expert appraiser could end up double-counting if they pick a DLOC (solely based on the high end of the RELP data) and also pick a fairly high DLOM (based on restricted stock studies)—and this may trigger an IRS audit.

How can you avoid this common mistake? Work with an experienced appraiser who will select a supportable DLOC and DLOM based on appropriate data.

Mistake #3: Ignoring a Near-Term Exit

Another common pitfall when picking a DLOM is failing to consider the potential impact of a near-term exit event. For example, selling the entire company to a third party shortly after the date of the gift would result in the gift recipient receiving cash for their stock. Yet many of the restricted stock studies referenced in the Job Aid support larger DLOMs based on the holding period (the time during which the holder of the subject interest cannot receive immediate liquidity for their interest in the business), so a near-term exit invalidates the comparison between the subject interest and the average discounts.

So, if your client is preparing to sell their company (or even just considering a sale), then the DLOM needs to be reduced. Don’t let this point slip through the cracks! The government typically has three years from the date of the gift or gift tax return to launch an audit, and any future sale of the stock (to a third party) is reportable to the IRS on another tax form.

How can you avoid this common mistake? Confirm that your client’s appraisal team has considered the potential for an upcoming sale of the business. Even better, plan the eventual sale of the business well ahead of time (say, five or more years before the owner expects to exit), and implement the gift as an early step in the process.

And One More Mistake: Failing to Choose the Right Professional Appraisal Team

Professionals in the valuation community who use the Job Aid should understand the three common pitfalls described above so they can help you avoid mistakes when picking discounts for a gift tax valuation. Work with an appraisal team that understands high-growth companies and how to value them and does this type of valuation frequently. By building a team that includes not only an experienced appraiser but also seasoned legal and tax professionals, you can reduce audit risk and ensure that all parties communicate effectively about future plans for the business.

Overlooking changes in circumstances regarding dividend policy, using the wrong benchmarks from the DLOC and DLOM databases, and ignoring the impending sale of the business are three major mistakes that will negatively impact your high-net-worth clients by unnecessarily exposing them to the risk of an IRS audit. But by frequently consulting an expert appraisal team, you can help these clients gain peace of mind while both protecting and growing their legacy. Contact PCE now for expert guidance.