The Value of Value

The Value of Value

Article posted in Compliance on 28 January 1999| comments
audience: National Publication | last updated: 18 May 2011
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Summary

What is value? In this edition of Gift Planner's Digest, San Francisco attorney and planned giving consultant Lynda S. Moerschbaecher explores the crucial role that establishing a correct value plays in the outcome of charitable gift plans.

by Lynda S. Moerschbaecher

Lynda S. Moerschbaecher is a well-known consultant and lawyer located in the San Francisco Bay Area whose practice extends nationwide. She works with individuals, closely held businesses, and financials advisors, in the areas of estate plans for clients of wealth, design, and structure of charitable/philanthropic transfers for dynamic personal benefit, creation of domestic and international private foundations, or new public charities, technical support, and document drafting for other financial advisors. Moerschbaecher speaks and writes on estate planning and philanthropic transfers that financially benefit the family as a group, lower or eliminate income, and estate taxes for high level wealth clients, and diversify and restructure assets for the owner. She has been a frequent speaker at the National Conference on Planned Giving and was a featured author for the inaugural issue of The Journal of Gift Planning.

Introduction

What is value? Value as a concept is often taken for granted, but if you stop to think about it, it is the very basis of every transaction we do in charitable gift planning. We are lowering value, raising value, trying to make value disappear, defending value, defining value, timing value, shifting value to others, and any number of other things related to value or valuation. Yet we take the concept of value in stride as if it were a concrete object we walk by each day on the way to work knowing it's there, but never really looking. Once in a while we should stop as we pass by and take a closer look.

The Concise Oxford Dictionary defines value to include the worth, the desirability or utility of a thing. It continues to say it is the amount of money or goods for which a thing can be exchanged in the open market--its purchasing power. The amount of money or goods for which a thing can be exchanged, however, can change overnight. Either up or down. So what is this ephemeral thing called value if it is so "unconcrete" as that?

So much of the tax law relating to estate planning or asset planning is based on the concept of value that it is probably the most litigated concept in the tax courts. Judges, lawyers, the Internal Revenue Service, and experts alike struggle to come to terms with this concept. Capturing the concept is akin to catching steam from a boiling cauldron. For the most part, a tax law definition has emerged: applying it, however, is not easy. The tax law follows the "willing buyer--willing seller" test. This test says value is the price a willing buyer will pay to a willing seller, both parties having reasonable knowledge of the relevant facts and neither being under compulsion to buy or sell. [Reg. Sec. 20.2031-1(b)] Value is not determined by a forced sale or in a market other than that in which the item is ordinarily sold.

Why is this very simple definition the subject of such close scrutiny by the tax authorities, and thus, the industry? Because everything we do with wealth structure, design, or planning is based on it, even though we do not really focus on it that way.

We are concerned about removing the value of assets transferred to charity, or charitable trusts, from the gross estate of the donor of those assets. If we cannot remove it, we sometimes try to establish a lower value, discounted for minority-held positions in closely held business or in parcels of real etstate. Other times, we forget that these very same discounts apply to the transferred gift. Valuation techniques combine favorably or unfavorably, as the case may be, with charitable gifts.

In addition, charitable deductions, whether for gift and estate tax or income tax are entirely based on this slippery concept called value. Appraisals are required to help establish this amount that represents a fair exchange, but are not a substitute for the "correct value," as we know from many rulings and cases. The IRS can always challenge the value and can assess penalties for gross misrepresentations of value, whether too high or too low.

In the field of planned giving, value forms the basis for much more than a donor's deduction. It forms the basis for the donor--beneficiary's payouts (and therefore general happiness with the transaction and ultimately with the planner or the charity involved). Charitable remainder trusts, charitable lead trusts, gift annuity payouts, and pooled income fund unit assignments are all based on this one concept. If one were to choose the single most important topic of work in this field, it would have to be the value and the process of establishing it, or valuation. Nevertheless, if a test were given to all planners on concepts of value and methods of valuation, most would flunk. Things such as penalties and penalty taxes are also based on value. For example, the excise tax on acts of self-dealing is based on the "amount" of the transaction, which is not always easy to determine. Accuracy related penalties are also based strictly on value, in fact on a concept that may be an oxymoron, "correct value." Required provisions of charitable remainder trusts include repayments to and from the trust for overvaluation and undervaluation of the trust assets. Everywhere you turn in this field you bump into value.

Intrinsic Versus Artificial Value

As you can see, we need to get a handle on what value really is and make it work for us. But how can we do that when value is something that not everyone agrees on and that can change in an instant? Is there really an intrinsic value to an asset? Let's assume that a group of artists in a small remote country carve little objects in wood very ornately and have done so for several centuries. But this year, another group, a group of well-heeled travelers happens to visit the place. They bring back with them a few of the objects. Soon at a dinner party back home, one of them talks with a friend about these little woodcarvings. Lo and behold, a friend who did not go on the trip asks if he can purchase one or more of them from the traveler. We have now reached the point where value must be established if the traveler is willing to sell his objects. We have a willing buyer under no compulsion to buy.

At this point, we must ask the question whether the objects actually have an intrinsic value, or whether value is some artificial creation of people involved in the process. Clearly, the object has not changed at all in its physical form. Yet, its worth or desirability has just changed. So a price for exchange must be established: The willing traveler/seller knows he will probably never go back to the remote country, but also knows these objects are "a dime a dozen" there. So what will he use as a basis for this exchange, "his" value or the value back there? To increase the uncertainty, let's assume the traveler has agreed to give up just one of these things, because he only brought back two. Just when the potential buyer thinks a deal has been struck, another dinner attendee walks up and begins to participate in the conversation. Of course, the listener is fascinated and decides that he can offer a higher price for the object so he does. The first buyer objects, which attracts some attention at this otherwise rather sedate dinner party. Soon a group of dinner attendees gather around to see what is the brouhaha. When they discover the topic of conversation, several of them also want to purchase the wood carved object, each raising the price slightly over the prior bidder. Has the object changed? Has its intrinsic value changed? Will it sell for a different price back in the remote country?

Soon, the hostess comes over, upset that the dinner party may turn into a heated argument. She understands the problem and suggests that the group form a limited liability company (LLC) to hold the object, and that they all purchase units in this LLC. Of course, this is a wise solution. Each holds a 1/10th interest. However, one of them wishes to give his share to his nephew, who everyone knows to be a flake, and with whom no one wants to be a joint owner. They all insist that whoever wants to dispose of his/her unit must first offer it to the group and they agree, as a group, on how much they will pay to recapture this valuable unit. Has the object's real value changed?

The group then decides that a holder may give away his or her interest, but only to an immediate family member. So the nephew does not get the unit, but the daughter does. However, when filing his gift tax return, dad argues that his 1/10th interest is not really worth 1/10th of the value of the object, because what he really owns is a right to a share of it, where it is an indivisible thing and he only holds a minority interest. The other nine people actually control the object, so his interest is less valuable than 1/10th. Should value change based on each of these occurrences?

All value is a contrivance. It does not exist apart from these occurrences and the relationships of people that create, alter, or destroy the value of any item.

The Measuring Stick

Rulers, thermometers, speedometers, altimeters, and other devices of measurement will not do for measuring valuation. We may agree that value exists, and the value is created by the acts of people related to the object in question. But how can we really measure the value, and when does valuation happen?

If value is so intangible and fleeting, how can the measurer grasp it just for a moment? The courts have grappled with that issue in relation to taxes for every year that the tax laws have been in effect. In the regulations under IRC section 2031, many rules are set forth for valuation. Just as, "What is income?" occupies an enormous amount of space in the income tax world historically, so does valuation occupy an enormous space on the gift and estate side of the tax ledger. Valuation concepts are specified for stocks and bonds, options and contracts, notes, interests in business, cash on hand or on deposit, household and personal effects, annuities, life insurance, estates for terms of years, remainders, reversions, life estates, and many other things. But this barely scratches the surface. The cases and rulings add complexity and texture to these rules. Many books and treatises attempt to explain the complexity of the rules.

For example, in the section on stocks and bonds, Reg. Sec. 20.2031-2(b)(l) states that the mean between the highest and lowest quoted selling prices on the valuation day is the fair market value for share or bond. But what if there were no sales that day, or if the stock were listed on several exchanges and each had a different mean price? Well, the regulations address those problems. These regulations though control transfer tax on shifts of wealth. What about the valuation required to set the unitrust amount for a taxable year? Does this same rule apply requiring the mean to be used, or can the opening or closing value of the market be used instead? These three values may be substantially different due to the market conditions overall, the industry condition or even the particular company. It does not seem that valuation for IRC Sec. 664 for setting a payout amount must follow the rules of IRC Sec. 2031 for transfers of wealth. Reg. Sec. 1.664-3(a)(1)(iv), Rules Applicable to Valuation merely states that all assets and liabilities must be taken into account on the applicable valuation date. Thus, on the same day the very same publicly traded stock for a decedent dying, or a person making a gift, or the trustee setting the unitrust amount, the value could be different. So the same asset may be valued differently, even by the same method.

Consider then that different assets have different characteristics, and therefore also require radically different methods of valuation. Every asset has at very least two parts, the underlying nature of the asset and also its ability to generate income. Both of these are used to capture this concept of value, and sometimes are used together. Income flow, or capitalization of an income rate, may be the best measure of certain assets, such as real estate subject to a long-term lease, a patent producing royalties, or other assets used as a base for the generation of income. However, not all assets are best viewed as income generators, and those that do not generate any income at all must be valued based on the nature of the asset itself, often by comparable sales if those exist.

In the field of planned giving, the determination of value comes into play in other ways--often because we are attaching a percent times some amount. In these cases, it is critical to understand what the percent is being multiplied by. That "what" is invariably value. Thus, every time you hear or see a percentage you must ask yourself, "Percent times what?"

For example, the simplest use is percent times yearly value to determine the unitrust amount. On the first day or business day of the taxable year, the trustee determines value of the trust assets. Easy, right? What about the trust that has raw land in its portfolio, or a note receivable? In the case of the note, the terms of the specific note in comparison to the prevailing rates in the market in general will be part of the value. So will the credit worthiness of the payor. Not so simple. The raw land might be contaminated, have a conservation easement on it, or be adjacent to a new lucrative shopping center. And consider all the types of assets that people transfer into CRTs, from patents to closely held stock, to exotic parcels of real estate, to annuities, to passive foreign investment company holdings.

All these weird assets need to be valued every year for percent times what. The right measuring stick is not always easy to find and is not always accurate. Who will the donor, the trustee, or the donee find to apply the appropriate measuring stick?

Who Determines Value?

When we think of who determines value, we generally think of appraisers. Since 1985, we also think of the term "qualified appraiser." Now, just who would choose a nonqualified appraiser if so much of our work relies on the concept of valuation, and when the exact measuring device is so hard to find? Obviously, the term qualified appraiser came about for a reason. Prior to 1985, there were many valuation abuses in the charitable field. Art gifts were overvalued regularly by several hundred percent of what the IRS determined to be the "correct value." Is there such a thing? Correct value is a strange concept in that it is not a value at all according to the well acceptable definition of willing buyer--willing seller test. Correct value is what the IRS or the courts finally determine. How does that relate to the legal definition found in the regulations under IRC Sec. 2031? Neither the IRS nor the court is a seller or a buyer, so how do they know what a willing buyer would pay? The courts get around this by saying the test is that of a hypothetical willing buyer and willing seller.

Congress decided in 1984 (effective 1985) that it was time to impose certain restrictions on valuations and established the rules on qualified appraisals and qualified appraisers. In our field, the "who" question became a narrower one. Who would be acceptable for determining value for income tax deductions, where the value of the deduction exceeded $5,000 (for nonpublicly traded assets), was only one person, a qualified appraiser, or one who held himself or herself out to the public to appraise specific type of property in question, and who would agree to sign the appropriate tax form under penalty of perjury. Would you do that when, as we have seen, value is such a slippery concept? Perhaps it would help to tell you that the appraiser who runs afoul of these rules essentially risks disbarment, i.e., he or she may not do appraisals that have any affect on the internal revenue laws or taxes. Nevertheless, many brave souls are doing qualified appraisals.

But appraisers are not the only ones who must value assets. So must the trustee of the unitrust, whether lead or remainder type, and the pooled income fund. They may or may not hire an appraiser to do the valuation. A bank or trust company subject to state or federal regulation will hire an appraiser for any nonpublicly traded stock. An individual or a charity serving as trustee does not always do so, and does not have the same banking regulations imposed on them. Are they at risk for their valuations? They certainly are. The potential complainants are the IRS where the unitrust beneficiaries have pulled out too much in the way of current trust distribution, the charitable remainderman, any successive beneficiary, and the state attorney general.

Certain parties are prevented from valuation in certain situations, such as charities valuing gifts received, or the issuer of the property valuing it. The who question, while narrower than it used to be, still leaves open much room for having an inappropriate or unqualified person performing the valuation in this field. It also provides a basis, or reason, for finding the most qualified person to do the job.

When Is The Value Determined?

In the description of capturing the escaping steam from a boiling pot is the answer to the question of when the value is determined. Value only lasts for a brief moment in time, basically forming a quick snapshot of the moment. In the very next moment, the value may and will likely change.

This is very evident in the case of the gift to a CRT. When the donor has the appraisal done or the value is found on a public exchange, a value is set. Then, when he or she transfers it to the trust, the trustee must set a value for the payment of the unitrust amount. There may be a slight or very large difference in value between these two moments. As to an asset requiring an appraisal, the value may have been made up to 60 days prior to the transfer. The trustee is not bound to set the same value for the trust as the donor has for his or her income tax charitable deduction. Time and circumstances may have caused a different value. Then the trustee may choose to sell the asset and put it on the market, at which time it may have an altogether different value.

The when question in valuation is critical. The carved wooden object just before dinner had a substantially lower value than just after dinner. Valuation cannot exist but for a moment in time. Time is an essential ingredient in the very definition of value, but can you find it in the willing buyer--willing seller test used by the IRS and the courts? It is strangely lacking, but may be implied.

Altering Value

After all this effort at determiring of appropriate value, people try to change that value by many different techniques. Minority discounts, lack of marketability discounts, and other techniques to make value disappear, or in some cases appear, are applied to the value of an asset. Buy/sell agreements are created to control the value of the sale or purchase of an asset. Ownership is split among entities by using partnership interests, or trusts, where certain rights are retained and only other rights are subject to valuation of assets transferred. Some of these techniques are bundled together for a more dynamic effect.

For example, the use of a charitable lead trust (especially unitrust version for its generation-skipping advantages) splits an asset into an income interest value for the charity, and a remainder interest value for the grandchildren. Thus, the value of what is shifted to the grandchildren is already discounted, and transfer taxes and generation-skipping taxes are only applied to the value of the remainder interest. What if, however, the funding asset is a minority interest in an asset, such as a closely held business, a limited partnership, LLC, or a parcel of real estate? Is this minority interest discounted first for its minority position, and perhaps also for lack of marketability, and then again for the remainder interest? It certainly appears so. For sure, the IRS would argue it the other way around where the gift vehicle was a charitable remainder trust.

Conclusion

Valuation is a subject that has not been given enough attention in the field of charitable giving. It is the very foundation of our work, and the ideas need to be more fully explored as to how they apply to each type of gift arrangement We take for granted the concept of valuation until something goes wrong, like an overvaluation, and the distribution of too much money to a CRT beneficiary from whom the trustee must now request it back. We should do some preventive work to learn these concepts, as well as possibly preventing embarrassing situations with clients and donors, not to speak of costly errors. The IRS is relentless on the issue of valuation. We should always be vigilant in this regard.

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