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How COVID-19 Is Impacting the IRS and Valuation Audits 

11.08.2020

Like every organization, the COVID-19 pandemic is impacting the IRS. And, of course, this has a ripple effect on valuation experts in terms of the impacts to the review and audit process for tax returns that include valuations. The virus has added to the troubles at the agency, which is still reeling from the effects of the government shutdown and budget cutbacks.  

During a recent webinar, Michael Gregory (Michael Gregory Consulting LLC) gave some advice on preparing valuations for estate and gift tax purposes in today’s environment. Gregory worked for the IRS for almost 30 years, much of the time dealing with valuation matters. He is now in private practice, and he stressed that his views and opinions are his own and not those of the IRS.  

Hark back to 2008? Unlike the 2008 economic downturn, the IRS now has much less staff doing valuation work—about half of what it had back then, reports Gregory. Therefore, staffing is a concern that may impact the quality of the review process. The IRS can close out more cases faster with a less rigorous attention to quality, so there is a danger in that regard. Also, Gregory thinks that Congress is asking the IRS to be more aggressive with respect to valuation-related penalties. The IRS issued an internal memorandum in January that allows agents to apply penalties on appraisers in the Small Business Self Employed (SBSE) division where the Estate and Gift (E&G) program is located without valuation specialist review. This is potentially a dangerous initiative toward business valuers. The major appraisal organizations have all responded with their concerns to the U.S. Treasury Department and to the IRS.

As the agency did back in 2008, there will be more IRS attention to certain elements of valuations. “They focused on the low-hanging fruit because that was the easiest to do,” he says. The first and foremost red flag is a discount for lack of marketability (DLOM), especially if DLOMs are being increased without adequate explanation. Second on the IRS radar screen has been S corporations because this is related to the issue of tax effecting, although it is not as prominent anymore due to tax law changes and recent court cases, Gregory notes. The third red flag is reasonable compensation. These three areas will continue to be targeted as the most likely areas of noncompliance the IRS will scrutinize while it has less resources to work with. 

What about the selection process for returns? Is there a “hit list”? Gregory explains that tax returns are selected for review and placed in three “stacks”: (1) yes, a definite audit; (2) yes, if time permits; and (3) no audit. As to the question of whether returns are selected based on who prepared the valuations, the answer is “yes and no,” Gregory observes. On a national level, there is no formal list of that kind. If there were, it would be subject to disclosure under the Freedom of Information Act. On a local level, it’s a different story. While there may be no formal list, returns may be targeted based on the experiences IRS staff members have had with the expert or firm that prepared the valuation or the tax practitioner or firm that prepared the return. “That’s just human nature,” he says.  

What to do. Based on his experience and how the IRS reacted during the 2008-09 downturn, here are some things to consider when preparing a valuation report that may get picked for review:  

  1. Explain DLOM. This is the most common challenge the IRS makes related to valuations. In the wake of the 2008 financial crisis, the IRS set its sights on valuations that simply increased the DLOM without explaining why. To avoid audit trouble for valuations the current pandemic impacted, you should fully explain your DLOM assumptions and alternatives.  
  2. Rethink weightings of approaches. “At a time like the present, in many cases the income approach is the only reasonable alternative for an ongoing business,” Gregory writes in a recent article. The market approach will be less relevant than before, and the asset approach has traditionally not generally been used for going concerns.  
  3. Consider multiple scenarios. Gregory advises that you “seriously consider” using several discount and growth rates for different time frames (e.g., short term, midterm, and long term). Also, multiple scenarios for projections that are probability weighted should be considered.  
  4. Include commentary on subsequent events. If you have a valuation date of Dec. 31, 2019, and the valuation report is dated after the pandemic became known or knowable, “you may need some discussion of subsequent events,” he says.  
  5. Learn from your peers. We’re in uncharted territory. Your colleagues in the valuation profession are a great source of information and help. Gregory advises that you network with your peers, read articles, look to your professional organization, and listen to webinars to learn what others are doing to tackle the tough valuation issues in today’s world.  

If you have questions about your business valuation, contact Jason Buhlinger, Principal, Transaction Advisory and Litigation Support, at jbuhlinger@bswllc.com or 314.983.1310.

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