Some clients and their advisors may think it's okay to use a 409A valuation report for a gift or estate filing. While they can get away with it if there is no audit, it is not advisable. Section 409A valuations create a “safe harbor,” which the IRS recognizes as a reasonable method of ensuring that the exercise price is at FMV. However, 409A Valuation Reports are not filed with the IRS.

Equity Compensation Value

Section 409A of the Internal Revenue Code states that compensation deferrals under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent that they are not subject to a substantial risk of forfeiture and are not are previously included in gross income. Compensation is deferred for stock options that are issued at an exercise price (ie, the price at which an underlying security can be bought or sold when a call or put option is traded) greater than or equal to the fair value of share market (FMV). on the date of grant.

A private company must hire a qualified independent professional appraiser to determine the FMV of the equity compensation. Valuation professionals are typically engaged to value the common stock of a client company, and the client then uses this value to set an exercise price of the options being granted and to determine FMV (or fair value when also consistent with Accounting Standards codification topic 718) of options.

Estate and gift tax assessments

Appraisals of businesses or business interests are often needed for estate planning purposes, such as determining the likely amount of estate or gift taxes to help plan before the owner's death. In the case of a deceased individual's estate, an appraisal of a business interest owned by the estate is often necessary for the preparation and filing of an estate tax return (IRS Form 706).

In the case of a gift, an appraisal report determines how many lifetime exemptions the taxpayer uses and sets a statute of limitations for checking (and sometimes paying a gift tax). It is filed with the gift tax return (IRS Form 709). Unlike the 409A Valuation Report, the valuation report for gift and estate purposes is attached to the applicable tax return and filed with the IRS.

Five dangers

Assessments are very purpose specific. How the client will use the valuation dictates the applicable standard of value, the valuation methods used, the content of the report, the depth of due diligence, the effective date of the valuation and the interest on the capital being valued, among other factors. The value standard – FMV – is the same for the 409A Valuation Report and gift and estate valuations. But then things change. There are at least five reasons (and more subtle ones) why there is potential risk and liability in using a 409A Valuation Report for an estate or gift tax filing:

1. FOUNDATION. 409A valuations are conducted under the guidance of the AICPA's Practical Guide – Valuation of Equity Securities of Private Companies Issued as Compensation – published in 2013. Valuations of gifts and estates are subject to various IRS revenue rulings (for example, 59-60, -287 and 93-12), Internal Revenue Code (for example, Chapter 14, Sections 2701-2704) and Tax Court precedence. These may have a material impact on how estimates prepared for these various purposes are completed.
2. Audit risk. Because valuation reports prepared for 409A purposes are not filed with the IRS, they are subject to virtually no audit risk if prepared by an independent third-party valuation professional. On the other hand, since gift and estate valuation reports are attached to the taxpayer's return, an actual tax is often paid or, in the case of many gift tax returns, a recording of the taxpayer's lifetime exemption amount is made. , gift and estate valuation reports have significantly higher audit risk than 409A valuation reports. In the event of an audit, using a 409A estimate for gift and estate purposes exposes a client to additional risk.
3. Adequate IRS disclosure. The current standard for disclosure of estimates under federal gift tax filing is described in the IRS's Adequate Disclosure Rules. The 3-year statute of limitations on gift taxes begins on the filing date of Form 709 only if the gift is “adequately disclosed. The submission of an appraisal report prepared by a qualified appraiser will satisfy the appropriate disclosure requirements regarding valuation of each gift transfer if the report meets the requirements of Treasury Regulations Section 301.6501(c)-1(f)(3). Because no such rules exist for 409A valuations, 409A Valuation Reports are not written to meet the Rules Appropriate IRS Disclosure As a result, using a 409A valuation report for a gift tax filing risks an audit indefinitely in the future.
4. Basic interest. The underlying capital interest valued in a 409A valuation report may differ from that gifted or included in the estate. For example, in an estate tax situation, the various classes of stock owned by the decedent are aggregated for valuation purposes.
5. Attorney/client privilege. A client's estate planning attorney often hires the appraisal professional on behalf of the client so that the appraisal report is covered by attorney-client privilege and work product protection in the event of an audit. A 409A report is not covered.

While there are several reasons not to use a 409A Valuation Report for an estate or gift tax filing, referring to one can be very helpful. If a 409A appraisal report was recently completed, it helps save time (and, therefore, fees) in completing a gift tax appraisal. Ultimately, it will depend on the quality of the 409A report.

Chris Mellen, ASA, MCBA, CVA, ICVS, CM&AAis Senior Managing Director at VRC