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On Jan. 22, 2020 after no public hearing, no public workshops or any apparent public input, the Internal Revenue Service released an internal memorandum1 (the memo) regarding a change in the process for penalties on appraisers who provide appraisals for the Small Business Self Employed (SBSE) division. The SBSE addresses business taxpayers with assets equal to or less than $10 million dollars. It’s also the division where the IRS Estate and Gift tax program is located. There are no changes for any other divisions associated with the memo. However, information from IRS sources indicates that appraisers are now applying this change in process in the Large Business and International division too. The new process allows an IRS agent with no experience in valuations to make the decision to investigate and penalize an appraiser without the multiple levels of internal review that were previously required. The IRS can impose a penalty on an appraiser if the appraised value is either under 65% or over 150% of the “proper value.”2
There had been some indication before the memo was released that a change was afoot. In January 2019, the IRS quietly indicated that it would simplify the process that had been in place since 2007 regarding penalties on appraisers, but only in certain areas. I discovered this news in May 2019 and shared it with the American Society of Appraisers (ASA), which coordinated and shared the information with other major appraisal organizations and the American Institute of Certified Public Accountants (AICPA). These organizations responded timely in May and June with letters to the Treasury Department and IRS raising a series of concerns. Following up on these letters from May and June has indicated no response from the IRS or Treasury Department.
The IRS Commissioner confirmed this change was coming in July when he indicated that the IRS was going to be “aggressive” in the application of penalties.3 Feedback from clients and other practitioners indicates that the IRS is being more aggressive. In December 2020, I wrote an editorial for Business Valuation Update regarding the IRS’ lack of response and continued silent approach.4 These events are having a direct impact on those valuers completing appraisals for trusts, estates and gifts.
IRC Section 6695A
The penalties on appraisers stem from Internal Revenue Code Section 6695A. IRC Section 6695A(b) states that:
(b) Amount of penalty. The amount of the penalty imposed under subsection (a) on any person with respect to an appraisal shall be equal to the lesser of—
(1) the greater of—
(A) 10 percent of the amount of the underpayment (as defined in section 6664(a)) attributable to the misstatement described in subsection (a)(2), or
(B) $1,000, or
(2) 125 percent of the gross income received by the person described in subsection (a)(1) from the preparation of the appraisal.
For example, assume for an estate the taxpayer has a value of $1 million and the IRS has a value of $3 million dollars. The appraisal fee paid was $16,000 to the appraisal firm and the tax rate is 40%. Here’s how you would calculate the penalty:
- Section 6695A(b)(1)(A) indicates a value of 10% of the tax or ($3 million – $1 million) x 40% x 10% = $80,000.
- Section 6695A(b)(1)(B) is $1,000.
- Take the greater of 6695A(b)(1)(A) ($80,000) or 6695A(b)(1)(B) ($1,000). That amount is $80,000.
- Multiply the Section 6695A(b)(2) fee of $16,000 to the appraiser by 125%. That amount is $20,000.
- Take the lessor of 6695A(b)(1) or 6695A(b)(2). That amount is $20,000.
So, the penalty on the appraiser is $20,000 in this example.
This penalty can be very substantial and, in many cases, may be 125% of the fee paid to the appraiser. As such, the IRS wanted to set up a series of checks before the application of the penalty to be fair.
With Section 6695A(c), the IRC also offered an exception to the application of the penalty:
(c) Exception
No penalty shall be imposed under subsection (a) if the person establishes to the satisfaction of the Secretary that the value established in the appraisal was more likely than not the proper value.
The proper value is determined by the IRS, the applier of the penalty. The IRS was concerned with being both the judge and enforcer of the penalty and so wanted to have checks put into the system to avoid an overly aggressive application of the penalty. The proper value may not be the agreed amount on examination, for example. The proper value is dependent on the application of appraisal standards to the facts known by the appraiser when the appraisal was completed. Often on examination, additional facts may be uncovered resulting in an agreed dollar amount with the taxpayer different from what was known and applied by the taxpayer’s valuer.
The Historical Process
Since 2007, the IRS has had a system in place that required multiple levels of review for the potential application of Section 6695A5 for the consideration of a penalty on an appraiser.
The IRS was concerned that an overly aggressive agent, manager or valuer could potentially apply the penalty based on: lack of knowledge in valuation theory and practice; a personality conflict; internal bias; or other reasons, and wanted to ensure both integrity and fairness in the penalty’s application. The historical process indicated that if the IRS was considering any potential penalty, several steps were required before it could launch an investigation on an appraiser. The appraisal and the concern raised by an agent, estate and gift tax attorney or IRS valuer were sent to a penalty coordinator valuation manager who was specifically charged with oversight of the penalty for approximately half of the United States. That manager would then contact two other valuers who would review the facts independently. If the penalty coordinator valuation manager and the other two valuers all concurred that a penalty investigation was warranted, then the taxpayer’s appraiser would be contacted and a separate penalty investigation would commence. This process was intended to prevent frivolous penalties being raised. It also reduced potential penalties when the appraiser wasn’t given all the facts, was misled by the taxpayer or for any other reason that indicated that the taxpayer’s appraiser clearly made a good faith effort in the application of appraisal standards.
Let’s now look at the new process for SBSE according to the IRS memo.
The New Process
The new process indicates there’s no need for any review by the penalty coordinator valuation manager and two other appraisers. Rather, any agent with the agent’s manager’s concurrence can recommend the application of the penalty. There’s no need for an IRS valuer to even be involved with the case. The agent (without proper training, education or experience) can make this decision regarding a valuation issue. It’s possible that an IRS valuer could review and make a recommendation to the agent for a penalty. In either instance, if the agent manager concurs in the application of a penalty, an investigation can be initiated. This process is inconsistent with the process followed by the IRS for issuance of other penalties.
Industry Response
When this became apparent to the major appraisal organizations and the AICPA, there was an immediate response. The ASA6 took the lead and coordinated a written response to the IRS with 11 other professional appraising organizations in May. Their three-page written response states in part:
Not only does this new process run counter to the notion of due process and administrative restraint (as was established under the original regime after the passage of the Pension Protection Act and the adoption of IRC 6695A in 2006), it places outsized control and responsibility in the hands of examiners or attorneys who may lack any formal valuation training or specialized knowledge as to the subjects of the underlying valuation without a clear process for introducing relevant expertise into the review.
The letter also states:
In sum, we write not to simply critique the new review process, but to encourage the Service to work collaboratively with the valuation profession to find a way forward that maintains the rigor that existed under the previous review program while addressing resource constraints and other issues that led to the recent change. It is our belief that, together, we can find a solution that is fair and works for everyone.
- Their major concerns were:
- The new process has no checks and balances.
- The new process lowers the standard for application of the penalty and will cost those not guilty additional time and money to address the situation unfairly.
A public session on the initial implications associated with Section 6695A resulted in changes in the process and the application of letter 4477 to not accuse taxpayer appraisers of a penalty at the initiation of an investigation. There was no public session on the changes associated with the Jan. 22, 2020 internal memorandum change.
The AICPA sent the letter7 to the IRS in June, and it followed up with a public announcement to its membership and the public on their major concerns8 and identified several issues. Some of the major concerns the AICPA raised were:
- There was no notice for public comment on the change.
- Those applying the penalty aren’t properly trained nor do they have experience in this area.
- Other factors may impair judgment of those enforcing the penalty.
- Reasonable people can disagree—a review by an independent third party(s) is needed in this highly factual area of valuation.
Regarding the new process’ application going forward, the AICPA raised similar concerns and stated that:
The AICPA stands ready to work collaboratively with the IRS in addressing the tax laws of the United States, including the issues addressed in this correspondence.
Comments From IRS Officials
In July, IRS Commissioner Charles Rettig testified before Congress regarding penalties. An article in Forbes9 indicates what Commissioner Rettig sternly stated:
Mr. Rettig did not mince words. His IRS will ‘aggressively pursue non-compliant taxpayers . . . [with] visible civil and criminal enforcement efforts’. (Emphasis in original)
He also indicated that “fairness” would be applied.
Having worked at the IRS for 28 years from front line specialist to executive level and having headed up business valuation nationally for 11 years, I believe that “aggressive” means something different to IRS employees than “assertive.” “Assertiveness” means to review the facts, the law, the application of the law and to apply penalties when appropriate. The underlying theme is to promote voluntary compliance. I believe even if unintended, “aggressiveness” means something else to examiners. Aggressiveness implies if there’s a potential for the application of a penalty, then aggressively apply the penalty on cases. In my personal experience, examiners would be encouraged with both recognition and awards to aggressively apply penalties. Only those with the highest level of integrity would be able to hold the line in the face of these types of pressures to ensure fairness with taxpayers. Examiners may justify to themselves that the case could close out of examination, be submitted to Appeals and Appeals would determine if the penalty should be applied or not. In that way, an examiner could justify the application of a “questionable” application. At that point, Appeals could sort out the facts and potentially settle the case based on the hazards of litigation. With this type of guidance and potential impact on taxpayer appraisers, the IRS appears to be taking an extremely aggressive position on the application of Section 6695A on appraisers for appraisals applied to SBSE cases.
Cheryl Teifer, IRS director of Field Operations Engineering spoke at the ASA 2020 International Conference.10 After she spoke, the international president of ASA, Lorrie Beaumont, appreciated her verbal assurances that IRS appraisers will continue to be involved in reviews of taxpayer appraisals, but she also requested “our strong preference is for those verbal assurances to be reduced to writing.” It’s expected that the IRS valuers will continue to review taxpayer appraisals. It isn’t at all clear that the IRS will have multiple reviews in the application of potential appraiser penalties as indicated in writing with the Jan. 22, 2020 memo on SBSE cases.
Penalty Documentation
Mr. Paul Hamann,11 the president of RCReports,12 contacted me to explore penalty documentation on CPAs and in particular valuers working on reasonable compensation issues. He was also exploring Section 6695A penalties as documented by the IRS. I provided him with various potential sources to explore at the IRS regarding documentation on penalties associated with his questions. He contacted the IRS Statistics of Income, the Office of Professional Responsibility and the Office of Chief Counsel for Procedure and Administration without success. Reference was made to the IRS Data Book for 2020.13 Table 26 of the IRS Data Book for 2020 provides “Civil Penalties Assessed and Abated, by Type of Tax, and Type of Penalty”14 for the years 1993 to 2019. Exploring 2019 data in this table, it’s unclear where Section 6695A penalties fall, and Hamann indicated that all IRS employees were “helpful as they could be, but in the end the statistics are not being compiled at the detail level (he) was interested in.”15 It appears that the Section 6695A penalty may be categorized within individual and estate and trust income taxes with civil penalties related to accuracy. This would mean it’s buried in the following totals: There were 573,070 total penalties for a total amount of $1,164,789,000. Of this total number of penalties, 49,318 (9%) were abated by $269,581,000 (23%).16
Advice for Attorneys
When you’re working with an appraiser, understand that the appraiser needs to: receive all relevant information associated with the valuation; be independent; and be concerned about the potential for a penalty directly on the appraiser that may amount to 125% of the fee your client is paying for the appraisal for an estate or gift tax valuation.
Endnotes
1. www.irs.gov/pub/foia/ig/lmsb/lbi-20-0120-0001.pdf.
2. For further clarification of other elements associated with the penalty, see Michael A. Gregory and Renee Marino, “IRS Oversight of CPAs Who Provide Valuation Services,” The Tax Adviser (Nov. 1, 2013), www.thetaxadviser.com/issues/2013/nov/gregory-nov2013.html.
4. Michael A. Gregory, “Commentary on Recent Statements by the IRS Regarding the Change to Appraisal Review,” Business Valuation Update (December 2020).
5. www.law.cornell.edu/uscode/text/26/6695A.
9. Jason B. Freeman, “IRS Assures Congress: Aggressive Enforcement Efforts Are Ahead,” Forbes (July 2, 2020), www.forbes.com/sites/jasonbfreeman/2020/07/02/irs-assures-congress-aggressive-enforcement-efforts-are-ahead/?sh=7b8e3b3d27e8.
10. https://sub.bvresources.com/bvwire/October2020Issue217-3.html.
11. www.linkedin.com/in/paulrcreports/.
13. www.irs.gov/statistics/soi-tax-stats-irs-data-book.
15. Conversation between Michael A. Gregory and Paul Hamann on Jan. 27, 2021.
16. Supra note 14.