What the IRS Looks at When Evaluating a

Business Valuation Report

Contrary to popular belief the IRS is not a homogenous entity. Since 2000 it has been made up of 11
external business units focused on specific customers. These divisions have been operating
independently since 2000. As such policies and procedures have diverged from year 2000 to today.
However the specialists in the IRS related to business valuation provide valuation services to all of the
divisions at the IRS and are familiar with these differences between the divisions. This article focuses on
what the IRS looks at when evaluating a business valuation report with information from selected
chapters of Michael Gregorysi book Business Appraisals and the IRSii. This article introduces some of
the concepts from this book and a corresponding video being offered by the Kansas Society of CPAs.iii
Most business appraisers providing valuation reports to the IRS from the private sector work with the
Small Business Self Employed (SBSE) division (assets $10 M or less) or with the Large Business and
International (LB&I) division (over $10 M in assets). SBSE is also where the Estate and Gift (E&G) tax
function is housed that handles all E&G cases regardless of dollar amount. Any of the units could be
chosen to describe how the classification, audit, appeals and potential litigation process works at the
IRS, but a brief synopsis of the E&G function will illustrate the process.
The first major take away for the business valuer is to request your client attach a copy of the business
valuation report to the return when filed. The national classification process at the Cincinnati Service
Center will typically have two business valuers and two estate and gift tax attorneys from some state to
review the return and appraisal. For this to be a blind classification, the E&G attorneys will classify all of
the returns except for their home state. These experienced business appraisers will review the report to
see if it was completed by a credentialed appraiser and if the report appears to meet professional
standards. If there are no questions that may suffice, but if there is no appraisal attached this increases
the chances of questions and the return being sent to the field.
At the local field office the return is classified again by a local E&G attorney and business valuer who has
the local knowledge of valuation firms, accounting firms and legal entities that may have been involved
with the return. They classify it using the original notes from the national classifiers and locally
identified criteria. The returns will be categorized as to be audited, to be audited if we have time,
and will not be audited.
Keep in mind the returns being requested are a demand pull for inventory for the local E&G group to
audit. This is not a supply push process based on the number of returns filed with the IRS. This means
the criteria for what is being audited continually changes depending on the number of returns entering
the system.
For business valuers the major areas of concern through classification are:

Discounts
The income method looking at adjustments to income and the development of the
discount rate and growth rate

The market approach with guideline companies or transactional data bases with an
explanation of the selection process
The cost approach with a real property appraisals when applicable
The reconciliation process and weighing of methods to reach a conclusion of value

The IRS has a host of common errors they look for in reports. These fall into the categories of general,
math, logic, standards and documentation (why). IRS business valuers have been trained with the
National Association of Certified Valuers and Analysts (NACVA) materials and so may use their check listiv
to evaluate the quality of the report. This is not comprehensive, but is a good source and fairly
consistent with the standards used by the ASA, IBA, AICPA and USPAP.
An issue with inconsistent treatment by the IRS revolves around tax affecting. Some at the IRS believe
this is a factual issue while others believe this is a legal issue based on the seven court cases the IRS has
won on this issue starting with the Gross case US. TC Memo 1999-54. Valuing Interests in S Corpsv
presents insight into these cases and the more common methods for valuing S-Corps. Specific
recommendations are made regarding the application of multiple methods by the business appraiser.
Another common area for the IRS to explore technically is reasonable compensation with a concern of
overcompensation on C-corporations and under compensation on S-Corporations. Typically the IRS sees
adjustments in these areas by valuers as well as unusual items, large nonrecurring items as well as other
adjustments to the income statement and balance sheet. Not seeing adjustments in these areas without
comments can raise questions.
These concepts and other ideas are presented and elaborated on in Mikes video with practical
commentary to help you explore what the IRS looks at when evaluating a business valuation report.
Access to this video, which also offers 2.0 hour of CPE credit, is available through the Kansas Society of
CPAs.
i

Michael Gregory worked for the IRS for 28 years as a specialist through executive level. In 2011 he founded
Michael Gregory Consulting, LLC. His web page is www.mikegreg.com . He can be reached at 651-633-5311 and
at mg@mikegreg.com. All rights reserved Michael Gregory Consulting 2015
ii
Michael A. Gregory, Business Appraisals and the IRS, (2013) 271 pages
iii

http://www.kscpa.org/professional_development/course/BV211/business_valuation_what_the_irs_looks_at_whe
n
iv
http://www.nacva.com/bv_checklist/bv_checklist.asp
v
Michael A. Gregory, Valuing Interests in S Corps, (2013) 63 pages