The Essential Executor's Handbook: A Quick and Handy Resource for Dealing With Wills, Trusts, Benefits, and Probate (2016)
The Appraiser and Valuation Methods
Why Values Matter
It may seem obvious that executors need to know what their estates are worth. And that is a correct instinct. But the reasons executors need to know precise values is actually more complex. You not only need to put a value on everything, you need to assign values that will be universally accepted. And establishing these universally accepted values is important for four reasons.
1. Fairness—If a will or trust requires that a beneficiary receive an equal share of the estate but does not specify what comprises that share, accurate and accepted values are needed to first calculate the total value of the share and then to decide how to satisfy that share. Or if the will or trust requires that a beneficiary receive a specific dollar amount but, again, does not instruct you as to how to pay that bequest, you need accurate values to make an equitable distribution. If the entire estate was comprised of cash, this would be an easy problem to solve. Without cash, proper valuations are indispensable.
2. Tax Basis—A rule that is widely known among financial professional but less so among laymen is the Step-Up Basis Rule. The rule is simply this: When someone dies, the cost basis of most of their assets instantly becomes the date of death value. This is important because cost basis is what we use to calculate capital gain. For example, let’s say you buy a share of stock at $10 and then sell it for $15, you have a $5 capital gain. And capital gains are taxed. But if you didn’t sell it and died when that share was worth $15, the price you were deemed to have paid for it would instantly become $15. If you were to then sell that share for $15, there would be no capital gain and, therefore, no tax on it. Pretty cool, huh? Knowing what assets are worth when someone dies justifies paying little or no tax when they are later sold.
3. Fiduciary Duty—As an executor or a trustee, you have an obligation to assign values to assets that conform to universally acceptable standards. In short, you don’t get to guess.
4. Liability—Your own financial well-being is dependent on the use of universally accepted valuations. For example, let’s say that you look at the decedent’s last statement from his stock broker. The statement is less than a month old. On that statement, it shows that 100 shares of X Corporation are worth the same as 100 shares of Y Corporation. And let’s say that the will or trust instructs you to distribute the stock equally to the decedent’s two children. So you give the X Corporation stock to John and the Y Corporation stock to Sue. Sue finds out that, on her father’s date of death, the 100 shares of X Corporation was worth 10 times what her Y Corporation stock was worth because, the day before her father died, Y Corporation was named as a defendant in a multi-billion-dollar lawsuit, causing the stock to plummet. Suffice to say that Y Corporation isn’t going to be the only one being sued. You have enough to worry about without being sued for malfeasance.
Having said all of this, one rule of accepted valuation is that what something sells for is deemed to be its value. But unless you are selling assets on the decedent’s date of death (which is highly unlikely), that value may be higher or lower than the date of death value. And date of death value is the number you are looking for.
The Internal Revenue Service, Probate Courts, and local taxing authorities all agree that the Federal Treasury Regulations for valuing all manner of property are the gold standard. However, those regulations make it clear that one rule does not fit all and that there are very different rules for valuing different kinds of assets. Here we are going to review the rules for valuing the following: (1) real estate, (2) securities (e.g., stocks and bonds), (3) life insurance, (4) cash accounts (e.g., checking, savings, certificates of deposit), (5) businesses, (6) vehicles, and (7) tangible personal property (i.e., the Knick-Knack Estate). I don’t expect you to become an appraiser but, just as with selecting an accountant or lawyer, you need to know the rules so that you select and oversee the proper professional.
Homes, vacation homes, and investment real estate (i.e., rental property) are usually the most valuable assets in any estate. They are also the assets with the greatest potential capital gain. For example, my parents purchased their home in 1957 for $25,000. I sold it in 2010 for $250,000. That is a capital gain of $225,000! Had it not been for the Step-Up Basis Rule, their estates would have been liable for over $30,000 in income tax. Had it not been for all the repairs that it required, I could have sold their home for $350,000, resulting in tax in excess of $50,000! But the Basis Step-Up Rule says that their home’s basis was equal to its date of death value. Accordingly, it was important that a date of death value was established in a way consistent with the Federal Treasure Regulations and that, in turn, requires the assistance of a licensed real estate appraiser.
More often than not, a licensed real estate appraiser will look to see what comparable homes in the neighborhood have sold for recently (aka Comps). When there are no comparable sales, valuation becomes more complex and appraisers will resort to other methods to reach their opinions. But it is the fact that the appraiser is licensed that is key. And that’s because, to be licensed, the appraiser must complete a course of study, work with a licensed appraiser to gain experience, and then pass the state’s licensing examination. Accordingly, their opinions are rarely challenged—even by the Internal Revenue Service. In fact, although the Treasury Regulations do not require it, the IRS insists on the opinion of a licensed real estate appraiser before they will accept the value we submit to them on a Federal Estate Tax Return.
In my practice, I come across individuals who actually believe that a home’s value is equal to the county’s assessment (the value the county uses to calculate real estate tax). Nothing could be farther from the truth. Urban and suburban counties have an immense bias in favor of higher values because the higher the value, the higher the real estate tax. For example, after the real estate market crashed in 2008, one county in Northern Virginia came up with a creative solution to the impending drop in their tax revenue. They acknowledged that the value of houses had dropped but insisted that the value of the land the houses sat upon went up. As a result, assessments—and the resulting real estate taxes—did not decline. It was not a popular decision. Under extreme public pressure, the county later reversed its policy.
On the other hand, in some rural areas of the country, assessments have not changed in decades. Those counties require less revenue and therefore have less motivation to change assessments. As a result, home assessments fall well below their true values. In short, an assessment is never a reliable valuation.
There are, however, informal valuations that are often as reliable as the opinion of a licensed real estate appraiser. The website, Zillow.com, for example, is actually very reliable. Nevertheless, the Internal Revenue Service is taking a wait-and-see approach for now and still insists on the opinion of an actual flesh and blood appraiser.
One of the treasury’s more common-sense rules involves the valuation of stocks and bonds. The rule is that you take the average of the date of death high and low bids on the stock you wish to value. (I said common-sense method of valuation; I didn’t say it would make sense to someone who has never traded stocks.) Let’s break down the rule for those of you who have no experience with the securities market. A “bid” is the amount of money offered for a single share of stock (usually through a stock exchange like the one in New York). On the date of death, there was a bid that was the highest one that day. Likewise, on the date of death, there was a bid that was the lowest one that day. You simply add the two bids together and divide by two.
For example, let’s say that the decedent owned 10 shares of General Motors. On the date of death, the high bid for a single share of stock in General Motors was $51 and the lowest bid was $49. The date of death value of a single share of stock in General Motors, therefore, was $50 ($49 plus $51 equals $100; $100 divided by 2 equals $50). Before the rise of the Internet, this information was only available in print form (e.g., newspapers). Now, however, high and low bids on any date (not just today) can be found in a flash. Of course, even with the aid of computers and websites, if you have a thousand different stocks to value, it’s going to take you some time. On the other hand, if the decedent had their stocks with a brokerage, such as Merrill Lynch or Edward Jones, their computers will serve up all of those date of death values faster than you can say, “easy money.”
However, only publicly traded stocks are bid upon on a daily basis. Stock in private companies is not for sale on the stock exchange. If the decedent owned stock in such a company, you will need to contact the company directly and ask what they would have paid to redeem the decedent’s stock on the date of death. (Some companies are better at this than others.) Often there is an agreement among the stockholders that sets this redemption value. In some cases, the board of directors sets the redemption value at their regular meeting. If a stock is not publicly traded, you will have to make due with one of these alternate methods.
For example, while settling my parents’ estates, I came across a small dividend check from a bottled water company in Pennsylvania. The check stub indicated that my father owned 48 shares in his name alone. That is, it was a Probate Estate asset. If those 48 shares were worthless—or even near worthless—I could abandon them and spare myself a probate case. If they had significant value, I was going to have to drive almost 200 miles to my parent’s county of residence and be sworn in as executor just to redeem those few shares.
A quick online search confirmed my suspicion that the company’s stock was not traded on any stock exchange. So, I looked them up and gave them a call. A very nice woman told me that, at the directors meeting closest to my father’s date of death, a value of $48,000 was given to my dad’s 48 shares. So, I was off to the Keystone State to become executor.
You would think something as common-sense as life insurance would be easy to value. The decedent puts down a bet that he is going to die during the term of the insurance and the insurance company bets against him. The premium is the wager and the pre-established death benefit is the payout. Makes sense to any gambler but, unfortunately, it’s not quite that simple.
The first question you have to ask yourself is who is the insured? Usually, when executors discover that the decedent owned life insurance, they just assume that the decedent was the one whose life was insured. And, in most cases, they would be right. However, it is also possible to own insurance on the life of someone else. The decedent may have owned insurance on his spouse, for example. Is that worth anything? Again, it all depends.
If the insurance on the spouse is what is known as term life insurance, there is just a death benefit. However, since the spouse is not the one who has died, the policy has no value. On the other hand, some life insurance policies have what is known as a cash value. At any time, the policy can be exchanged (i.e., surrendered) for the cash value. If that is the case, then the policy did have value; the cash value of the policy on the decedent’s date of death even though he was not the one insured.
To make this all the more complex, you have to understand that insurance companies don’t pay anything on the date of death. There is an entire claims process that must be completed before the life insurance proceeds are paid. The insurance company will want information on the decedent, the policy, and the beneficiary. They will want to know if the beneficiary wants the proceeds paid out in a lump sum, in installments, or, in many cases, held for the beneficiary in a sort of bank account. And, of course, they are going to want proof that there has, in fact, been a death. While this whole process is snaking along, the insurance company is paying interest on the amount that was actually due to the beneficiaries on the date of death but which has not yet been paid. When the check finally arrives, it will not be an even number. So, for example, even though the insurance policy sets the death benefit at $50,000, the check will be larger than that. The excess is the interest. And here we get technical. For while the death benefit is considered an asset of the Contract Estate, the interest is income to the beneficiary. What is the difference you ask? The difference is that the death benefit is subject to death taxes. The interest is subject to income taxes—an important distinction that escapes almost everyone except your accountant and the Internal Revenue Service.
As was the case with my grandmother, some people like to have cash on hand. They may keep it in a safe or, like my grandmother, may tape it to the underside of drawers. In such cases, valuation is simple. Add up the money. That is your value. But that’s not what we are talking about here. Here we are talking about money held for the decedent by financial institutions such as banks, brokers, and, as we have just seen, life insurance companies.
Cash accounts come in many forms. Most people are familiar with checking and savings accounts but may be less familiar with share accounts, money market accounts, and certificates of deposit. It doesn’t really matter. They are all essentially loans to the financial institutions and those institutions pay interest in return (although not in every case). All you need to do to value a cash account is to call the bank, broker, or insurance company and ask for the balance in each account at close of business on the date of death. Those are your values. However, just as with life insurance, these accounts continue to generate interest after the date of death. And, just like life insurance, the balance in the account at the close of business on the date of death is an asset. The interest earned since then is income. Assets are subject to death taxes. Interest is only subject to income taxes.
The vast majority of Americans don’t own a business. However, there are still a lot who do. If your decedent owned a business, it is very important that you understand two things: (1) the business must be accurately valued, and (2) you are not going to be the one to do it. Methods of business valuation are numerous, extraordinarily complex, and well beyond the scope of this book. So, just as with real estate, you are going to need a business appraiser.
On the other hand, it is possible to establish a value for the business in advance and, if not done in an abusive manner, the IRS will accept it. The technique is called valuation by Buy-Sell Agreement. In short, any time before the business owner dies, he may enter into an agreement with a prospective buyer (usually a partner or employee). The purchase price of the business, as set forth in the agreement, becomes its value.
There are two kinds of Buy-Sell Agreements: funded and unfunded. An unfunded agreement does not tell you how the buyer is paying for the business. A funded agreement, on the other hand, identifies the source of the purchase money. In such cases, the purchase money is almost always provided by life insurance. That is, the life of the business owner is insured for the same amount of money as the purchase price of the business. There are two advantages to this arrangement. First, the sale is not dependent on the buyer coming up with the cash. And, second, the executor now has additional liquidity to pay the decedent’s bills. For these reasons, Funded Buy-Sell Agreements are extremely popular and very common. So, before hiring an appraiser, thoroughly review the decedent’s business records and interview all employees and partners. If there is a Buy-Sell Agreement in place, an appraiser won’t be needed. The business’s value will be the purchase price established by the agreement.
However, remember I said that the IRS would accept the Buy-Sell Agreement valuation method provided that it was not used in an abusive fashion. To the IRS, any method of valuation that promotes “form over substance” is abusive. Accordingly, a Buy-Sell Agreement, funded or not, that sets the selling price at $1 is abusive and will be disallowed. Of course, the business may only be worth a dollar but the burden of proof is on the executor.
In the absence of proof, the IRS has the prerogative to value the business themselves. And although the rank and file of IRS staff is comprised of poorly trained accountants, they are by no means qualified appraisers. In fact, there have been many cases where the IRS used the “capitalization method” to value small businesses. The capitalization method is best illustrated by asking, “At today’s interest rates, how much would an asset have to be worth to generate a given amount of gross revenue?” So, for example, if a small business grosses $100,000 per year and current interest rates are 1%, then the business must be worth a hundred times $100,000 or $10 million! Don’t be shocked. Such nuttiness is the norm for the IRS. So, make no mistake: In the absence of a Buy-Sell Agreement, you will need a qualified appraiser.
Cars are easy to value. Simply consult a publication known as the Kelley Blue Book (aka The Blue Book). There you will find values for virtually every car ever made. Each car will have three values: retail, private party, and trade. Retail is the price that a used car dealer would ask for the car. Private party is the price you could ask if you put the car out on the lawn with a “For Sale” sign on the windshield. And trade is the credit a dealership would give you if you bought a new car and used the decedent’s car as part of the payment. These values are usually within a few thousand dollars of each other. And, since the vast majority of used cars are not worth all that much, the Internal Revenue Service really doesn’t care which value you use. Officially, they prefer to see the private sale value. But, having said that, even they won’t haggle over the few dollars difference between the retail value and the trade value on a 1972 Plymouth Duster.
When it comes to other vehicles, from airplanes to lawn tractors, things become a little less clear. In the absence of a clearly detailed valuation method (e.g., average high-low bid for stocks) the treasury regulations lean toward fair market value. Fair market value simply means what you can sell it for. This is also known as “passing the buck.” At some point, the drafters of the treasury regulations simply threw up their hands and said, “We can’t come up with an arbitrary value for everything! Figure it out for yourselves!” So there you have it. When it comes to vehicles other than cars, it’s all on you. In such cases, you have two choices: (1) make an educated guess, or (2) sell the vehicle. The IRS may take exception to your educated guess and, if it means more money for the treasury, trust me, they will. But, remember, the selling price of anything within a year of the date of death is presumptively its true fair market value. Just remember that transferring a title to a mint-condition World War II P51 Mustang fighter plane to your brother-in-law in exchange for a case of beer will be considered “form over substance” and summarily disallowed.
Tangible Personal Property
Just to refresh your memory, tangible personal property is what makes up the Knick-Knack Estate. It is anything with intrinsic value, no matter how little that value might be. For the most part, the IRS proceeds on the assumption that if you haven’t insured an item, it can’t be worth very much. Therefore, an insured engagement ring will need to be valued at its insured value. On the other hand, if an engagement ring was not insured because it can be replaced with a quarter and a gum ball machine, it can be exempted from valuation.
This can be problematic if your decedent carried insurance on an item that was once valuable but is now near worthless. For example, my father loved cameras. For decades he bought one after another after another and dutifully insured them for the purchase price. However, he failed to recognize the affect that superior digital photography had on the value of film cameras. As a result, he always renewed his insurance policies for the same values (and, disturbingly, his insurance agent let him). I was forced to itemize each and every one of his film cameras on his Federal Estate Tax Return per its insurance valuation. Of course, had he not specifically bequeathed the cameras to one of my brothers, I could have sold them (assuming I could find a buyer) and, in so doing, established their true values.
Of course the bulk of the tangible personal property will be only slightly north of worthless. Nevertheless, the executor has a duty to liquidate any tangible personal property that is not specifically bequeathed to someone. Whether you sell it at an auction, through the want ads, to a business that buys estate jewelry, or even to a pawn shop, what you get for it is the fair market value.
Universally accepted valuation of the decedent’s assets is important for four reasons: fairness to the beneficiaries, establishing a tax basis, meeting your fiduciary duty, and protecting yourself from lawsuits. The method of valuation varies with the nature of the asset. Real estate value is most often established by a licensed appraiser. Stocks and bonds are valued using the average high-low bid method. Life insurance is usually the stated death benefit even though the proceeds you receive may be partly interest. Cash accounts with banks are the account balances at the close of business on the date of death. Businesses, as with real estate, require the opinion of a licensed appraiser. The value of cars is established by a book such as the Kelley Blue Book. And, finally, tangible personal property is valued at either its insured value or sale proceeds.
Things to Do
1. Update your list of assets and debts using the accepted and proper valuations.
2. Provide a copy of your list to both your lawyer and your accountant.