VALUATION AS A CHALLENGE FOR TAX ADMINISTRATION.

• Author: Lederman, Leandra

INTRODUCTION

A 1963 article opened with the statement that "[o]ne of the most difficult problems in federal tax administration is the determination of the value of ownership interests where there is no ascertainable market quotation, as in the case of the stock of closely-held business enterprises." (1) Valuation issues remain challenging today. (2) Traditionally, federal tax valuation cases have arisen in connection with the estate or gift tax or the federal income tax consequences of a transaction such as a charitable donation or the sale of a business. (3) Those disputes continue to arise, along with the difficult valuation issues raised by "transfer pricing" for transactions between related companies. (4) In addition, recent proposals for a federal wealth tax (5) have highlighted the importance of valuation issues because such a tax would require periodic valuations of high-value assets. (6)

Valuation issues are challenging for two main reasons. The first is the opposing incentive the taxpayer has from the tax agency. (7) For example, where the receipt of an asset gives rise to tax, the taxpayer generally would benefit from a lower valuation. (8) In a self-reporting system, such as the U.S. federal income and transfer tax systems, taxpayers therefore have a financial incentive to report self-serving valuations in an effort to reduce their taxes.

The government can challenge the taxpayer's valuation, of course, but that requires an audit. Audit rates are generally low, (9) due to resource constraints. The Internal Revenue Service (IRS) in particular has seen its audit rates decline since 2010, (10) as Congress has starved it of funding. (11)

Where the tax administration does audit the taxpayer, that can spark protracted litigation. (12) For example, multiple U.S. Tax Court opinions authored by the late, renowned Judge Tannenwald (13) admonished the parties for taking up significant court time with valuation litigation. (14) Litigation is costly for both parties, and valuation litigation may put the IRS at a disadvantage, at least compared to sophisticated taxpayers. (15)

The second issue valuation poses is simply measurement accuracy: finding an approach or formula that fairly values private assets, or assets of a particular type. For example, even the valuation of real estate, which has highly developed systems of comparables, (16) varies widely in quality across U.S. jurisdictions that impose property taxes. (17) This measurement issue can be ameliorated with improvements in technology and methodology. For example, computers make the use of comparables in real estate valuation faster and more systematic than it would otherwise be. (18) Improvements in technology do not necessarily eliminate valuation disputes, however. In fact, they can make valuation litigation more expensive. (19)

A key problem for tax administration, therefore, is how to minimize erroneous, self-serving valuations. This Essay examines that issue. In so doing, it highlights, in Part I, the importance that third parties to the taxpayer-government relationship act at arm's length from the taxpayer. The Essay also draws on the tax compliance perspective to make some preliminary observations in Part II about valuation methodologies.

1. VALUATION AS A TAX ADMINISTRATION ISSUE

   1. Structural Systems

      As a general matter, enforcement of a law may be least costly when there is a structural system that spurs compliance. An easy example is a speed bump: the physical structure of the road impedes drivers from exceeding the speed limit, even without monitoring. (20) Although it does not involve a physical object, a withholding tax is something of a structural system because it takes taxes off the top, before the taxpayer/payee receives funds. (21) Federal income tax withholding is very successful at spurring accurate reporting by payees. (22) The IRS estimates a ninety-nine percent voluntary compliance rate on amounts subject to income tax withholding. (23)

      Applying this idea to valuation, a structural system that limits the possibility of self-serving valuations should be helpful to the tax administration. An approach recently proposed by Professors Saez and Zucman in connection with a proposal for a wealth tax could fall into this category if it is adjusted to reflect the taxpayer's incentives. Saez and Zucman's discussion proceeds asset category by asset category and appears to come from the perspective of how the IRS can obtain valuation information. (24) In two contexts--insured art and real estate--they suggest having the IRS use valuations done for other reasons. (25)

      Where such non-tax valuations could serve as a structural constraint on tax noncompliance is where the taxpayer's incentives in the two contexts oppose each other. For example, a taxpayer who owns art has an incentive not to undervalue it for insurance purposes because that would result in undercompensation if the art were stolen. That valuation could be helpful to the tax system in contexts in which a higher valuation generally results in higher taxation, such as under the estate tax or a wealth tax. This is analogous to a bank examining past tax returns to determine a prospective borrower's income--while the borrower has an incentive to overstate income to get the loan, the borrower's incentive for tax purposes is to understate income. In effect, this approach uses the opposing context to create a friction that helps reduce misstatements. (26)

      By contrast, IRS reliance on real estate valuations done in other contexts likely would not provide a similar structural constraint. With respect to real estate, Saez and Zucman point to both Zillow and local property tax assessments as sources of information for the IRS. (27) Neither reflects a taxpayer-reported valuation that inserts a friction with respect to the federal tax context.

      Both information sources also pose other problems for tax administration. Although Zillow reflects the technological advance that big data permits, it varies in its accuracy, (28) due in part to errors in the underlying public data Zillow relies on. (29) Local assessments have serious problems, including variance in quality (30) and systematic biases. (31) Real estate valuations can already be contentious. (32) Were the IRS to rely on subnational governments' assessments, that would increase taxpayers' stakes in those valuations, likely increasing appeals. It would also raise legal questions regarding the extent to which the IRS could, in a sense, delegate tax valuation issues to state and local tax authorities.

   2. Which Third Parties Are Helpful?

      (1). Third-Party Reporting

      As noted above, tax withholding is highly effective at spurring payee compliance. (33) Withholding is also accompanied by reporting by the payor to the IRS and the taxpayer of the amount paid and the amount withheld. (34) Third-party information reporting even without withholding is also quite successful at spurring tax compliance. Where a payor is required to report to the IRS and the taxpayer the amount paid to the taxpayer (but no withholding is required), the IRS estimates a voluntary compliance rate of ninety-five percent. (35) That high compliance rate contrasts with an estimated voluntary compliance rate of only forty-five percent for amounts subject to income tax that are not subject to withholding or third-party reporting. (36) In effect, the presence of a third-party information reporter reduces the taxpayer's opportunity to evade tax because the taxpayer knows that the government has been notified of the payment. (37)

      In theory, third-party reporting of valuations should also be helpful, assuming that the third party is acting at arm's length from the taxpayer. (38) And there is some evidence of a procompliance effect of third-party reporting in the wealth tax context. Professors Saez and Zucman highlight that effect with a comparison of countries:

      In Sweden and Denmark, two countries with extensive third-party reporting of wealth, Seim and Jakobsen et al. find small avoidance and evasion responses: a 1% wealth tax reduces reported wealth by less than 1%.... In Switzerland, where there is no third-party reporting of financial wealth (due to bank secrecy), Brulhart et al. find very large responses to wealth taxation: a 1% wealth tax lowers reported wealth by 23-34%. (39) However, Saez and Zucman note that, for Switzerland, "[t]his extremely large estimate is extrapolated from very small variations in wealth tax rates over time and across Swiss cantons and hence is not as compellingly identified as the other estimates based on large variations in the wealth tax rate." (40) Thus, further research on the effect of third-party reporting on valuation accuracy would be helpful.

      (2). Other Third Parties

      It is important to note that not all third parties to the taxpayer-government relationship act at arm's length. Some third parties have an interest in helping the taxpayer lower the tax bill. (41) For example, consider a low-stakes valuation issue: the value of common household items donated to charities. To help taxpayers compute their charitable deductions, charities such as Goodwill and the Salvation Army provide online value guides. (42)

      To some extent, the fact that these charities sell the donated items in a thrift shop provides a structural constraint on inflated amounts in the donation value guides. For example, Goodwill sells almost all clothing items of the same type at the same initial price, so the $4 valuation in its value guide of a shirt or blouse generally reflects the approximate store price for that type of item. (43) But where a thrift store sells items at widely varying prices, that structural constraint is reduced. For example, the Salvation Army lists in its valuation guide a range of $5 to $207 for a picture/painting. (44) It is also possible that charities may compete for donations on this front by suggesting higher donation amounts to the...