IRS Valuation Guidance
Mines, Oil and Gas Wells, & Other Natural Deposits
In this blog post, we discuss portions of Treasury Regulation 1.611 and its additional guidance when determining the fair market value of mineral properties.
The Internal Revenue Service provides guidelines for the valuation of closely-held companies and presents a working definition of fair market value;
What is Fair Market Value?
The Internal Revenue Service’s Revenue Ruling 59-60 presents a working definition of fair market value:
2.2 Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.
A similar definition is found in the International Valuation Glossary – Business Valuation (the “Glossary”), where fair market value is:
A standard of value considered to represent the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, each acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of the relevant facts.
Treasury Regulation Section 1.611
While the above definitions relate to fair market value, Treasury Regulation Section 1.611-1(d)(2) provides guidance in determining the fair market value of mineral oil and gas properties. It similarly provides that “the fair market value of an [oil and gas] property is the amount which would induce a willing seller to sell and a willing buyer to purchase.” This value may depend on various factors, such as the location, size, quality, and quantity of the mineral deposit, the production history and potential, the operating costs and revenues, and the market conditions and prices.
The Internal Revenue Service (IRS) provides some guidance on how to determine the fair market value of a mineral property in Treasury Regulation Section 1.611–2(d)-Determination of fair market value of mineral properties, and improvements, if any. This regulation states that, if possible, the cost or market approach should be used before a discounted cash flow analysis (DCF).
The cost approach is based on the principle of substitution. It assumes that a buyer would not pay more for a mineral property than the cost of acquiring or developing a similar property with similar characteristics. The cost approach involves estimating the replacement cost of the mineral property, which may include the costs of exploration, development, equipment, land, etc. The replacement cost can then be adjusted for factors such as physical deterioration, functional obsolescence, and economic obsolescence.
The market approach is based on applying comparable transaction metrics to the subject property’s measures. It assumes that a buyer would pay a similar price for a mineral property as other buyers have paid for comparable properties in recent transactions. The market approach involves identifying and analyzing recent sales of similar mineral properties in the same or similar markets. If applicable, the sales prices are then adjusted for differences in location, size, quality, quantity, production history and potential, operating costs and revenues, and market conditions and prices.
Treasury Regulation 1.611-2(d) lists specific examples for the market approach:
The district director will give due weight and consideration to any and all factors and evidence having a bearing on the market value, such as cost, actual sales and transfers of similar properties and improvements, bona fide offers, market value of stock or shares, royalties and rentals, valuation for local or State taxation, partnership accountings, records of litigation in which the value of the property and improvements was in question, the amount at which the property and improvements may have been inventoried or appraised in probate or similar proceedings, and disinterested appraisals by approved methods.
A discounted cash flow analysis (DCF) is based on the principle of income capitalization. It assumes that a buyer would pay a price for a mineral property that reflects the present value of its expected future cash flows. A DCF analysis involves projecting the future cash flows of the mineral property over its remaining economic life, which may include revenues from production and sales, operating expenses, taxes, royalties, capital expenditures, and salvage value. The future cash flows are then discounted to their present value using an appropriate discount rate that reflects the risk and return of investing in the subject property.
The IRS has listed ten essential factors in determining the fair market value for mineral deposits by the DCF, or present value method:
- The total quantity of mineral in terms of the principal or customary unit (or units) paid for in the product marketed,
- The quantity of mineral expected to be recovered during each operating period,
- The average quality or grade of the mineral reserves,
- The allocation of the total expected profit to the several processes or operations necessary for the preparation of the mineral for market,
- The probable operating life of the deposit in years,
- The development cost,
- The operating cost,
- The total expected profit,
- The rate at which this profit will be obtained, and
- The rate of interest commensurate with the risk for the particular deposit
The IRS states that if none of these methods can be applied with reasonable accuracy, then any other method that is consistent with generally accepted appraisal practices may be used. However, the IRS also cautions that any method used to determine the fair market value of a mineral property must be based on facts and circumstances known at the specified date of valuation. Therefore, any later discoveries or developments or subsequent improvements in methods of extraction and treatment of the mineral product should not be considered.
Determining the fair market value of a mineral property can be a complex and challenging task. It requires careful analysis of various data sources, assumptions, professional judgment, and experience. Buyers, sellers, and Big Four Auditors have reviewed and relied on our oil and gas valuations. These oil and gas valuations have been utilized for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes throughout the United States and internationally.
Contact a Mercer Capital professional today to discuss your valuation needs in confidence.