Metodología

a. General Description of Defined Value Clauses and “Formula Transfer” vs.

“Formula Allocation” Approaches. In making transfers of hard-to-value interests,

such as limited partnership interests in an FLP, some planners have structured gifts or sales of a specified dollar amount of limited partnership interests. One attorney has analogized this to going to a gas station and asking for $10 worth of gasoline. While that seems straightforward enough (and is strikingly similar to marital deduction formula clauses that are commonly accepted in testamentary instruments), the IRS objects, largely on the grounds that the clause would make IRS gift tax audits meaningless.

There are two general types of traditional defined value clauses, “formula transfer clauses” and “formula allocation clauses.”

(1) Formula Transfer Clause. A “formula transfer clause” limits the amount

transferred (i.e., transfer of a fractional portion of an asset, with the fraction described by a formula). An example of a very simple fractional formula transfer clause, which the IRS approved back in 1986 in Technical Advice Memorandum 8611004 (but would no longer approve), is as follows:

such interest in x partnership…as has a fair market value of $_________.

Another example, somewhat more complicated but still simple in concept (designed to produce a small gift if the IRS asserts higher values for gift tax purposes to help counter a Procter “mootness”attack) is as follows:

I hereby transfer to the trustees of the T Trust a fractional share of the property described on Schedule A. The numerator of the fraction is (a) $100,000 [i.e., the desired dollar value to be transferred by gift] plus (b) 1% of the excess, if any, of the value of such property as finally determined for federal gift tax purposes (the ‘Gift Tax Value’) over $100,000. The denominator of the fraction is the Gift Tax Value of the property.

McCaffrey, Tax Tuning The Estate Plan By Formula, 33rd ANNUAL

HECKERLING INSTITUTE ON ESTATE PLANNING ¶ 402.4 (1999).

(2) Formula Allocation Clause. A “formula allocation clause” allocates the

amount transferred among transferees (i.e., transfer all of a particular asset, and allocate that asset among taxable and non-taxable transferees by a formula). Examples of non-taxable transferees includes charities, spouses, QTIP trusts, “incomplete gift trusts” (where there is a retained limited power of appointment or some other retained power so that the gift is not completed for federal gift tax purposes), and “zeroed-out” GRATs. With this second type of clause, the allocation can be based on values as finally determined for gift or estate tax purposes, or the allocation can be based on an agreement among the transferees as to values. For example,

the McCord and Hendrix cases used the second type of clause with the

allocation being based on a “confirmation agreement” among the transferees. The two other cases addressing formula allocation clauses have both involved clauses that were based on finally determined estate (Christiansen) or gift (Petter) tax values.

The formula allocation clause is significantly more complicated and by its nature includes multiple parties other than just the donor and donees. In all of the reported cases so far, these types of cases have involved a charity to receive the “excess value” over the stated dollar amount passing to family members.

b. Four Cases Have Approved Formula Allocation Clauses With “Excess” Value

Passing to Charity. Four cases have previously recognized formula allocation

defined value clauses McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006);

Christiansen v. Commissioner, 130 T.C. 1 (2008), aff’d, 586 F.3d 1061 (8th Cir.

2009), Petter v. Commissioner, T.C. Memo. 2009-280, aff’d¸ 653 F.3d 1012 (9th Cir. 2011), and Hendrix v. Commissioner, T.C. Memo. 2011-133).

As mentioned above, those cases have taken different valuation approaches in the formula allocation. Two of the cases relied on an agreement among the transferees as to valuation (McCord and Hendrix) and the other two cases on finally determined estate (Christiansen) or gift (Petter) tax values.

Synopsis

In Wandry v. Commissioner T.C. Memo 2012-88, the court upheld a stated dollar

value “formula transfer” clause of, in effect, “that number of units equal in value to $x as determined for federal gift tax purposes.” This is a very important development in the structuring of defined value transfers. This case literally opens up the simplicity of giving “$13,000 worth of LLC units” to make sure the gift does not exceed a desired monetary amount, or giving “$5,000,000 worth of LLC units” to make sure the donor does not have to pay gift tax as a result of the transfer of a hard-to-value asset. For sure, the planner would use a little more verbiage than that, but the simplicity of that kind of transfer is what the court recognized in Wandry. This is a much simpler approach than the formula allocation approach involving charities that has been approved in four earlier cases. While this kind of transfer seems straightforward enough (and is strikingly similar to marital deduction formula clauses that are commonly accepted in testamentary instruments), the IRS objects, largely on the grounds that the clause would make IRS gift tax audits meaningless. The court rejects those arguments in Wandry.

Parents made gift assignments of “a sufficient number of my Units as a Member of [an LLC], so that the fair market value of such Units for federal gift tax purposes shall be as follows: [stated dollar values were listed for various donees].” Following the list of dollar values was a general statement making clear that the donor intended to have a good-faith determination of such value by an independent third party professional, but if “the IRS challenges such valuation . . . , the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.”

The court, in an opinion by Judge Haines, held that the parents made gifts of a specified dollar value of membership units rather than fixed percentage interests in the LLC. The gift tax returns and the attached schedules reported gifts of those dollar amounts. Unfortunately, the descriptions of the gift assets on the return created some confusion by referencing specific percentage interests, rather than clearly describing the gifts as a particular dollar amount worth of units, but Judge Haines concluded that the parties clearly intended to make dollar value gifts and the schedules of the gift tax returns indeed reported the gifts as gifts of specific dollar values. The court also rejected an argument by the IRS that the capital accounts control the nature of the gifts and that the capital accounts reflect gifts of fixed percentage interests. To the contrary, the court determined that the underlying facts determine capital accounts, not the other way around. Book entries do not override more persuasive evidence that points to the contrary. (A further problem with the structure of the transaction, which interestingly was not criticized by the court, was that the donor waited 19 months to obtain an appraisal to know the number of units that were transferred under the formula assignment.)

Finally, the court addressed the IRS’s argument that the formula assignment was an invalid “savings clause” under the old Procter case. Judge Haines concluded

that the transfers of Units having a specified fair market value for federal gift tax purposes are not void as savings clauses — they do not operate to “take property back” as a condition subsequent, and they do not violate public policy. As to the public policy issue, the court quoted the Supreme Court’s conclusion that public policy exceptions to the Code should be recognized only for “severe and immediate” frustrations, and analyzed why the three public policy issues raised in the Procter case do not apply. First, the opinion responds to the concern that the clause would discourage the efforts to collect taxes by reasoning that the IRS’s role is to enforce the tax laws, not just to maximize revenues, and that other enforcement mechanisms exist to ensure accurate valuation reporting. As to the second and third policy concerns raised by Procter,

the court responded that the case is not “passing judgment on a moot case or issuing merely a declaratory judgment,” because the effect of the case to result in a reallocation of units between the donors and the donees. The court in particular noted that prior cases addressing the public policy issue have involved situations in which charities were involved in the transfers, but concluded that the lack of a charitable component in these transfers does not result in a “severe and immediate” public policy concern.

As discussed below, this case is not being appealed by the IRS, but the IRS has filed a nonacquiescence in the case.

Basic Facts

All of the facts were stipulated by agreement of the IRS and the donors. Parents made gifts of limited partnership interests beginning January 1, 2000, as advised by their tax attorney, of specific dollar amounts rather than a set number of units. (Apparently, the IRS did not raise any issues about the gifts of the limited partnership interests and they were not involved in this case.) The partnership assets were later contributed to an LLC, which also housed a family business. Parents continued their gift giving program of LLC units in a similar fashion. Because the number of membership units equal to the desired value of their gifts on any given date could not be known until a later date when a valuation could be made of the LLC’s assets, the attorney advised that “all gifts should be given as specific dollar amounts, rather than specific numbers of membership units.” On January 1, 2004, each of the parents wished to give LLC units equal to their $1,000,000 gift exemption amounts equally among their four children and their $11,000 annual exclusion amounts to each of their four children and five grandchildren. Pursuant to their attorney’s advice they made gifts of LLC units

“so that the fair market value of such Units for federal gift tax purposes” equaled

those desired dollar amounts.

The actual assignment documents that each of the parents used is as follows [the actual full assignment document is quoted because it may serve as a helpful form for defined transfer assignments by planners in the future]:

I hereby assign and transfer as gifts, effective as of January 1, 2004, a sufficient number of my Units as a Member of Norseman Capital, LLC, a Colorado limited liability company, so that the fair market value of such Units for federal gift tax purposes shall be as follows:

Name Gift Amount Kenneth D. Wandry $261,000 Cynthia A. Wandry 261,000 Jason K. Wandry 261,000 Jared S. Wandry 261,000 Grandchild A 11,000 Grandchild B 11,000 Grandchild C 11,000 Grandchild D 11,000 Grandchild E 11,000 1,099,000

Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date. Furthermore, the value determined is subject to challenge by the Internal Revenue Service (“IRS”). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if after the number of gifted Units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.

The donors and family members’ understanding of the nature of the gifts is summarized by the court (and stipulated by all parties) as follows--

The only gifts with respect to Norseman membership units that petitioners ever intended to give were of dollar amounts equal to their Federal gift tax exclusions. At all times petitioners understood and believed that the gifts were of a dollar value, not a specified number of membership units. Petitioners’ tax attorney advised them that if a subsequent determination revalued membership units granted, no membership units would be returned to them. Rather, accounting entries to Norseman’s capital accounts would reallocate each member’s membership units to conform to the actual gifts.

An independent appraiser valued the LLC assets as of January 1, 2004 in its report issued July 26, 2005, finding that a 1% Norseman interest was worth $109,000. Based on that value, the CPA entered on an undated and handwritten ledger that adjustments were made to the capital accounts in 2004, decreasing the parents’ combined capital accounts by $3,603,311 attributable to the gifts,

resulting in increases to capital accounts to each of the children and grandchildren of approximately $855,745 and $36,066, respectively.

The CPA prepared gift tax returns for the parents. Consistent with the gift documents, each of the parent’s returns reported total gifts of $1,099,000 and attached schedules reporting net transfers of $261,000 to each of the four children and $11,000 to each of the five grandchildren. However, the schedules “describe the gifts to petitioners’ children and grandchildren as 2.39% and .101% Norseman membership interests, respectively (gift descriptions). Petitioners’ C.P.A. derived the gift descriptions from the dollar values of the gifts listed in the gift documents and the gift tax returns and the $109,000 value of a 1% Norseman membership interest as determined by the K&W report.” [In retrospect, the gift descriptions should have been more detailed, reflecting them as dollar value gifts.]

The IRS audited the gift tax returns. The parties ultimately agreed upon $132,134 as the value of a 1% interest in the LLC, and the IRS took the position that the gifts were of the percentage amounts listed in the “gift descriptions” and that multiplying those percentage amounts times the stipulated value of a 1% interest resulted in a gift tax deficiency.

Holdings

(1) The parents made gifts of a specified dollar value of membership units rather than fixed percentage interests in the LLC.

(2) The transfers of Units having a specified fair market value for federal gift tax purposes are not void as savings clauses because they do not operate to “take property back” as a condition subsequent, and do not violate public policy. As to the public policy issue, the court quoted the Supreme Court’s conclusion that public policy exception to the Code should be recognized only for “severe and immediate” frustrations, and analyzed why the three public policy issues raised in the Procter case do not apply. The court in particular concluded that the lack of a charitable component in these transfers does not result in a “severe and immediate” public policy concern.

Analysis of “Procter” Issue

(1) Assignments Are Not Void as Savings Clauses Because They Do Not

Operate to “Take Property Back” Upon a Condition Subsequent. The IRS

argued that the assignments were an improper use of a formula to transfer assets in violation of principles established in Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944). In Procter, the trust indenture making the gift included the following clause:

Eleventh: The settlor is advised by counsel and satisfied that the present transfer is not subject to Federal gift tax. However, in the event it should be determined by final judgment or order of a competent federal court of last resort that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all the parties

hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically

be deemed not to be included in the conveyance in trust hereunder

and shall remain the sole property of Frederic W. Procter free from the trust hereby created. (Emphasis added)

[Observation: The literal language of the transfer document in Procter

contemplates that there is a present transfer that counsel believes is not subject to gift tax, and that any property “hereby transferred” that would be subject to gift tax is “deemed” not to be included in the conveyance. This is different from the clause in Wandry that only purported to transfer a specified dollar value of property and nothing else.]

The court in Wandry summarized that the “Court of Appeals for the Fourth Circuit held that the clause at issue operated to reverse a completed transfer in excess of the gift tax . . . [and] was therefore invalid as a condition subsequent to the donor’s gift.” (The court also summarized Proctor’s public policy analysis; that is discussed below.)

The court reviewed other cases that have rejected attempts to reverse completed gifts in excess of gift tax exclusions. (Ward v. Commissioner, 87 T.C. 78 (1986); Harwood v. Commissioner, 82 T.C. 239 (1984), aff’d without

published opinion, 786 F.2d 1174 (9th Cir. 1986).) The court reviewed other

cases that have recognized valid formulas to limit the value of a completed transfer. (Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008), aff’d, 586 F.3d 1061 (8th Cir. 2009)(defined value disclaimer so that assets in excess of defined value passed to charities); Estate of Petter v.

Commissioner, T.C. Memo. 2009-280, aff’d 653 F.3d 1012 (9th Cir. 2011);

McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), rev’g, 120 T.C. 358

(2003).) (Interestingly, the court did not cite Hendrix v. Commissioner, T.C. Memo. 2011-133 (June 15, 2011), which also upheld a defined value sale/gift transfer.) The court noted that King v. United States, 545 F.2d 700 (10th Cir. 1976) upheld a formula that adjusted the purchase price of shares sold to a trust for children if the IRS determined the fair market value of the shares to be different than the sale price, but the court viewed that as an adjustment to the consideration paid in the sale rather than an adjustment of the shares transferred, and therefore not controlling in this case.

To determine what types of clauses are valid and which ones are not, the court focused on the analysis in Estate of Petter, which drew a distinction between a “savings clause,” which is not valid, and a “formula clause,” which is valid.

A savings clause is void because it creates a donor that tries ‘to take