Wills and Trusts

Wyatt, Tarrant & Combs, LLP

Effectiveness of Defined Value Clauses and Formula Gifting

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In John H. Hendrix et ux. v. Commissioner, T.C. Memo. 2011-133, the taxpayer assigned fixed dollar amounts of S corporation stock to GST trusts – by gift and a sale for a note – with any (all) excess being assigned to a donor advised fund at a community foundation. The assignments required that the assignees determine among themselves the number of shares each would have and disputes would be decided by arbitration. The allocation was agreed to among the donees about a month after the assignments. The family had an appraiser and the community foundation had a second appraiser review the appraisal for fairness. The court upheld the effectiveness of the allocation.

The Tax Court approved a charitable allocation clause in Estate of Anne Y. Petter et al. v. Commissioner, T.C. Memo. 2009-280. Mrs. Petter created the Petter Family, LLC (PFLLC) and funded it with UPS stock. Mrs. Petter then gave units to two grantor trusts, sold additional units to those trusts, and made a gift to two community foundations of still more units. The transfers were by formula:

“Transferor wishes to assign 940 Class T Membership Units in the Company (the “Units”) including all of the Transferor’s right, title and interest in the economic, management and voting rights in the Units as a gift to the Transferees.” Donna’s document is similar, except that it conveys Class D membership units. Section 1.1 of Terry’s transfer document reads:

Transferor * * *

1.1.1 assigns to the Trust as a gift the number of Units described in Recital C above that equals one-half the minimum dollar amount that can pass free of federal gift tax by reason of Transferor’s applicable exclusion amount allowed by Code Section 2010(c). Transferor currently understands her unused applicable exclusion amount to be $907,820, so that the amount of this gift should be $453,910; and

1.1.2 assigns to The Seattle Foundation as a gift to the A.Y. Petter Family Advised Fund of The Seattle Foundation the difference between the total number of Units described in Recital C above and the number of Units assigned to the Trust in Section 1.1.1.

The gift documents also provide in section 1.2:

The Trust agrees that, if the value of the Units it initially receives is finally determined for federal gift tax purposes to exceed the amount described in Section 1.1.1, Trustee will, on behalf of the Trust and as a condition of the gift to it, transfer the excess Units to The Seattle Foundation as soon as practicable.

The Foundations similarly agree to return excess units to the trust if the value of the units is “finally determined for federal gift tax purposes” to be less than the amount described in section 1.1.1.

***

Recital C of the sale documents reads: “Transferor wishes to assign 8,459 Class T [or Class D] Membership Units in the Company (the “Units”) including all of the Transferor’s right, title and interest in the economic, management and voting rights in the Units by sale to the Trust and as a gift to The Seattle Foundation.” Section 1.1 reads:

Transferor * * *

1.1.1 assigns and sells to the Trust the number of Units described in Recital C above that equals a value of $4,085,190 as finally determined for federal gift tax purposes; and

1.1.2 assigns to The Seattle Foundation as a gift to the A.Y. Petter Family Advised Fund of The Seattle Foundation the difference between the total number of Units described in Recital C above and the number of Units assigned and sold to the Trust in Section 1.1.1.

Section 1.2 of the sale documents differs slightly from section 1.2 of the gift documents. In the sale documents, it reads: “The Trust agrees that, if the value of the Units it receives is finally determined to exceed $4,085,190, Trustee will, on behalf of the Trust and as a condition of the sale to it, transfer the excess Units to The Seattle Foundation as soon as practicable.” Likewise, the Seattle Foundation agrees to transfer shares to the trust if the value is found to be lower than $4,085,190.

The court found no abuse in this sort of formula transfer:

The Fifth Circuit held in McCord that what the taxpayer had given was a certain amount of property; and that the appraisal and subsequent translation of dollar values (what the donor gave each donee) into fractional interests in the gift (what the donees got) was a later event that a court should not consider. 461 F.3d at 627. In Christiansen, we also found that the later audit did not change what the donor had given, but instead triggered final allocation of the shares that the donees received. 130 T.C. at 15. The distinction is between a donor who gives away a fixed set of rights with uncertain value — that’s Christiansen — and a donor who tries to take property back — that’s Procter. The Christiansen formula was sufficiently different from the Procter formula that we held it did not raise the same policy problems.

A shorthand for this distinction is that savings clauses are void, but formula clauses are fine. But figuring out what kind of clause is involved in this case depends on understanding just what it was that Anne was giving away. She claims that she gave stock to her children equal in value to her unified credit and gave all the rest to charity. The Commissioner claims that she actually gave a particular number of shares to her children and should be taxed on the basis of their now-agreed value.

Recital C of the gift transfer documents specifies that Anne wanted to transfer “940 Class T [or Class D] Membership Units” in the aggregate; she would not transfer more or fewer regardless of the appraisal value.18 The gift documents specify that the trusts will take “the number of Units described in Recital C above that equals one-half the * * * applicable exclusion amount allowed by Code Section 2010(c).” The sale documents are more succinct, stating the trusts would take “the number of Units described in Recital C above that equals a value of $4,085,190.” The plain language of the documents shows that Anne was giving gifts of an ascertainable dollar value of stock; she did not give a specific number of shares or a specific percentage interest in the PFLLC. Much as in Christiansen, the number of shares given to the trusts was set by an appraisal occurring after the date of the gift. This makes the Petter gift more like a Christiansen formula clause than a Procter savings clause.

In actual fact, the IRS on audit determined that the PFLLC units were worth more than the taxpayer’s appraiser. Thus, additional units were allocated to charity and Mrs. Petter was eligible for an additional income tax deduction. But, as of what date? The court concluded as of the date of the original transfer:

Here we have a conundrum, for the events of the gift happened as follows:

  • March 22, 2002 — Gift of 940 shares, split between trusts and foundations. Letters of intent to foundations.
  • March 25, 2002 — Sale to trusts
  • April 15, 2002 — Moss Adams appraisal report
  • Later in 2002 — The Seattle Foundation “books” the value of the allocated shares on the basis of the Moss Adams appraisal. The Kitsap Community Foundation’s records recognize the A.Y. Petter Family Advised Fund as of December 31, 2002. In May 2003, Richard Tizzano, president of the Kitsap Community Foundation, signed Anne’s Form 8283 for 2002, acknowledging receipt of PFLLC units on March 22, 2002.
  • Fall 2007 — Bill Sperling [of the Seattle Foundation] notified of new appraisal for PFLLC units and beginning of reallocation.
  • February 2008 — Tax Court trial. Reallocation ongoing.

Anne says she should be able to take the entire charitable deduction at the time of the gift, in 2002. The Commissioner says that only some of the stock went to the charities in 2002, which means Anne or her estate should take a deduction for the gift of the rest of the stock in some later year not before us.

Section 25.2511-2(a), Gift Tax Regs., provides: “The gift tax is not imposed upon the receipt of the property by the donee, nor is it necessarily determined by the measure of enrichment resulting to the donee from the transfer, nor is it conditioned upon ability to identify the donee at the time of the transfer.” Anne made a gift for which, at the time of transfer, the beneficiaries could be named but the measure of their enrichment could not yet be ascertained. The Commissioner is comfortable with this ambiguity when considering whether the gift is completed or not, and states that tax treatment should not change simply because a donee’s identity becomes known at a date later than the date of the transfer. By analogy, we see no reason a donor’s tax treatment should change based on the later discovery of the true measure of enrichment by each of two named parties, one of whom is a charity. In the end, we find it relevant only that the shares were transferred out of Anne’s name and into the names of the intended beneficiaries, even though the initial allocation of a particular number of shares between those beneficiaries later turned out to be incorrect and needed to be fixed.

***

The allocation of units based on the Moss Adams appraisal, as an event occurring after the date of the gift, is outside the relevant date of the transfer, so anything that worked to change that allocation after the fact is not relevant to our current inquiry. We also don’t consider dispositive the date when the charities “booked” the value of the units, or the amounts the charities booked at the time of the initial transfer, both because those actions also occurred after the transfer and because Anne had no control over the Foundations’ internal accounting practices. We therefore agree with Anne that the appropriate date of the gift for tax purposes is March 22, 2002. The parties will submit calculations reflecting the amount of the gift and corresponding charitable deduction.

The Ninth Circuit upheld the Tax Court in Estate of Anne Y. Petter et al. v. Commissioner, (9th Cir. 2011). The IRS did not make a broad Procter type argument but rather argued that where a formula allocated assets to charity based on values as finally determined for Federal gift tax purposes, the audit itself was a condition precedent that ought to void the gift tax charitable deduction for any additional transfers to charity on account of the audit. The Ninth Circuit disagreed, stated:

Ultimately, the IRS argues that because the foundations would not have received the additional units but for the IRS audit, the additional transfer of units to the foundations was dependent upon a condition precedent. Adopting the IRS’s “but for” test would revolutionize the meaning of a condition precedent. In one sense, the IRS is correct that but for its audit, the foundations would not have obtained additional LLC units, but that is because the IRS believed the estimated value was not the true fair market value. Either of the trusts or either of the foundations could also have challenged the Moss Adams valuation of the LLC units, although it was unlikely that they would have done so. But this practical reality does not mean that the foundations’ rights to additional LLC units were contingent for their existence upon the IRS audit. Treasury Regulation § 25.2522(c)-3(b)(1) asks whether a transfer “is dependent upon . . . a precedent event in order that it might become effective,” not whether a transfer is dependent upon the occurrence of an event so that the transferred assets actually change hands. An analogy to a simple contract illustrates this point. Consider a contract between A and B, in which A agrees to pay B $1000 in exchange for B’s services. If A enters into this contract knowing that he has no intention to pay and if B then performs his side of the bargain, B will receive the $1000 only if he sues A in court. But for B’s lawsuit, B would not receive the money he deserves. But B’s filing of the lawsuit — though an event that must occur for B to be paid — is not a condition precedent to B’s receiving the $1000. That is so because B’s entitlement to this sum is in no way dependent upon the filing of a lawsuit; A’s duty to perform arose when B performed under the contract.

Citing I.R.C. § 2001(f)(2), the IRS further argues that a value as finally determined for gift tax purposes means the value shown on a taxpayer’s return, unless the IRS conducts a timely audit and challenges that value. Because the Taxpayer used the term “as finally determined for federal gift tax purposes,” the IRS claims that rather than transferring a particular number of units whose fair market value added up to the dollar amounts specified in the transfer agreements, the Taxpayer actually transferred a particular number of units whose pre-defined value — $536.20 per unit, the value reported on the Taxpayer’s gift tax return — added up to those dollar amounts. “And at that value, the foundations had rights to 1,773.91 and 93.47 units, and no more. The additional 4,503.82 and 237.04 units that the foundations subsequently were to receive were the result of the audit and the parties’ agreement that the value of each unit was $744.74.”

But the Taxpayer’s transfer agreements do not specify the value of an individual LLC unit. The gift documents assign to each of the two foundations the difference between 940 units and “the number of Units . . . that equals [$453,910],” while the sale documents assign to one foundation the difference between 8459 units and “the number of Units . . . that equals a value of $4,085,190 as finally determined for federal gift tax purposes.” Aside from the fact that only the dollar formula clause of the sale documents uses the phrase “as finally determined for federal gift tax purposes,” a taxpayer who files a return cannot conjure up a value for federal gift tax purposes out of thin air; rather, she must use federal gift tax valuation principles. Under these principles, the value of an asset “as finally determined for federal gift tax purposes” is the fair market value of that asset. See Treas. Reg. § 25.2512-1 (“[I]f a gift is made in property, its value . . . is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”); cf. Succession of McCord v. Comm’r, 461 F.3d 614, 627 n.34 (5th Cir. 2006) (“There is no material difference between fair market value determined under Federal gift tax valuation principles and fair market value as finally determined for Federal gift tax purposes.” (citation and internal quotation marks omitted)). Thus, the Taxpayer did not transfer to the foundations the number of units equal to a defined dollar amount divided by $536.20; rather, she transferred the number of units equal to the defined dollar amount divided by the fair market value of a unit. The Moss Adams appraisal confirms this point; it states, on the first page, that its purpose “is to express an opinion of the fair market value of the [units].”

The opinion concludes with the suggestion that the IRS change its regulations:

Contrary to the IRS’s argument, the additional transfer of LLC units to the foundations was not subject to a condition precedent within the meaning of Treasury Regulation § 25.2522(c)-3(b)(1). Under the terms of the transfer documents, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula. This formula had one unknown: the value of a LLC unit at the time the transfer documents were executed. But though unknown, that value was a constant, which means that both before and after the IRS audit, the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the Taxpayer’s transfer was dependent upon an IRS audit. Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive. Accordingly, we hold that Treasury Regulation § 25.2522(c)-3(b)(1) does not bar a charitable deduction equal to the value of the additional units the foundations will receive. “[W]e expressly invite[ ] the Treasury Department to ‘amend its regulations’ if troubled by the consequences of our resolution of th[is] case.” Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 713 (2011) (quoting United Dominion Indus., Inc. v. United States, 532 U.S. 822, 838 (2001)).

In Joanne M. Wandry et al. v. Commissioner, T.C. Memo. 2012-88, the issue was whether a formula clause, not involving a charity, would be effective. The clause in question read like this:

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.

An appraisal determined that a 1% interest was worth $109,000, thus the Form 709 showed that each child received 2.39% and each grandchild 0.101%. On audit the IRS determined an increase and before the Court the parties agreed that 2.39% was worth $315,000 and 0.101% worth $3,346. The Court rejected the Procter argument:

Respondent argues that the public policy concerns expressed in Procter apply here. We disagree. As we have previously stated, the Supreme Court has warned against invoking public policy exceptions to the Code too freely, holding that the frustration caused must be “severe and immediate”. See Commissioner v. Tellier, 383 U.S. 687, 694 (1966). In Estate of Petter v. Commissioner, T.C. Memo. 2009-280, we held that there is no well-established public policy against formula clauses. The Commissioner’s role is to enforce tax laws, not merely to maximize tax receipts. See Estate of Christiansen v. Commissioner, 586 F.3d at 1065. Mechanisms outside of the IRS audit exist to ensure accurate valuation reporting. Id. For instance, in the cases at hand the donees and petitioners have competing interests because every member of Norseman is entitled to allocations and distributions based on their capital accounts. Because petitioners’ capital accounts were understated, the donees were allocated profits or losses that should have been allocated to petitioners. Each member of Norseman has an interest in ensuring that he or she is allocated a fair share of profits and not allocated any excess losses.

With respect to the second and third Procter public policy concerns, a judgment for petitioners would not undo the gift. Petitioners transferred a fixed set of interests to the donees and do not seek to change those interests. The gift documents do not have the power to undo anything. A judgment in these cases will reallocate Norseman membership units among petitioners and the donees. Such an adjustment may have significant Federal tax consequences. We are not passing judgment on a moot case or issuing merely a declaratory judgment.

In Estate of Petter we cited Congress’ overall policy of encouraging gifts to charitable organizations. This factor contributed to our conclusion, but it was not determinative. The lack of charitable component in the cases at hand does not result in a “severe and immediate” public policy concern.

The IRS can be expected to object that the donors do not have the same interest in enforcing an accurate gift that a charity would. Discussing Petter the opinion states:

Respondent does not interpret Estate of Petter properly. The Court of Appeals described the nature of the transfers and the reallocation provision of the clause at issue in Estate of Petter as follows:

Under the terms of the transfer documents, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula. This formula had one unknown: the value of a LLC unit at the time the transfer documents were executed. But though unknown, that value was a constant, which means that both before and after the IRS audit, the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the Taxpayer’s transfer was dependent upon an IRS audit. Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive. * * *

Id. at 1023. We apply each part of the Court of Appeals’ description above to petitioners’ gifts:

Part I: “Under the terms of the transfer documents, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula.”

Here, under the terms of the gift documents, the donees were always entitled to receive predefined Norseman percentage interests,5 which the gift documents essentially expressed as a mathematical formula. For each of petitioners’ children, this formula was expressed as:

$261,000
x = _______________
FMV of Norseman

Similarly, for petitioners’ grandchildren this formula was expressed as:

$11,000
x = _______________
FMV of Norseman

Part II: “This formula had one unknown: the value of a LLC unit at the time the transfer documents were executed. But though unknown, that value was a constant”

Petitioners’ formula had one unknown, the value of Norseman’s assets on January 1, 2004. But though unknown, that value was a constant. The parties have agreed that as of January 1, 2004, the value of a 2.39% Norseman membership interest was $315,800. Accordingly, the total value of Norseman’s assets on January 1, 2004, was approximately $315,800 divided by 2.39%, or approximately $13,213,389. This value was a constant at all times.

Part III: “[B]efore and after the IRS audit, the foundations were entitled to receive the same number of units.”

Before and after the IRS audit the donees were entitled to receive the same Norseman percentage interests. Each of petitioners’ children was entitled to receive approximately a 1.98% Norseman membership interest.

     $261,000
1.98% = ___________
$13,213,389

Similarly, each of petitioners’ grandchildren was entitled to receive approximately a .083% Norseman membership interest.

    $11,000
.083% = ___________
$13,213,389

Part IV: “Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the Taxpayer’s transfer was dependent upon an IRS audit. Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive.”

Absent the audit, the donees might never have received the proper Norseman percentage interests they were entitled to, but that does not mean that parts of petitioners’ transfers were dependent upon an IRS audit. Rather, the audit merely ensured that petitioners’ children and grandchildren would receive the 1.98% and .083% Norseman percentage interests they were always entitled to receive, respectively.

It is inconsequential that the adjustment clause reallocates membership units among petitioners and the donees rather than a charitable organization because the reallocations do not alter the transfers. On January 1, 2004, each donee was entitled to a predefined Norseman percentage interest expressed through a formula. The gift documents do not allow for petitioners to “take property back”. Rather, the gift documents correct the allocation of Norseman membership units among petitioners and the donees because the K&W report understated Norseman’s value. The clauses at issue are valid formula clauses.

The IRS non-acquiesced in Wandry but did not appeal, 2012-46 I.R.B. 543.

A key issue is ensuring that the gift tax return reflects the formula, rather than merely stating the result of the formula.

Turney P. Berry
Louisville, Kentucky

Author: robmalinesq

I am an estate planning and probate attorney in Memphis, Tennessee.

Leave a reply. Please note that although this blog may be helpful in informing clients and others who have an interest in information privacy and security, it is not intended to be legal advice. The information on this blog also should not be relied upon to form an attorney-client relationship.

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