Wills and Trusts

Wyatt, Tarrant & Combs, LLP


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State Reformation to Update Provisions Left Over From the Original GST Did Not Create New GST Problems

In PLR 201322025 a decedent’s GST trust called for a distribution of $250,000 to a son’s trust, a number tied to the GST in effect before 1986. The trust contained a provision to update the $250,000 amount if the Code changed. When the decedent died in 1987 the executor exempted all of the assets from GST and now the trustee has obtained a court order to distribute all of the assets to the son’s trust. The IRS determined there were no adverse GST, gift, or estate tax consequences.

Turney P. Berry
Louisville, Kentucky


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Late Disclaimer OK: Disclaimer within Nine Months of Awareness

In PLR 201334001 the IRS determined disclaimers were timely on the following facts:

Grantor created Trusts several years before his death on Date 1, a date before January 1, 1977, for the benefit of the lawful lineal descendants of his daughter (Daughter), per stirpes. Daughter’s son, Grandson is the current beneficiary of Trusts. Upon the death of Grandson, Grandson’s son (Taxpayer) will be entitled to income distributions from Taxpayer’s per stirpital share of Trusts. The income distributions will continue until the earlier of Taxpayer’s death or the perpetuities date. Upon termination of each of the Trusts, any remaining trust property will be distributed to Taxpayer and Taxpayer’s brother, per stirpes.

Taxpayer, who is over 18 years of age, represents that Taxpayer learned of the transfers creating his interests in Trusts on Date 2. Taxpayer further represents that he had no knowledge that he possessed any interest in Trusts, prior to Date 2. Taxpayer proposes to execute and timely file and deliver a written disclaimer to the trustees for each of Trust 1, Trust 2, Trust 3, and Trust 4, on or before Date 3, stating that he irrevocably, unconditionally and without qualification, disclaims and refuses to accept any interest that would otherwise pass to Taxpayer under the relevant provisions of Trusts. The disclaimers will be valid under Statute 1 and Statute 2. Date 3 is a date occurring not more than nine months after Date 2.

The ruling states:

Section 25.2511-1(c)(2) of the Gift Tax Regulations provides, in relevant part, that, in the case of taxable transfers creating an interest in the person disclaiming made before January 1, 1977, where the law governing the administration of the decedent’s estate gives a beneficiary, heir, or next-of-kin a right completely and unqualifiedly to refuse to accept ownership of property transferred from a decedent (whether the transfer is effected by the decedent’s will or by the law of descent and distribution), a refusal to accept ownership does not constitute the making of a gift if the refusal is made within a reasonable time after knowledge of the existence of the transfer. The refusal must be unequivocal and effective under the local law. There can be no refusal of ownership of property after its acceptance. In the absence of the facts to the contrary, if a person fails to refuse to accept a transfer to him of ownership of a decedent’s property within a reasonable time after learning of the existence of the transfer, he will be presumed to have accepted the property.

The U.S. Supreme Court has recognized that, under the predecessor to this regulation, an interest must be disclaimed within a reasonable time after obtaining knowledge of the transfer creating the interest to be disclaimed, rather than within a reasonable time after the distribution or vesting of the interest. Jewett v. Comm’r, 455 U.S. 305 (1982). The requirement in the regulations that the disclaimer must be made within a “reasonable time” is a matter of federal, rather than local law. Id. at 316. Whether a period of time is reasonable under the regulations is dependent on the facts and circumstances presented.

In this case, Taxpayer will execute each disclaimer within nine months of learning of the transfers creating his interests in each of Trust 1, Trust 2, Trust 3, and Trust 4. Accordingly, based upon the information submitted and the representations made, we conclude that Taxpayer’s proposed disclaimers of his interests in Trusts, if made on or before Date 3, will be made within a reasonable time after Taxpayer learned of the existence of the transfers under § 25.2511-1(c)(2). Furthermore, provided that Taxpayer’s disclaimers are valid under State law and assuming the other requirements of § 25.2511-1(c)(2) are met, Taxpayer’s disclaimer of his interests in Trusts will not be taxable gifts under § 2501.

Turney P. Berry
Louisville, Kentucky


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Estate of Kite: Sale of Business to Children for a Deferred Private Annuity

In Estate of Virginia V. Kite et al. v. Commissioner, T.C. Memo. 2013-43, the court confronted the sale of a partnership (“KIC”) in 2001 by Mrs. Kite to her children, in exchange for a private annuity that would begin in 10 years. Mrs. Kite was then 74 and had a greater than 50% chance of living for more than 18 months and in fact she had a 12.5 year life expectancy. However, Mrs. Kite died in 2004. The Court upheld the transaction as being bona fide for full and adequate consideration, stating as follows:

Before participating in the annuity transaction, Baldwin [another limited partnership], which was wholly owned by the Kite children or their trusts, contributed approximately $13.6 million of assets to KIC. As a result, the Kite children did not need to rely on the assets already held by KIC to make the annuity payments. In addition, the Kite children did not transfer the assets underlying the KIC interests back to Mrs. Kite after the annuity transaction was completed. In fact, they did not make any distributions from KIC, but allowed the KIC assets to accumulate in order to have income available when the annuity payments became due. The Kite children therefore expected to make payments under the annuity agreements and were prepared to do so.

Mrs. Kite also demonstrated an expectation that she would receive payments. Mrs. Kite actively participated in her finances and over the course of her life demonstrated an immense business acumen. Accordingly, it is unlikely that Mrs. Kite would have entered into the annuity agreements unless they were enforceable and, more importantly, she could profit from them. In addition, Mrs. Kite, unlike the surviving spouse in Estate of Hurford, was not diagnosed with cancer or other terminal or incurable illness. In fact, the record, which includes a letter from Mrs. Kite’s physician, establishes to the contrary — that Mrs. Kite was not terminally ill and she did not have an incurable illness or other deteriorating physical condition. Mrs. Kite and her children reasonably expected that she would live through the life expectancy determined by IRS actuarial tables, which was 12.5 years after the annuity transaction. Indeed, if Mrs. Kite lived to her life expectancy as determined by IRS actuarial tables, she would have received approximately $800,000 more in annuity payments than the value of her KIC interests. At a minimum, Mrs. Kite would have made a profit with the potential of a greater return if she lived longer. Continue reading


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Effects of limitations on Crummey Withdrawal Rights: in terrorem clauses and Mandatory Arbitration provisions

What is the effect of a mandatory arbitration and in terrorem clause on Crummey rights? In CCA 20120826 an issue was whether purported withdrawal rights were sufficient to create a present interest. The CCA states:

To be a present interest, a withdrawal right must be legally enforceable. For example, if a trust provides for withdrawal rights, and the trustee refuses to comply with a beneficiary’s withdrawal demand, the beneficiary must be able to go before a state court to enforce it. See Cristofani v. Commissioner, 97 T.C. 74 (1991); Restatement of the Law of Trusts § 197 (Nature of Remedies of Beneficiary); Bogert, Trusts and Trustees Vol. 41, § 861 (Remedies of the Beneficiary and Trustee).

As a matter of public policy, the federal courts are the proper venue for determining an individual’s federal tax status, and the federal courts are not bound by the determinations of a private forum (such as Other Forum) concerning such status. Alford v. United States, 116 F.3d 334 (8th Cir. 1997). Likewise, as a matter of public policy, a State court will not take judicial notice of a private forum’s (or group’s or sect’s) construction and determination of State law pertaining to a trust agreement, such as the Trust in this case. Cite 2. These determinations are strictly within the purview of the State courts. Cite 3; Cite 4.

Under State law, a trust clause may prohibit a beneficiary from seeking civil redress. Cite 5. Although the State legislature made a public policy decision to allow a beneficiary to make certain inquiries without fear of risking forfeiture, these “safe harbors” are not relevant here. Cite 6.

Under the terms of the Trust in this case, a beneficiary cannot enforce his withdrawal right in a State court. He may only press his demand before an Other Forum and be subject to the Other Forum’s Rules. Notwithstanding any provisions in the Trust to the contrary, the Other Forum will not recognize State or federal law. If the beneficiary proceeds to a State court, his existing right to income and/or principal for his health, education, maintenance and support will immediately terminate. He will not receive any income or principal for his marriage, to buy a home or business, to enter a trade, or for any other purpose. He will not have withdrawal rights in the future, and his contingent inheritance rights will be extinguished. Thus, a beneficiary faces dire consequences if he seeks legal redress. As a practical matter, a beneficiary is foreclosed from enforcing his withdrawal right in a State court of law or equity.

Withdrawal rights such as these are not the legally enforceable rights necessary to constitute a present interest. Because the threat of severe economic punishment looms over any beneficiary contemplating a civil enforcement suit, the withdrawal rights are illusory. Consequently, no annual exclusion under § 2503(b) is allowable for any of the withdrawal rights. See Rev. Rul. 85-24, 1985-1 C.B. 329; Rev. Rul. 81-7, 1981-1 C.B. 474.

Is the ruling correct? In Rev. Rul. 83-108 notice was not given in the year of the gift at all, but rather was given in the next year. No notice is arguably a greater obstacle to the exercise of withdrawal rights than mandatory arbitration or an in terrorem clause. On the other hand, may a cut off of rights be so substantial as to de facto limit a purported withdrawal right?

Turney P. Berry
Louisville, Kentucky


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LP and LLC Interests As Present Interests

The issue of whether the gift of a limited partnership or limited liability company qualifies for the annual exclusion arose in Hackl v. Commissioner, 118 T.C. 279 (2002), affd. 335 F.3d 664 (7th Cir. 2003) with the lower court and Seventh Circuit deciding such interests were future interests because the interests received by the donees were restricted and the asset in the entity was a tree farm. In Price v. Commissioner, T.C. Memo, 2010-2, the Tax Court followed Hackl and, arguably, expanded its reach. The opinion focuses on the inability of the partners to compel distributions or to transfer the units.

It is undisputed that under the partnership agreement the donees have no unilateral right to withdraw their capital accounts. Furthermore, section 11.1 of the partnership agreement expressly prohibits partners from selling, assigning, or transferring their partnership interests to third parties or from otherwise encumbering or disposing of their partnership interests without the written consent of all partners. As stated with respect to analogous circumstances in Hackl v. Commissioner, 118 T.C. at 297, transfers subject to the contingency of approval (by the LLC manager in Hackl and by all partners in the instant cases) “cannot support a present interest characterization, and the possibility of making sales in violation thereof, to a transferee who would then have no right to become a member or to participate in the business, can hardly be seen as a sufficient source of substantial economic benefit.”

Moreover, because of the operation of section 11.2 of the partnership agreement, it appears that the donees are not even properly characterized as limited partners in the partnership.

***

But even if it were to be assumed, contrary to the foregoing analysis, that the donees did somehow become substituted limited partners, it would not affect our conclusion that contingencies stand between the donees and their receipt of economic value for the transferred partnership interests so as to negate finding that the donees have the immediate use, possession, or enjoyment of the transferred property. Pursuant to section 11.1 of the partnership agreement, unless all partners consented the donees could transfer their partnership interests only to another partner or to a partner’s trust. In addition, any such purchase would be subject to the option-to-purchase provisions of section 11.4 of the partnership agreement, which gives the partnership itself or any of the other partners a right to purchase the property according to a complicated valuation process but without providing any time limit for exercising the purchase option with respect to a voluntary transfer.

***

Because the partnership owned real properties generating rents under long-term leases, we believe that the partnership could be expected to generate income at or near the time of the gifts. The record fails to establish, however, that any ascertainable portion of the income would flow steadily to the donees. To the contrary, the record shows that the partnership’s income did not flow steadily to the donees–there were no distributions in 1997 or 2001.

Pursuant to the partnership agreement, profits of the partnership were distributed at the discretion of the general partner, except when otherwise directed by a majority in interest of all the partners, both limited and general. Furthermore, the partnership agreement stated that “annual or periodic distributions to the partners are secondary to the partnership’s primary purpose of achieving a reasonable, compounded rate of return, on a long-term basis, with respect to its investments.”

Petitioners allege that the partnership is expected to make distributions to cover the donees’ income tax liabilities arising from the partnership’s activities. Section 7.3 of the partnership agreement, however, clearly makes such distributions discretionary: “Neither the partnership nor the general partner shall have any obligation to distribute profits to enable the partners to pay taxes on the partnership’s profits.” Because the timing and amount of any distributions are matters of pure speculation, the donees acquired no present right to use, possess, or enjoy the income from the partnership interests.

Without citation of legal authority, petitioners contend that the general partner has a “strict fiduciary duty” to make income distributions to the donees. We are not persuaded that such a fiduciary duty, if it exists, establishes a present interest in a transferred limited partnership interest where the limited partner lacks withdrawal rights.10 Moreover, because (as previously discussed) the donees are not substituted limited partners, there is significant question as to whether under Nebraska law the general partner owes them any duty other than loyalty and due care.11 Cf. Kellis v. Ring, 155 Cal. Rptr. 297 (Ct. App. 1979) (holding that under California law the assignee of a limited partner’s partnership interest could not bring suit against the general partner for alleged breaches of fiduciary duty).

A common suggestion since Hackl has been that donees be given a put right to the donor. Although not squarely addressed by Judge Thornton the language of the opinion suggests that could be ineffective:

Petitioners allude to the possibility of the donees’ selling their partnership interests to the general partner. It must be remembered, however, that the general partner is owned by petitioners and that its president is Mr. Price, who engineered the gifts of partnership interests to his children in the first instance. If the possibility of a donor’s agreeing to buy back a gift sufficed to establish a present interest in the donee, little would remain of the present interest requirement and its statutory purpose would be subverted if not entirely defeated.

The same issue arose in district court in John W. Fisher et ux. v. United States, 105 A.F.T.R.2d 2010-1347 (S.D. Ind. March 11, 2010). There an LLC owned undeveloped land on Lake Michigan. The short opinion rejects the taxpayers’ claims of an annual exclusion:

The Fishers make three arguments in support of their assertion that the transfers of interests in Good Harbor to the Fisher Children were gifts of “present interests in property.” Treas. Reg. § 25.2503-3(b). The Court considers each in turn. First, the Fishers argue that upon transfer, the Fisher Children possessed the unrestricted right to receive distributions of Good Harbor’s Capital Proceeds. However, under the Operating Agreement, any potential distribution of Good Harbor’s Capital Proceeds to the Fisher Children was subject to a number of contingencies, all within the exclusive discretion of the General Manager. Operating Agreement §§ 4.2.3-.3.4. Accordingly, the right of the Fisher Children to receive distributions of Good Harbor’s Capital Proceeds, when such distributions occur, is not a right to a “substantial present economic benefit.” Hackl, 335 F.3d at 667; see Commissioner v. Disston, 325 U.S. 442, 449 (1945) (holding that when a trust provides for the distribution of the corpus or trust income only after some uncertain, future event, the trustee possesses a future interest.)

Second, the Fishers argue that upon transfer, the Fisher Children possessed the unrestricted right to possess, use, and enjoy Good Harbor’s primary asset, the Lake Michigan beach front property. See Pls.’ Br., Dkt. No. 33, at 9 (citing the affidavit of one of the Fisher Children, James A. Fisher). However, there is no indication from Good Harbor’s Operating Agreement that this right was transferred to the Fisher Children when they became “Member[s]”8 and “Interest Holder[s].”9 Regardless, the right to possess, use, and enjoy property, without more, is not a right to a “substantial present economic benefit.” Hackl, 335 F.3d at 667. It is a right to a non-pecuniary benefit.

Lastly, the Fishers assert that upon transfer, the Fisher Children possessed the unrestricted right to unilaterally transfer their interests in Good Harbor. The Fishers argue that this right is a present interest in property. Cf. Hackl, 335 F.3d at 667-68 (holding that the Hackls’ gifts were not gifts of present interests, because “Treeco’s restrictions on the transferability of the shares meant that they were essentially without immediate value to the donees.”).

Under Section 6.1, the Fisher Children may unilaterally transfer their right to receive distributions from Good Harbor, but only if certain conditions of transfer are satisfied. Operating Agreement § 6.1.1-6.1.5. Among these conditions is Good Harbor’s right of first refusal, which effectively prevents the Fisher Children from transferring their interests in exchange for immediate value, unless the transfer is to one of the Fisher’s descendants (a “family member”). Id. § 6.1.4-6.1.5. Even an attempted transfer to a family member is not without restrictions. Id. §§ 6.1-6.1.1.6, 6.1.5. Therefore, due to the conditions restricting the Fisher Children’s right to transfer their interests in Good Harbor, it is impossible for the Fisher Children to presently realize a substantial economic benefit. Cf. Wooley v. U.S., 736 F.Supp. 1506, 1509 (S.D. Ind. 1990) (Dillin, J.) (holding that Wooley’s gifts to his partners’ capital accounts were gifts of present interests, because “each partner had the unrestricted and immediate right to withdraw [the] gifts. . . .”).

The Tax Court reached the contrary conclusion in Estate of George H. Wimmer et al. v. Commissioner, T.C. Memo. 2012-157 (2012). There the partnerships were initially created in California but moved, in 1997, to Georgia, and owned marketable securities. The transfers at issue were made in 1996-2000. The court noted that the partnership would receive income and thus the partners would owe income tax. Under California and Georgia law, unmodified by the partnership agreement, the general partner had a fiduciary duty to distribute tax liability amounts to the partners. The opinion states:

In describing the general partners’ powers, the partnership agreement, as initially written and as restated, provided that the general partners “possess full and exclusive power to manage, control, administer and operate Partnership business and affairs * * * subject, in all events, to fiduciary duties to Limited Partners and the continuing duty to advance the Partnership’s purposes and best interests”. Under California law, partners have fiduciary duties toward each other and because of such duties may not take advantage of, or otherwise put adverse pressure on, other partners when conducting partnership business. See, e.g., Leff v. Gunter, 658 P.2d 740, 744 (Cal. 1983); BT-I v. Equitable Life Assurance Soc’y, 89 Cal. Rptr. 2d 811, 815-816 (Ct. App. 1999) (citing Cal. Corp. Code sec. 15643 (West 1991) (repealed 2006)). In Georgia, general partners owe fiduciary duties to limited partners, including the duty to act in the utmost good faith and with the finest loyalty, which the limited partners are entitled to enforce. See, e.g., Hendry v. Wells, 650 S.E.2d 338, 346 & n.9 (Ga. Ct. App. 2007).

According to the Grandchildren Trust documents, the trust’s only asset was a limited partnership interest, which, given the transfer restrictions described above, could not be liquidated or otherwise exchanged for cash. Notably, the partnership’s sole asset was dividend-paying stock.9 As a limited partner, and on behalf of the Grandchildren Trust, the trustee was allocated its proportionate share of the dividends paid each year. Because the Grandchildren Trust had no other source of income, distributions of partnership income to the trustee were necessary to satisfy the Grandchildren Trust’s annual Federal income tax liabilities. The Court holds that the necessity of a partnership distribution in these circumstances comes within the purview of the fiduciary duties imposed on the general partners. Therefore, the general partners were obligated to distribute a portion of partnership income each year to the trustee.

The partnership agreement provided that after allocating partnership net profits and losses, and every item of income, gain, loss, deduction, and credit proportionately among the partners in accordance with their respective percentage interests consistent with section 704, distributions of net cash flow shall be made to the partners in proportion to their respective percentage interests. Because distributions must be pro rata, any distribution to the trustee triggered proportionate distributions to the other partners. The estate has thus proven that, on the date of each gift, some portion of partnership income was expected to flow steadily to the limited partners. Indeed, the record shows that the partnership made distributions pro rata from dividends paid each year at issue.10

Finally, the Court holds that, with respect to the third prong, the portion of income flowing to the limited partners could be readily ascertained. The partnership held publicly traded, dividend-paying stock and was thus expected to earn dividend income each year at issue. Because the stock was publicly traded, the limited partners could estimate their allocation of quarterly dividends on the basis of the stock’s dividend history and their percentage ownership in the partnership.

Footnote 10 is as follows:

The Court notes that, unlike the taxpayers in Hackl and Price, decedent, in his fiduciary capacity as general partner of the partnership, made distributions each year at issue and was required to do so. See Hackl v. Commissioner, 118 T.C. 279, 298 (2002), aff’d, 335 F.3d 664 (7th Cir. 2003); Price v. Commissioner, T.C. Memo. 2010-2.

Wimmer suggests that limited partnership gifts have certain advantages over LLC unit gifts. The effect of a present interest requirement, if any, on charitable gifts ought be considered too.

Turney P. Berry
Louisville, Kentucky


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Effectiveness of Defined Value Clauses and Formula Gifting

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