In an extremely important taxpayer victory, the United States Tax Court issued a memorandum opinion upholding the use of a defined value formula clause to fix the value of the donor’s gift for federal gift tax purposes. Wandry v. Commissioner, T.C. Memo 2012-88 (March 26, 2012). This type of formula clause is intended to prevent unanticipated gift tax from arising on a transfer, even if the IRS audits the transaction. Although Wandry is only a memorandum opinion, meaning that it has not been reviewed by the entire Tax Court, and may be appealed, it certainly is a positive step for taxpayers in the defined value clause arena.
In April 2001, Albert and Joanne Wandry and their children started Norseman Capital, LLC, a Colorado limited liability company (“Norseman”). Albert was designated to serve as the initial manager of Norseman. On January 1, 2004 Albert and Joanne gifted interests in Norseman to their children and grandchildren. The amount of each gift was defined in the assignment as follows:
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 for federal gift tax purposes shall be as follows:
1. Kenneth Wandry $ 261,000
2. Cynthia Wandry $ 261,000
3. Jason Wandry $ 261,000
4. Jared Wandry $ 261,000
5. Grandchild A $ 11,000
6. Grandchild B $ 11,000
7. Grandchild C $ 11,000
8. Grandchild D $ 11,000
9. Grandchild E $ 11,000
Although the Donors did not have a completed appraisal at the time of the gift, the Assignment document also contained the following:
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 united shall be adjusted accordingly so that the value of the number of units gifted to each person equals the amount set forth above.
An appraisal was issued on July 26, 2005 concluding that a 1% Norseman membership interest was worth $109,000. Gift tax returns were filed for Albert and Joanne for 2004 reporting net transfers from each donor of $261,000 to their children and $11,000 to their grandchildren. In addition, the gift tax return schedules described the gifts to the children as a 2.39% Norseman membership interest ($261,000 / $109,000), and the gifts to the grandchildren as a .101% Norseman membership interest ($11,000 / $109,000). These membership interests where derived by dividing the total dollar value gifted to each descendant by the appraised value of a 1% interest.
The IRS audited Albert and Joanne’s gift tax returns in 2006 alleging that the each donor actually made gifts of a 2.39% interest to each child and a .101% interest to each grandchild (rather than gifts of $261,000 and $11,000, respectively). The IRS sought to increase the value of the 2.39% Norseman membership interests from $261,000 (as reported on each donor’s gift tax return) to $366,000, and the .101% Norseman membership interests from $11,000 (as reported on each donor’s gift tax return) to $15,400. Albert, Joanne and the IRS eventually agreed to increase the value of the 2.39% and .101% Norseman membership interests to $315,800 and $13,346, respectively.
The key issue in this case was whether Albert and Joanne actually made gifts of a 2.39% and .101% Norseman membership interest to their descendants, or whether they made a gift of a fixed dollar amount of Norseman membership interests. If Albert and Joanne gifted a fixed percentage of Norseman membership interests, then an increase in the value of the 2.39% and .101% membership interests would result in gift tax. However, if it was determined that Albert and Joanne made a gift of a fixed dollar amount, then no gift tax would result because the value of the gift would remain unchanged. In essence, the formula under the assignment would operate to adjust the percentage membership interest transferred by Albert and Joanne at an amount less than 2.39% and .101% so that each donee only received those membership interests equal in value to the stated gift.
The IRS asserted the following arguments:
1. The descriptions contained in the gift tax returns of a specific percentage membership interest was a binding admission by Albert and Joanne that they transferred fixed percentage membership interests;
2. The capital accounts of Norseman, which were adjusted after the gifts to show the children and grandchildren as the owners of a 2.39% interest and .101% membership interest, controlled the nature of the gifts by Albert and Joanne;
3. The specific language of the gift documents transferred a fixed percentage of membership interests to the donees; and
4. The adjustment clause contained in the assignments is void for Federal tax purposes as contrary to public policy.
The Tax Court rejected all of the IRS arguments, holding:
1. The fact that the descriptions in the gift tax return included a specific percentage membership interest was not controlling because such percentage membership interest was merely based on the net dollar value reported by each donor and the appraisal. Albert and Joanne reported their gifts of a net dollar value consistent with the gift documents.
2. State law controls in determining the nature of the donees legal interest in property, not the capital accounts of an LLC. The Court noted that capital account entries are always tentative until a final adjudication or the expiration of the statute of limitations.
3. The clause contained in the assignments was a valid formula clause which operated to correct the allocation of Norseman membership units among Albert, Joanne and the donees after the appraisal was determined to have understated Norseman’s value. This was not an attempt to reverse a completed gift of a fixed percentage membership interest.
4. There is no well-established public policy against formula clauses. The use of a formula clause such as this, which merely defines the rights transferred and does not undo a prior transfer, does not create a “severe and immediate” public policy concern.
Wandry represents a landmark case in the defined value clause arena. Although taxpayers have had success with similar clauses in recent years (McCord, Hendrix, Christiansen, Petter), this is the first case which did not involve the use of a charity to receive any amount in excess of what a donor intended to gift. For example, in Petter, McCord and Hendrix, the donor gifted a specific number of units, which were allocated between the non-charitable donee and charity pursuant to a formula. If the IRS increased the value of the gifted units on audit, then the number of units allocated to the non-charitable donee decreased while the number of units allocated to the charity increased. Essentially, the charity was in place to receive any amount in excess of what the taxpayer intended to be subject to gift tax. The Wandry case, however, validates what some practitioners have been asserting since McCord – that a charity is not required to avoid unanticipated gift tax. This is significant because some taxpayers simply do not want to involve a charity.
Since the case of Proctor v. Commissioner in 1944, the IRS has attacked the use of clauses designed to avoid gift tax. The IRS has historically been successful in these challenges. In recent years, however, courts appear to be more accepting of formula gifting clauses. What has developed is a fine-line distinction between “savings clauses”, which are void, and “defined value clauses”, which are gaining acceptance. To the untrained eye, the clauses appear to almost be identical; however, the consequences of using the wrong clause are drastic.
A savings clause is void because it operates to undo a prior completed transfer because of an event (such as a court decision) occurring after the completion of a gift. A basic example of a savings clause is “I give a 10% interest in ABC, LLC to my son, but if the value of this 10% interest is finally determined to be greater than $100, then the interest transferred shall be adjusted.” A defined value clause is valid because operates to irrevocably transfer a fixed value. A basic example of a defined value clause would be “I give to my son $100 worth of my interest in ABC, LLC.” The difference lies in what the donor is giving away. With a defined value clause, son is entitled from the outset to nothing more than $100 worth of ABC, LLC. With a savings clause, the son is entitled to 10% from the outset, unless a subsequent event occurs which changes what son is entitled to.
With the end of 2012 fast-approaching, and gift tax exemptions scheduled to plummet from $5,120,000 to $1 million beginning in 2013, defined value formula clauses may become even more popular for 2012 gifts. If properly drafted, a donor could potentially utilize the full $5,120,000 exemption in 2012 while minimizing exposure to gift tax. Here are a few points to consider if you intend to make or draft a defined value formula gift:
1. Obtain an appraisal in advance or contemporaneously with the gift. Although Albert and Joanne did not obtain an appraisal until after the gift documents were executed, this factor was certainly not favorable to the taxpayer.
2. Use grantor trusts as donees. A significant drawback of the defined value clause is deciding how to allocate ownership and tax items during the period in which the IRS is still able to audit the transaction. If too much property is allocated to the donee, then it may be necessary to amend several years of income tax returns. However, if the donee is a grantor trust, then all tax items will be included on the grantor’s return during the years of uncertainty. No amended returns should be necessary.
3. Prepare gift tax returns consistent with the formula gift. As shown in Wandry, the IRS will likely use any inconsistencies against the donor on audit. Do not overlook the importance of filing an accurate and complete gift tax return!
4. Formula gifts work well if a single asset is gifted, but not so well if multiple assets are transferred. If you or your client intend to gift multiple assets, consider transferring the assets to an entity first, and then making a formula gift of the entity interest.
It is no secret that the IRS absolutely despises defined value formula clauses and it is unlikely that they will give up their fight because of Wandry. Therefore, practitioners and donors should remain cautious in utilizing these type of clauses. The IRS can still appeal Wandry, which would lie in the Tenth Circuit. There is marginally favorable precedent already in the Tenth Circuit (See King v. Commissioner). However, the Tax Court stated in Wandry that it did not view King as controlling because it was not “squarely on point.” This may or may not deter the IRS from appealing Wandry to the Tenth Circuit. The IRS may instead choose to find a similar case in another jurisdiction (outside of the Fifth (McCord, Hendrix), Ninth (Petter) or Tenth Circuits) and try for a more favorable outcome. Alternatively, the IRS may forgo the court system altogether and issue regulations to limit the use of defined value clauses, as invited by the Ninth Circuit during oral arguments in Petter.