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A Formula for Success: Ninth Circuit Aligns with Fifth and Eighth Circuits on Formula Clause

By : Ori Bash, ASA

In Estate of Anne Y. Petter et al. v. Commissioner, No. 10-71854 (9th Cir. 2011), the Court affirmed a decision by the Tax Court[i] that allowed for the use of a “formula value” clause.  In the Petter case, the Ninth Circuit joins the Fifth and Eighth Circuits on the issue of allowing formula value clauses. 


The taxpayer created the Petter Family LLC (“PFLLC”) and transferred approximately $22.6 million worth of UPS stock in exchange for membership units in PFLLC.  The taxpayer then created two trusts, one for each of her children.  As part of the taxpayer’s estate plan, she transferred membership units as a gift and partly by sale to the two trusts, and coupled the transfers with simultaneous gifts of membership units to two charitable foundations[ii].  The transfer documents included a dollar formula clause, which assigned to the trusts a number of  units worth a specified dollar amount, with the remainder of the units assigned to the foundation.  In addition, the documents contained a reallocation clause, which obligates the trusts to transfer additional units to the foundations if the value of the units the trusts initially received is finally determined for federal gift tax purposes to exceed the specified dollar amount.

Based upon the taxpayer’s valuation expert’s fair market value of $536.20 per unit[iii], each trust received 8,465.31 units. Additionally, the Seattle Foundation received 1,773.91 units and the Kitsap Community Foundation received 93.47 units.  The IRS audited the gift tax return and determined a value per unit of $794.39. Two weeks before trial, the taxpayer and the IRS settled on a value of $744.74 per unit. Under the aforementioned formula value clauses in the gift documents, the Seattle Foundation and the Kitsap Community Foundation were entitled to additional units given that the value of the units at the time of transactions was adjusted upward. The IRS issued a notice of deficiency in the amount of $2,115,797, a deficiency calculation that disallowed the incremental tax benefit from the additional transfers of units to the charities.

The Tax Court determined that the taxpayer was entitled to a charitable deduction equal to the value of the additional units in PFLLC the foundations were to receive.  The Tax Court largely based its decision upon its belief that the formula value clauses were not against public policy, and that the foundations’ receipt of additional units in PFLLC was not subject to a condition precedent.

The Ninth Circuit’s Response

Upon appeal, the Court rejected the Service’s view that the gifts of the additional units in PFLLC to the foundations were dependent upon an IRS audit as a condition precedent under Treasury Regulation § 25.2522(c)-3(b)(1). The Court noted that “either of the trusts or either of the foundations could also have challenged the Moss Adams valuation of the units, although it was unlikely that they would have done so.  But this practical reality does not mean that the foundations’ rights to additional units were contingent for their existence upon the IRS audit.” The Court further cited McCord v. Commissioner[iv], and Estate of Christiansen v. Commissioner[v] agreeing with their reasoning and conclusions, finding that they were equally applicable in this case. In McCord, agreements for the assignment of limited partnership interests to children and trusts included a formula clause allocating additional value to a charity in the event the fair market value of the assigned interests exceeded a specified amount. This was designed to provide a charitable deduction for any increase in value from an audit of the parents’ gift tax returns.  The Tax Court’s majority decision rejected the formula clause used in the valuation of gifts of interests.  This decision was later reversed by the Fifth Circuit.  In Christiansen, the Eighth Circuit’s unanimously approved a formula disclaimer that operated much in the same manner as defined values clauses and rejected the IRS’s arguments that the clause violated public policy.


Three Circuits have now aligned on the acceptance of formula value clauses, as the IRS’ multiple attacks were ultimately and thoroughly rejected by the Court.  While the decision did not provide insight to the determination of the stipulated fair market value, Petter is another victory for the taxpayer that supports formula value clauses, an important estate planning tool.   

[i] Estate of Anne Y. Petter v. Comm’r. T.C. Memo 2009-280

[ii] For the sale portion of the transfer, each trust executed a 20-year promissory note bearing an interest rate of 5.37 percent

[iii] Based on the fair market value of the underlying assets, a 46% lack of marketability discount (average indication from two studies), and a 13.3% lack of control discount (closed-end funds data)

[iv] 461 F.3d 614, 627 n.34 (5th Cir. 2006)

[v] 586 F.3d 1061 (8th Cir. 2009)

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