Formula clauses have become a popular estate planning tool, and for very good reasons. After all, when making gifts, the donor is faced with an unpleasant source of risk: valuation. What if the appraisal is challenged? With a big enough valuation discrepancy, significant gift taxes might be due. This has kept a number of wealthy clients from making otherwise-advisable gifts.
This week, the Tax Court kindly offers a solution. In Wandry,1 the formula clause applied to a 2004 gift of discounted interests in an LLC survived the Service’s challenge. Even better, this was not (as in Petter, see below) a case where the formula, if adjusted due to a valuation challenge, benefited a charity. This was a pure intra-family gift. Not only that – the Court’s discussion of the case background also provides contract language and a step-by-step analysis that practitioners might use as a “how to” guide.
On August 7, 2001, Albert and Joanne Wandry (“Petitioners”), along with their four children, formed Norseman Capital, LLC (“Norseman”) and began a gift giving program. In connection with the gift giving program, the Petitioners’ tax attorney advised them that: (1) the number of Norseman member units equal to the desired value of their gifts on any given date could not be known until a later date when a valuation could be made of Norseman’s assets; (2) all gifts should be given as specific dollar amounts, rather than specific numbers of member units; and (3) all gifts should be given on December 31 or January 1 of a given year so that a mid-year closing of the books would not be required.
On January 1, 2004, the Petitioners assigned and transferred as gifts, a significant number of member units in Norseman to their four children and five grandchildren2. The gift documents further stated (referred to hereinafter as the “adjustment clause”):
Although the number of member units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted member 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. If, after the number of gifted member 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 member units shall be adjusted accordingly so that the value of the number of member units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.
The IRS argued that the Petitioners are liable for substantial gift taxes because they transferred completed gifts of fixed percentage interests to the donees and the gifts exceed the Petitioners’ federal gift tax exclusions. The Petitioners argued that they did not transfer fixed Norseman percentage interests to the donees. Rather, they transferred Norseman percentage interests to the donees equal in value to the amounts set forth in the gift documents. They further argued that the IRS’ public policy concerns do not apply to the adjustment clause.
The taxpayers initially claimed a 39 percent discount on their Form 709 gift tax returns. After the Service filed a deficiency notice with a valuation implying a 14.5 percent discount, the parties had negotiated a compromise settlement on the valuation, stipulating a valuation of the gifted member interests at a 26 percent discount. Both donors gifted about $1 million each, in total, to several children and grandchildren.
The Court cited Knight3 as an example where the gift tax returns served as the determining description for gifts (as opposed to the transfer documents) since the taxpayers claimed that their gifts were worth less than the fixed dollar amount stated in the transfer document. The Court contrasts this with the fact that the petitioners at all times understood, believed, and claimed that they gifted fixed dollar amounts.
On the issue of public policy, the Court began its analysis with Procter4, which it has previously described as the “cornerstone of a body of law” regarding impermissible transfer clauses, along with other cases where the courts invalidated attempts to reverse completed gifts in excess of the Federal gift tax exclusions due to the public policy argument. In Procter, the formula value clause was held contrary to public policy primarily since any attempt to collect the tax would defeat the gift, thereby discouraging efforts to collect the tax. For cases where the formula clause was upheld, the Court cited King5, McCord6, Christiansen7, and Petter8.
In its analysis of precedent cases, the Court drew a distinction between a “savings clause”, which the taxpayer may not use to avoid the tax imposed by section 2051, and a “formula clause”, which is valid. The Court notes that a savings clause is void because it creates a donor that tries to “take property back”, whereas a “formula clause” is valid because it merely transfers a “fixed set of rights with uncertain value.”
In Petter, it notes that the transfer documents provided that the donors transferred an “ascertainable dollar value of stock” as a fixed set of rights even though the unit themselves had an unknown value. While that value was unknown at the transfer date, the value of a membership unit on any given date is constant, with no contingencies for the transfers to be effective.
The Court also states that it is inconsequential that the adjustment clause reallocates membership units among petitioners and the donees, rather than to a charitable organization. While the charitable aspect of the formula value clause contributed to its decision in Petter, it was not determinative. Accordingly, the Court explicitly states that the lack of charitable component in formula value clauses does not result in a “severe and immediate” public policy concern.
This case is certainly a huge win for the Wandry family. But Wandry may also serve as the final nail in the coffin for formula value clause challenges by the IRS. Practitioners may now confidently rely on formula value clauses not only as another tool for estate planning with a charitable component, but also in situations where no charitable giving is contemplated. Planners will still need to take care in structuring formula clauses in order to avoid the “savings clause” distinction. And yet, with the guidance provided in Wandry, the pitfalls in structuring such transactions may now be navigated around. The upshot of the case, therefore, seems to be that formula clauses are about to become much more frequent in ordinary estate planning practice.
1Wandry v. Comm’r, TC Memo 2012-88.
2The fair market value of such member units for federal gift tax purposes were $261,000 to each of their four children and $11,000 to each of their five grandchildren. Thus, the total amount of the gift was $1,099,000. The Petitioners’ independent third-party appraisal determined an overall discount of 39 percent, while the IRS countered with a 14.5 percent discount. Prior to the trial, both the IRS and the Petitioners compromised on a 26.2 percent overall discount.
3Knight v. Comm’r, 115 T.C. 506 (2000).
4Comm’r v. Procter, 142 F.2d 824, 827-828 (4th Cir. 1944).
5King v. U.S., 545 F.2d 700 (10th Cir. 1976). Public policy issue not addressed as transaction was a sale, not a gift.
6McCord v. Comm’r, 461 F. 3d 614 (5th Cir. 2006)
7Christiansen v. Comm’r, 130 T.C. 1 (2008)
8Estate of Petter v. Comm’r, T.C. Memo. 2009-280