The use of “defined value clauses” or “value definition formulas” in making gifts has received much attention and possibly a boost from a decision this
year of the United States Tax Court in Wandry v. Commissioner, T.C. Memo 2012-88. Wandry seems to extend the effectiveness of such techniques
beyond what previous case law permitted. But Wandry is not well-settled law on this subject, its reasoning is troubling, and it should not be relied
on except with great care, especially since the IRS has filed a Notice of Appeal.
Many assets that are the subject of gifts to family members do not trade in any market and therefore are hard to value. Examples are undivided interests in
real estate and membership units in family limited partnerships or LLCs. Donors understandably want to be able to make such gifts without a risk of a gift
tax audit that could be a hassle and an expense and could result in increased gift tax. Just as in the days when one could drive into a gas station and ask
for “five dollars’ worth of regular,” without specifying the number of gallons, there is an intuitive notion that a donor ought to be able to make a gift
of any stated amount expressed in words like “such interest in X Partnership, an ... limited partnership, as has a fair market value of $13,000.” The value
of that gift appears to be $13,000, no matter what kind of property is given. The IRS approved a gift using that very language in Technical Advice
Memorandum 8611004 (Nov. 15, 1985). (The ellipsis is in the version of the TAM that was made public; the deleted word appears to have been Oklahoma.)
But since 1985, the IRS has become less sympathetic and has challenged such audit-resistant formulas, often citing Commissioner v. Procter, 142 F.2d
824 (4th Cir. 1944), a case with unusual facts in which the court found a provision in a document of transfer that “the excess property hereby transferred
which is deemed by [a] court to be subject to gift tax ... shall automatically be deemed not to be included in the conveyance” to be contrary to public
policy because it would discourage the collection of tax, would require the courts to rule on a moot issue, and would seek to allow what in effect would be
an impermissible declaratory judgment.
In Knight v. Commissioner, 115 T.C. 506 (2000), the Tax Court sided with such an IRS challenge to an attempt to transfer “that number of limited
partnership units in [a partnership] which is equal in value, on the effective date of this transfer, to $600,000.” As a result, the court redetermined the
value subject to gift tax. It was generally believed, however, that the result in Knight could have been avoided if the taxpayers had acted more
consistently and carefully. Despite the apparent attempt to make a defined-value gift, the gifts shown on the gift tax return were stated merely as
percentage interests in the partnership. Moreover, the taxpayers contended in court that such interests were actually worth less than the “defined”
Field Service Advice 200122011 (Feb. 20, 2001) addressed, negatively, the facts generally known to be those of McCord v. Commissioner, 120 T.C. 358
(2003), in which the taxpayers had given limited partnership interests in amounts equal to the donors’ remaining GST exemption to GST-exempt trusts for
their sons, a fixed dollar amount in excess of those GST exemptions to their sons directly, and any remaining value to two charities. The IRS refused to
respect the valuation clauses. The IRS acknowledged that the approach in question was not identical to Procter, because it used a “formula” clause
that defined how much was given to each donee, while Procter involved a so-called “savings” clause that required a gift to be “unwound” in the
event it was found to be taxable. Nevertheless, the IRS believed the principles of Procter were applicable, because both types of clauses would
recharacterize the transaction in a manner that would render any adjustment nontaxable. The IRS reached similar conclusions in Technical Advice Memoranda
200245053 (July 31, 2002) and 200337012 (May 6, 2003).
When McCord itself was decided by the Tax Court, the court avoided the formula issue by dwelling on the fact that the assignment document had used
only the term “fair market value” not “fair market value as determined for federal gift tax purposes.”
In Succession of McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), the Court of Appeals for the Fifth Circuit reversed the Tax Court
totally, scolded the Tax Court majority soundly, and remanded the case to the Tax Court to enter judgment for the taxpayers. The court said that “although
the Commissioner relied on several theories before the Tax Court, including ... violation-of-public policy [the Procter attack], … he has not
advanced any of those theories on appeal. Accordingly, the Commissioner has waived them.” But, in the view of many, the Fifth Circuit said other things
that are hard to understand unless the court was comfortable with the use of defined value clauses in that case.
Estate of Christiansen v. Commissioner
, 130 T.C. 1 (2008) (reviewed by the court), addressed the use of value formulas in the different context of a disclaimer of a testamentary transfer. The
decedent’s will left her entire estate to her daughter, with the proviso that anything her daughter disclaimed would pass to a charitable lead trust and a
charitable foundation. The daughter disclaimed a fractional portion of the estate, with reference to values “finally determined for federal estate tax
purposes.” Noting that phrase, the Tax Court, without dissent, rejected the Service’s Procter argument and upheld the disclaimer to the extent of
the portion that passed to the foundation. (The court found an unrelated technical problem with the disclaimer to the extent of the portion that passed to
the charitable lead trust.) In a pithy eight-page opinion, the Eighth Circuit affirmed. 586 F.3d 1061 (8th Cir. 2009).
In Estate of Petter v. Commissioner, T.C. Memo 2009-280, the Tax Court upheld gifts and sales to grantor trusts, both defined by dollar amounts “as
finally determined for federal gift tax purposes,” with the excess directed to two charitable community foundations. Elaborating on its Christiansen
decision, the court stated that “[t]he 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.... A shorthand for this distinction is that savings clauses are void, but formula
clauses are fine.” The court also noted that the Code and Regulations explicitly allow valuation formula clauses, for example to
define the payout from a charitable remainder annuity trust or a grantor retained annuity trust, to define marital deduction or credit shelter bequests,
and to allocate GST exemption. The court expressed disbelief that Congress and Treasury would allow such valuation formulas if there were a
well-established public policy against them. On appeal, the Government did not press the “public policy” Procter argument, and the Ninth Circuit
affirmed the taxpayer-friendly decision. 653 F.3d 1012 (9th Cir. 2011).
Hendrix v. Commissioner
, T.C. Memo 2011-133, was the fourth case to approve the use of a defined value clause with the excess going to charity, although the court emphasized the
size and sophistication of the charity, the early participation of the charity and its counsel in crafting the transaction, and the charity’s engagement of
its own independent appraiser.
In Wandry v. Commissioner, T.C. Memo 2012-88, the donors, husband and wife, each defined their gifts 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 Units for federal gift tax purposes shall be as follows: [Here each donor listed children
and grandchildren with corresponding dollar amounts.]
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.
The court stressed the now familiar “distinction between a ‘savings clause’, which a taxpayer may not use to avoid [gift tax], and a ‘formula clause’,
which is valid.... A savings clause is void because it creates a donor that tries ‘to take property back’.... On the other hand, a ‘formula clause’ is
valid because it merely transfers a ‘fixed set of rights with uncertain value’.” The Tax Court then compared the Wandrys’ gifts with the facts in Petter and determined that the Wandrys’ gifts complied. Most interesting, the court said (emphasis added):
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
Norseman membership units among petitioners and the donees because the [appraisal] report understated Norseman’s value. The clauses at issue are valid
This is a fascinating comparison, because it equates the rights of the charitable foundations in Petter that were the “pourover” recipients of
any value in excess of the stated values with the rights of the children and grandchildren in Wandry who were the primary recipients of the
stated values themselves.
In a way, the facts of Wandry were the reverse of the facts in Petter. The effect of the increased value in Petter was an increase in what the charitable foundations received, whereas the effect of the increased value in Wandry was a decrease in what the
donees received. The analogs in Wandry to the charitable foundations in Petter were the donors themselves, who experienced an increase in what they retained as a result of the increases in value on audit.
It is also telling that in the court’s words the effect of the language in the gift documents was to “correct the allocation of Norseman membership
units among petitioners and the donees because the [appraisal] report understated Norseman’s value.” Until Wandry, many observers had believed that
the courts had approved not “formula transfers” but “formula allocations” of a clearly fixed transfer. In fact, the Wandry court used a variation of
the word “allocate” five times to describe the determination of what was transferred and what was retained. But the “allocation” was between the donees and
the original donors. “Allocation” to the donors looks a lot like retention by the donors, if not a way to “take property back.” It is a cause
for concern that the court did not acknowledge that tension, but continued to use “allocation” language to justify what in economic effect defined what was transferred by the donors, not merely how the transferred property was allocated among donees.
Significance of Wandry
There is now a taxpayer victory in a defined value case that does not involve a “pourover” to charity of any excess value, which some observers have viewed
as quite a breakthrough. The Wandry court concluded by again acknowledging the absence of a charity and saying that “[i]n 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.”
Thus, Wandry appears to bless a simpler fact pattern that more closely conforms to the common sense “five dollars’ worth of regular” approach that
many observers, apparently even the IRS in 1985, have thought should work.
The Government timely filed a notice of appeal of Wandry with the Tax Court on August 29, 2012. It remains to be seen if the Justice Department will
pursue that appeal, which would go to the Tenth Circuit. Pending the outcome of the appeal, estate planners committed to presenting clients with the widest
possible selection of options may consider the benefits and risks of the Wandry approach. But the risks must include the possibility of a challenge
by the IRS. While the weight of case law has now accumulated behind defined value clauses with a “pourover” to a charity that has actively monitored and
participated in the transaction, it would be wrong to think the IRS will view the isolated case of Wandry as an occasion for it to change its mind
about other uses of a technique it obviously does not like. Moreover, if a Wandry-style defined value formula were challenged by the IRS, the
taxpayer’s defense would include the unenviable task of trying to explain the Wandry opinion’s troubling use of “allocation” language to justify
what in effect is a defined transfer formula. Unless and until that tension in the Wandry opinion is resolved, perhaps (but not necessarily)
on appeal, Wandry should be relied on only with great caution.
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