Morrison & Foerster LLP: Making Gifts Using Defined Value Clauses: Not Necessarily Void as Against Public Policy

Morrison & Foerster LLP: Making Gifts Using Defined Value Clauses: Not Necessarily Void as Against Public Policy

By Danielle T. Zaragoza, Esq., Morrison & Foerster LLP

Given the relatively large federal gift tax applicable exclusion amount available for taxable gifts in 2011 and 2012, many clients have made or are considering making significant gifts before the end of this year.  For a client who wants to make gifts of hard-to-value assets to use his or her full exclusion amount, but not exceed it this year, there is a risk that the IRS could challenge the valuation claimed on the gift tax return which could result in an unintended gift tax liability.  In Wandry v. Commissioner,1 the Tax Court has provided some comfort that a properly drafted defined value clause is not contrary to public policy and should be respected by the IRS, thereby allowing taxpayers to take advantage of their full applicable exclusion amounts with little risk that challenges by the IRS to valuation would result in gift taxes being due.

A defined value clause generally provides that if the IRS successfully challenges the valuation claimed by the taxpayer, the amount gifted would be reduced to fit within the annual exemption or credit amounts.  A defined value clause is a technique used by estate planners to reduce the risk of an unintended gift tax liability.  However, there is the additional risk that the IRS and the courts would not respect such a clause because they are seen as contrary to public policy.  As noted in Commissioner v. Procter,2 a defined value clause would likely discourage the government's tax collection because "the only effect of an attempt to enforce the tax would be to defeat the gift" and is therefore against public policy.

However, in recent years, formula clause gifts have been upheld in previous Tax Court cases when excess value would have been transferred to charity.  The presence of a charitable beneficiary was seen as a third party who could and would insure valuation accuracy and as supporting another favorable public policy-encouraging charitable gifting. 

Wandry, decided in March 2012, is significant because no charity was involved and the court expressly stated that the formula clause in the transfer documents is not void as contrary to public policy.  Given this recent decision, it is likely that formula clauses that describe gifts as a specific dollar amount, rather than a specific number of units or percentage interest of a hard-to-value asset, may become a standard planning tool for estate planners. 

Below is a summary of the Wandry case and the decision.

  • On August 7, 2001, Albert and Joanne Wandry (petitioners) and their children formed Norseman Capital, LLC (Norseman), and the petitioners used interests in Norsemen to continue a gift-giving program of making annual exclusion gifts and additional gifts in excess of their annual exclusions, but within their unified credit amount, to their children and grandchildren.
  • The petitioners' tax attorney advised them that: (1) the number of Norseman membership 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 membership units; and (3) all gifts should be given on December 31 or January 1 of a given year so that a midyear closing of the LLC's books would not be required.
  • The petitioners executed separate assignments and memorandums of gifts which included the following "adjustment clause" paragraph:

"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."

  • The IRS argued that petitioners gifted a fixed percentage of Norseman interests to their children and grandchildren and those gifts exceeded the petitioners' Federal gift tax exclusions; therefore, the petitioners were liable for the tax imposed by Internal Revenue Code section 2501. The IRS further argued that the "adjustment clause" created a condition subsequent to the completed gifts and is void for Federal tax purposes as contrary to public policy.
  • The Tax Court, discussing precedent and prior relevant decisions, noted that there was "a distinction between a 'savings clause,' which a taxpayer may not use to avoid the tax imposed by section 2501, 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'."
  • Finding that the "adjustment clause" at issue in Wandry is a valid formula clause, and acknowledging that there was no charitable beneficiary in the case, the Tax Court states:

"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 [the date of the gift], 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 the petitioners and the donees because the [valuation report] understated the Norsemena value."

Of course, Wandry is only a Tax Court memorandum opinion, subject to appeal by the IRS.  Even if the IRS does not appeal the decision, it is unlikely that the IRS will acquiesce to this decision.  Therefore, conservative planners and clients may still want to include a charitable beneficiary in gifting plans that use defined value clauses to take advantage of a client's full applicable exclusion amount before the end of 2012.


1. TC Memo 2012-88 [enhanced version available to lexis.com subscribers].

2. 142 F.2d 824, 827 (4th Cir. 1944) [enhanced version available to lexis.com subscribers].

 

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Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.

© Copyright 2012 Morrison & Foerster LLP.  This article is published with permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

 

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