Take-Away:  Defined-value clauses are popular when a hard-to-value asset like real estate or a closely-held business interest is gifted or sold. By expressing the asset transferred using a specific dollar amount, the IRS is frustrated in its efforts to revalue the asset on audit and find a disguised gift. The successful use of a defined-value clause in Wandry v Commissioner, Tax Court Memo, 2012-88 brought even more attention to the effective use of a defined-value clause to protect against a different, higher, value that arises in an IRS gift tax audit. This month the Tax Court issued yet another decision that ‘throws some shade’ on the use of a Wandry defined-value clause in either a gift or sale transaction.

Background: The Tax Code imposes a tax on the transfer of property by gift. [IRC 2501(a).] When property is transferred for less than adequate and full consideration, the amount by which the value of the property exceeded the value of the consideration received is deemed a gift. [IRC 2512(b).] If property is exchanged for ‘adequate and full consideration’ it is not a gift for federal gift tax purposes if it is bona fide, arm’s-length, and free from any donative intent. [Treas. Regulation, 25.2512-8.] A transaction between family members is subject to special scrutiny, and the presumption is that the transfer between family members is a gift. Frazee v Commissioner, 98 Tax Court 554 (1992.)

  • Risk on Audit: When the asset that is the subject of the transfer is hard-to-value, like real estate, oil and gas interests, or fractional interests in closely held business entities like a limited partnership, where valuation discounts are claimed, it is a good bet that the value of the reported transfer will be carefully examined by the IRS on audit. Often those audits lead to a notice of gift tax deficiency, since the IRS’s appraiser identifies a higher value than that of the donor’s appraiser.
  • Transfer Formulae: To mitigate the risk of the IRS disagreeing with the reported value of the asset transferred on a federal gift tax return [Form 709], some estate plans resort to the use of a formula to describe the subject of the gift. Often those formulae are self-adjusting, so that if the IRS places a higher value on the item that was gifted, then the formula returns the ‘overage’ back to the donor. These self-adjustment provisions are called savings clauses.
  • Savings Clauses Ignored: Unfortunately, there is a long history of court cases that clearly state that savings clauses will not be respected by the IRS, or the courts. A savings clause is essentially an adjustment to the transferred asset. Courts will reject savings clauses because they rely on conditions subsequent, e.g. an IRS audit adjustment,  to adjust the gifts or transfers so that size of the transfer, as measured either in dollar amount or percentage, could not be known. This rejection of savings clauses was announced in a case where the court ignored a clause that adjusted part of a gift to ‘automatically be deemed not included in the conveyance in trust hereunder and shall remain the sole property of the taxpayer’ because the adjustment would be triggered only by a final judgment or order of a competent federal court of last resort that any part of the transfer is subject to gift tax. Commissioner v Procter, 142 F.2d 824 (1944.) This has led to a long line of federal court cases where a formula is found to be, in effect, an unenforceable savings clause.

Wandry:  Formula transfer clauses received a reprieve, however, in Wandry v Commissioner, Tax Court Memo, 2012-88 (2012.) The Tax Court looked to the transfer documents, rather than subsequent events, to decide the amount of property given away by the taxpayer in a completed gift. The Wandrys made gifts specifying that a ‘sufficient number’ of Units in their LLC be transferred as gifts so that the fair market value of such Units ‘shall equate to specific dollar amounts as indicated in the gift documents’- $261,000 to each child and $11,000 to each grandchild. The use of this  defined-value was found not to be a savings clause. As part of the gift transfer instruments the following key provisions were included:

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 of the date of the gift, but must be determined after such date based on all relevant information of that date…. Furthermore, the value determined is subject to challenge by the 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 final valuation and a final determination of 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.

Accordingly, a specific dollar amount was assigned to the LLC units being transferred, not a specific number or percentage of the units. By identifying the number of units transferred by a fixed dollar amount, the goal was to limit the number of units transferred to that identified dollar amount, even if the value of the units later changed on audit by the IRS.

Example: The donor executes an Assignment that provides ‘I transfer no more than $5,000,000 of shares of stock in ABC corporation to the Family Trust using fair market value principles as used for the calculation of federal estate tax purposes subject to the adjustment as described in Wandry.’ If the donor has an available transfer tax exemption amount of $5.0 million, the donor is assured that the IRS cannot on a subsequent audit assign a larger value to the stock that is transferred and thus find an implied gift- only $5.0 million of the shares of ABC stock (whatever their value) were the subject of the transfer. Consequently, if the IRS places a higher value on the shares of ABC stock transferred after audit, fewer shares ofABC  stock will ultimately be titled in the name of the Family Trust.

With the Tax Court’s approval of a defined-value formula gift in Wandry, (albeit a nonbinding Tax Court Memo decision, without any precedential value) more transactions started to use this type of formula to minimize the exposure to taxable gifts when the IRS audited the transaction and challenged the value of the reported transfer.

But now we have Nelson to contend with.

James C Nelson et ux. V. Commissioner, No.27313-13, No.27321-13, Tax Court Memo, 2020-81 (June 10, 2020)

Facts: I will spare you a recitation of all of the facts in this 50 page Tax Court decision. Much of the decision focused on valuation discounts claimed in the gift and sale of family limited partnership interests. Instead, only  that part of the decision with regard to a defined value formula will be summarized. Suffice it to say that the taxpayer lost on the valuation discount arguments as well.

Mrs. Nelson made both a gift and entered into a sale of her limited partnership interests in a family limited partnership that held multiple operating businesses and a holding company. Mrs. Nelson used defined-value clauses in each instrument of transfer.

  • Gift: The Gift and Assignment of Limited Partnership Interest gift memo recites: Nelson desires to make a gift and to assign to the Trust her right, title, and interest in a limited partnership interest having a fair market value of TWO MILLION NINETY-SIX THOUSAND AND NO/100THS DOLLARS ($2,096,000) as of December 31, 2008-as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.
  • Sale: The Sale and Assignment of Limited Partnership Interest memo recites: Nelson desires to sell and to assign to the Trust her right, title, and interest in a limited partnership interest having a fair market value of TWENTY MILLION AND NO/100THS DOLLARS ($20,000,000) as of January 2, 2009 -as determined by a qualified appraiser within one hundred eighty (180) days of the effective date of this Assignment.
  • Neither Assignment instrument contained a clause that defined fair market value or subjected the limited partnership interests to reallocation after the valuation date. While dollar amounts were stated, the timing of the valuation was postponed to the appraisal date.
  • Nelson gave the Trust a promissory note for $20 million. The note provided for interest at 2.06% and 10% interest on matured, unpaid amounts. Interest compounded annually. The note was secured by the limited partnership interests that Mrs. Nelson sold. Interest only was paid annually on the promissory note to Mrs. Nelson until the end of 2017.
  • A formal appraisal was obtained for the limited partnership transfers. The value of a 1% limited partnership interest was determined by an appraisal. Using that value for both the gift and the sale of limited partnership interests, the appraiser calculated the gift at 6.14% of the total limited partnership units and the sale at 58.65% of the total limited partnership units. The partnership agreement and capital accounts were then amended to reflect these percentage transfers of limited partnership interests.
  • A gift tax return was filed for the gift. Mr. and Mrs. Nelson split the gift, reporting the aggregate value of $2,096,000. The sale of the limited partnership interests were not reported on their federal gift tax return.
  • On audit, the IRS claimed that the value of each half of the gift was worth $1,761,009 (not $1,048,000) and the value of the limited partnership sold was undervalued by $13,607,038.

Litigated Issue: One of the contested issues before the Tax Court was the nature of Mrs. Nelson’s gift and sale. Simply stated, the issue was whether Mrs. Nelson transferred limited partnership interests of $2,096,000 and $20,000,000 (defined values) or she transferred percentage interests of 6.14% and 58.65% (which percentages would reflect any additional value if the IRS identified a higher value for the limited partnership units.) Mrs. Nelson argued that the transfer instruments clearly show that her intent was to transfer specific dollar amounts, not fixed percentages. Mrs. Nelson relied on several court decisions including Wandry.

Tax Court: The Tax Court held that transfers of percentage interests in the limited partnership had occurred, not transfers of a fixed dollar amount. To reach this conclusion, the Tax Court:

  • Qualified Formula: Distinguished an earlier McCord valuation formula decision that favored the taxpayer, by noting that in McCord the fair market value as part of its formula was not qualified, unlike in Mrs. Nelson’s transfers. By qualified the Court meant that the appraiser in Nelson had to identify a value of the limited partnership interests, albeit months after the transaction.
  • The Terms, Not the Donor’s Intent, Binds the Court: Found that with regard to each of the court decisions that Mrs. Nelson relied upon, including McCord and Wandry, none applied to the formula Mrs. Nelson used. In those cases the terms of the formula used was respected even though a percentage amount was not known until fair market value was subsequently determined, because the dollar amount was known. “Petitioners argue that we should construe the transfer clauses here as more akin to the formula clauses that were upheld in McCord, Petter and Wandry, that is, read them as transferring dollar amounts rather than percentages. However, as part of their argument, they cite evidence of their intent, which includes their settlement discussions with the IRS Appeals and subsequent adjustments to reflect changes in valuation to reflect those discussions.” In short, the Court looked only to the actual terms in the transfer documents, not embellished by what Mrs. Nelson had attempted to accomplish.
  • Fair Market Value is Qualified: Focused on the Assignment clauses themselves and not the parties’ subsequent actions or Mrs. Nelson’s claimed intent. The transferred limited partnership interests expressed a fair market value of a specified amount as determined by an appraiser within a fixed period. “The clauses hang on the determination by an appraiser within a fixed period; value is not qualified, further, for example, ‘as that determined for Federal estate tax purposes’….’fair market value’ here already is expressly qualified…Petitioners ask us, in effect, to ignore ‘qualified appraiser…within a fixed period’ and replace it with ‘for federal gift and estate tax purposes’…While they may have intended this, they did not write this. As the texts of the clauses required the determination of an appraiser within a fixed period to ascertain the interests being transferred, we concluded that Mrs. Nelson transferred a 6.14% and a 58.35% of limited partner interests in Longspar [the limited partnership] to the Trust as was determined by Mr. Shrode [the appraiser she hired] within a fixed period.” Thus, magic language ‘fair market value as determined for federal estate tax purposes’ was missing from the formulae.
  • Timing of the Valuation: To summarize, due to the language used in the defined-value formula the timing of the valuation limited partnership interests created the problem for the taxpayer.

Conclusion: This is an important decision, as it casts some doubt on the use of a Wandry-type defined-value clause in a gift or sale transaction. Comparing the assignment language used in Wandry with the assignment language used in Nelson, it is difficult to discern much difference. Both donors used appraisers. Both used dollar amounts to ‘limit’ what was gifted. While the Nelson assignment required that the appraisal be completed within as specified period after the transfer, that does not make it fundamentally different what was contemplated by the language used in Wandry. What was lacking in Nelson was: (i) reference to the standard of fair market value used for tax reporting purposes; and (ii) language that adjusted the number of units transferred if the IRS disagreed with the fair market value used in the initial appraisal to report the gift. Overall, the Tax Court judge seemed to ‘split hairs’ to find that percentages were gifted by Mrs. Nelson, rather than express dollar amounts identified in the transfer instruments. Surely that was Mrs. Nelson’s intent. If there is any take-away from the Nelson decision, it would be to incorporate verbatim the language used in Wandry’s assignment document any time a defined-value clause is to be used to avoid subsequent federal gift tax exposure.