Defined Value Formula Transfers: A Second Look

Take-Away: With the currently large federal gift tax exemption amount ($11.4 million per person), there is arguably less concern with regard to getting the value of the gifted interest wrong and thus inadvertently triggering a federal gift tax liability. However,  if the federal gift tax exemption drops back to a lower amount, e.g. Bernie Sander’s ‘For the 99.8 Percent Act’s’ $1.0 million gift tax exemption, defined value formula gifts may be back in vogue. With the IRS’s recent success in arguing estate inclusion using IRC 2036(a)(2) (Powell v. Commissioner; Cahill v. Commissioner), more thought needs to go into the use of  a defined value formula gift if, through the use of that formula, business interests ultimately remain held by the transferor.

Background: Defined value formula gifts for hard-to-value assets like real estate and closely held business interests suddenly became popular with the Tax Court’s Memo decision Wandry et al, 103 Tax Court Memo, 2012-88. The use of a defined value formula clause to describe the subject of the gift only transfers that amount of property interest that would be covered by the donor’s then available federal gift tax exemption amount, expressed in a dollar amount. If the IRS audits the reported gift and comes up with a different (higher) value for the transferred property, only the dollar amount specified in the defined value formula is ultimately transferred, which results (consistent with the donor’s intent) that no gift is made beyond the donor’s then available gift tax exemption amount expressed as a dollar amount. Therefore, even if the IRS audits the gift and concludes the subject of the gift had a higher value, no gift tax can be imposed due to the dollar limit of the gift. However, with that higher value determined by the IRS, that means that some of the interest that was supposed to have been transferred remained with the donor.

Example: Charlie Businessman has previously made taxable gifts of $7.0 million. With the 2017 Tax Act’s increase in the applicable transfer tax exemption amount ($11.4 per taxpayer), Charlie now has $4.4 million of transfer tax exemption available to him. Charlie, wary of the traction gained in the media by Bernie Sander’s tax proposal (i.e. a $1.0 million gift tax exemption amount), decides he wants to use most of the balance of his available federal transfer tax exemption before he loses it with yet another change in the tax laws from Congress. Consequently, Charlie decides he wants to gift $4.2 million of his interest in ABC, Inc. to his son.

Example of Defined Value Formula Gift: An example of a defined value gift is the following:

“I, Charlie Taxpayer, give, assign and transfer (referred to as ‘this transfer’) shares of common stock in ABC, Inc. a Michigan corporation bearing, the following values as of the date of this transfer, to John Taxpayer, transferee: Dollar Amount of Three million ($4,400,000.00) dollars value of the shares of common stock, no par value, of ABC, Inc. This transfer of the shares of common stock in ABC Inc. is intended to constitute, and it does constitute, the complete and irrevocable transfer of all of the described shares of stock common in ABC, Inc. equal to $4.40 million. This transfer is a gift without any consideration. I have had a good-faith determination of the fair market value of ABC, Inc. stock by an independent third-party professional appraisal who is experienced in such matters and who is qualified to make such a valuation determination. Based upon that valuation determination, the number of shares of ABC, Inc. common stock so transferred is 4,277. However, if the IRS challenges such valuation and a final determination of a different value is made by the IRS, or by a court of law, the number of gifted and transferred shares of common stock in ABC, Inc.to John Taxpayer shall be adjusted accordingly so that the number of shares of ABC, Inc. common stock gifted to John Taxpayer equals the dollar amount previously identified, i.e. $4.40 million, 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. I declare under the penalties of perjury that the prior statements are true and correct. This gift of common stock in ABC, Inc., including stock powers separate from share certificates, is effective as the date of my signature below.”

Limitations: The practical problem with the use of a Wandry-type defined value formula transfer is that if there is a readjustment of value after an IRS audit, some of the transferred interest is left (remains) with the donor (or seller if the transfer of the hard-to-value interest is a sale) i.e. it is not transferred, which may not be optimal for business or personal reasons. This retention of an could become a problem, for example, if S corporation stock held by an electing small business trust (EBST) sells the S corporation stock using a Wandry-type defined value formula; if some stock remains with the selling EBST, problems could arise with regard to maintaining the corporation’s S election. An even bigger problem is the IRS’s success in the last couple of years when it asserts that any retained control with others in a transferred business entity will result in estate inclusion on the donor’s death using IRC 2036(a)(2), i.e. Powell; Cahill. Following the above example, if on the IRS audit a different value is determined for the stock in ABC, Inc., fewer shares will be transferred to John Taxpayer, and Charlie will continue to own shares in ABC, Inc. that he had intended to gift to his son, raising the retained controlling interest problem caused by IRC 2036(a)(2).

Possible Solution: Commentators have coined the phrase two-tiered Wandry clause to deal with the problem presented if the IRS determines a higher value for the asset transferred, which results in some of the asset remaining in the name of the transferor. The two-tiered Wandry approach is essentially a two-part transaction that occurs simultaneously. The first part is the conventional Wandry defined value formula transfer (sale or gift) that uses the dollar amount formula to describe what is being gifted by the donor. The second part is the simultaneous sale of any ‘residual/retained’ shares (or other assets, if any) caused if the Wandry re-adjustment clause if it is activated on the IRS’ re-determination of the gift’s value. That second transaction results in the simultaneous sale of the ‘retained’ portion of the incomplete gift, for a price that is finally determined by the IRS that results from its re-determination of value on audit for gift tax purposes. The terms of payment under the second transaction could be for either cash or a promissory note given to the donor. Following the prior example, John Taxpayer would enter into a purchase agreement with Charlie agreeing to purchase any shares in ABC, Inc. that remain with Charlie after the IRS’s audit that results in a different value for the shares of stock in ABC, Inc.

Powell and Cahill Problem Mitigated: The key with regard to the second transaction is that no interest remains with, or is ‘retained’ by the donor/transferor, which is how the IRC 2036(a) (2) problem disappears. IRC 2036(a) (2) provides that if the decedent (i.e. the lifetime donor) could have exercised any retained rights over the property “alone or in conjunction with any other person” the transferred interests will be included in the donor-decedent’s taxable estate. For example, if the donor through the operation of the adjustment clause portion of the defined value formula gift ‘retains’ some right to participate in the control the transferred interest, e.g. the right to participate in a vote to distribute dividends in conjunction with the other shareholder, then the value of the gifted interest like shares of stock is included in the donor’s taxable estate at death. That is pretty much what the Tax Court held in both Powell and Cahill. Therefore, the second simultaneous transaction in the two-tied Wandry clause will assure that no equity remained with the donor in order to ensure that the transferred (gift) property cannot result in an in conjunction with another control any of the interests transferred by the donor. Alternatives to the automatic sale of the ‘retained’ interest using the Wandry defined value formula could be the automatic transfer of the ‘retained’ interest either to a grantor retained annuity trust (GRAT), to a qualified terminable interest trust (QTIP) established for the donor’s spouse, to a charity, or to what is called an incomplete gift trust, all of which would remove the ‘retained’ interest from the donor’s taxable estate, while also avoiding any current gift tax implications.

Conclusion: We could be entering a period, or maybe we are already in the period, where individuals will be motivated to make lifetime gifts following the ‘use it or lose it’ philosophy with the sunset looming over the $11.4 million federal gift tax exemption. While some individuals may be inclined to wait until the sunset is upon us, i.e. December 31, 2025 before making taxable gifts, Bernie Sanders’ recent proposal to limit gift-tax free lifetime gifts to $1.0 million should incentivize some individuals currently sitting on the fence to move forward with their lifetime gifts. If the subject of the lifetime gift is a hard-to-value asset like real estate, artwork, or a closely held business interest, then a Wandry defined value formula gift should be considered. If a defined value formula gift is used, and the subject of the gift is a closely held family business interest or LLC interest or partnership, then the two-tiered Wandry formula gift needs additional consideration to avoid the gifted interest’s inadvertent inclusion in the donor’s taxable estate under IRC 2036(a) (2).