Take-Away: Formula gifts and sales are growing in popularity with regard to hard-to-value assets. The formula is used to avoid the possibility of an imputed taxable gift after an IRS audit. While some formula gifts work, other formula transfers are viewed against public policy and consequently ignored.

Background: With increasing frequency, individuals are using defined value formula gifts in an attempt to remove the uncertainty from the valuation process or to avoid unintended gift tax consequences of a transfer, whether the transfer is a gift or the sale of a hard-to-value asset like real estate, closely held business interests, or fractional interests in assets. However not all formulas are alike when it comes to the courts.

Savings Clauses: A savings clause is basically a provision that is included in a transfer document, e.g. deed, assignment, bill of sale, that seeks to adjust the amount of property that is being transferred or the amount of consideration that is being paid if it is later determined (by the IRS, on audit) that the transferred property has a value that is different from that originally assigned to the property in the transfer transaction.

Example: Donald wants to give $50,000 to each of his 3 nephews. Donald transfers 25 LLC units to each of his nephews Huey, Dewey, and Louie, using an Assignment instrument. For purposes of his gifts, Donald values the LLC units at $2,000 per LLC unit. Donald’s Assignment of the LLC units to each of his 3 nephews provides: “Each party to this Assignment agrees that if it should be finally determined for federal gift tax purposes that the fair market value of each LLC unit exceeds, or is less than, $2,000 per unit, an adjustment will be made in the number of the LLC units constituting the gift so that Donald will give to his nephew Huey [or Dewey or Louie] the maximum number of LLC units the total value of which does not exceed $50,000. Any adjustment so made which results in an increase or decrease in the number of LLC units transferred by Donald will be made effective as of the date of this Assignment, and any distributions paid by the LLC thereafter shall be recomputed and reimbursed as necessary to give full effect to this Assignment.” If the IRS subsequently determines that the LLC units have a value of $5,000 per unit, then each of Huey, Dewey, and Louie would return 15 LLC units to Donald pursuant to the Assignment, and each nephew would only retain 10 LLC units.

Contrary to Public Policy: It should come as no surprise then that the IRS does not like savings clauses and several federal courts have supported the IRS. For example, in Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944)  a such a ‘return to transferor’ savings clause was held to be void and against public policy because (i) it discouraged the collection of a gift tax, (ii) it would require the Tax Court to rule on a moot case, and (iii) it would have the effect of invalidating a final judgment against the transferor. Similarly, the Tax Court in Ward v. Commissioner, 87 Tax Court 78 (1986) found that “a condition that causes part of a gift to lapse if it is determined for federal gift tax purposes that the value of the gift exceeds a given amount, so as to avoid a gift tax deficiency, involves the same sort of trifling with the judicial process condemned in Procter.”

IRS: Making its position abundantly clear, the IRS later in Revenue Ruling 86-14 stated that it will ignore savings clauses for federal gift tax purposes finding them to violate public policy because the savings clauses discourage the enforcement of the gift tax laws. The IRS’ position is that a formula gift tied to a different result after an IRS audit is a condition subsequent that is prohibited.

Exception: Only a couple of federal court decisions have found such adjustment clauses to be acceptable and not contrary to public policy, but those cases were in the context of an arm’s-length, unrelated party, transaction. See, King v. United States, 545 F.2d 700 (10th Cir. 1976 and Estate of Dickenson, 63 Tax Court 771 (1975.)

Formula Gift Allocation Clauses: The tide started to turn against the IRS’s public policy position about 15 years ago. In a string of Federal Court of Appeals decisions formulas were upheld because the excess property that had been transferred after the IRS audit was not returned to the transferor. In these cases,  the total value of the subject gift was not subject to an adjustment; the re-allocation of the excess gifted property was among the recipients of the transferred, not returned to the transferor. In each of these cases [McCord v. Commissioner, 461 F. 3d 614 (5th Cir 2006, reversing 120 Tax Court 358 (2003); Christensen v. Commissioner, 130 Tax Court 1, (2008) aff’d 586 F.3d 1021 (8th Cir 2009); Estate of Petter v. Commissioner, Tax Court Memo, 2009-280, aff’d 653 F.3d 1012 (9th Cir. 2011);   Hendrix v. Commissioner, Tax Court Memo 2011-133)] the formula re-allocated the excess gifted asset after IRS audit between family members and a charity, with the charity expressly receiving the excess amount.

  • Charitable Recipient: Consequently, rather revert the excess property under the transfer-formula to the transferor, the excess property was transferred to a charity and thus qualified for the federal gift tax charitable deduction. In short, the formula allocated any increase in value determined by the IRS on audit to the charitable donee. What was important to each court in these published decisions was that the charities had a vested interest in receiving what they were entitled to receive and the charities were presumed to be prepared to defend their interests (under the allocation formula) because the charities’ managers and governing boards had a fiduciary obligation subject to regulation by state attorney generals to protect their charity and its rights. Each court also mentioned, in passing, that the government’s public policy expressly favors supporting charitable gifts. A formula gift allocation clause is, however, complicated because of the need to have an alternate gift recipient (done) meaning a charity, a marital deduction trust, or a grantor retained annuity trust- a contingent donee where the IRS could not collect a gift tax with the transfer.

Defined Value Clause:  The next iteration of formula clauses was the now-famous Wandry v. Commissioner, Tax Court Memo 2012-88 (2012). A defined value clause refers to the amount that is being given, not the number of units being transferred. Often this type of clause is used because, by necessity, the value of the asset transferred could not be determined as of the date of the gift, i.e. the appraisal was obtained after the gift, or the appraisal is being obtained and the donor wants to make the gift as of the date of the appraisal. As such, the defined value gift is used to facilitate the transfer to deal with the uncertainty of the value. Equally important, a defined value clause is not designed to adjust if the IRS challenges the value of the transferred property on audit.

  • Wandry: In Wandry, the number of LLC units transferred were to be based on the appraisal the donors had ordered. If the IRS challenged the valuation and a final determination of a different value of the transferred LLC units was made by the IRS, or a court, the number of gifted LLC units given to each of the donee equalled the dollar amount specified in the Assignment or the Gift Agreement. The Assignments expressly stated that the formula was to work 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.” Thus, the donees were entitled to receive pre-defined interests which were expressed as a mathematical formula in which the one unknown was the value of an LLC unit at the time the transfer documents were executed, i.e. a defined value (or amount) of the property to be transferred; while the value per LLC unit was unknown, the gift value to the donee was a constant.

Audit: Interestingly, the Tax Court in its decision noted that absent the IRS’s audit the donees might never have received the correct LLC percentage interest to which they were entitled. But that did not mean that parts of the Wandry’s gifts depended on an IRS audit. “Instead, an audit merely assured that the children and grandchildren would receive the LLC interests that they were always entitled to receive. It was inconsequential that the adjustment clause reallocates membership units among the donees and the donors, rather than a charitable organization” alluding to the Petter and Christensen decisions. What was most surprising about Wandry was that through the use of the defined value formula, the excess property was permitted to ‘revert’ to the donor without the need to have the excess property pass to a charity or another donee where a gift tax could not be assessed.

Public Policy: The Tax Court also rejected the IRS’ public policy concerns originally expressed in Procter. The Tax Court judge noted that there is no well-established public policy against formula clauses: “The role of the IRS is to enforce the tax laws, not maximize tax receipts.”

Non-Acquiescence: Sadly, Wandry  is only a Tax Court Memorandum opinion, so its precedential value is limited. Moreover, while the IRS initially filed an appeal with the Ninth Circuit Court of Appeals, it later dropped its appeal, and subsequent to that,  then published a non-acquiescence to Wandry, which means the IRS has not yet ‘thrown-in-the-towel’ on defined value formula transfers. [I.R.B. 2012-46.]

Practical Observation: With this history it is understandable why defined value formulae are now popular when gifting or selling hard-to-value assets. That said, they still clearly remain on the IRS’s ‘watch list.’ If a defined value transfer (gift or sale) is used, the donor’s Form 709 Federal Gift Tax Return should describe the gift as a dollar amount, and not a specific number of shares or units or percentage interest in the transferred asset. Yet, in order to satisfy the IRS’s adequate disclosure rules, the gift tax return should probably also identify the number of shares or units that the donor is claiming to have transferred. This should be done by describing the gift first as a dollar amount, and then with an additional explanation.

Example of Disclosure: “The taxpayer transferred $2,500,000 of her interest in ABC, LLC in the form of membership units to the donee, Donald. Based on the appraisal by Honest John Appraisal Services, PC, the amount transferred by the taxpayer equated to a 2.5 percent interest in ABC, LLC. However, the amount the taxpayer transferred a fixed amount of LLC units, and the percentage interest will be adjusted if there is a final determination of a different value for federal gift tax purposes, such that the value of the interest transferred to the donee Donald equals $2,500,000.”

Conclusion: Wealthy individuals are encouraged to make use of their currently available large applicable exemption amounts by making lifetime gifts in 2021. The use of a defined value clause to implement such gifts, especially if a hard-to-value asset is the subject of the gift, makes a lot of sense.