Transfer Tax Formula Clauses

Quick-Take: A defined value clause can be an effective way to avoid federal gift or estate taxes.

Background: It is too early to tell after the One Big Beautiful Bill Act (OB3) whether there will be larger gifts in the future due either to a $15 million applicable exemption amount per person (adjusted for inflation in future years) and/or the desire to preserve low basis assets for inclusion in the decedent’s gross estate to obtain an adjustment to fair market value, i.e., a basis ‘step-up’ on death. [IRC 1014.] Assuming that big-ticket gifts will continue to be an important part of estate planning, part of that planning may include the effective use of define value clauses, either to avoid gift taxes or exploit valuation discounts.

Formula Transfers: Periodically past missives have covered the effective use of a formula clause to avoid gift tax exposure for hard-to-value assets that are the subject of the transfer. These clauses have been successfully used with gifts or bargain-sales of LLC membership units, family limited partnership interests, real estate,  and other hard-to-value assets like collectibles or artwork. Then there have been failures where a formula transfer clause was rejected by the Tax Court. These court decisions have provided some guidance for planners, but often the outcome remains hard to predict. For a formula clause to be effective to avoid a federal gift or estate tax, it must use language that precisely describes the effect of the formula. A short history of formula clauses follows.

Proctor – Reverter Clauses: One of the first decisions that addressed the viability of a define value clause was Commissioner v. Proctor, 32 AFTR 750, 142 F.2d 824 (4^th Circuit). The clause used was straightforward. It provided that if the value of the transferred property was determined by the IRS on audit to be higher than the value that the donor reported for gift tax purposes, the property automatically reverted to the donor, In other words, it was a self-serving  ‘savings clause’ or backstop built into the transfer document to protect the donor from gift tax liability. The Tax Court held that the reverter provision was against public policy and thus it could be ignored by the court when assessing gift tax liability.

Petter- Charitable Contingent Donee: In Estate of Petter, 108 AFTR2d 2011-5593, the decedent’s estate was shielded from federal estate taxes by effectively using the federal estate tax charitable deduction. The estate instrument provided that any value in excess of a specified, defined, amount, was to be transferred by the decedent’s estate to a charity. Rather than revert to the transferor, the transfer was complete for transfer tax purposes, but the identity of the recipient(s) was tied to the amount that that IRS determined to be transferred from the decedent’s estate. Since the charity’s directors had a fiduciary duty to assure that the charity received the correct (full) amount under the decedent’s transfer formula, that was sufficient for the court to find the formula effective and not a subterfuge to avoid estate taxes. This type of formula that re-allocates interests in the transferred property between a taxable donee (heir) and a non-taxable donee (charity), was also successfully used to avoid federal transfer taxes in Hendrix v. Commissioner, Tax Court Memo 2011-133, McCord v. Commissioner, 461 F.3d 614 (5^th Circuit), and Christiansen v. Commissioner, 130 Tax Court 1 (8^th Circuit.

Wandry – Dollar Amount:  Wandry v. Commissioner, Tax Court Memo 2012-88, attracted considerable interest by the estate planning community. Wandry’s formula defined the donor’s transfer as a specific dollar value or amount, e.g.,  “as finally determined for federal gift tax purposes.” The clause provided that a specific value, expressed in dollars, that the donor intended to be transferred, i.e., the value of the transferred asset is fixed from inception regardless of the value the IRS ultimately assigns to the asset. Accordingly, only the percentage of the property being transferred is subject to adjustment on IRS audit. If the IRS, or the Tax Court, later increases the value of the transferred property, the percentage interest is merely reallocated, with no additional gift tax exposure to the donor. This was a departure from the Petter- type of defined value formula which relied on a non-taxable recipient to escape taxation. With Wandry, the reallocation effect of the formula was between the donee and the donor. In short,  the effect of which was a reverter, without the need to name a charity as a potential distribute. While Wandry was not reversed on appeal, the IRS continues to refuse to formally acquiesce to the court’s decision, viewing it as a disguised reverter provision that Procter clearly rejected as against public policy.

Nelson – Fixed Percentage Interest: In Nelson v. Commissioner, Tax Court Memo 2020-81 (later affirmed by the 5^th Circuit Court of Appeals), the donor’s transfer instrument contained a clause that defined the value of the property that was determined by a qualified appraiser within 90 days after the transfer was completed. The Court focused on the language of the formula clause, and the timing within which the appraisal had to be completed, as not fixing the value to the final determination for gift tax purposes. This word-formula, with its subsequent condition, bound the donor to the gift of a specific percentage interest that was later found to have a higher value. This triggered a federal gift tax imposed on that larger percentage interest that was transferred. The formula’s language precluded any further adjustment.

2024 Green Book: Back in 2024 the Treasury’s Green Book proposed a legislative response to defined value clauses as part of its Guidance Plan. It proposed that “if a gift or bequest uses a defined value formula clause that determines value based on the result of involvement of the IRS, then the value of such gift or bequest will be deemed to be the value as reported on the corresponding gift or estate tax return.” The proposal went on to identify only two exceptions to this general rule. The first is if the value is to be determined by someone other than the IRS, like an appraiser, within a reasonably short period of time after the transfer. The second is if the clause is being used for estate tax purposes to define a marital or charitable bequest. Since this proposal was floated by Treasury while Biden was President, it should come as no surprise that anything with Biden’s name attached to it was dead on arrival with President Trump.

Practicalities: If a hard-to-value asset is to be transferred, either via gift or bequest, there are some pretty obvious take-aways from the previously discussed court decisions.

1. Fair Market Value: The transferred equity interest needs to be based on the fair market value of the interest as finally determined for federal transfer tax purposes. This ‘magic language’ is what both Wandry and Petter compel.
2. Avoid Adjustments: Avoid referring to a dollar amount ‘to be determined,’ by a qualified appraiser within a specified period, as was the case in Nelson. That formula was interpreted by the court to prevent any future adjustment because it effectively locked in the percentage of the transferred equity interest.
3. Be Consistent: If the formula in the transfer instrument refers to a specific dollar amount, then the gift or estate tax return needs to use the same language. Referring to a specific dollar amount in the transfer instrument but then reporting the gift on Form 709 as specific number of shares or a percentage interest raises a red flag with the IRS and invites a challenge to the defined value clause used in the transfer document.
4. Make Intent Clear: It is important to focus on and explain the desired result in the transfer formula. If an adjustment is to be made in the price based on a final valuation for gift or estate tax purposes, the formula should state the transferor’s intent.

Conclusion: Whenever the discussion of gifting hard-to-value assets comes up without causing a taxable gift,  consider the utility of a defined value gift formula. Just be careful how that formula is phrased.

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