‘Enhanced’ Defined Dollar Value Formula Transfers

July, 2018

The 2017 Tax Cut and Jobs Act provides more incentives for individuals to gift assets either to their family members or to dynasty-type irrevocable trusts. The temporary increase in the applicable transfer tax exemption amount by $5.6 million per individual encourages the wealthy to consider making large gifts when no federal gift tax will be due. But even when making gifts may become more popular to shift income and/or appreciation away from the donor’s taxable estate, there remains the challenge to value the gift in order to remain below the donor’s available gift tax applicable exemption amount. This is not a problem if cash is the subject of the gift. It is a much bigger problem if the subject of the gift is a hard-to-value asset like real estate, artwork, collectibles, or closely held business interests such as limited partnership interests or a family owned limited liability company membership interest.

One popular way to make a gift of hard-to-value property interests is with the use of a defined dollar value gift. An example is when the donor makes a defined dollar formula gift of that amount of the transferred property interest that is equal to $5.6 million. Instead of identifying the gift as a number of units or shares in the subject property, the gift is a defined dollar amount of those units or shares. The object is to tie the dollar amount to the donor’s then available gift tax applicable exemption amount. This technique was successful in the Tax Court case Wandry, Tax Court Memo, 2012-88, nonacq., which partially overruled Technical Advice Memo (TAM) 8611004 to the extent the TAM held that a gift is made when the statute of limitations expires if the transferred percentage interest of the entity exceeds the fair market value of the dollar formula transfer.

The defined dollar value formula at issue in Wandry used, in part, the following language:

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 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 valuation redetermination by the IRS and/or a court of law.

The Tax Court in Wandry thus approved the effective use of a defined dollar value formula gift to foreclose a successful challenge by the IRS on audit to the value reported for the taxable gifts of hard-to-value assets, giving new life to formula based gifts. One of the rationales provided by Judge Haines was that there are other enforcement mechanisms to ensure accurate valuation reporting of the gift.

The Service initially filed an appeal of the Tax Court’s decision, but it later withdrew the appeal. Instead the Service filed a non-acquiescence to that decision, which cast a cloud on the effective use of a defined dollar value formula when making gifts of hard-to-value assets. In its Action on Decision 2012-004, the Service said that the final determination of value for federal gift tax purposes is an occurrence beyond the taxpayer’s control, citing Reg. 25.2511-2(b.)

An innovative planning technique recently suggested by S. Stacy Eastland of Houston, Texas, may prompt many donors to overcome their reluctance to use a defined dollar value formula gift (a reluctance caused, in part by the Service’s non-acquiescence in Wandry), by adding the donee’s decision to the size of the ultimate gift. Mr. Eastland suggests coupling the donor’s defined dollar value formula gift with the donee’s qualified formula disclaimer that adopts the language used in the defined dollar value formula. The steps to implement the ‘coupled’ independent transactions include the following:

  1. The donor transfers assets to a trust using a defined dollar value formula gift that defines the gift of the hard-to-value property in an express dollar amount;
  2. The trust instrument expressly anticipates that the trust beneficiaries might disclaim some or all of their interests in the trust.
  3. The trust beneficiaries, using the same defined dollar value amount formula that appears in the donor’s gift transfer instrument, execute qualified disclaimers.
  4. The trust instrument directs that any disclaimed amount by the trust beneficiaries using a qualified disclaimer will revert to the donor of the gift. The amounts disclaimed, called additional property, will be held by the trustee, per the trust instrument, only as an agent until the additional property is returned to the donor.
  5. The trust instrument expressly provides that the trustee does not have to accept any additional property. Any interest in property that is in excess of the original property transferred to the trust under the defined dollar value formula gift is treated as additional property, held by the trustee in an agency capacity. As a result, the trustee has not accepted the additional property in its fiduciary capacity, thus foreclosing the IRS from arguing that the beneficiary’s disclaimer is invalid because the trustee violated its fiduciary duty by accepting the transferred property.
  6. The trust instrument also expressly provides that any additional property can be commingled with other trust assets held by the trustee-agent until the additional property is returned to the donor.
  7. Both the trust’s material purpose clause and the donor’s transfer document used to fund the trust express the donor’s intent that no trust relationship is to exist with regard to any property that is not transferred to the trust under the defined dollar value formula, i.e. the settlor’s clear intent is that the additional property is not to be held in the trust.

Coupling the defined dollar value gift with a qualified formula disclaimer should achieve the goal to deter the IRS from challenging the value of the gift on subsequent audit. The Wandry type of defined dollar value formula gift has been approved by the Tax Court and found not to be contrary to public policy, which was for a long time the IRS’s primary challenge to the use of formula gifts, that a condition subsequent adjusted the size of the gift. Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944). But the IRS’s refusal to acquiesce to the result in Wandry caused donors to continue to steer clear of using defined dollar value formula gifts. But the IRS has long held that formula disclaimers by beneficiaries are permissible. Treas. Reg. 25.2518-3(b), Example 15. Courts have often approved formula disclaimers by trust beneficiaries. Estate of Christiansen, 586 F.3d. 1061 (CA -8, 2009.) When the two formulae (gift and disclaimer) are combined, a definite dollar amount remains in the trust, regardless of what the IRS may later assert on a future audit, a result arguably not controlled by the donor, but by the beneficiary of the donee-trust, thus addressing the Service’s non-acquiescence in Wandry.

One could expect that when faced with the ‘coupled’ formula gift and disclaimer, the IRS will insist that some pre-existing arrangement was in place between the donor and the trust beneficiaries, and argue that the trust beneficiaries had no economic reason to make a qualified disclaimer of a portion of the gifted interest to the trust. On its face that would be a compelling argument. But if the donor’s gift to the trust was a net gift, or a net-net gift, where the trust beneficiary (or the trust) was charged with paying either federal gift taxes, or possibly federal estate taxes imposed under IRC 2035, then the trust beneficiaries would have a strong economic motive to file a qualified disclaimer to prevent any personal liability for those transfer taxes from arising, which is particularly the case if the subject of the gift was illiquid and not readily available to pay any contingent gift or estate tax liability the donee would assume under the net-net gift approach.

The ‘coupled’ defined dollar value formula gift approved by the Tax Court in Wandry with the formula qualified disclaimer by the trust beneficiary, approved in the Treasury Regulations, is a clever way to deal with the IRS’s refusal to accept defined dollar value formula gifts. This strategy, using a net gift or a net-net gift condition to the gift, should be seriously considered when individuals plan to make gifts of hard-to-value property interests.

WRITTEN BY:

George F. Bearup

Senior Trust Advisor

Before joining Greenleaf Trust in 2016, George Bearup practiced law in Michigan for over four decades, gaining prominence in trusts and estate planning. A longstanding Fellow of the nationally recognized American College of Trusts and Estates Council (ACTEC), he has been included on Best Lawyers in America for over 30 years, and the Michigan Super Lawyer list for more than a decade. George is a frequent author and speaker for the Institute of Continuing Legal Education, as well as a chapter author and former co-editor of the ICLE publication, Michigan Revocable Grantor Trusts (2d and 3d editions). His articles have been published in Michigan Bar Journal and Michigan Probate and Estate Planning Journal. George earned a B.A. from the University of Michigan magna cum laude, and a J.D. from Northwestern University School of Law, after graduating with honors.