Tax Court Further Loosens the Strings on Formula Gifts

by Charles (Chuck) Rubin

The Internal Revenue Code provides for a tax on gifts. However, annual exclusion gifts of $13,000 per recipient and gifts that do not exhaust a donor’s available unified credit will not generate a current gift tax. Thus, donors often seek to make gifts that come within, but that do not exceed, the above exemptions and credits.

This can be difficult if the gift is of property and not cash, since the precise value of the gift may not be known. Therefore, donors will want to include terms to their gift that if the value, as determined by the IRS, exceeds what was expected, the amount gifted will be scaled back to come within the exemption or credit amounts. However, at least since the case of Commissioner v. Procter, 142 F.2d 824, 827-828 [32 AFTR 750] (4th Cir. 1944), donors have run a significant risk that the IRS and courts would not respect such arrangements.

In recent years, several favorable taxpayer cases have upheld somewhat complex arrangements that seek to accomplish such adjustments, such as Estate of Petter v. Commissioner, T.C. Memo. 2009-280 [TC Memo 2009-280], aff'd, 653 F.3d 1012 [108 AFTR 2d 2011-5593] (9th Cir. 2011) and Estate of Christiansen v. Commissioner, 130 , T.C. 1 (2008). The taxpayers in the favorable cases have melded the gift-giving with either gifts to charities or disclaimers. These elements were added in large part because established gift tax law for charitable gifts and disclaimers allows for the use of “formulas” to define the amount of a gift, and also to bring in third parties that will purportedly enforce the clause or that have favorable public policy elements (such as enhancing charitable gifting).

The Tax Court has now ruled in favor of a donor that used a formula gift, but did not include any charitable gifts or disclaimers. Such an arrangement is of course much easier to implement in a usual gift-giving scenario, and thus substantially lowers the bar for taxpayers who want to use formula gifts to avoid inadvertent gifts.

The case largely turns on the formula which defines the gift as a given dollar amount of property. Thus, while an initial property transfer based on the taxpayer’s estimation of value will be undertaken, the amount of property transferred will be readjusted if the subsequent appraisal, the IRS or the courts determine a different value. This is to be distinguished from a gift of a fixed amount of property, that will later involve additional transfers of property back or forth based on IRS valuations. Is there really a difference between the two? It is hard to say. What is clear is how to draw a qualifying transfer that the Tax Court likes: express the amount of property transferred as a formula, as a stated dollar value to be transferred. The only variable should be the finally determined value for the property that is to be transferred. The court found the following language from Petter to be central to this issue:

Under the terms of the transfer documents, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula. This formula had one unknown: the value of a LLC unit at the time the transfer documents were executed. But though unknown, that value was a constant, which means that both before and after the IRS audit, the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the Taxpayer's transfer was dependent upon an IRS audit. Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive.

Some additional important points and observations from this case include:

a. The donees were family members of the donor. Thus, the court did not believe the family relationship alone would void the effective operation of the formula clause although this was not expressly discussed.

b. While Petter included language regarding the policy of encouraging gifts to charitable organizations, that factor was not determinative to the acceptance of a formula clause. Here, there was no charity involved and the court expressly noted that this element of Petter was not a requirement to an effective formula gift.

c. In drafting a formula and transfer arrangement, it should be clear that the donor’s intent was to transfer only a certain fixed dollar amount of property, and not to transfer a fixed amount of property that would be later readjusted.

d. The properties transferred here were interests in a partnership. The IRS argued that since the capital accounts were adjusted to provide for the initial number of units transferred, that fixed the amount of the gift by state law and a later revaluation could not undo the gift. The court rejected this, both on legal grounds, and on the factual that it was not clear that the capital accounts had been adjusted for the gifts based on the initial transfer amount. What happens in a case when the capital accounts are formally adjusted based on the initially determined transfer amount so that the factual argument is not available to a taxpayer? Based on the language of the court, even in that situation it would appear that this would not create a basis for a taxable gift because of the legal argument that the capital accounts do not control.

Does this case mean that formula gifts can be undertaken now without charitable or disclaimer elements? Perhaps yes, but more conservative planners may still want to include the charitable or disclaimer elements for more certainty, at least until additional favorable precedent arises.

Joanne M. Wandry, et al. v. Commissioner, TC Memo 2012-88

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Charles (Chuck) Rubin, Gutter Chaves Josepher Rubin Forman Fleisher P.A. | Attorney Advertising

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Charles (Chuck) Rubin

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