By many accounts Wandry v. Commissioner, T.C. Memo 2012-88 (Mar. 26, 2012), was 2012’s estate planning case of the year. Wandry was significant because it was the first reported case to hold that a “formula transfer clause” was valid and represented the first time a court had approved a defined value clause gift when a charity was not involved. Although Wandry is significant primarily for those doing gift and sale planning, it also provides a very useful way to think about the disclaimer of hard-to-value assets.
Disclaimers have long been a popular tool in the estate planner’s toolbox, especially over the past decade when federal estate tax laws have been constantly changing. Notwithstanding the fact that portability is now permanent, disclaimer planning will continue to be useful, particularly in states with de-coupled state estate taxes. One of the key advantages of the disclaimer-based estate plan is its flexibility. It allows the surviving spouse to use the optimal (rather than unlimited) marital deduction and appropriately use the deceased spouse’s estate tax exemption to fund the credit shelter trust. The surviving spouse can decide within nine months after the predeceasing spouse’s death whether, and to what extent, to fund the credit shelter trust based on a review of then-applicable tax laws, her financial needs, and her anticipated life expectancy. Historically, this flexibility has made the disclaimer estate plan a popular choice.
Notwithstanding the disclaimer-based estate plan’s several advantages, there are instances when such plans can be less user-friendly. One situation in which the implementation of the disclaimer-based estate plan can be problematic is when hard-to-value assets must be allocated between the marital share and the credit-trust share. Although the allocation of assets between the marital share and the credit-trust share is relatively straightforward, when the assets consist of cash or marketable securities, the process is more delicate when the assets are closely held business interests or real estate. When the allocation involves assets whose valuation is more subjective, there is a risk of over-funding the credit-shelter share and triggering an estate tax liability.
This potential problem is illustrated by the following hypothetical. Husband and Wife live in a state with a de-coupled state estate tax with a $1 million state estate tax exemption. Husband dies with a $2 million estate comprising 200 units in an LLC and $1 million of cash and investments. Wife has her own separate estate worth $2 million. Wife believes the date of death value of Husband’s LLC interest is $5,000 per unit. Conventional planning to minimize state estate taxes would have $1 million of Husband’s estate allocated to the credit shelter share with the other $1 million going to the marital share. Under a disclaimer-based estate plan, Wife might disclaim all 200 of the LLC units and keep the liquid assets. If the LLC units really had a fair market value of $5,000 each, the credit-shelter share would be funded with $1 million. But, if the units were ultimately determined to have a fair market value of $6,000 each, the credit share would be funded with $1.2 million, thus triggering a state estate tax liability.
How might Wife use a disclaimer-based estate plan and guard against this valuation risk? There are several potential solutions. First, Wife could choose to take a conservative approach and disclaim a fractional share of the LLC units certain to keep the amount allocated to the credit-shelter share safely below $1 million. Perhaps she would disclaim only 75% of the units so that if the fair market value of the units was finally determined to be $6,000 each, the credit share would be funded with only $900,000. But such an approach can leave money on the table.
Another way Wife could guard against allocating too many units to the credit-shelter share would be to use a fractional formula disclaimer under Internal Revenue Code § 2518(c)(1) and the corresponding regulations. Such formulas are not new, of course. They have been used in testamentary planning for years. Wife’s formula disclaimer might renounce “that portion of Husband’s estate that does not qualify for the federal estate tax marital deduction, plus the largest pecuniary amount (if any) that can be added to such amount without incurring state estate tax.” Treas. Reg. § 25.2518-3(d), ex. 20, provides an example of such a fractional-share disclaimer.
A third approach to limiting the amount of the hard-to-value assets transferred to the credit-shelter share would be to disclaim an explicit pecuniary amount of the asset described by a formula. Treas. Reg. § 25.2518-3(c) clearly authorizes the disclaimer of a pecuniary amount. Wandry provides a conceptual framework for what such a pecuniary-formula disclaimer might look like.
Wandry is the latest in a string of cases involving defined-value clauses. As indicated, it is significant primarily because it was the first such case to approve a defined-transfer clause with no charitable donee involved. Before Wandry, the defined-value cases generally involved “defined allocation clauses” when all or a clearly fixed portion of a taxpayer’s interest in an asset was transferred to charitable and noncharitable beneficiaries. The amounts passing to the respective beneficiaries were described by a formula that allocated to the noncharitable beneficiaries a specific portion of the asset, defined as an amount less than the taxpayer’s applicable exclusion amount, and allocated to the charitable beneficiary the remainder of the interest. The effect of the formula was to limit the amount of property transferred to the noncharitable beneficiaries and to ensure the taxpayer-transferor did not make a taxable gift; under the formula, if the value of the property transferred was ultimately determined to be greater than the value reported by the donor on his gift tax return, the excess value was to be allocated to the charitable beneficiary. See McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), rev’g 120 T.C. 358 (2003); Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008) (reviewed by the court), aff’d, 586 F.3d 1061 (8th Cir. 2009); and Estate of Petter v. Commissioner, T.C. Memo 2009-280. Unlike the prior defined-value cases, the formula used in Wandry did not allocate the interests the donors transferred between charitable and noncharitable beneficiaries; rather it defined how much property was to be transferred to each noncharitable donee. The formula at issue in Wandry was a formula-transfer clause, not a formula-allocation clause. Even though the formula-transfer clause in Wandry was used for purposes of gifting, it is the author’s contention that that clause also provides a useful framework for disclaimers of hard-to-value assets.
In Wandry, the Tax Court approved gifts of LLC units made by Mr. and Mrs. Wandry using a formula clause that transferred units equal to stated dollar values (pecuniary amounts) to children and grandchildren. Mr. and Mrs. Wandry made $11,000 annual exclusion gifts to each child and grandchild and used the full $1 million applicable exclusion amount with gifts to their children. The gifts to the children and grandchildren were described on assignments and memoranda of gift. The Tax Court recited the language of the gift documents on page 5 of its opinion. Each gift document provided:
I hereby assign and transfer as gifts, effective as of January 1, 2004, a sufficient number of my Units as a Member of Norseman Capital, LLC, a Colorado limited liability company, so that the fair market value of such Units for federal gift tax purposes shall be as follows:
Name Gift Amount
Kenneth D. Wandry $261,000
Cynthia A. Wandry $261,000
Jason K. Wandry $261,000
Jared S. Wandry $261,000
Grandchild A $11,000
Grandchild B $11,000
Grandchild C $11,000
Grandchild D $11,000
Grandchild E $11,000
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 Internal Revenue Service (“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 a valuation redetermination by the IRS and/or a court of law.
In the view of the Tax Court, Mr. and Mrs. Wandry made gifts of specified dollar values of membership units rather than of fixed percentage interests in the LLC. According to the court, at all times the donors believed the gifts were of a dollar value, not a specified number of units. The court analyzed the gifts as follows:
- Under the terms of the gift documents, the donees were always entitled to receive predefined Norseman percentage interests, which the gift documents essentially expressed as a mathematical formula. For each of the Wandry children the formula was expressed as: X=$261,000/(FMV of Norseman)
- This formula had one unknown—the value of Norseman’s assets on January 1, 2004. But though unknown, that value was constant.
- Before and after the IRS audit, the donees were entitled to receive the same Norseman percentage interests. Each donee-child was entitled to receive that Norseman percentage interest that had a value of $261,000. After the redetermination of the value of Norseman by the IRS, the percentage interest each child was entitled to was reduced; each of the donee children was entitled to receive approximately a 1.98% Norseman membership interest, rather than the 2.39% interest determined by the taxpayers’ appraiser.
The Tax Court approved Mr. and Mrs. Wandry’s gifts to their children and grandchildren, holding that the formula-transfer clause used in the assignments and memoranda did not violate the condition-subsequent prohibition of Commissioner v. Proctor, 142 F.2d 824 (4th Cir. 1944), and that the absence of a charity to take a portion of the property transferred under the Wandrys’ formula did not render the formula an impermissible condition subsequent or violate public policy.
Signaling its continued disapproval of defined-value clauses, the IRS has indicated it will not acquiesce in the Wandry decision. I.R.B. 2012-46 (Nov. 13, 2012). Clearly, the IRS remains uncomfortable with taxpayers using defined-value clauses to describe the amounts of their gifts. Formula disclaimers, however, have long been approved under the disclaimer regulations. Moreover, the disclaimer of a pecuniary portion of a hard-to-value asset was explicitly approved by the Eighth Circuit Court of Appeals in Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008) (reviewed by the Court), aff’d, 586 F.3d 1061 (8th Cir. 2009). Consequently, a pecuniary formula, similar to the one used in Wandry, should be a sound way to describe the disclaimed portion of a hard-to-value asset.
In Christiansen, Christine Christiansen Hamilton, the decedent’s only child and the executor of the decedent’s estate, disclaimed her interest in the estate “as finally determined for federal estate tax purposes” for all amounts over $6.35 million. The decedent’s will provided that 25% of any disclaimed amounts were to go to a charitable foundation. The Commissioner denied the estate’s claimed charitable deduction for amounts passing to the foundation as a result of the disclaimer, maintaining that the parties’ agreed-on adjustment to the valuation of certain partnership interests served as post-death, post-disclaimer contingencies that disqualified the disclaimer under IRC § 2518 and Treas. Reg. § 20.2055-2(b)(1). The Tax Court disagreed with the Commissioner and allowed the charitable deduction for the amounts passing to the foundation as a result of the partial disclaimer.
Before the Eighth Circuit, the Commissioner argued that fractional disclaimers that have the practical effect of disclaiming all amounts above a fixed-dollar amount should be disallowed. According to the Commissioner, disclaimers such as the one made by the decedent’s daughter fail to preserve a financial incentive for the Commissioner to audit an estate tax return because with such a disclaimer any post-challenge adjustment to the value of an estate would consist entirely of an increased charitable donation. The Commissioner argued such disclaimers should be categorically disqualified as against public policy because there would be no possibility of enhanced tax receipts as an incentive for the Commissioner to audit the return and ensure accurate valuation of the estate.
The Eighth Circuit Court of Appeals affirmed the Tax Court and held that the disclaimer executed by the decedent’s daughter was a valid partial disclaimer of a fixed dollar amount. The court held that references to value “as finally determined for estate tax purposes” were not references that were dependent on post-death contingencies that would disqualify a disclaimer. Because the only uncertainty at the time of the disclaimer was the calculation of the value to be placed on the foundation’s right to receive 25% of the estate in excess of $6.35 million, and because no post-death events outside the context of the valuation process were alleged as post-death contingencies, the disclaimer was a qualified disclaimer. Responding to the Commissioner’s assertion that a disclaimer of all amounts above a fixed-dollar amount should be disallowed as against public policy, the court declared that the Commissioner’s role is not merely to maximize tax receipts and conduct litigation based on a calculus about which cases will result in the greatest collection; the Commissioner’s role is to enforce the tax laws. The court stated it was not necessary for the Commissioner to serve as a watchdog against the under-valuations of the disclaimed assets because, with a fixed-dollar-amount partial disclaimer, the contingent beneficiaries taking the disclaimed property have an interest in ensuring that the executor or administrator does not under-report the estate’s value. Consequently, a partial disclaimer of a fixed pecuniary amount above a specified dollar amount is valid under the disclaimer regulations and does not contravene public policy.
Applying the Wandry formula to the hypothetical situation above, the surviving spouse’s disclaimer might look something like this:
I hereby disclaim a sufficient number of LLC Units so that the fair market value of said Units for state and federal estate tax purposes shall be $1,000,000. Although the number of Units disclaimed is fixed as the date of this disclaimer, that number is based on the fair market value of the disclaimed Units. I understand the value of the Units as reported on the decedent’s estate return is subject to challenge by the Internal Revenue Service and/or the State Department of Revenue. If the IRS or the State Department of Revenue challenges such valuation and a final determination of a different value is made by the IRS, the State Department of Revenue or a court of law, the number of Units disclaimed shall be adjusted accordingly so that the value of the Units disclaimed does not exceed $1,000,000, 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.
This disclaimer would be a renunciation of a given dollar amount of the LLC units, rather than a fixed percentage or fractional portion of the units. Under the terms of this disclaimer, there would be transferred to the credit-shelter trust that percentage of the LLC units that equaled (or was less than) $1 million. Consequently, there would be no adverse tax consequence if the value of the units were finally determined to be greater than the amount reported on the decedent’s estate tax return. If there was a valuation adjustment, the credit-shelter trust would simply be funded with a different (lesser) percentage of the units.
The partial disclaimer of a pecuniary amount of the units would be preferable to a disclaimer of a fixed percentage or fraction of the units, which could result in an over-funding of the credit-shelter trust in the event of a valuation adjustment. Moreover, the disclaimer of a pecuniary amount can be conceptually easier for clients to grasp. In the hypothetical, Wife, having disclaimed $1 million of LLC units into the credit shelter trust, could then elect portability for the unused portion of Husband’s federal exclusion amount to hedge against a future appreciation in the value of her estate.
Disclaimers will continue to be important postmortem planning tools. The disclaimer of hard-to-value assets, however, can pose certain difficulties. The pecuniary-transfer formula used in Wandry represents an easy way to think about, and express, a formula amount that can be used to minimize the valuation risk associated with the disclaimer of hard-to-value assets to a credit shelter trust. The Eighth Circuit’s opinion in Christiansen makes clear such formula disclaimers are not void as against public policy, notwithstanding the IRS’s hostility.