Gift Planning with Formula Clauses: From Procter's Progeny to Wandry World ( Part 1)

Probate & Property Magazine: Volume 28 No. 01

N. Todd Angkatavanich is a partner in the Wealth Planning group of Withers Bergman, LLP, in Greenwich, Connecticut. Liam D. Crane is an associate at Stoel Rives, LLP, in Seattle, Washington. Stephen Putnoki-Higgins is an associate at Withers Bergman, LLP, in New Haven, Connecticut.

Although lifetime transfer planning is an important agenda item for many wealthy families, there are significant attendant risks. From a transfer tax standpoint, one of the main risks arises when a person transfers assets that are difficult to value: the IRS, or state tax authority, may challenge the value of the transferred property as reported by the transferor on the gift tax return.

For many wealthy families, transferring assets during life from one generation to the next is a basic element of estate planning. There are a number of reasons why the transfer of assets during life is often preferable to testamentary transfers, from both tax and managerial perspectives. From a tax standpoint, making lifetime gifts allows a parent to remove the income, value, and growth attributable to the gifted asset from the parent’s taxable estate. In addition, because many states impose a separate estate tax, but only Connecticut and Minnesota impose a separate gift tax, one may reduce the effect of state estate taxes at death by making taxable gifts during life. There are also many nontax reasons why families prefer making lifetime transfers rather than passing assets at death. Parents can take comfort in seeing to it that their children learn how to handle investments, or manage a family business, before they have passed away. Older parents may prefer making transfers during life because they no longer feel comfortable managing a large percentage of their family’s assets, or they may simply want to be around to watch their children enjoy the increased standard of living that the gifts provide. Whatever the motivation, lifetime transfer planning is a dominant aspect of the estate planning process for many wealthy families.

Although lifetime transfer planning is an important agenda item for many wealthy families, there are significant attendant risks. From a transfer tax standpoint, one of the main risks arises when a person transfers assets that are difficult to value: the IRS, or the state tax authority, may challenge the value of the transferred property as reported by the transferor on the gift tax return. Such challenges are not uncommon, because transfer planning often involves the transfer of assets that are not easily marketable and that are, therefore, hard to value. The risk resulting from a successful valuation challenge by the IRS is that the transferor will be subject to greater gift tax, as well as interest and potential penalties. IRC § 6662.

Valuation Clauses: Tools to Reduce Risk and Uncertainty

Over the years, estate planners have tried to minimize the transfer-tax risk associated with a revaluation by using valuation clauses in their transfer documents. These valuation clauses are generally formulaic attempts to adjust or define the amount of transferred property that will be subject to gift tax. In the event of a valuation that is successfully challenged by the IRS, these clauses operate to adjust, redefine, or reallocate the amount of property transferred, the amount of consideration received by the transferor, or the way the property will be allocated among certain donees, all in an attempt to protect the transferor from liability for the additional gift taxes imposed by the IRS on the revaluation of the transferred assets. Considering the relatively high gift tax rate, and the liabilities that may result from a person unwittingly making a gift that exceeds the available gift tax exemption, it would be reasonable to assume that a planning option like this would or should be available to taxpayers. Indeed, from the perspective of the taxpayer/client, such a planning approach, which simply attempts to use the full gift tax exemption that the government has provided, but no more of it, seems like a completely reasonable and rational expectation. The reality, however, is that a person who wants to take advantage of the gift tax exemption by transferring assets may not have $5.34 million of cash or marketable securities readily available and would want to make gifts of other assets, like real estate, closely held business interests, or other assets lacking a readily determined value.

Nevertheless, the IRS has historically taken a hostile view toward valuation clauses, taking the position that these valuation clauses violate public policy because they disincentivize IRS gift tax return audits. Unfortunately for estate planners, this antagonistic view of valuation clauses has, until recently, largely been supported by judicial precedent. Particular rulings over the past decade, both in the U.S. Tax Court and at the Federal Circuit level, have indicated a softening of this view, however, and have provided some guidance for certain acceptable uses of valuation clauses. This softening was most recently illustrated in the March 2012 decision in Wandry v. Commissioner, 103 T.C.M. (CCH) 1472 (2012), in which the court upheld a formula gift of as many units of a closely held LLC as equaled a specified dollar amount. Along with a number of cases from the past decade that were indicative of a growing acceptance of formula transfers in certain circumstances, Wandry has provided many estate planners with a reason to believe that valuation clauses are becoming a more widely accepted method for reducing gift tax risks when planning with hard-to-value assets.

Given Wandry’s importance as a guidepost to the estate planning community in the future use of valuation clauses, this article, which is presented serially because of length, is partly intended to provide an analysis of the Wandry ruling and how practitioners should view it against the backdrop of over 50 years of jurisprudence on this controversial topic. To develop a fuller understanding of how different types of valuation clauses have evolved and been used over time, however, Part 1 of this article will provide an in-depth overview of valuation clause jurisprudence and track the path whereby the IRS developed its antagonistic view of valuation clauses.

After Part 1 analyzes the early jurisprudence that established the IRS’s antagonistic view of valuation clauses, Part 2 of the article, which will appear in the March/April issue of Probate & Property, will examine rulings from the past decade that evidence a gradual change in the way valuation clauses are viewed, before finally turning to a discussion of Wandry and its implications for the future use of valuation clauses.

Early Forms: Value- and Price-Adjustment Clauses

Valuation clauses have taken various forms over the years. One of the earliest valuation clauses was a relatively uncomplicated provision that retroactively adjusted the amount of property transferred, or the amount of consideration paid, by the transferee. In effect, these valuation clauses basically functioned as “savings” clauses, in the sense that such clauses could effectively save the taxpayer from unintended gift tax consequences in the event of an IRS revaluation and thereby preserve the taxpayer’s desired gift tax consequences. For example, for a transfer that was intended to be completely sheltered by the annual gift tax exclusion, such a clause might state that, in the case of a final judgment determining that any part of the transfer did generate gift tax, either (1) the portion of the transferred property with a value in excess of the annual exclusion would be returned to the transferor or (2) the transferee would pay consideration to the transferor in an amount equal to the excess value, to neutralize the tax effect of the excess gift. Clauses of this form are generally referred to as “value-adjustment” or “price-adjustment” clauses because they operate, after the date of conveyance, by adjusting either the value transferred or the consideration paid. Value- and price-adjustment clauses were the first type of valuation clause that estate planners used, and, in the 1940s, they also became the first type of clause to garner significant attention from the revenue authorities.

Procter and Subsequent Jurisprudence

In Commissioner v. Procter, the first significant case to address the use of value-adjustment clauses, the Fourth Circuit refused to recognize the validity of such a clause. 142 F.2d 824 (4th Cir. 1944). The transaction at issue in Procter involved a taxpayer who had transferred certain property interests into a trust for the benefit of his children. The taxpayer was advised by counsel that the transfer should not be subject to gift tax. Nonetheless, written into the trust instrument was a provision providing that, if a court determined that any part of the transfer was subject to gift tax, the excess property subject to gift tax would be deemed to have been retained by the taxpayer and not, therefore, transferred at all.

In its analysis, the Fourth Circuit ruled that the value-adjustment clause in Procter was a “condition subsequent” to the transfer, in violation of public policy. The Fourth Circuit enumerated several public policy considerations for reaching this conclusion. First, the Fourth Circuit reasoned that this type of formula clause would “discourage the collection of the tax by the public officials charged with its collection” because even successful IRS challenges regarding the value transferred would result in no gift tax due, because the clause would restore any property subject to tax to the original donor. Procter, 142 F.2d at 827. Second, because the trust beneficiaries were not a party to the tax litigation challenging the value of the gift, they would not be bound by the ruling. Accordingly, the beneficiaries could presumably try to retain the full gift amount after the litigation concluded, even if the value-adjustment clause were upheld. Finally, the Fourth Circuit reasoned that upholding the clause would waste judicial resources and obstruct justice because any ruling on the value of the gift would immediately become moot because the amount of property transferred would be adjusted by application of the adjustment clause.

Though Procter was only a circuit-level case, its reasoning and the public policy concerns it voiced gave the IRS solid ground to develop its long-standing opposition to all valuation and other “savings” clauses that provide for retroactive transfer adjustments in the case of subsequent, adverse gift tax consequences. An early example of this was Rev. Rul. 65-144, 1965-1 C.B. 442, in which the IRS objected to certain trust provisions that functioned as “savings” clauses for gift tax purposes. In that ruling, the IRS was presented with an irrevocable charitable remainder trust that gave the trustees broad fiduciary powers. To prevent any of the fiduciary powers from being interpreted in a way that might threaten the availability of the gift tax charitable deduction, a “savings” clause in the trust document stated that such fiduciary powers would be revoked if they resulted in the loss of the gift tax charitable deduction. Echoing Procter’s public policy concerns, the IRS concluded that the “savings” clause was a condition subsequent and would not be given effect. Though Rev. Rul. 65-144 did not deal specifically with a valuation clause, it was one of the early examples of the IRS’s position that “savings” clauses, which come into effect only on subsequent conditions, should not be respected.

Although the IRS’s hostility toward valuation clauses began to develop in the decades after Procter, the courts did not provide a significant amount of further guidance. During this period, the Tenth Circuit issued one of the only significant decisions to address valuation clauses in Procter’s immediate wake. King v. United States, 545 F.2d 700 (10th Cir. 1976). King involved a taxpayer who transferred closely held stock to trusts established for his children in return for a purchase price purportedly equal in value to the transferred stock. The transfer documents included a price-adjustment clause, providing that, in the case of IRS revaluation of the transferred stock, the stock purchase would be similarly adjusted, thereby ensuring that there was full and adequate consideration for the sale. After the IRS challenged the initially determined value of the stock, the parties went to court, with the enforceability of the price-adjustment clause being a key issue. The price-adjustment clause was upheld by the district court and by the Tenth Circuit on appeal. In upholding the clause, the Tenth Circuit focused on the fact that an independent appraiser was used and that the transfer terms were negotiated by the taxpayer’s attorney and the trustee of the children’s trusts, evidencing an arm’s-length transaction, meant to be for fair market value, without donative intent. Because it was at arm’s-length, the transaction was presumed to have been “made for adequate and full consideration in money or money’s worth” under Treas. Reg. § 25.2512-8. Although this ruling provided some support for price-adjustment clauses, the focus on the arm’s-length nature of the transfer meant the decision was not a blanket approval of such clauses.

Unlike the courts, the IRS has expressed its disapproval of value and price adjustment clauses consistently. Relying on the reasoning in Procter and Rev. Rul. 65-144, the IRS issued Rev. Rul. 86-41 in 1986, 1986-1 C.B. 300, which clearly stated the IRS’s position: value- and price-adjustment clauses should not be enforceable. In that revenue ruling, the IRS considered the validity of value- and price-adjustment clauses used in two situations, both of which involved the transfer of real interests. The first situation involved a value-adjustment clause contained in the real estate deed. It provided that, if the transferred property was revalued by the IRS at an amount greater than $10,000 (therefore generating a gift tax, because the annual exclusion from gift tax was then $10,000), the donee would be required to return to the donor a fraction of the real estate large enough to reduce the gift value to $10,000 as of the date of the gift. This clause, acting to revoke a portion of the initial gift, was similar to the clause used in Procter. The second involved a price-adjustment clause that was also contained in the real estate deed. Instead of requiring a revocation of a portion of the gift, the clause provided that, in the case of IRS revaluation at an amount greater than $10,000, the donee would have to pay the donor consideration in an amount equal to the excess. Citing the public policy concerns discussed in Procter and Rev. Rul. 65-144, the IRS reaffirmed its view that value- and price-adjustment clauses should not be respected because they discourage tax collection by rendering tax audits useless on completion. Id. The IRS did not view the value- and price-adjustment clauses differently from each other, stating that it was “irrelevant” that the price-adjustment clause recharacterized the transfer as a “partial-gift/partial-sale” transaction. In addition, the IRS contrasted the use of value- and price-adjustment clauses in donative transfers (like the transfers at issue) from the use of such clauses in arm’s-length transactions, likely because of the similar distinction made in King, discussed above.

Just a short time after the IRS released Rev. Rul. 86-41, the Tax Court released its opinion in Ward v. Commissioner, 87 T.C. 78 (1986), another case dealing with a value-adjustment clause. The taxpayers in Ward tried to transfer their ranching business to their three adult sons. To effectuate the transfer, the taxpayers executed gift agreements that transferred 25 shares of stock in the operating business to each son. The gift agreements stated that each share was worth $2,000 and that the agreements were intended to transfer a $50,000 interest in the business to each son. To preserve this intent, a value-adjustment clause was included in each gift agreement, which stated that if a single share in the ranching corporation was finally valued for gift tax purposes at more than $2,000 (resulting in a total gift to each son of greater than $50,000), the number of shares each son received would be reduced so that each son would still receive only $50,000 in value.

The Tax Court invalidated the value-adjustment clauses used in the gift agreements based on the same public policy reasons given in Procter. The Tax Court also noted that donative transfers are generally treated as completed gifts and valued for gift tax purposes as of the time of the transfer, even if a contingency beyond the donor’s control could cause some of the gifted assets to be returned to the donor. The court observed that such a contingency could result in a reduction in the value of the completed gift but that Treas. Reg. § 25.2511-1(e) disallows such a reduction if the contingency cannot be properly valued. Because Ward’s contingency (that is, whether the IRS would successfully challenge the value of the transferred property) was impossible to value, the Tax Court ruled that the taxpayers could not reduce the value of the gift.

With the Tax Court expressing concern in Ward that an unpredictable contingency could operate after a transfer to revoke a portion of a gift, it remained unclear how the Tax Court would view a price-adjustment clause that simply required the donee, in the event of an IRS revaluation, to pay additional consideration to the donor equal to the amount of the excess gift value. The IRS had indicated its disapproval of such price-adjustment clauses in Rev. Rul. 86-41 (discussed above), but the Tax Court had not yet ruled on the validity of such clauses. Indeed, a price-adjustment clause was upheld in King (discussed above). The King court seemed to favor price-adjustment clauses over value-adjustment clauses because price-adjustment clauses would not affect the “nature of the transaction” by revoking a portion of the transfer after it had already occurred. Still, the status of price-adjustment clauses was uncertain.

The Tax Court cleared up some of this uncertainty and reduced the hope for price-adjustment clauses in Estate of McLendon v. Commissioner, 66 T.C.M. (CCH) 946 (1993). In McLendon, the taxpayer sold an interest in certain partnerships and real estate to his son and to trusts for the benefit of his daughters, in exchange for an annuity agreement in his favor. Realizing that there was no adequate, objective way to assign a value to the interests sold, the taxpayer included a “savings” clause in the annuity agreement. The savings clause provided that the annuity purchase price would be increased (and interest paid), if the IRS revalued the transferred assets at a higher amount. Accordingly, if a revaluation occurred, the transferees would have to pay additional consideration to the taxpayer, but, unlike Procter, no part of the transfer could be subsequently revoked.

This distinction, however, did not affect the Tax Court’s decision, because it agreed with the IRS’s position in Rev. Rul. 86-41, again dusting off Procter’s public policy concerns. Restating the Procter concerns, the McLendon court noted that it would “make little sense to expend precious judicial resources to resolve the question of whether a gift resulted from the private annuity transaction only to render that issue moot.” Still channeling Procter, the Tax Court also stated that a ruling revaluing the private annuity agreement would have no binding effect on the taxpayer’s son or the trusts at issue, and, therefore, that there was no guarantee that the terms of the price-adjustment clause would actually be followed. As a result of these policy concerns, the Tax Court ruled that the price-adjustment clause should not be given effect.

At the time, McLendon was the Tax Court’s latest ruling on the effectiveness of rather simple price-adjustment clauses, but the invalidity of similarly structured valuation clauses used in intra-family transactions remains fairly certain. The IRS‘s negative stance on such clauses was recently reaffirmed in two further technical advice memoranda. TAM 200245053 (Nov. 8, 2002); TAM 200337012 (Sept. 12, 2003). In both of those memoranda, the IRS was faced with taxpayers who attempted to structure intra-family trust transfers by entering into agreements that purportedly transferred a fractional property interest defined by reference to the finally-determined gift-tax value of the entire property interest. In both situations, the taxpayer argued that Procter should not apply as precedent because the clause at issue was a “value-definition” clause. In essence, these value-definition clauses claimed to sell a fixed interest in the asset; however, the purchase and sale agreement stated that the amount sold could change to the extent that an IRS revaluation was inconsistent with the appraised value. Nonetheless, the value of the fractional property interest transferred could, in fact, be determined before a final gift tax valuation was obtained because, on the day after the day that the first agreement was signed, which was long before the final gift tax value of the transferred property interest had been determined, both taxpayers entered into transfer agreements, stating that 100% of the taxpayer’s property interest was transferred, irrespective of the fractional language that was incorporated into the initial agreements. Therefore, the IRS ruled in both situations that the clauses operated to revoke a portion of the initial fractional transfer and, following Procter, were ineffective for gift tax purposes.

As will be explained further in Part 2 of this article, the value definition clauses described above might have survived the Procter analysis if the taxpayers had not effectively contradicted what was stated in the initial agreement by entering into the second agreement. After expanding on the nature and usefulness of value-definition clauses to survive Procter’s previously lethal analysis, the sequel to this article will chart the recent growth in support of the use of value-allocation clauses as expressed in such cases as McCord v. Commissioner, 120 T.C. 13 (2003), rev’d, 461 F.3d 614 (5th Cir. 2006), Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009), Estate of Petter v. Commissioner, 98 T.C.M. (CCH) 534 (2009), and Hendrix v. Commissioner, 101 T.C.M. (CCH) 1642 (2011). After admitting that the factual circumstances of such cases leave some uncertainty as to whether and when value-allocation clauses will be respected and may be unpalatable to less charitably inclined transferors, Part 2 will culminate with a discussion of Wandry, its analytical bases, and how, despite the case’s undeniable significance for future gift planning, practitioners should approach Wandry with cautious optimism, remaining ever mindful of its limited precedential value and the IRS’s lingering hostility.

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