By John W. Porter and Stephen T. Dyer
John W. Porter is a partner in the Houston, Texas, office of Baker Botts LLP and the Section Council representative of the Litigation, Ethics and Malpractice Group. Stephen T. Dyer is a partner in the Houston, Texas, office of Baker Botts LLP.
For hard-to-value assets, uncertainty regarding transfer taxes is a major risk. Well-advised taxpayers hire valuation experts to support their positions. A business or trophy property may hang in the balance. The IRS can and in some cases has taken aggressive positions not supported by an expert, particularly at audit. See, e.g., Estate of Dunn v. Commissioner, 301 F.3d 339 (5th Cir. 2002). Even at trial, expert opinions for the IRS can be extreme. In a valuation dispute, the taxpayer is sometimes able to make only one argument: that his appraiser’s valuation is correct.
Clients want better and more arguments. They are looking for a level of transfer tax certainty that is difficult to provide when transferring hard-to-value assets. In an effort to increase tax certainty, estate planners often use formula transfer clauses. With these clauses, the taxpayer possesses additional arguments to avoid the imposition of transfer tax.
Formula transfer clauses seek to limit transfer tax risk by (1) adjusting the property transferred or the consideration received based on values “finally determined for tax purposes” or (2) specifying the value of a property interest transferred.
In a line of cases going back to 1944, the IRS has experienced a measure of success in challenging certain types of formula clauses. But two recent taxpayer victories in cases involving dollar value formula clauses bring the issue to the forefront: Succession of McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), and, more recently, Christiansen v. Commissioner, 130 T.C. No. 1 (2008).
Some Formulas Sanctioned by Treasury or IRS
Estate planners regularly use formula transfers. Some of these are sanctioned in the Treasury Regulations or in IRS pronouncements. As a taxpayer correctly argued to the Fifth Circuit:
Although the Government attempts to sidestep the point, the fact is that formula transfers are commonly used and specifically sanctioned in a number of lifetime and testamentary transfer situations to avoid the imposition of gift, estate, and generation-skipping transfer taxes. The standard unified credit bequest combined with a marital deduction bequest for the benefit of a surviving spouse is a common use of a value definition clause. The IRS specifically sanctioned these types of clauses in Revenue Procedure 64-19, 1964-1 CB 682. Likewise, a bequest of a transfer of unused federal generation-skipping transfer (“GST”) tax exemption is another common valuation definition clause. GST tax regulations specifically sanction using formula allocations of the GST tax exemption to ensure that a generation-skipping transfer is exempt from GST tax or that a generation-skipping trust has an inclusion ratio of zero. Treas. Reg. §§ 26.2632-1(b)(2)(ii) (lifetime transfers), 26.2632-1(d)(1) (testamentary transfers). The Treasury Regulations also specifically sanction disclaimers (unqualified refusals to accept property) using formula language—Example 20 of Treas. Reg. § 25.2518-3(d) delineates a fractional disclaimer amount with a numerator equal to the smallest amount that will allow the Estate to pass free of federal estate tax and a denominator equal to value of the decedent’s residuary estate. See also T.A.M. 8611004 (November 15, 1985).
Reply Brief of Appellants, Succession of McCord v. Commissioner, No. 03-6070, at 7–8.
Other sanctioned formulas involve GRATs and charitable trusts. To be a “qualified interest” under Code § 2702, a GRAT annuity must convey “the right to receive fixed amounts payable not less frequently than annually.” The Regulations indicate that “[a] fixed amount means . . . [a] stated dollar amount . . . or [a] fixed fraction or percentage of the initial fair market value of the property transferred to the trust, as finally determined for federal tax purposes.” Treas. Reg. § 25.2702-3(b)(1)(ii). The Regulations further state that “[i]f the annuity is stated in terms of a fraction or percentage of the initial fair market value of the trust property, the governing instrument must contain provisions meeting the requirements of Treas. Reg. § 1.664-2(a)(1)(iii) of this chapter (relating to adjustments for any incorrect determination of the fair market value of the property in the trust).” Treas. Reg. § 25.2702-3(b)(2). The Regulations governing charitable remainder annuity trusts provide as follows:
The stated dollar amount may be expressed as a fraction or a percentage of the initial net fair market value of the property irrevocably passing in trust as finally determined for Federal tax purposes. If the stated dollar amount is so expressed and such market value is incorrectly determined by the fiduciary, the requirement of this subparagraph will be satisfied if the governing instrument provides that in such event the trust shall pay to the recipient (in the case of an undervaluation) or be repaid by the recipient (in the case of an overvaluation) an amount equal to the difference between the amount which the trust should have paid the recipient if the correct value were used and the amount which the trust actually paid the recipient. Such payments or repayments must be made within a reasonable period after the final determination of such value.
Treas. Reg. § 1.664-2(a)(1)(iii).
Adjustment Clauses and IRS Challenges to Them
A formula adjustment clause can be one of two types. One type provides that if the finally determined value of transferred property exceeds a specific dollar amount, the size of the transferred interest is reduced to correlate to the amount. The other type requires the transferee to return consideration to the transferor equal to the difference in values.
The IRS believes such clauses should be ignored, asserting that the provisions are void as against public policy because the condition subsequent renders any IRS challenge meaningless. The Fourth Circuit considered a formula adjustment clause in Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944). In Procter, the taxpayer provided that, if any part of the transfer was subject to tax, the property subject to tax would be deemed excluded from the transfer (and thus returned to the taxpayer). The Procter court held that the clause did not eliminate the taxable gift because it imposed a condition subsequent violative of public policy and would be “trifling with the judicial process” in a way that would inhibit tax collection, because attempts to enforce the tax would defeat the gift and would require the court to pass on a tax issue rendered moot by the court’s decision itself.
Similarly, in Ward v. Commissioner, 87 T.C. 78 (1986), the taxpayer made a gift of stock, reserving the right to revoke the gift to the extent the value was finally determined for gift tax purposes to exceed a certain amount. The Tax Court rejected the power of revocation, holding that the clause violated public policy under a Procter analysis. The Tax Court also has ignored adjustment clauses in Harwood v. Commissioner, 82 T.C. 239 (1984), aff’d, 786 F.2d 1174 (9th Cir. 1986), and Estate of McLendon v. Commissioner, 66 T.C.M. (CCH) 946 (1993), rev’d on other grounds, 77 F.3d 477 (5th Cir. 1995).
Taxpayers, however, were not without a court victory even before McCord and Christiansen. In King v. United States, 545 F.2d 700 (10th Cir. 1976), the taxpayer sold stock to trusts, providing for a purchase price adjustment if the finally determined value was higher that the stated price. The King court distinguished Procter, noting that the sole purpose of the Procter clause was to rescind the transaction, whereas the price adjustment clause in King did not affect the “nature” of the transaction. The court added that “an attempt to avoid valuation disputes with the IRS agents by removing incentive to pursue such questions is not contrary to public policy in the absence of a showing of abuse.” The IRS later took a view opposed to King in Rev. Rul. 86-41, 1986-1 C.B. 300.
Defined-Value Transfers by Gift— McCord
In McCord v. Commissioner, 120 T.C. 358 (2003), the taxpayers made a gift of an 82% limited partnership interest to their sons, to trusts for the benefit of their children and grandchildren, and to two charities. Under the Assignment Agreement, the sons and the trusts collectively received a portion with a fair market value of $6.9 million; the remaining portion passed to the charities. The taxpayers left it to the donees to determine how the interest should be divided consistent with this dollar value formula. Three months after the transfers, the donees reached an agreement (the “Confirmation Agreement”) in which the charities accepted a 5.1% interest. Six months later, the partnership redeemed the charities’ interests for cash.
The IRS challenged the transaction under the substance-over-form doctrine, public policy considerations, and the integrated transaction doctrine. The majority of the Tax Court did not rely on the IRS’s arguments in refusing to respect the formula clause. Instead, the majority interpreted the transaction as if the McCords had given the interests as agreed on by the donees in the Confirmation Agreement and ignored the dollar value formula in the Assignment Agreement. The majority allowed a charitable deduction equal to its determined value of the 5.1% interest.
Judges Chiechi and Foley (the trial judge) concurred in part and dissented in part. They believed the Assignment Agreement should govern the property rights transferred and the value of the gift to the taxable donees was the amount specified in the Assignment Agreement.
Judges Laro and Vasquez dissented. They would have allowed a charitable deduction only for the amount received by the charities in the redemption, based on the IRS’s arguments.
The Fifth Circuit reversed the majority’s decision in Succession of McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006). The Fifth Circuit emphasized that the fair market value of the interests transferred must be determined on the date of the gift:
The Majority’s key legal error was its confecting sua sponte its own methodology for determining the taxable or deductible values of each donee’s gift . . . . This core flaw in the Majority’s inventive methodology was its violation of the long-prohibited practice of relying on post-gift events. Specifically, the Majority used the after-the-fact Confirmation Agreement to mutate the Assignment Agreement’s dollar-value gifts into percentage interests in MIL. It is clear beyond cavil that the Majority should have stopped with the Assignment Agreement’s plain wording. By not doing so, however, and instead continuing on to the post-gift Confirmation Agreement’s intra-donee concurrence on the equivalency of dollars to percentage of interests in MIL, the Majority violated the firmly-established maxim that a gift is valued as of the date that it is complete; the flip side of that maxim is that subsequent occurrences are off limits.
Id. at 626. Thus, like Judges Chiechi and Foley, the Fifth Circuit focused on the interests transferred in the Assignment Agreement, not the percentage interests later agreed to by the donees in the Confirmation Agreement.
The Fifth Circuit did not address the IRS’s public policy argument under Procter, observing that the IRS had waived the argument by failing to brief it. Id. at 623. In the very same sentence, however, the court noted that instead of asserting its public policy and related arguments, the Commissioner has “instead—not surprisingly—devoted his efforts on appeal solely to supporting the methodology and holdings of the Majority” of the Tax Court. Id. (In the authors’ view, this language indicates that the Fifth Circuit did not think much of the IRS’s Procter argument in the context of the McCord facts.)
Two additional McCord-style cases are currently pending before the Tax Court: Hendrix v. Commissioner, No. 10503-03; and Rosenbaum v. Commissioner, No. 13028-03.
Defined-Value Transfers at Death— Christiansen
Christiansen v. Commissioner, 130 T.C. No. 1 (2008), concerned a defined-value disclaimer. The decedent left her estate to her daughter. Under the will, 75% of any disclaimed assets would pass to a charitable lead annuity trust (CLAT) and 25% to a private foundation (the “Foundation”). The principal assets of the estate were 99% limited partnership interests in two partnerships. The daughter disclaimed a fractional share of the estate exceeding $6.35 million, based on values “as finally determined” for estate tax purposes.
The IRS challenged both the valuation of the partnership interests and the effect of the formula disclaimer on the size of the charitable deduction the estate was entitled to receive. Before trial, the parties reached agreement on the values of the limited partnership interests. The agreement increased the gross estate from 6.51 million to $9.6 million and increased the value of the properties passing to the CLAT and the Foundation. The issue for the court was whether a charitable deduction would apply to the additional value passing to charity.
A majority of the Tax Court held that the disclaimer was not qualified for the 75% passing to the CLAT because the daughter was a contingent remainder beneficiary of the CLAT. Judge Swift and Judge Kroupa (the trial judge) dissented from this portion of the opinion. Both believed the disclaimer was qualified.
Regarding the 25% passing to the Foundation, the Tax Court unanimously validated the formula disclaimer and allowed a charitable deduction. The court noted that the transfer was the result of a disclaimer governed by Treas. Reg. § 20.2055-2(c), which relates back to the decedent’s death as if it had been part of the will. The court also stated:
The regulations speak of the contingency of “a transfer” of property passing to charity. The transfer of property to the Foundation in this case is not contingent on any event that occurred after Christiansen’s death (other than the execution of the disclaimer)—it remains 25 percent of the total estate in excess of $6,350,000. That the estate and the IRS bickered about the value of the property being transferred doesn’t mean the transfer itself was contingent in the sense of being dependent for its occurrence on a future event. Resolution of a dispute about the fair market value of assets on the day Christiansen died depends only on a settlement or final adjudication of a dispute about the past, not the happening of some event in the future. Our Court is routinely called upon to decide the fair market value of property donated to charity—for gift, income, or estate tax purposes.
130 T.C. No. 1, at 30. The court rejected the IRS’s public policy argument, noting that it was “hard pressed to find any fundamental public policy against making gifts to charity—if anything the opposite is true. Public policy encourages gifts to charity, and Congress allows charitable deductions to encourage charitable giving.” Id. at 32–33. Rejecting the IRS’s Procter analogy, the court noted:
This case is not Procter. The contested phrase would not undo a transfer, but only reallocate the value of the property transferred among Hamilton, the [CLAT], and the Foundation. If the fair market value of the estate assets is increased for tax purposes, then property must actually be reallocated among the three beneficiaries. That would not make us opine on a moot issue, and wouldn’t in any way upset the finality of our decision in this case.
Id. at 33–34. The court added that a charity’s directors, as well as executors of an estate, owe fiduciary duties that are enforceable by the IRS and the state’s Attorney General.
Planning Issues Generally
Although sound arguments exist for a taxpayer to assert that the public policy holding in Procter and its progeny should not be followed in today’s world given the broad approval granted to a variety of formula clauses in IRS pronouncements, practitioners should be cautious when using adjustment clauses that cause property to be returned to the donor (or deemed never transferred) similar to those used in Procter and Ward. Defined-value planning, however, involves a different structure than addressed by the courts in Procter and its progeny because no condition subsequent is present.
Practitioners should be aware that the charitable techniques of McCord and Christiansen are different from each other in terms of the effect of a successful IRS challenge to value. A McCord-type of defined-value formula (a transfer of interests of a specific dollar value to noncharity donees with the remainder to charity, not based on values as finally determined for transfer tax purposes) turns on the state law property rights transferred. If, after the transfer, the donees reach an arm’s length agreement regarding the allocation of the interests among themselves under the formula, a successful IRS challenge to the value of the interests transferred does not change that allocation. On the other hand, a Christiansen-type of defined-value formula (a transfer of interests of a specific dollar amount to noncharity donees with the remainder to charity, based on values as finally determined for transfer tax purposes) is affected by a successful IRS challenge to the value of the interest transferred. Under that type of a clause, if the value of the interest transferred is increased, the size of the interest passing to charity is likewise increased. That increase applies for state law purposes whether or not an additional charitable deduction is ultimately allowed.
For a McCord-type of defined-value formula, both the IRS and the courts will examine any pre-transfer dealings with the charity. It is important for the taxpayer to be able to demonstrate that the transaction with the charity was at arm’s length and that there was no pre-arranged deal between family members and the charity providing that the charity would receive a specific interest in the entity transferred. As the Fifth Circuit noted in McCord:
Neither the Majority Opinion nor any of the four other opinions filed in the Tax Court found evidence of any agreement—not so much as an implicit, “wink-wink” understanding—between the Taxpayers and any of the donees to the effect that any exempt donee was expected to, or in fact would, accept a percentage interest in MIL with a value less than the full dollar amount that the Taxpayers had given to such a donee two months earlier.
McCord, 461 F. 3d at 620. In this regard, it is also helpful for the charity to have its own counsel review the transaction and, if the charity deems appropriate, obtain its own valuation analysis.
Testamentary vs. Inter Vivos Transfers
With testamentary defined-value transfers involving charities, it is often difficult to set a formula in the will because the value of the estate is a moving target. Thus, clients may prefer dollar value formula disclaimers like the one used in Christiansen. This type of formula allows, but does not require, the children to disclaim assets to a charity selected by the decedent in his or her will.
Charitable disclaimer planning like Christiansen generally requires all beneficiaries of the estate to act together. If all do not disclaim, the defined-value structure will have a “leak” that leads to estate tax if valuation is successfully challenged by the IRS, because not all of the increase in value passes to charity. Careful consideration should also be given to the drafting of debts, expenses, and tax allocation provisions, because the boilerplate of many wills simply allocates those obligations to the residue of the estate.
Noncharitable Defined-Value Transfers (Briefly)
For clients without the requisite charitable intent, or worried about family members negotiating with the charity over the percentage interests received by each donee in a McCord-type transaction, a defined-value transfer using a GRAT might be considered. The structure would consist of a transfer of interests equal to a specific dollar amount to non-GRAT donees, with the remainder passing to a GRAT based on values as finally determined for transfer tax purposes. In the event of a successful valuation challenge by the IRS, the increased value would result in a larger transfer to the GRAT and, as required by Code § 2702, increase the annuity owed to the donor. This type of transaction is similar to the consideration adjustment structure used in King. The difference is that, in a King transaction, the property transferred to each recipient does not shift as it would in the case of a GRAT; rather, the amount the recipient is required to pay is based on the value of the property as finally determined for transfer tax purposes. What might make the GRAT more desirable than the consideration adjustment provision in King is that the Regulations under Code § 2702 offer some comfort if faced with a Procter argument. In addition, if the GRAT is not a “zeroed-out” GRAT, a successful IRS challenge would result in some additional tax being due, which would make it difficult for the IRS to argue, as it did in Procter, that the clause violated public policy.
Although the decisions in McCord and Christiansen provide guidance about formula clauses that will be respected by the courts, the IRS will continue to assert that formula clauses outside those specifically sanctioned in its pronouncements violate public policy and should not be respected. Careful consideration should be given to the type of clause used, the effect of any value adjustment, and the client’s desire for finality regarding the allocation of transferred property. n