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May 22, 2013 The Tax Lawyer

Public Policy and Petter v. Commissioner: The Potential for Abuse with Formula Allocation Clauses

Vol. 66, No. 2 - Winter 2013

Daniel A. Perez


    Petter v. Commissioner, decided August of 2011, was one of the final nails in the coffin of the Service’s decades-long, public-policy-based argument against the use of valuation clauses in estate planning gift transactions. As part of an estate plan, Anne Y. Petter (taxpayer) made gifts of interests in a limited liability company (LLC) to trusts opened in the names of two of her children and to two donor-advised funds opened with charitable foundations.  In order to shield the transfers from taxes, the gifts were expressed as formulas matched to a specific dollar value rather than as a specific number of shares in the LLC. If an audit led to the revaluation of the LLC and the determination that gift tax was due on any portion of the gifts to the trusts, the transfer documents required that only a portion be reallocated to the charitable foundation recipients.5 The reallocation provision distinguishes this type of estate planning technique—referred to as a formula allocation clause—from earlier valuation-based methods.

    This estate planning technique is problematic in that it discourages audits by the Service and, in doing so, heightens the risk that the gift will be undervalued and that a considerable portion of the gift will escape taxation. When the Service audited the transaction at issue in Petter, it disregarded the reallocation provision of the transfer document and claimed a tax deficiency of over $2 million. By overriding the Service’s judgment, the Ninth Circuit’s decision has increased the probability that similar sums will escape taxation in the future. The U.S. Tax Court’s recent decision in Wandry v. Commissioner, which builds off Petter, broadens the courts’ permissive stance toward valuation-based methods and further implicates their public policy concerns.

    This Note argues that the Ninth Circuit erred in not applying Regulation section 25.2522(c)-3(b)(1) to disallow the taxpayer’s deduction. The court should have considered the understanding of contingent gifts and their public policy implications provided by Commissioner v. Procter. This Note then argues that a plain language reading of Regulation section 25.2522(c)-3(b) (1) is ambiguous and, when read alongside Procter, should also have been resolved in favor of disallowing the deduction.

    Part II of this Note provides the background for an analysis of a formula allocation clause gift transaction—the type of transaction at issue in Petter— including a description of the mechanics of the technique and the relevant case law addressing it and other valuation-based methods. Part III describes the specific facts of Petter and provides a summary of the Tax Court and Ninth Circuit’s decisions. Part IV provides an argument for why Procter was relevant both to application of the Regulation and to the public policy considerations at issue and also provides an argument for why the Ninth Circuit’s plain language reading of section 25.2522(c)-3(b)(1) was incomplete. Part V offers a brief conclusion.

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