The Tax Court in Wandry v. Commissioner (T.C. Memo 2012-88) has upheld a formula clause used by a couple for a program of gifting the interests in a family limited partnership (FLP).
Formula clauses are used by taxpayers to avoid unintended gift, estate and generation-skipping transfer (GST) tax consequences when transferring property. There are two general types of formula clauses: A definition clause defines a transfer by reference to the value of a possibly larger, identified property interest; and a savings clause retroactively adjusts the value of a transfer due to a subsequent valuation determination.
The IRS has been successful challenging savings clauses for gift, estate and GST tax purposes, arguing that they are against public policy because they prevent the IRS from properly administering the Code. The definition clause is a relatively new type of clause that has generally been respected by courts for gift, estate and GST tax purposes.
In Wandry, a couple established an FLP and embarked on a gift-giving program of gifting interests in the FLP annually. Their estate planning attorney advised them that (1) the number of FLP units equal to the desired value of their gifts on any given date could not be known until a later date when a valuation of the FLP's assets could be made, (2) all gifts should be given as specific dollar amounts rather than specific numbers of membership units, and (3) all gifts should be given on Dec. 31 or Jan. 1 of a given year, so that a midyear closing of the books would not be required. Based on this advice, the following formula clause was used to set the amount of the annual transfers:
Consistent with the transfer documents, the gift tax returns reported total gifts of $1,099,000, and the schedules supporting the gift tax returns reported net transfers from each spouse of $261,000 and $11,000 to their children and grandchildren, respectively. However, the schedules describe the gifts to the children and grandchildren as percentage interests in the FLP (not specific dollar amounts). The couple's accountant had derived these percentage interests based on an appraisal valuing a 1 percent interest in the FLP. The IRS audited the couple's 2004 gift tax returns and determined a deficiency based on the percentage interests listed in the schedules to each spouse's gift tax returns.
At trial, the IRS alleged the couple was liable for the deficiency amount because (1) the gift descriptions, as part of the gift tax returns, are admissions that petitioners transferred fixed FLP percentage interests to the donees; (2) the FLP's capital accounts control the nature of the gifts, and the FLP's capital accounts were adjusted to reflect the gift descriptions; and (3) the gift documents themselves transferred fixed FLP percentage interests to the donees. The IRS further argued that the formula clause created a condition subsequent to the completed gifts and was void for federal tax purposes as contrary to public policy, citing the 1944 case Commissioner v. Procter (142 F.2d 824).
The Tax Court quickly dispensed with the first two arguments by the IRS. Regarding the descriptions of the gifts on the gift tax returns as percentages of the FLP as opposed to a specific dollar amount, the court noted that the description of the gifts on the gift tax return was consistent with the gift tax documents transferring a specific dollar amount of FLP interests. Regarding capital accounts being adjusted related to specific percentages, the court determined that the adjustments in the capital accounts were "tentative" and subject to change once final values were determined. Therefore, it determined that the capital accounts do not control the nature of the gifts by the couple.
The Tax Court next addressed the validity of the valuation clause. The court first took note that other federal courts have held that formula clauses were valid to limit the value of a completed transfer, citing Estate of Christiansen v. Commissioner (130 T.C. 1, aff'd 586 F.3d 1061); Estate of Petter v. Commissioner (T.C. Memo. 2009-280, aff'd 653 F.3d 1012); and McCord v. Commissioner (461 F.3d 614). The court then reviewed its opinion in Petter regarding its examination of Procter and other cases, to draw a distinction between a "savings clause," which a taxpayer may not use to avoid gift tax, and a "formula clause" (in the form of a definitive value), which was valid to limit the value of the assets transferred. It noted that a savings clause is void because it creates a scenario in which the taxpayer tries to take property back. On the other hand, a formula clause is valid because it merely transfers a fixed set of rights with uncertain value. The difference depends on an understanding of what the donor was trying to transfer. It further noted that in Petter, it ruled the formula clauses were valid because the ascertainable dollar value of stock transferred was a fixed set of rights even though the units had an unknown value. It also noted that on appeal the Ninth Circuit agreed with the holding that although the value of each membership unit in the limited liability company (LLC) was unknown on the date of the gift, the value of a membership unit on any given date was constant. Therefore, under terms of the formula clauses at issue, the donees received a fixed number of membership units and no contingencies existed in order to render the transfers otherwise ineffective on the date of transfer.
The IRS attempted to distinguish the case before the Tax Court from Petter. It argued that unlike in Petter, where the taxpayers transferred a fixed set of rights with uncertain value, the taxpayers in the current case transferred an uncertain set of rights. It further argued that the formula clauses were void as savings clauses because they operated to take back property upon a condition subsequent — a gift tax audit. The Tax Court concluded that the IRS's interpretation of Petter was misguided. It then quoted the holding of the Ninth Circuit and applied the holding to the current case on a step-by-step basis:
- Part I: "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." The Tax Court determined that under the formula clause used in the case before it, the donees were always entitled to receive predefined interests in the FLP, which the gift tax documents expressed as a mathematical formula.
- Part II: "This formula had an unknown — the value of an LLC unit at the time the transfer documents were executed. But though unknown, that value was a constant." The Tax Court determined that in the case before it, the couple's formula had one unknown: the value of the FLP's assets on the date of transfer. But although unknown, that value was a constant on any given date.
- Part III: "Before and after the IRS audit, the foundations were entitled to receive the same number of units." The Tax Court noted that, similarly, in the current case, the donees were entitled to receive the same FLP percentage interests.
- Part IV: "Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that the part of the taxpayer's transfer was dependent upon the IRS audit. Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive." The Tax Court noted that in the case before it, the IRS audit merely ensured that the donees received the property to which they were always entitled.
The Tax Court reasoned that it was inconsequential that the formula clause reallocates membership units among petitioners and the donees rather than a charitable organization because the reallocations do not alter the transfers. As of the date of the transfer, each donee was entitled to a predefined FLP percentage interest expressed through a formula. The court concluded that the transfer documents do not allow the petitioners to take property back. Instead, the documents correct the allocation of FLP membership units among the taxpayers and the donees because the appraisal of the FLP understates the FLP's value. Therefore, the court ruled that the formula clauses were valid.
The Tax Court next addressed the public policy concerns expressed in Procter. The Tax Court concluded that there was no well-established public policy against formula clauses. It reasoned that the IRS's role is to enforce tax laws, not merely to maximize tax receipts. It further reasoned that mechanisms outside the IRS audit exist to ensure accurate valuation reporting — the most significant of which was that the members of the FLP had an interest in ensuring that they were allocated their fair share of profits and not allocated any excess losses. Regarding other concerns in Procter, the court determined that a judgment in favor of the taxpayers would not undo the gift, as they transferred a fixed set of interests to the donees, and neither they nor the transfer documents had the power to undo anything. It determined that a judgment in favor of the taxpayers would simply reallocate FLP membership units among taxpayers and the donees. It further concluded that it was not passing judgment on a moot case or issuing a declaratory judgment.
This case is significant because under the formula clause, the reallocation of FLP units in the event of an understatement or overstatement of the amount transferred occurs between the donors and the donees. The previous cases validating formula clauses (i.e., Petter, Christiansen, and Hendrix v. Commissioner, T.C. Memo. 2011-133) contain formula clauses that reallocated closely held interests among the donees. Once the donors parted with the transfers, the formula clauses did not operate to reallocate any interest back to the donor. Charities were among the donees in these cases, so that any excess transfers over and above the specified dollar amount would be reallocated to the charity, making the excess transfer eligible for the gift tax charitable deduction under Section 2522. Thus, no unintended gift tax consequences were produced. The Tax Court's ruling in Wandry would alleviate the need to use a charity as a donee when using a formula clause.
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