Estate of Petter v. Commissioner, Ruling Affirms “Charitable Cap Adjustment Clause”

A federal appeals court affirmed a popular technique that sidesteps gift taxes, even if the IRS is successful in challenging the underlying valuation. (Ninth Circuit United States Court of Appeals, Tax Ct. No. 25950-06 Opinion, Estate of Anne Y. Petter v. Commissioner.)

Anne Petter inherited United Parcel Service stock from an uncle who was among the company's first investors. In May 2001, when the top gift and estate tax rate was 55%, she held $22 million of stock which she transferred to a family owned limited liability company (“LLC”). She both gave and sold units of the LLC to two trusts in 2002, and coupled the transfers with simultaneous gifts of LLC units to two charitable foundations.

The transfer documents include both a dollar formula clause, which assigned to the trusts a number of LLC units worth a specified dollar amount and assigned the remainder of the units to the foundations; and a reallocation clause, which obligates the trusts to transfer additional units to the foundations if the value of the units the trusts initially receive is later determined for federal gift tax purposes to exceed the initial specified dollar amount.

The value of the LLC interests transferred reflected valuation discounts of approximately 53% from the net asset value. Upon exam, the IRS countered with a 21% discount and they ultimately split the difference and settled on an aggregate valuation discount of approximately 35%.

From the IRS viewpoint, the higher valuation had two significant gift tax consequences. First, it meant that the taxpayer had underreported the value of the units transferred as gifts to the trusts and, accordingly, the taxpayer’s gifts exceeded the unused portion of her lifetime unified tax exemption. Second, it meant the shares sold to the trusts were sold for “less than full and adequate consideration,” and thus were transferred partly by sale and partly by an additional gift to each trust, computed by deducting the price of the installment notes from the fair market value of the shares transferred. Additionally, the IRS concluded that the dollar formula clauses were void as against public policy and refused to allow the taxpayer to take an additional charitable deduction for the value of the additional units that would pass to the foundations following the upward valuation adjustment. As a result, the IRS issued a notice of tax deficiency for just over $2.1 million and concluded that the defined value clauses were void for public policy reasons and declined to permit the taxpayer to take a charitable deduction for the value of any additional units transferred to the charities as a result of the upward valuation adjustment.

With agreement as to the value of the LLC interests, the Tax Court was left with the issues of whether Anne should be allowed to avoid additional gift tax through the adjustment clauses in the gift and sales documents, and whether Anne should be allowed a charitable contribution deduction for the resulting additional transfer of units to the charities. The Tax Court sided with the taxpayer, rejecting the IRS’s arguments that the dollar formula clauses were void as against public policy. It also found the charities’ receipt of additional units was not dependent on a condition precedent. The IRS appealed to the 9th Circuit.

On appeal the IRS argued that IRC Sec. 2522(a) and related regulations disallowed the charitable transfers because they were dependent on a condition precedent. The IRS claimed that the foundations would not have received the additional units but for its determination of a deficiency. However, the court declared “Adopting the IRS’s “but for” test would revolutionize the meaning of a condition precedent.” The 9th Circuit explained, “We do not think that the dollar formula clauses…contain a condition precedent. Rather, the taxpayer’s transfers became effective immediately upon execution of the transfer documents and delivery of the units. The only possible open question was the value of the units transferred, not the transfers themselves.”

One of the challenges in planning intra-family transfers is determining the value of the assets to be transferred. While taxpayers generally obtain independent appraisals, the IRS is not bound by the appraisal and frequently does challenge them; particularly the amount determined by the appraiser for minority interest and other discounts. Thus, it is difficult for estate planners to assure that they are not making taxable gift. A gift will result where an asset is sold to children or trusts for their benefit, if the value is ultimately determined for federal gift tax purposes to be higher than the purchase price. Under the defined value and formula valuation clauses, a taxpayer is given some protection against the risk of making an unintended gift by providing that a charity will receive any portion of the transfer above a fixed value.