Tax Court Upholds Defined Value Gift Formula Clause in Wandry v. Commissioner, T.C. Memo 2012-88 (March 26, 2012)

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 an annual program of gifting interests to a FLP. 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.

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 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. 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 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.

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.