Just how far should we take this taxpayer victory?
The Tax Court’s March 26, 2012 memorandum decision in Wandry v. Commissioner1 is monumental for defined value clause (DVC) planning. Donors should now be able to rely on the opinion to plan in a manner that substantially reduces the risk of unexpected gift and generation-skipping transfer (GST) taxes when transferring hard-to-value assets. Although other techniques using DVCs have been recognized prior to Wandry, all prior cases approving these transactions involved a charitable beneficiary. Wandry is groundbreaking, because it holds that no charity is required for the donor to successfully implement this useful technique. The remaining question is just how far planners can take this decision without becoming too aggressive. Wandry is a memorandum opinion, and we’re still waiting to see whether the Internal Revenue Service appeals. But, we think planners can take it pretty far.
Defining the Clause
Donors use DVCs to define a gift’s fair market value (FMV) by reference to a fixed dollar amount, often determined through a formula. Rather than transferring a fixed quantity of property, such as a 25 percent interest in a family limited partnership (FLP), the donor transfers a fixed dollar amount worth of property, such as $5 million worth of FLP interests. By fixing the dollar amount, the donor can determine the transfer tax consequences immediately upon making the gift.
A DVC is particularly useful when transferring hard-to-value property, such as minority interests in FLPs or closely held corporations. The IRS will often challenge the FMV of such interests because the donor will claim a discount for the inherent lack of marketability and lack of control. If the donor has transferred a fixed quantity of property and the IRS successfully revalues the property, the donor would have made a larger gift than originally expected. This can result in unintended gift or GST tax (or in the use of more applicable exclusion amount or GST tax exemption than intended). But, if the donor has transferred property equal to a fixed dollar amount, revaluation simply means the donor has transferred a smaller quantity of property than originally expected. The gift’s FMV doesn’t change, because its value was fixed by the terms of the gift itself.
The controversy surrounding DVCs stems from their evolution from so-called “savings clauses.” A savings clause differs from a DVC because a savings clause seeks to “undo” the gift (or a portion of the gift) if unintended gift tax would result, rather than define the transferred value as a part of the gift itself.
The foundational case invalidating a savings clause was Comm’r v. Procter.2 In Procter, the donor transferred his remainder interest in two trusts in further trust for the benefit of his children. The transfer was subject to a savings clause that provided that if a court were to determine that any part of the transfer was subject to gift tax, that part would be deemed not to have been transferred. The U.S. Court of Appeals for the Fourth Circuit denied the donor’s use of the savings clause as a violation of public policy. Procter held that savings clauses are void against public policy because they: (1) discourage the collection of tax by negating the tax assessment upon triggering the clause; (2) result in court decisions becoming moot upon entering a judgment, obstructing justice; and (3) render a judgment self-defeating and undermine the court’s authority. Subsequent to Procter, the IRS successfully continued to assert its public policy arguments against savings clauses.3
The lone taxpayer victory among these early cases was King v. United States,4 in which the Tenth Circuit upheld the application of a “price adjustment clause” in a sale of stock between the taxpayer and trusts the taxpayer had settled for the benefit of his children. The clause in King required the payment of additional consideration in the event the IRS revalued the stock. The Tenth Circuit found that the transaction was in the ordinary course of business at arm’s length, and therefore, the price adjustment clause was enforced.
Recognizing the body of case law rejecting savings clauses, planners turned to DVCs to produce the desired tax results. A DVC is premised on the idea that it’s fundamentally different from a savings clause with respect to the property transferred. Rather than relying on IRS or judicial redetermination as a condition subsequent to undo a transfer, a DVC defines as a condition precedent the fixed dollar amount that’s transferred. Indeed, this distinction has now proven its merit in the courts that have faced the issue. Over the last six years, three federal court of appeals cases have laid the foundation for Wandry.5
Beginning in 2006, the IRS suffered its first major defeat when the Fifth Circuit ruled for the donors in McCord v. Comm’r.6 The donors used a DVC to allocate the value of their entire interest in their FLP among four GST trusts, their four sons and two charitable organizations. The assignment agreement provided that the trusts were entitled to an interest in the FLP equal to the donors’ remaining GST tax exemptions. The sons received an interest equal to $6.9 million, reduced by the amount passing to the GST trusts. One charity received $134,000 worth of the interests, and any excess above the defined amounts passed to a second charity. The Tax Court held for the IRS, basing its valuation on post-gift agreements among the beneficiaries as to the percentage interests each would receive. The Fifth Circuit overruled the Tax Court and held that DVCs fixed the dollar amounts that the donors transferred to the GST trusts and their sons. Accordingly, no gift tax resulted because any excess value upon revaluation passed the charity as the residual beneficiary.
Estate of Christiansen v. Comm’r7 followed McCord. In Christiansen, the decedent’s child disclaimed her interest in her mother’s estate as to any amount exceeding $6.35 million, as finally determined for federal tax purposes. The mother’s will provided that any amount disclaimed passed to charities. Both the Tax Court and the Eighth Circuit upheld the use of the DVC in the disclaimer, stating that such a clause doesn’t violate public policy, particularly when a charity stands to benefit from its use. The courts reasoned that when a DVC is used, there’s no condition subsequent in the transaction to raise the Procter public policy concerns.
In 2011, the Ninth Circuit added its opinion in Estate of Petter v. Comm’r,8 in which the validity of DVCs was extended to traditional gift-sale planning involving a defective grantor trust. The donor gifted to the trust an interest in a family limited liability company (LLC) with an FMV equal to the donor’s remaining gift tax exemption, and the trust then purchased $4 million worth of LLC interests. Any LLC interests transferred in excess of these amounts passed to charity. The Ninth Circuit found that the donor’s use of the DVCs didn’t present public policy concerns sufficient to invalidate the clause.
A Groundbreaking Decision
Wandry involved a far simpler transaction than the previous cases. The donors transferred interests in their family LLC directly to their four children and five grandchildren. There were no trusts or charities. In fact, Wandry involved what we call a “naked” DVC, meaning there was no residual beneficiary to take in the event of an IRS redetermination.
Under each donor’s gift, each child received an interest worth $261,000, and each grandchild received an interest worth $11,000. The language of the assignment is worth noting:
Although the number of [membership units] gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted [membership units], which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date. Furthermore, the value determined is subject to challenge by the [IRS]. I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted [membership units] is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted [membership units] shall be adjusted accordingly so that the value of the number of [membership units] gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.
Approximately a year and a half after the assignment, the donors’ appraiser issued his valuation. Their accountant then used the valuation to prepare a ledger for the LLC’s capital accounts and for the donors’ gift tax returns. The ledger showed an increase in the donees’ capital accounts and a decrease in the donors’ capital accounts.
The donors’ gift tax returns reported total gifts of $1.099 million for each donor and listed the dollar amounts transferred to each child and grandchild. A schedule attached to the gift tax returns, however, showed that each child received a 2.39 percent interest in the LLC and each grandchild received a .101 percent interest in the LLC. These percentages corresponded to the appraiser’s valuation.
The IRS disputed the valuation and the use of the DVC to transfer fixed dollar amounts worth of LLC interests. In Tax Court, the IRS asserted three arguments against the donors’ use of the DVC, including the historic public policy arguments.
First, based on Knight v. Comm’r,9 the IRS argued that, by the terms of the schedule attached to the donors’ gift tax return, they had transferred a fixed number of LLC interests rather than a fixed dollar amount. In Knight, the donors had filed a gift tax return reporting the transfer of a fixed dollar amount of partnership interests to their children. When challenged in Tax Court, however, the donors in Knight argued that they had transferred a number of partnership interests worth less than the fixed dollar amount. The Tax Court held that this argument opened the door for the IRS to argue that the interests were worth more than the fixed dollar amount.
In Wandry, however, the Tax Court found that the donors had done nothing to expose themselves to this argument. The gifts on the gift tax return itself were reported as fixed dollar amounts, notwithstanding the attached schedules reflecting specific LLC interests. The donors bolstered this conclusion with consistent testimony and evidence at trial demonstrating their intent to transfer a fixed dollar amount in the LLC.
Second, the IRS argued that the capital accounts maintained on the LLC books and records should control the gift tax treatment. This argument was based on case law holding that a gift of stock is complete when a change in ownership is reflected in a corporation’s books and records.10 Similarly, the IRS argued that a percentage change in the capital accounts of the LLC corresponded to a transfer of a percentage interest in the LLC. To hold otherwise would create an administrative burden in amending years of income tax returns. The Tax Court disagreed and ruled that the terms of the gift determine the effect on the capital accounts; the capital accounts don’t necessarily indicate the terms of the gift.
Third, the IRS argued that under Procter, the DVC was void against public policy. Accordingly, the donors should be treated as having transferred a fixed percentage interest in the LLC, not a fixed dollar amount. The Tax Court addressed King, as an appeal of its decision would lie in the Tenth Circuit, but found the facts to be distinguishable. As a price adjustment clause, the King clause required additional consideration, whereas the Wandry clause simply defined the fixed dollar amount being transferred.
The Tax Court further rejected the IRS’ argument that McCord and its progeny weren’t applicable on the basis that the Wandry clause didn’t include a charitable beneficiary. Reasoning that the cases approving of DVCs were based on the nature of the property rights transferred and not on whether a charity was involved, the Wandry court held there was no distinction between the Wandry clause and the McCord-type clauses including charities.
Wander from Wandry
The Wandry decision is driven by a fundamental understanding of the property rights transferred under a DVC and the recognition that those rights materially differ from the set of rights subject to a savings clause. The Tax Court acknowledged this by creating a road map in which it set forth the elements of a DVC. These elements are: (1) the donees under the clause are entitled to a predefined percentage interest expressed as a mathematical formula; (2) the value of the transferred entity is unknown at the time of the transfer, but that value is a constant; (3) before and after an IRS audit, the donee is entitled to the same percentage interest; and (4) an audit merely ensures that the donees receive the percentage interest to which they were always entitled.
So long as a particular DVC comports with the road map, the clause should fix the amount of the gift. Nonetheless, several facts from the case should be noted in evaluating how far from the facts of Wandry a DVC can vary without becoming a bad facts case and jeopardizing a clause’s validity.
The foremost question is whether Wandry is equally applicable to transactions involving a sale, rather than a gift. As Petter extended the reasoning of McCord, the reasoning in Wandry supports the validity of a DVC in a sale transaction. No conceptual difference exists between the use of a DVC in a gift versus a sale. Wandry should apply accordingly.
Planners would also do well to note the language used in the Wandry clause. The clause was clear in expressing that the transfer was of a fixed dollar amount worth of LLC interests, not of a fixed percentage interest. Interestingly, the clause also refers to adjustments for valuation “in the same manner as a federal estate tax formula marital deduction.” The reference to the marital deduction is unnecessary, but the Tax Court made clear that the concept is important. The clause should use the approved formula to transfer a percentage interest in the entity equal to the defined value divided by the FMV of the transferred entity. This formula ensures that there’s no condition subsequent because, by definition, the FMV controls the percentage transferred.
Another important element is uncertainty as to value. In Wandry, this uncertainty existed because the donors hadn’t yet obtained an appraisal of the LLC interests and because of the likelihood of an IRS redetermination. The latter seems implicit in almost any transaction of this nature. The former doesn’t appear to be essential, so long as some degree of uncertainty remains. Given the Tax Court’s analysis, it seems unlikely that the clause’s success would depend on when the appraisal is obtained.
But Don’t Get Lost
Make no mistake—Wandry is a huge taxpayer victory. Planners should be cautious, however, about becoming overly aggressive or imprudently lax in implementing DVCs. Some of the facts leave room for neglect. Other facts, though not detrimental to the donors, could be viewed less favorably by other judges and should be avoided in future planning.
Most significant was the donors’ inconsistency on their gift tax returns. Although they successfully avoided the Knight argument, any inconsistency presents a risk of opening the door to allow the IRS to argue that a fixed percentage, rather than a fixed dollar amount, was transferred. As such, any reference to the amount transferred should always be expressed as a dollar amount, rather than a percentage. The transaction may necessitate listing the property transferred on a schedule attached to a trust, in a restated operating agreement, or, as in Wandry, on a schedule attached to the gift tax return. From a practical standpoint, the interest may need to be expressed as a fixed percentage. Any time such a reference is made, it’s essential to highlight that the stated percentage is subject to the original terms of the gift, which should always be expressed as a fixed dollar amount, not a fixed percentage interest. Planners should state the formula whenever possible; otherwise, they should provide a thorough explanation in a footnote in the document. Fortunately for the donors in Wandry, they were able to provide enough evidence that the transfer was of a fixed dollar amount. Best practice dictates not having to put a client in that position.
The Wandry clause also stated that the donors intended to make a “good-faith determination” of the FMV. Although the case is silent on just how large of a discount the donors claimed, the IRS revaluation suggested a value that was 40 percent higher than the value reported on the gift tax return. These facts certainly favor the taxpayers, as Wandry apparently involved a large discount. If a donor retains a qualified appraiser who prepares a substantive written report, it would be difficult for the IRS to argue that the donor, in relying on such appraisal, didn’t act in good faith in implementing the clause. Conversely, we caution against unsubstantiated discounts. A DVC should never be used as a substitute for the opinion of a qualified appraiser. We doubt courts would be as sympathetic in such a case.
Administration of the entity while the transaction remains open to audit also presents some challenges. The IRS argued this issue with respect to the Wandry capital accounts. Because the percentage interest to which each donee is entitled can’t be determined until a final determination has been made or the statute of limitations has expired, the proper allocation of income from the entity may be unknown for several years. This may necessitate subsequent amendments to the parties’ income tax returns to adjust the allocations in accordance with revaluation. Although the IRS lost this argument, this issue, at the very least, presents an administrative burden.
The burden can be remedied easily. Rather than transferring outright ownership, as in Wandry, any transfer using a DVC should be made to a defective grantor trust. This way, the donors will report the income allocable to the transferred interests, negating any need to amend returns in the event of redetermination. If a donor genuinely wants to transfer outright ownership, the trusts can be terminated upon the expiration of the statute of limitations.
Our final caution is that Wandry is a Tax Court memorandum opinion. It didn’t receive en banc review, as in Christiansen. Although we’ve yet to see whether the IRS will appeal, we certainly don’t expect it to acquiesce. If the IRS does appeal, and the Tenth Circuit upholds the Tax Court decision, the debate would be settled. If, however, the highest authority not involving a charity remains a Tax Court memorandum decision, there may be enough uncertainty to encourage more conservative planning. Potential also exists for IRS regulation of DVCs in the future. Because the IRS has failed to win its battle in litigation, it may turn to its regulatory authority to try to constrain the use of these clauses.
A major consideration in deciding how aggressively to plan is whether to include a residual beneficiary, charitable or non-charitable or whether to regularly use a Wandry-type naked DVC. A conservative and charitably inclined client may prefer using a charitable residual beneficiary in light of the appellate-level authority on point. Other clients, who may be less conservative or not as charitably inclined, may prefer a non-charitable residual beneficiary, such as a marital trust or incomplete gift trust or a naked DVC.
Choosing between a non-charitable residual beneficiary and a naked DVC requires further thought. Although the use of a non-charitable residual beneficiary contains a common characteristic with McCord and its progeny, in that a third party is involved to provide additional incentives to fair valuation, we note that nowhere in the Wandry reasoning was this element essential. Moreover, there’s no authority approving of a DVC with a non-charitable residual beneficiary. Wandry, on the other hand, would serve as substantial authority for purposes of avoiding penalties when using a naked DVC. If forced to choose, we favor the naked DVC, given the direct authority on point and the simplicity of the transaction.
The client must also bear in mind that, regardless of whether the client chooses a non-charitable residual beneficiary or a naked DVC, if the clause isn’t respected, the client will owe gift tax. Even though the objective of the planning is to avoid unexpected gift tax, given the tax exclusive nature of the gift tax versus the estate tax, this may actually produce tax savings. The client should evaluate his ability and willingness to pay gift tax should the clause be disregarded. If the client lacks liquidity or otherwise abhors the idea of paying gift tax, then using a charitable residual beneficiary is the only certain approach, given the appellate-level authority.
As with many tax positions that involve risk, the prudent course of action is to explain the various techniques to the client, including the inverse relationship between complexity and risk with this planning. With proper advice, the client can select the technique that appropriately matches his preferences.
At the same time, planners should evaluate these issues on the basis that the legal reasoning in Wandry is solid. It’s based on the Ninth Circuit’s analysis in Petter, which the Tax Court meticulously applied in laying out its road map. None of those elements require the use of a charity or other residual beneficiary for the legal reasoning to remain valid. Instead, the Tax Court fundamentally recognized that the set of property rights transferred under a DVC materially differs from that under a savings clause. In the end, the best argument for relying on Wandry, even beyond the four corners of the opinion, is that it’s right.
1. Wandry v. Commissioner, T.C. Memo. 2012-88.
2. Comm’r v. Procter, 142 F.2d 824 (4th Cir. 1944).
3. See, e.g., Ward v. Comm’r, 87 T.C. 78 (1986); Harwood v. Comm’r, 82 T.C. 239 (1984); Estate of McLendon v. Comm’r, 66 T.C.M. (C.C.H.) 946 (1993), rev’d on other grounds, 135 F.3d 1017 (5th Cir. 1998); Revenue Ruling 86-41, 1986-1 C.B. 300.
4. King v. United States, 545 F.2d 700 (10th Cir. 1976).
5. See also Hendrix v. Comm’r, T.C. Memo. 2011-133.
6. McCord v. Comm’r, 461 F.3d 614 (5th Cir. 2006).
7. Estate of Christiansen v. Comm’r, 586 F.3d 1061 (8th Cir. 2009).
8. Estate of Petter v. Comm’r, 653 F.3d 1012 (9th Cir. 2011).
9. Knight v. Comm’r¸ 115 T.C. 506 (2000).
10. See Thomas v. Thomas, 197 P. 243 (Colo. 1921).