The year 2012 was truly noteworthy in the estate-planning profession. Of the many 2012 developments, cases addressing the efficacy of defined value clauses for federal gift tax purposes, what constitutes a present interest for purposes of the federal gift tax annual exclusion and whether the federal estate tax marital deduction is allowable with respect to transfers to same-sex surviving spouses are without doubt among the most interesting and important.
Defined Value Clauses
In Wandry v. Commissioner,1 Joanne M. and Albert D. Wandry made gifts of units in a limited liability company (LLC) to their children and grandchildren. The documents by which the gifts were implemented stated that a transfer was being made to each donee of a number of units so that the total fair market value of such units for federal gift tax purposes would be $261,000 per child and $11,000 per grandchild. The documents described, in detail, the process by which a third-party professional would appraise the value of the gifted units and how the number of gifted units to each donee would be adjusted in the event of a subsequent challenge by the Internal Revenue Service. The documents even went so far as to analogize the adjustment of the number of gifted units in the event of a gift tax return audit to how the amount of assets passing under a marital deduction formula is adjusted when asset values are re-determined by the IRS or a court.
Contrary to the position asserted by the IRS, the Tax Court concluded that the literal language in the gift documents was determinative and that the donors, pursuant to such language, gave their children and grandchildren gifts having a stated dollar amount that was to be satisfied by LLC interests measured in terms of a number of units. The IRS had urged that the value definition provisions in the gift documents were unenforceable and violated public policy because they couldn’t operate with assured accuracy in the absence of an IRS audit and that such an audit would change what the donees were entitled to receive. Judge Harry Allen Haines’ response was that the gift documents prescribed clearly, unambiguously and precisely what the donees were entitled to receive; the audit just ensured the result.
Significantly, the court stated that the absence of a charitable spillover provision didn’t render the formula clauses invalid because, although the formula reallocated units among the donors and the donees, the reallocation didn’t alter the transfers. The donors couldn’t “take property back.” The formulas mandated what the donees were entitled to receive in the first instance.
The IRS filed a Notice of Appeal to the U.S. Court of Appeals for the 10th Circuit on Aug. 28, 2012, but dropped the appeal on Oct. 16, 2012. On Nov. 13, 2012, the IRS issued an action on decision indicating its nonacquiescence.2 (For additional discussion of Wandry, see “An Election Year Race—For Taxpayers,” Radd L. Riebe, in this issue, p. 32.)
Annual Exclusion Gifts
In Wimmer v. Comm’r,3 George and Ilse Wimmer, as trustees of their respective revocable trusts, formed the George H. Wimmer Family Partnership, L.P., a limited partnership under California law. The partnership was funded with and always held publicly traded stock and cash. A partnership agreement amendment later changed the governing law from California to Georgia. George and Ilse were the initial general partners and limited partners. The partnership agreement severely restricted most transfers of partnership interests (permitting such transfers only with the consents of the general partners and at least 70 percent of the limited partners) and limited the circumstances in which a transferee could become a substituted limited partner. Transfers were permitted, without restrictions, only to incumbent partners or any related party. Incumbent partners and related parties could become substituted partners without the consent of existing partners.
On several occasions from 1996 through 2000, the Wimmers made gifts of partnership interests to related parties, including their children, their grandchildren and a trust for the benefit of their grandchildren. The governing instrument of the trust contained valid and effective Crummey withdrawal right provisions.
In 1996, 1997 and 1998, the partnership made distributions to the partners to enable them to pay federal income tax on income attributed to them from the partnership. Beginning in 1999, the partnership made regular distributions of all net partnership income, and the partners were able to make withdrawals from their capital accounts.
The Tax Court held that the partnership interest gifts qualified for the federal gift tax annual exclusion because the gifts, at the times they were completed, conferred substantial present economic interests on the donees. The court reached this conclusion notwithstanding its finding that the donees hadn’t received unrestricted and non-contingent rights to immediate use, possession or enjoyment of the gifted limited partnership interests themselves. The court focused on whether the donees had received such rights in the income and noted that, if they had received such rights, the gifts would be considered present interest gifts under Internal Revenue Code Section 2503(b).
With respect to the donees’ rights in partnership income, the court stated that the taxpayer would have to prove, based on surrounding circumstances, that: (1) the partnership would generate income; (2) some portion of that income would flow steadily to the donees; and (3) that portion of income could be readily ascertained. The court concluded that each of these tests was satisfied on each date a gift of a partnership interest was made. First, the partnership held publicly traded, dividend-producing securities. Second, the fiduciary duties owed by the general partners under the partnership agreement, as well as under California and Georgia laws, ensured that some portion of partnership income would flow steadily to the donees. The court believed the general partners, to fulfill such fiduciary duties, had no legal choice but to distribute to the trust for the grandchildren an amount sufficient to enable the trust to satisfy its federal income tax liabilities because the trust had no assets other than its limited partner interests. Because the partnership agreement required all distributions to be pro rata among all partners, any distribution to the trust triggered proportionate distributions to the other partners (including, but not limited to, all donees). Third, the portion of income the donees could expect to receive each year could easily be estimated by reference to the dividend-paying history of the stocks held in the partnership and each donee’s percentage interest in the partnership.
Marital Deduction for Same-Sex Couples
In Windsor v. United States,4 Edith Windsor married Thea Clara Spyer in Canada. Edith and Thea changed their residency to New York. Thea died as a resident of New York in 2009. Edith served as personal representative of Thea’s estate. Edith, as personal representative, filed a federal estate tax return and claimed a marital deduction. The IRS denied the marital deduction because Edith and Thea’s union didn’t meet the definition of “marriage” in Section 3 of the Defense of Marriage Act (DOMA).5
Edith, as personal representative, asserted a claim against the United States for a refund in the amount of $363,053 (the amount of federal estate tax paid as a result of disallowance of the marital deduction). Edith argued that Section 3 of DOMA violated the equal protection clause under the Fifth Amendment to the Constitution. On Feb. 23, 2011, after the suit was filed, the Department of Justice declined to defend DOMA. However, the Bipartisan Legal Advisory Group of the U.S. House of Representatives (BLAG) retained counsel and took primary responsibility for defending DOMA in this and other cases.
The U.S. District Court for the Southern District of New York granted summary judgment in favor of Edith, as personal representative, ruling that Section 3 of DOMA was unconstitutional.6 BLAG appealed to the U. S. Court of Appeals for the Second Circuit.
The Second Circuit, after disposing of a technical question of standing and determining that Baker v. Nelson,7 409 U.S. 810 (1971) didn’t require Section 3 of DOMA to be upheld, concluded that Section 3 should be subject to “intermediate scrutiny” (rather than the “rational basis” test) in determining whether it was constitutional. Under intermediate scrutiny, legislation must be found to be “substantially related to an important government interest” if it’s to survive equal protection clause analysis. The court observed that “substantially related” means that the explanation for the legislation must be “exceedingly persuasive.”
In addressing BLAG’s arguments, the Court of Appeals opined that there’s no need for a consistent definition of marriage because Congress has typically left all issues dealing with marriage to the states. The court found that, although protecting the public fisc is always an important government objective, Section 3 of DOMA is too broad to be “substantially related to fiscal matters.” The Second Circuit further found that Congress’ desire to preserve a traditional understanding of marriage is insufficient under intermediate scrutiny and that Section 3 of DOMA doesn’t achieve this goal, because it leaves many other issues involving marriage to the states. Finally, the Second Circuit found that encouraging responsible procreation is an important government objective but that Section 3 of DOMA wasn’t substantially related to that objective because it doesn’t encourage opposite sex couples to engage in responsible procreation.
The court, therefore, found that Section 3 of DOMA violates the equal protection clause. The marital deduction in Thea’s estate was thus allowed.
On Dec. 7, 2012, the U.S. Supreme Court agreed to review the Second Circuit’s decision.
Wandry, Wimmer and Windsor each, in its own way, is groundbreaking and has the potential to have pervasive impact on how we advise clients and design estate plans. Wandry sets a new standard for drafting defined value clauses, a very powerful estate-planning tool. Unlike all previous cases in which such clauses have been validated,8 Wandry shows how to achieve success without a charitable spillover provision. Wimmer breaks a string of IRS victories9 in which the gift tax annual exclusion wasn’t allowed for gifts of restricted interests in entities. Wimmer may provide a roadmap for the future design of entities when annual exclusion gifts of equity in such entities are anticipated. Windsor is the first federal appellate court decision holding Section 3 of DOMA unconstitutional and will likely be examined very carefully by the Supreme Court of the United States.
1. Wandry v. Commissioner, T.C. Memo. 2012-88 (March 26, 2012).
2. AOD 2012-04, 2012-46 I.R.B. (Nov. 13, 2012).
3. Wimmer v. Comm’r, T.C. Memo. 2012-157 (June 4, 2012).
4. Windsor v. United States, 2012 U.S. App. LEXIS 21785 (Oct. 18, 2012).
5. Defense of Marriage Act, 1 U.S.C. Section 7.
6. Windsor v. U.S., 833 F. Supp.2d 394 (S.D.N.Y. June 6, 2012).
7. Baker v. Nelson, 409 U.S. 810 (1971).
8. Estate of Petter v. Comm’r, T.C. Memo. 2009-280, aff’d, 2001-2 U.S.T.C par. 60,623 (9th Cir. 2011); Hendrix v. Comm’r, T.C. Memo. 2011-133; Estate of Christiansen v. Comm’r, 130 T.C. 1 (2008), aff’d, 586 F.3d 1061 (8th Cir. 2009); Succession of McCord v. Comm’r, 120 T.C. 358 (2003), aff’d, 461 F.3d 614 (5th Cir. 2006).
9. Price v. Comm’r, T.C. Memo. 2010-2; Fisher v. U.S., 105 A.F.T.R.2d 2010-1347 (S.D. Ind. 2010); Hackl v. Comm’r, 118 T.C. 279 (2002), aff’d, 335 F.3d 664 (7th Cir. 2003).