After a 2006 opinion from the U.S. Court of Appeals for the Fifth Circuit in McCord v. Commissioner,1 many practitioners expanded their use of defined value clauses for certain transfer tax planning strategies. But many lawyers remained reluctant to implement the technique without further assurance. Although McCord offered positive precedent, particularly in the Fifth Circuit's jurisdiction, the cautious noted that the decision did not address head-on the Internal Revenue Service's public policy arguments lurking in the Fourth Circuit's 1944 opinion in Comm'r v. Procter.2 Fears persisted that, outside the Fifth Circuit, adverse precedent from Procter and its progeny regarding transfer tax savings clauses might be applied to hold defined value clauses void against public policy.
When the Tax Court decided Estate of Christiansen3 in 2008 and rejected these public policy arguments, many practitioners found an additional level of comfort. And recently, the Eighth Circuit affirmed the Tax Court's decision,4 denying the IRS commissioner's appeal against defined value clauses. Better yet, the Tax Court has reinforced the same in Estate of Petter v. Comm'r with respect to a gift-sale transaction with an intentionally defective grantor trust (IDGT).5
So, now, it seems that permissible planning techniques using defined value clauses are finally becoming better defined.
Different From Savings Clauses
Current techniques using defined value clauses have grown out of previous and less successful attempts to use savings clauses. Generally speaking, defined value clauses and savings clauses are used in connection with estate, gift and generation-skipping transfer (GST) tax transactions.
The use of such clauses is intended to provide donors with efficient use of transfer tax credits and exemptions and with certainty regarding the extent of transfer tax liability resulting from a transaction.
In theory, a defined value clause or savings clause would be particularly useful when transferring assets that are difficult to value, such as interests in family limited partnerships (FLPs) and closely held corporations. In practice, any possible benefits from using savings clauses have been nullified by adverse case law.
Thus, if defined value clauses are to have any viability, it is necessary to distinguish between them and savings clauses. The importance of the recent Christiansen and Petter decisions lies in such distinction.
A savings clause is designed to negate the imposition of transfer tax liability by removing a power or changing a provision that is expressly granted in the instrument. It therefore overrides the other express power or provision. As evident in case law and IRS rulings,6 savings clauses traditionally came in one of two forms. Either the savings clause would revoke a portion of the transfer in the event adverse transfer tax results arose, or it would require the transferee to tender consideration to offset any adverse transfer tax result. For example, if a donor were transferring stock in a closely held corporation estimated to be worth X dollars and the stock was finally determined to be worth X plus Y dollars, the savings clause would require the donee to return Y dollars worth of the stock to the donor or to pay the donor Y dollars as consideration.
In contrast, a defined value clause seeks to define, by reference to a specific dollar amount or formula, the amount being transferred — either by gift or by sale. Rather than transferring a particular asset, percentage interest or number of shares, as the case may be, the defined value clause designates the value of the interest transferred. Translating that value into ownership of specific property typically occurs in the aftermath of the initial defined value transaction.
Thus, a defined value clause differs from a savings clause in some important respects. Unlike a savings clause, a defined value clause does not impose a condition subsequent resulting in a reversion of property to the donor or the payment of additional consideration by the donee. Instead, the clause defines the amount transferred by a fixed dollar amount or formula. It may address excess valuation as finally determined for federal transfer tax purposes by including a nominal fraction of any excess as part of the gift itself or by allocating the excess to one or more additional donees.
Demise of Savings Clauses
Procter was the first major case to invalidate the use of a savings clause. The donor transferred his remainder interest in two trusts in further trust for the benefit of his children. The terms of the transfer provided that if a court of competent jurisdiction found that any part of the transfer was subject to gift tax, such part would be deemed not to have been transferred.
In upholding the IRS' assessment of gift tax, the Fourth Circuit found that the savings clause was void as a condition subsequent and contrary to public policy. Its three public policy concerns became the baseline for future decisions. Namely, the court reasoned that savings clauses are void against public policy because they:
- discourage the collection of tax by negating the tax assessment upon triggering the clause;
- result in court decisions becoming moot upon entering a judgment; and
- render a judgment self-defeating and undermine the court's authority.
At first, it wasn't clear that Procter would become prevailing law. In King v. United States,7 the Tenth Circuit upheld the application of a savings clause in a sale between the taxpayer and trusts he had settled for the benefit of his children. The sales agreement provided for an adjustment to the purchase price, and thus the payment of additional consideration, in the event that the IRS revalued the shares. Although the commissioner argued for the application of Procter, the court distinguished the facts in King. As a factual finding, the transaction had occurred in the ordinary course of business at arm's length. Thus, the Tenth Circuit held that the transfer was for full and adequate consideration and the savings clause was not void.
Ultimately, though, it was Procter, not King, that the Tax Court followed, and King became the exception rather than the rule. In Ward v. Comm'r,8 the Tax Court rejected a savings clause that resulted in a reversion to the donor. In Harwood v. Comm'r9 and Estate of McLendon v. Comm'r,10 it rejected savings clauses that required consideration to be paid to the donor upon revaluation. Revenue Ruling 86-4111 drove home the point, concluding that savings clauses, whether resulting in a reversion to the donor or requiring payment of consideration by the donee, were invalid on public policy grounds. The IRS refused to acknowledge such clauses, reasoning that savings clauses discourage effective tax enforcement by triggering conditions subsequent, thereby rendering examination fruitless.
Defined Value Clauses Evolve
What Procter and its progeny made clear was that if donors were to achieve the objectives of a savings clause — efficient use of transfer tax credits and exemptions and certainty of tax liability when transferring hard-to-value assets — an alternative planning technique would be required. In theory, a defined value clause could achieve this objective. Because a defined value clause does not trigger a condition subsequent, the clause does not function to “undo” the transaction. It merely seeks to define or allocate value passing among donees in a manner consistent with the donor's specified intent. Thus, courts issuing decisions with respect to defined value clauses ought not view such decisions as self-defeating; if the defined value clause is fixed to finally determined values, such decisions would determine the parties' substantive rights.
Of course, potential for abuse could still lurk in the use of such a clause. But as the case law has established, ensuring competing interests in structuring a defined value transaction reduces such risk.
As the use of defined value clauses evolved following the demise of savings clauses, the IRS appeared, at least initially, to be receptive to them. Although its 1986 private letter ruling12 provided little in the way of meaningful substance, the PLR did conclude that a defined value transfer of partnership interests was valid, so long as the value transferred was equal to the valued defined. But in 2001, 2002 and 2003,13 the IRS changed directions and issued three pronouncements against defined value clauses. It held that a defined value clause using finally determined values was no different from the savings clauses in Procter and Ward and that it would make no distinction between the use of savings and defined value clauses.
In the face of the adverse authority regarding savings clauses and the IRS' hard line, the first true test for defined value clauses came in McCord, in which the donors used a defined value clause to transfer interests in their family partnership. Using an assignment agreement, the donors transferred their entire interest in the partnership to four irrevocable trusts, their four sons, and two charitable organizations. Under the assignment agreement, the trusts were to receive an interest in the partnership equal in value to the donors' remaining GST exemption. The sons were given an interest in the partnership equal to $6.9 million less the amount given to the trusts, and one of the charities was entitled to a $134,000 interest in the partnership. Any interest in the partnership in excess of these amounts was to pass to the second charity. All the donees were independently represented and had the right to retain their own appraisers.
Subsequent to the assignment agreement, the donees determined the value of the partnership and computed their respective percentage interests. The trusts and the sons then reacquired the partnership interests passing to the charities. The IRS revalued the partnership, and, disregarding the application of the defined value clause, assessed a $2 million gift tax deficiency against the donors.
Although the Tax Court held that the defined value clause was invalid, the Fifth Circuit upheld the donors' use of the clause. The defined value clause determined the amount that the donors transferred to each of the donees, so the donors' gift tax liability was fixed on the date of the assignment agreement. According to the Fifth Circuit, the post-gift allocation of the interests among the donees could not be taken into consideration in valuing the gifts.
McCord provided positive precedent for the use of defined value clauses, but it left open the critical question regarding whether such clauses were susceptible to the same public policy attacks that led to the demise of savings clauses. Because the Fifth Circuit did not address the Procter arguments, uncertainty remained. The commissioner had advanced these arguments in Tax Court, but apparently decided against arguing them on appeal. Some wondered whether the commissioner chose to reserve these arguments for testing in a jurisdiction perceived to be less taxpayer-friendly than the Fifth Circuit. That test came in Christiansen.
Defined Value Clauses Prevail
At issue in Christiansen was a qualified disclaimer executed through a defined value clause. The decedent's only child and executrix of the estate, disclaimed her interest in the estate as to any amount exceeding $6.35 million, as finally determined for federal tax purposes. The decedent's will provided that of any amounts disclaimed, 25 percent was to pass to a charitable foundation, of which the daughter was a board member, and the other 75 percent was to pass to a charitable lead annuity trust (CLAT), of which the daughter was a trustee. The decedent's estate tax return reported a gross estate valued at just over $6.5 million. In light of the daughter's disclaimer, this left about $150,000 to be split among the charitable foundation and the CLAT. The bulk of the decedent's estate consisted of FLP interests for which the estate claimed a 35 percent “minority interest” discount. On audit, the IRS took issue with the discount, and the parties settled on revaluation of the gross estate at about $9.5 million.
Of course, revaluation necessitated a reallocation under the defined value clause. Application of the clause meant that the additional $3 million in value would pass to the charitable foundation and the CLAT. The estate argued for a charitable deduction for such amounts. Although the Tax Court found the disclaimer with respect to the CLAT invalid on technical grounds, it considered the effectiveness of the defined value clause as to the amount passing directly to the charitable foundation.
Unlike McCord, this time the commissioner did invoke Procter, asserting that the clause effected a condition subsequent and was void against public policy. Tax Court Judge Holmes' opinion emphasized that the transfer was complete as of the decedent's date of death, as the qualified disclaimer related back to such date, and it was simply the value of such completed transfer that needed to be determined. Thus, there was no condition subsequent.
As to the public policy arguments, the commissioner relied strongly on the proposition that such clauses would discourage audit of estate returns because any deficiency in estate tax would simply be offset by an additional charitable deduction. The Tax Court disagreed. It recognized that public policy arguments do have a place in the construction of tax law. But the court cautioned the commissioner against relying too heavily on such a doctrine. Invocation of public policy is appropriate when the threat posed is severe and immediate. Not only did the court conclude that no such public policy concern existed, but also it noted that the effect of the defined value clause was actually to promote an important public policy: tax deductions for charitable giving. The court was unequivocal about the distinction between savings clauses and the defined value clause at issue. The disclaimer did not “undo” a transfer; it merely reallocated the value of the transferred property among the named beneficiaries.
The Tax Court's opinion provided practitioners with stronger support for moving ahead with defined value planning. But appellate-level precedent was still lacking.
In November of 2009, the Eighth Circuit finally issued the precedent many had been waiting for. Although the appellate opinion in Christiansen made no express reference to Procter, it rebuffed the public policy argument just as strongly as the Tax Court had.
Again, the commissioner argued that upholding such a clause would provide no possibility of increased tax revenue as there would be no incentive to audit the return to ensure accurate valuation. As such, the Eighth Circuit confronted the issue of whether defined value clauses, at least when used as a disclaimer, should be void per se. The court conceded that the use of such clauses may “marginally” detract from the incentives to audit. But it declined to recognize an obligation to construe the tax law in a manner that maximizes the incentive to audit.
To the contrary, three prevailing reasons weighed against the commissioner.
First, the IRS' job is not to maximize revenue, but is instead to supervise and enforce the tax law. This role is expressly described in the Internal Revenue Code.14 Second, no clear congressional intent suggests that the tax law must be interpreted in a manner that maximizes audit incentives. In fact, so far as the facts in Christiansen were concerned, a much stronger and more clearly articulated intent to promote charitable giving favored upholding the clause. Third, and most damaging to the continuing viability of the commissioner's public policy arguments, the Eighth Circuit reasoned that incentives to accurately value the transferred assets existed even in the absence of the commissioner's audit of the tax return. Notably, competing fiduciary duties provide a non-judicial mechanism to ensure against mis-valuation. Even though the decedent's daughter served in multiple roles, as primary beneficiary, as executrix, as trustee of the CLAT and as a board member of the foundation, her discretion within these roles was conditioned by the fiduciary duties she owed in each. State and federal law would impose material liability for any misdealing she might have committed in such capacities. Thus, forces beyond the threat of IRS audit encouraged proper valuation of the estate. Moreover, when charitable entities are involved, oversight by the state attorney general and the commissioner's power to revoke tax-exempt status ensure that the charitable interests are properly protected against self-dealing. For these reasons, the Eighth Circuit rejected the commissioner's public policy arguments as a matter of law.
The Eighth Circuit opinion should provide practitioners with greater confidence in using defined value clauses, particularly in light of its broad language. But recognize that Christiansen involved a qualified disclaimer; what was still missing in its aftermath was precedent directly addressing defined value clauses in the context of a gift-sale transaction. Fortunately, just three weeks after the Eighth Circuit decided Christiansen, the Tax Court weighed in with its opinion in Petter.
Petter takes the Christiansen holding one step further and applies it in traditional gift-sale planning with IDGTs.
In Petter, the donor formed the Petter Family Limited Liability Company (PFLLC) to hold stock that she had inherited from her uncle and settled two IDGTs for the gift-sale transaction. As the first step, the donor seeded each IDGT with an initial gift. The gift transaction transferred a specified number of membership units in PFLLC to each IDGT and to a charitable organization as transferees under the same gift document. Each IDGT was to receive a number of membership units equal to one-half of the donor's remaining gift tax unified credit, and each charity was to receive the transferred membership units exceeding this value.
As the second step, the donor assigned a specified number of membership units in PFLLC to each IDGT by sale and to each charity by gift. Each trust purchased units worth about $4 million, and any amount of the assigned units above $4 million passed to the charity. Under both the gift document and the sale document, the value of the PFLLC units was set to equal the value as finally determined for federal gift tax purposes. The charities retained outside counsel to advise on the transaction.
Following the execution of the gift and sale documents, the parties determined an allocation of the membership units based upon a formal appraisal. On audit, the IRS determined a substantially higher valuation of the membership units. It asserted that the membership units allocated to the IDGTs were transferred for less than full and adequate consideration and assessed about $4.3 million in gift tax against the donor. It also denied the donor a charitable deduction for the increased value of the units allocated to the charities under the clause.
Citing the Eighth Circuit's opinion in Christiansen, the Tax Court held against the commissioner. The donor had demonstrated that the charities' interests were properly represented, as independent counsel had argued for changes in the transaction documents and helped established a bona fide arm's length deal. Moreover, the charities were admitted as substituted members, not merely assignees, in PFLLC, ensuring that the managers owed them fiduciary duties.
The court echoed the Eighth Circuit's sentiments on the commissioner's right to revoke tax-exempt status of the charities and the duty of the attorney general to enforce laws against breach of fiduciary duty in the event of self-dealing. Also of note was the use of formula clauses in other transfer tax areas such as charitable remainder annuity trusts, grantor retained annuity trusts (GRATs), marital deduction transfers, GST tax allocations, and qualified disclaimers.
Based on these reasons, the Tax Court held that no severe or immediate threat necessitated the application of the commissioner's public policy arguments. In a notable taxpayer victory, it upheld the use of the defined value clause and permitted the donor a charitable deduction for the excess amounts passing to the charities, effective as of the original date of the gift-sale transaction.
Define the Future
Christiansen and Petter serve as highly positive precedent for practitioners wishing to advise clients to implement a defined value clause. Particularly in the context of gift-sale planning with difficult-to-value assets, such as interests in FLPs, defined value clauses can provide an important backstop to a well-supported appraisal. Several key points can be gleaned from the case law that should be kept in mind when relying on such strategies.
Competing independent fiduciaries on opposite sides of the transaction increase the bona fide nature of the clause. For this reason a defined value clause that allocates value among several donees is generally superior to one that merely defines the value with nothing more. In the later case, it may be harder to demonstrate bona fide negotiations about valuation of the transferred property. Moreover, by failing to address the treatment of any excess value resulting from finally determined valuation, such a clause may place value back in the hands of the donor, making it appear more like a savings clause. Including a nominal fraction of any excess as part of the gift itself may mitigate this consequence.15
What Christiansen and Petter demonstrate is that when more than just the donor and a single donee are involved, there's an added element of arm's length negotiation. For this reason, a clause that allocates among several donees generally provides a superior planning technique, as such donees will have opposing interests in determining the value of the transferred property.
When consistent with the donor's objectives, it is best to include a charity as a donee under the clause. Not only does this add another party to the transaction to negotiate valuation, it also adds protection against the Procter public policy arguments. The presence of a charity in the transaction gives the IRS power over valuation via its ability to revoke tax-exempt status, and the state attorney general also has the ability to check self-dealing. Furthermore, the presence of a charity allows the donor to flip the public policy argument in its favor, as excess value inures to the benefit of a charity, consistent with express congressional intent favoring charitable donations. Of course, a straight-faced argument requires more than a nominal contribution.
Though some contribution to charity is preferable, a charity need not be the only residuary donee. Similar to the clause in Christiansen, an allocation of excess value can be made among several donees. Other possible donees could include GRATs, inter vivos qualified terminable interest trusts, or a series of trusts structured as complete and incomplete gift trusts. In any event, it's best that the grantor's powers over such trusts be as limited as possible, and the appointment of an independent trustee is highly recommended.
But Be Careful
Finally, a precaution: although Christiansen and Petter provide taxpayer-friendly precedent, it's important that practitioners not get overly aggressive in this area. For starters, Petter is a Tax Court memorandum decision, and outside the Fifth and Eighth Circuits, no appellate-level precedent applies. Appeal on Petter, if the commissioner so chooses, will lie in the Ninth Circuit, so the final chapter for defined value clauses might not yet be written.
More importantly, a defined value clause is a safety net against subsequent revaluation. It is not a substitute for a thorough, reasonable and well-supported valuation from an independent appraiser. Abuse in this area could very well result in some of the possible checks against valuation becoming realities — namely, the revocation of tax-exempt status or state action against misgiving fiduciaries. In which case, taxpayers may once again find themselves on the losing side of a public policy argument.
Scott A. Bowman is an attorney in Proskauer Rose LLP's Personal Planning Department and practices in the firm's Boca Raton, Fla. office
- McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006).
- Comm'r v. Procter, 142 F.2d 824 (4th Cir. 1944).
- Estate of Christiansen v. Comm'r, 130 T.C. 1 (2008).
- Estate of Christiansen v. Comm'r, 104 A.F.T.R.2d (R.I.A.) 7352, ____ F.3d ____ (8th Cir. 2009).
- Estate of Petter v. Comm'r, T.C. Memo 2009-280.
- See, for example, Procter, supra note 2; Ward v. Comm'r, 87 T.C. 78 (1986); Harwood v. Comm'r, 82 T.C. 239 (1984); Estate of McLendon, 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.
- King v. United States, 545 F.2d 700 (10th Cir. 1976)
- Ward, supra note 6.
- Harwood, supra note 6.
- Supra note 6.
- Rev. Rul. 86-41, supra note 6.
- Private Letter Ruling 8611004 (Nov. 15, 1985).
- See Field Service Advice 200122011 (June 4, 2001); Technical Advice Memorandum 200245053 (Nov. 8, 2002); TAM 200337012 (Sept. 12, 2003).
- See Internal Revenue Code Section 7801(a)(1).
- See Carlyn McCaffrey, “Tax Tuning the Estate Plan by Formula,” 33 Heckerling Institute on Estate Planning, para. 402.4 (1999).