Since 2006, taxpayers have won three significant victories related to valuation clauses. Numerous articles have been written on McCord,1Christiansen2 and Petter,3 explaining both the legal underpinnings of those decisions and touting the advantages provided by valuation clauses when transferring hard-to-value assets.4 There's no denying that the estate planning community is steadily adopting valuation clauses, a trend only likely to accelerate in the coming years. With that in mind, it's time to think about the consequences that taxpayers will have to face when a valuation clause is actually implemented. That is to say, what happens when we get the value wrong and adjustments need to be made? Unfortunately, the answers aren't always clear.

What's a Valuation Clause?

Valuation clauses take several forms, but all attempt to mitigate the consequences of an inaccurate valuation. Imagine that John Jones wants to give $6 million worth of property to the Jones Family Trust (JFT), an intentionally defective grantor trust (IDGT), and he wants to give some other property to charity. If he wanted to give General Electric (GE) stock, it would be a simple matter because GE is a publicly traded company and readily valued. If John wants to give non-voting interests in a limited liability company (LLC) that owns $10 million of marketable securities, however, it's a more difficult exercise. If we hired three appraisers to determine what percentage of the non-voting LLC interests were worth $6 million, we would almost certainly end up with three different numbers. A non-voting interest in an LLC is a so-called “hard-to-value” asset and is therefore … well … hard to value. Honest people disagree. The solution is a valuation clause.

A valuation clause is used to allocate a fixed amount of property among a class of recipients in which the value may be adjusted at some point in the future. We know John is going to give away all of his non-voting interests; what we aren't certain about is who will end up owning those interests.

If Discount is Later Rejected

For our purposes, imagine that in June 2010, John agrees to sell $6 million of LLC interests to the JFT and donate the remaining LLC interests to charity. Based on an appraisal that indicates a 35 percent aggregate discount for lack of control and lack of marketability, John sells 92.31 percent of the LLC to the JFT and gifts 7.69 percent to charity. The deed of gift states that if there's a final determination of the value of the LLC interests for gift or estate tax purposes that differs from the appraisal, the JFT and the charity will exchange interests as necessary and make all other appropriate adjustments.

Let's further assume that in April 2011, John files a gift tax return disclosing the transaction. In June 2012, an audit begins and John is unable to reach a satisfactory accord with the auditor or at the appeals level. Ultimately his case goes to Tax Court. In August 2013, the Tax Court finds that the appraiser John used wasn't sufficiently rigorous in his methodology and rejects the 35 percent aggregate discount. The Tax Court also “scolds” the appraiser the Internal Revenue Service used and finds his 15 percent discount to be inaccurate. Instead, the Tax Court makes an independent determination of what the LLC interests were really worth, resulting in a 25 percent aggregate discount. Consistent with recent precedent, however, the Tax Court upholds the validity of the valuation clause. Neither side seeks an appeal. What are the consequences?

Gift Tax

One thing we seem to know is that John won't owe any gift tax. Since the Tax Court respected the valuation clause, the transaction will be treated as though additional interest in the LLC had been transferred to the charity, resulting in a charitable gift tax deduction and no gift tax payment. This is true, however, only if the parties respect the valuation clause themselves.5 If the correcting distributions discussed below aren't properly and timely implemented, the IRS would have another way of attacking the valuation clause.

Moving the Money

The terms of the valuation clause require ownership of the LLC to be re-allocated retroactively to June 2010 based on the finally determined value of LLC interests. With the 25 percent discount finally determined in August 2013, it turns out the transfer in June 2010 really resulted in the JFT owning only 80 percent of the LLC, not 92 percent, and the charity owning 20 percent, not the 8 percent figure calculated based on the original appraisal. Documenting the transfer of the additional LLC interest from the JFT to the charity is fairly simple. Indeed, it can probably be accomplished through a resolution of the LLC manager confirming current and historic ownership. Far more complicated is how to correct for the income distributed over the last three years.

Assume that the LLC earned exactly 5 percent a year and distributed 5 percent every June 1. That means over three years, $1.5 million would have been paid out and the JFT received $1.38 million of that distribution. As it turns out, the JFT should have only received $1.2 million so it needs to correct for the $180,000 that should have gone to the charity. Is it sufficient for the trust to simply pay that amount to the charity in 2013? How do we account for the lost opportunity to the charity to reinvest those funds? Should the trust pay interest on the distributions it improperly received and if so at what rate? The regulations governing charitable remainder trusts don't require the payment of interest on an errant payment,6 but there's no guidance as to whether a valuation clause adjustment will be treated in a similar fashion.

If the trust doesn't have the cash to make the charity whole, can it satisfy its debt to the charity using LLC interests, and doesn't that just raise the same uncertain valuation issue again? A court-determined 25 percent discount for a transfer in June 2010 doesn't mean the same discount would apply in August 2013.

Income Tax

There doesn't appear to be an affirmative duty to amend an income tax return that was filed in good faith even if the taxpayer subsequently learns of an error on the return.7 In this case, John will want to file amended income tax returns for all open years and encourage all other effected taxpayers to file amended returns to demonstrate that he's respecting the valuation clause. In addition, a higher-than-normal audit risk seems to exist for past returns since the IRS knows the ownership of the LLC wasn't reported accurately in prior years. What's more, John should be entitled to a larger income tax charitable deduction and a corresponding refund since more LLC interest went to charity than previously thought.

Ideally, amended 1065s should be prepared for the LLC showing the change in ownership and providing new K-1s to the JFT (really John, because this is a grantor trust) and the charity. Of course, John is no longer a member of the LLC and he can't compel the filing of the amended 1065s. If he files an amended return that's inconsistent with the K-1 issued by the LLC, he may also need to file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request.

In our example, tax returns have only been filed for 2010, 2011 and 2012, so it's still possible for John to file amended returns for all relevant years. This won't always be the case, of course. Typically, a taxpayer must file an amended income tax return within three years of the original filing to claim a refund.8 For cases that take too long to reach finality, this opportunity will be lost. McCord wasn't fully resolved until 10 years after the transfer, Christiansen went unresolved for eight years and Petter is still on appeal after eight years. Our example, therefore, appears a bit optimistic with regard to timing.

There also may be income tax consequences for the charity. Public charities are fully exempt from income tax, so shifting taxable income to them won't require them to make any additional payments, although a revised Form 990 is advisable for accuracy. Private foundations (PFs) generally pay a 2 percent excise tax based on their income, which can be reduced to 1 percent in certain circumstances, so a revised Form 990PF will be needed.9 Both public charities and PFs pay tax at corporate rates on unrelated business taxable income (UBTI), including debt-financed income from margin trading.10 If the LLC generated UBTI, the charity would need to file Form 990-T and pay the associated tax plus interest, and perhaps even a penalty for failing to pay on time.

A charitable lead annuity trust (CLAT) creates at least two possibilities. If the CLAT was established as a grantor trust, then the income shifting has no impact for income tax purposes. This is true because assets would be shifting from the JFT, itself a grantor trust, to the CLAT, another grantor trust. No matter which trust is reporting the income, it will all end up on John's tax return in the end.11 This would also be the case if an improper valuation resulted in assets being transferred to a grantor retained annuity trust (GRAT) or an inter vivos qualified terminable interest property (QTIP) trust, as both would be taxed as grantor trusts.12

If, on the other hand, the CLAT is a non-grantor trust, the income tax results will be quite different. The CLAT itself will report substantially more income, in our example nearly three times as much income, and will owe the tax, interest and penalties for the understatement of income and corresponding failure to pay the tax. A non-grantor CLAT is entitled to an income tax deduction for the amount paid to charity annually, so some of the additional income could be offset depending on the size of that charitable payment.13 The misvaluation means the CLAT will need to make a compensating payment in the year the valuation is finally determined, which is a required CLAT provision.14 That make-up payment, however, usually won't reduce the CLAT's tax liability for prior years. A trust's charitable deduction for a given year is only available if the payment is actually made, not merely because the obligation is incurred, and trust charitable deductions can only be carried back one year.15 If the LLC generated UBTI, the CLAT's income tax deduction could also be reduced.16

Given how long some of these cases have taken to be resolved, it's worth noting that if the grantor dies in the intervening period, any grantor trusts will become non-grantor trusts, and the risk of interest and penalties for underpayment of tax increases substantially.

Annuity Adjustments

Some commentators have suggested using a CLAT or a GRAT to receive any overflow resulting from a re-valuation since they can be “zeroed out,” resulting in no gift tax. This is based on the assumption that the annuity in both cases will simply increase because the value of the property passing to the CLAT or GRAT was incorrectly determined on the funding date. This may not be true, however.

The IRS could argue that the taxpayer made two errors. First, the taxpayer misvalued the property transferred to the trust. Second, the taxpayer was wrong as to what property was actually transferred to the CLAT or GRAT. The law is clear that for both a CLAT and a GRAT, a valuation error can be corrected with compensating payments once the proper value is determined.17 It's not clear that an error as to what property is transferred can be corrected in the same way, particularly when it's the taxpayer's choice to use a valuation clause that creates the uncertainty. The taxpayer would argue that the funding issue derives from the valuation issue and is therefore correctible. The IRS would claim the mistake of what was transferred to the trust is an independent issue and would further argue that (1) the transfer of additional interests to a GRAT several years later pursuant to the valuation clause constitutes a prohibited addition to the trust,18 (2) the transfer of additional interests to the CLAT wouldn't be deductible,19 or (3) the prior annuity payments can't be corrected since the mistake is what was transferred, not what the transferred property was worth. That would mean the trust annuity payment wasn't a “guaranteed” annuity, so the trust didn't qualify as a CLAT or GRAT. If the IRS were to prevail on any of those points, a substantial gift tax would be due.

PF Excise Taxes

Many states require charities to file annual reports that may need to be amended. In some cases, audited financial statements are required as part of those state filings. It may be appropriate for a charity to note that its assets are subject to a valuation clause on such statements and there's some uncertainty as to the total assets held by the charity.

If the charity is a PF, it may also owe an excise tax under IRC Section 4942 for failing to distribute 5 percent of its assets annually. That tax can be as high as 130 percent of the undistributed amount, although relief is available if “the failure to value the assets properly was not willful and was due to reasonable cause,” a correcting distribution is promptly made and the Secretary of the Treasury is notified of the correcting distribution.20 Subject to the issues identified above, if the charity was a CLAT, the annuity will automatically increase and the make-up payments can be made promptly without adverse consequences.

If the charity is a PF or a CLAT, this arrangement could also be an act of self-dealing. IRC Section 4941 specifically prohibits the lending of funds from a PF to a disqualified person, such as a substantial contributor or a trust that benefits the family of a substantial contributor. It will certainly be the taxpayer's position that an incorrect valuation isn't a loan, but the economic effect of the two are identical. It's not clear at this time whether it would be treated as a loan and what factors would be relevant. For example, if the officers of the PF had the taxpayer's appraisal evaluated by an independent expert and if the final valuation was very close to that of the initial appraisal, perhaps the IRS won't find any self-dealing. If the error is large and the officers complicit, perhaps there will be a different outcome. Similarly, if the officers of the PF were complicit in the inaccurate valuation, the IRS could argue there was private inurement and attempt to revoke the tax-exempt status of the charity altogether (whether public or private).

While less likely, a shift in ownership could also tip a PF or CLAT over the ownership limits set by IRC Section 4943 and constitute an excess business holding.21 Even less likely, an increase in the charity's ownership stake could also change the makeup of its overall investment portfolio enough to constitute a jeopardy investment under IRC Section 4944.

Government Reporting

In our example, the LLC created by John was funded with marketable securities. If instead, John was the substantial owner of a publicly traded company and he had placed that company's stock in the LLC, we would need to consider the implications under federal securities law. If John and certain of his affiliates beneficially owned 5 percent or more of the company's shares, he would be required to report his ownership and any transfers of company shares on a Schedule 13D or G and, if he owned 10 percent or more, reporting would also be required on Forms 3, 4 and 5. These forms have specific filing deadlines and, with respect to the reports on Forms 3, 4 and 5, the company itself must disclose if any shareholder makes late filings or fails to file a required form. If there's an adjustment to the ownership interest retroactive several years, it could render those filings false with potentially material consequences.

Risk of inaccurate government reports can be an issue in other contexts as well. Many industries like construction, trucking and alcohol distribution require comparable registration and reporting to retain the required business license. In our example, if the LLC was a liquor wholesaler, the initial transfer would have required approval by both state and federal regulators. Would the valuation clause need to be disclosed as part of that approval process? If not, would additional authorization be required when the Tax Court ruling required the charity's interest be increased from 7 percent to 20 percent? Would this be considered an unauthorized transfer that risked revocation of the required licenses, and what happens if the regulators leave the license in place but refuse to grant authority for the transfer?

Banking Issues

If the underlying company was an operating business, other issues are raised. Almost every operating business has a bank loan and/or line of credit. Such a business usually makes annual representations to the bank with regard to its ownership and balance sheet. The valuation clause and potential reallocation of ownership may be disclosed to the bank on such declarations. The corporate lending side of a financial institution rarely understands sophisticated estate planning techniques, so many clients will choose not to disclose this information if it's not strictly required. If the clause isn't disclosed and is later activated, this could constitute a material breach and enable the bank to accelerate the loan. Similarly, what if the JFT or the charity had listed the LLC interest on a loan application? Could omitting information about the valuation clause be a material breach? Even if the failure to disclose isn't a material breach, what would happen if the valuation clause was activated and the asset base of the JFT decreased materially because its interest in the LLC dropped from 92 percent to 80 percent?

Next Steps

The more complicated the underlying investment held by the LLC and the more complicated the financial affairs of the client, the greater the challenges posed by valuation clauses. This new tool was designed to minimize gift tax exposure when transferring hard-to-value assets, and it achieves that goal quite nicely. Like any tool, however, misuse can result in serious injury. There's a wide range of practical problems that may arise when a valuation clause is actually called into action. Estate planners need to be cognizant of these possibilities when deciding both whether to use a valuation clause and when drafting such clauses.

Endnotes

  1. McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006).
  2. Estate of Christiansen v. Comm'r, 586 F.3d 1061 (8th Cir. 2009).
  3. Estate of Petter v. Comm'r, T.C. Memo 2009-280 (currently on appeal to the U.S. Court of Appeals for the Ninth Circuit).
  4. See, e.g., Scott A. Bowman, “Defined Value Clauses — Better Defined,” Trusts & Estates (February 2010) at p. 14; Daniel L. Daniels and David T. Leibell, “Christiansen is a Boon for Charities,” Trusts & Estates (December 2009) at p. 14; David Thayne Leibell, “Charitable Lids Triumph Again” (January 2010), available at http://trustsandestates.com/wealth_watch/charitable-lids-win-in-petter0120/index.html.
  5. See, e.g., Knight v. Comm'r, 115 TC 506 (2000).
  6. Treasury Regulations Section 1.664-2(a)(1)(iii).
  7. So long as the return wasn't a “false or fraudulent return with the intent to evade tax,” or a “willful attempt” to defeat or evade tax (Internal Revenue Code Section 6501(c)(1) and (2)), there's a six year statute of limitations for the Internal Revenue Service to challenge a tax return even when the taxpayer omitted more than 25 percent of his gross income (IRC Section 6501(e)(1)).
  8. IRC Section 6511(a).
  9. IRC Section 4940.
  10. IRC Section 512(b)(4).
  11. Revenue Ruling 85-13.
  12. See, e.g., IRC Sections 677(a)(1) and (2).
  13. IRC Section 642(c)(1).
  14. Treas. Regs. Section 1.170A-6(c).
  15. IRC Section 642(c)(1).
  16. IRC Section 681(a).
  17. See, e.g., Revenue Procedure 2007-45, Rev. Rul. 72-395 and Treas. Regs. Section 25.2702-3(b)(2).
  18. Treas. Regs. Section 25.2702-3(b)(5).
  19. Treas. Regs. Sections 1.170A-6(c)(2)(i), 20.2055-2(e)(2)(vi)(a) and 25.2522(c)-3(c)(2)(vi)(a).
  20. IRC Section 4942(a)(2).
  21. This wouldn't be true in the case of John Jones, however, because the limited liability company is funded with marketable securities. If at least 95 percent of the gross income of an entity is derived from passive sources, it's not considered a business enterprise for purposes of the excess business holdings rule. IRC Section 4943(d)(3)(B).

Stephen Liss is a partner in the New Haven, Conn. office of Withers Bergman LLP with a private client practice that includes domestic and international estate planning, planned charitable giving and tax-exempt organizations