U.S. taxpayers were faced with a number of decisions in 2012, including whom to elect as president and whether to make transfers to avail themselves of the potentially disappearing $5.12 million gift tax exemption. The year was consumed by the presidential election, which forced legislative action to the sidelines and left taxpayers scrambling to complete substantial gifts before the celebration began in Times Square. However, the Tax Court marched on during the year and produced at least one major decision with a significant effect on the estate-planning and valuation worlds. Although not directly addressing valuation techniques or methodologies, the Tax Court’s decision related to the validity of defined value clauses (DVCs), which have the potential to provide greater certainty as to the transfer tax due from a taxpayer in connection with a gift. A successfully drafted DVC gives taxpayers and their advisors greater confidence in achieving maximum use of the available exemption, without the unwanted result of exceeding the maximum amount.
In 2012, filling one’s car with $20 worth of gas resulted in a wide variation in the number of gallons pumped—anywhere from four to seven gallons, depending on when and where you bought your gas. The similar simplicity of being able to make a gift of $5 million of closely held stock with the number of shares to be determined is a major positive development for taxpayers.
Estate of Wandry v. Commissioner1 upheld the validity of a dollar denominated formula transfer clause, and for the first time, without the inclusion of a charitable entity among the beneficiaries, as was determinative in preceding case law.2 The court’s conclusion that such formula clause transfers don’t violate public policy, as do savings clauses that return property to the donor, was a key component of the decision. The court observed that the role of the Internal Revenue Service is to enforce tax laws, not simply to maximize tax collections. In Wandry, the parents transferred a specified dollar value of member units, rather than a set number (or percentage), in a limited liability company (LLC).3 This breakthrough decision gives estate planners a viable alternative to making transfers of a fixed number of units or shares with an set appraised value claimed on the tax return, which is subject to a later per unit value change through an IRS audit. Now those same transfers may be of a set dollar value with any future value change as finally determined for estate and gift tax purposes affecting only the number of units transferred to satisfy the dollar amount of the gift. Should an IRS audit result in the increase of the value reported on the tax return of the implied number of units transferred, fewer units actually transfer, but the taxpayer incurs no additional taxes or penalties.
The valuation of assets without a defined and established trading market creates inherent uncertainty for taxpayers and their advisors. Ultimate tax liability, as finally determined for gift tax purposes, is a multi-year wait subject to decisions made in conjunction with IRS audits or court decisions. Wandry provides a taxpayer with the certainty of knowing how much tax is owed based on a set dollar amount transferred, while the uncertainty is shifted to the specific number of shares, units or interests given away. John W. Porter, a leading attorney in this area, interestingly points out that the use of formula clauses successfully co-exists with the IRS’ position in other areas of the Tax Code, such as marital deduction clauses, generation-skipping transfers, split-interest charitable trusts and transfers to grantor retained annuity trusts.4 The availability of a valid DVC for the types of major gifts transferred in 2012 was a fortuitous and timely development for taxpayers and their advisors.
Since the Tax Court decision, the Wandry case has taken several turns, with the IRS first appealing the decision to the U.S. Court of Appeals for the 10th Circuit in August, then voluntarily dismissing its appeal in October. By mid-November, the IRS formally announced its nonacquiescence to Wandry5 and signaled its intention not to follow the holding on a nationwide basis. (For additional discussion of Wandry, see “Wandry, Wimmer and Windsor,” Charles A. Redd, p. 10 in this issue.)
Bona Fide Sale Exception
The IRS continued to challenge family limited partnerships (LPs) in 2012 on Internal Revenue Code Section 2036(a) grounds. However, in two cases, the bona fide sale for full and adequate consideration exception was found applicable to avoid inclusion of the underlying partnership assets in the decedent’s estate.
In the first case, Estate of Stone et al. v. Comm’r,6 the partnership property consisted of woodland parcels that possessed development potential for residential homes near a lake that was created when a county water reservoir was established for a newly constructed water treatment facility. Over a period of years, the decedent and her husband had transferred 98 percent in limited partner interests to their children, children’s spouses and grandchildren. The parents each retained a 1 percent general partner interest. The decedent and her husband used the appraisal value of the woodlands as the basis for all computations of partnership interest values and didn’t discount the value of interests for gift tax purposes. Even though at the date of death, no residential property development had yet occurred, the court found that the decedent’s desire to have the woodland parcels held and managed as a family asset constituted a legitimate non-tax motive for her transfer of the parcels to the partnership.
The second case was Estate of Kelly v. Comm’r.7 This case involved the creation of four LPs. The decedent owned 27 real estate parcels, including two rock quarries, a subdivision with rental homes, a post office and a rural property with a large waterfall and picnic facilities. The court observed that the decedent’s ownership of this mix of properties required active management and would lead any prudent person to manage these assets in the form of an entity. Accordingly, the decedent had valid non-tax reasons to contribute property to the LPs and the bona fide sale exception in IRC Section 2036(a) applied. The court also addressed whether the decedent had a retained income interest under Section 2036(a), because the decedent owned 100 percent of the corporate general partner that received a management fee for services to the partnerships. The court stated that the partnership agreements called for a payment of income to the corporate general partner, not the decedent, and the court wouldn’t disregard the corporate general partner’s existence, its fiduciary duty and the partnership agreements. Moreover, the court found that the management fee paid was reasonable for the services provided.
Gift Tax Annual Exclusion
The court provided some additional clarity in what constitutes a present interest gift under IRC Section 2503(b). In Estate of Wimmer v. Comm’r,8 the Tax Court held that the transfer of a limited partner interest qualified for the gift tax annual exclusion. The partnership was invested in marketable securities that consisted of dividend-paying stocks. The court observed that:
Indeed, the limited partners not only received annual distributions but also had access to capital account withdrawals to pay down residential mortgages, among other reasons. Intent notwithstanding, the expectation that some portion of partnership income would flow steadily to the limited partners is supported by the general partners’ fiduciary duties . . .
The history and prospects of annual distributions to limited partners enabled the court to find that the limited partners received a substantial present economic benefit sufficient to render the gifts of LP interests present interest gifts on the date of each gift and qualify for the annual gift tax exclusion under Section 2503(b).
Presidential election years have many characteristics, but one of the more benign is that new legislation grinds to a halt. Typically, a period of no legislation is greeted with a sigh of relief; however, with the sunsetting of many important provisions in the trusts and estates community on Jan. 1, 2013, legislative and executive branch inaction creates more uncertainty for this coming year than usual.
Coupled with legislative uncertainty for estate planners is the question of how much transfer planning volume will remain in 2013, with the real possibility that many transfers that otherwise would have occurred in 2013 were pushed forward into the last quarter of 2012.
Beyond the impossible task of predicting what will happen in Washington this year, an interesting mismatch issue was identified, but not resolved, in Estate of Clyde W. Turner, Sr. v. Comm’r9 (Turner II), in which the taxpayer lost on the Section 2036(a) issue, but the partnership interests passed to the surviving spouse. The IRS has previously taken the position that even when Section 2036(a) applies, the marital deduction is measured by the value of what actually passes to the surviving spouse, which is a discounted LLC or partnership interests, and not by the undiscounted value of the underlying assets. This produces a mismatch between the higher value for the gross estate inclusion and the lower value for the marital deduction calculation, with a resulting tax liability for the estate. The government didn’t assert this mismatch issue in Turner II. Nevertheless, the court noted the issue, but appropriately left it for another day. We don’t expect the IRS to ignore this mismatch issue in the future, as the IRS continues its vigilant pursuit of Section 2036 revenue raising opportunities. We’re at the beginning of a second term for the Obama administration and with it comes the relative certainty that estate and gift taxes won’t go away; however, certain unsettling valuation issues that affected the estate and gift practice in the past, such as tax benefit treatment of S corporations, supporting lack of marketability discounts and validity of formula value clauses, will continue to perplex us in this new year.
1. Estate of Wandry v. Commissioner, T.C. Memo. 2012-88 (March 26, 2012).
2. Estate of Petter v. Comm’r, T.C. Memo. 2009-280 (Dec. 7, 2009); Estate of Christiansen v. Comm’r, 130 T.C. 1 (Jan. 24, 2008), aff’d, 586 F.3d 1061 (8th Cir. 2009); Estate of McCord v. Comm’r, 461 F.3d 614 (5th Cir. 2006), rev’g, 120 T.C. 13 (May 14, 2003).
3. For a thorough discussion of the Wandry case, see Andrew M. Katzenstein and Scott A. Bowman, “The Wandry Quandry,” Trusts & Estates (May 2012) at p. 42.
4. John W. Porter, “The Use of Formula Clauses to Transfer Hard-to-Value Assets: Where Are We?” 3rd Annual Notre Dame Tax & Estate Planning Institute (Sept. 21, 2012).
5. Internal Revenue Bulletin No. 2012-46 (Nov. 13, 2012).
6. Estate of Stone, et al. v. Comm’r, T.C. Memo. 2012-48 (Feb. 22, 2012).
7. Estate of Kelly, et al. v. Comm’r, T.C. Memo. 2012-73 (March 19, 2012).
8. Estate of Wimmer v. Comm’r, T.C. Memo. 2012-157 (June 4, 2012).
9. Estate of Clyde W. Turner, Sr. v. Comm’r, 138 T.C. 14 (March 29, 2012).