Defined Value Gifts: Does IRS Have It All Wrong?

Defined Value Gifts: Does IRS Have It All Wrong?

Article posted in Estate Planning on 3 April 2002| comments
audience: National Publication | last updated: 16 September 2012
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Summary

A defined value gift is a formula gift that is tied to both the value the client wants to give and the value of the gift as finally determined for gift tax purposes. In this article, reprinted from the December 2001 edition of Estate Planning Journal, Louisiana attorney L. Paul Hood analyzes defined value gifts used in connection with charitable family limited partnerships in light of recent developments.

by L. Paul Hood, Jr.

L. Paul Hood, Jr. is an attorney in Covington, Louisiana. He is also a fellow of the American College of Trust and Estate Counsel, and has previously written and lectured on estate planning.



RIA Estate PlanningThis article is reprinted with the publisher's permission from ESTATE PLANNING, a monthly journal on strategies for saving taxes, building wealth, and managing assets published by RIA under the WGL imprint. Copying or distribution without the publisher's permission is prohibited. To subscribe to ESTATE PLANNING or other RIA journals please call 800.950.1216 or visit http://www.riahome.com/journals/. For information on ESTATE PLANNING, click here


Clients who wish to make lifetime gifts often are deterred by a practical economic concern: how to limit the value of what is given away to the amount that they intend to give and no more. This intended limitation has both a tax and a nontax element to it. This issue is even more vexing when the client wants to give subjectively valued assets, particularly with respect to limiting the gift tax value. One method of gift giving that many clients consider is a formula gift that is tied to both the total value that they intend to give and the value of the gift property as finally determined for gift tax purposes. This article discusses so-called defined value gifts in the context of a recently issued Field Service Advice and a pending Tax Court case.

In FSA 200122011 ("FSA"), IRS considered the first of two questions: "Whether a formula clause that allocates additional value to a charitable donee in the event the value of the transferred property is redetermined for federal transfer tax purposes will be respected for federal transfer tax purposes?"

IRS answered: "The formula clause should not be given effect for federal tax purposes." The facts of the FSA supposedly are those of a docketed Tax Court case, McCord,1 that was tried in Houston before Judge Foley on 5/7/01 and still awaits decision at press time. The taxpayer's version of the facts in McCord differs significantly from the facts set forth by the IRS in the FSA. This article considers the uncontested facts from McCord but will infuse facts from the FSA with notice where appropriate, and analyzes the defined gift concept and formula gifts in general.

The formula gift and subsequent sale of the charities' interests

In both McCord as well as the FSA, the gift property consisted of limited partnership interests in a limited partnership (in McCord, a Texas limited partnership) that the donors had formed with their sons. The donors and their sons each contributed property to the partnership on formation. The donors took back only limited partnership interests in the exchange on formation, while the sons took back both general and limited interests.

Not long after the partnership was created, the donors made a formula donation of all their limited partnership interests to multiple donees via the same assignment instrument. The donors gave the first tranche of value, equal to their entire available GST exemptions, in trust for the benefit of the donors' grandchildren. The second tranche of value was an outright gift to their sons of a fixed amount in excess of the GST exemptions (in McCord, this apparently was a net gift). The third tranche of value was an outright gift to a charity of a fixed amount in excess of the first two gifts, and the fourth and final tranche of value was a residuary gift to another charity. The donation formula used in McCord was as follows:

(1) that portion of the Assigned Partnership Interest having a fair market value as of the date of this Assignment which is as much as but not more than the dollar amount ("Assignors' GST Amount") obtained by adding (i) the GST exemption provided for Assignors in section 2631(a) of the Internal Revenue Code of 1986 (the "Code"), which has not been allocated by them or by operation of law to any property transferred or deemed transferred by them before the date of this Assignment Agreement, to (ii) the value of any consideration received or deemed received by Assignors from ... [the] trustees of the GST Trusts, as a result of the transaction effectuated by this Assignment Agreement, is assigned in equal shares to [the GST Trusts];

(2) any remaining portion of the Assigned Partnership Interest having a fair market value as of the date of this Assignment Agreement which is as much as but not more than the dollar amount obtained by subtracting Assignors' GST Amount from $6,910,932.52, is assigned outright and in equal shares to ... [the donors' sons];

(3) any remaining portion of the Assigned Partnership Interest having a fair market value as of the date of this Assignment Agreement which is as much but not more than the dollar amount obtained by subtracting the dollar value of the portions assigned under subparagraphs (a) and (b) above from $7,044,932.52 is assigned to the Shreveport Symphony, Inc.; and

(4) any remaining portion of the Assigned Partnership Interest is assigned to Communities Foundation of Texas, Inc. for the benefit of the McCord Family Fund.

An appraisal allocated the donated partnership interests between the respective donees. According to the FSA, the charities were never admitted to the partnership, and the charities were only assignees. The FSA further alleged that the partnership agreement gave the partnership a right to call certain assignee interests held by charities for fair market value.

Within six months of the donation in the FSA, the partnership (controlled solely by the sons, who, together with trusts for the benefit of their children, were the only donees other than the two charities) exercised its option to call the charities' interests. The redemption price was based on a second appraisal. The FSA indicated that each charity executed a release of all claims on redemption, including the contingent right of the residuary charity to an increased interest in the event of IRS revaluation. The FSA further asserted that neither charity negotiated the price on either the allocation or redemption of its respective interests. In McCord, the taxpayers alleged that the charities were represented by separate counsel, were not required to sell, and had input into the appraisals and redemption price.

IRS' position. In both the FSA and McCord, IRS sought to increase the value of the donated limited partnership interests. The donors countered that any increase in value would accrue pursuant to the gift formula only to the residuary charity donee, and its assignee. Thus, the donors argued that revaluation would not increase the gift tax due because any increased gift tax value simply would increase the gift tax charitable deduction. In McCord, the donors also asked for an increased income tax charitable deduction if IRS was successful in raising the value of the donated limited partnership interests.

In the FSA, IRS applied the step-transaction doctrine, positing that the partnership formation, formula donation, and the call redemption of the charities' assignee limited partnership interests "was in substance a single integrated transaction the effect of which was to transfer a __ percent Class __ interest to the Sons." IRS further asserted that "the sole purpose of the presence of [the residuary charity donee] was to imbue the appraisals, which were an integral part of the donative plan, with the patina of third-party reliance." Citing Regs. 25.2522(c)-3(b)(1) and 25.2522(c)-3(b)(2), Example 1, as well as the transaction documents it reviewed in the FSA, IRS concluded that "[the residuary charity donee] would not receive any additional value should the Commissioner successfully determine that the value transferred was greater than that reported." IRS also disregarded the donation formula, finding that the formula violated the "principles" of Procter,2 stating:

Though Procter involved a savings clause as opposed to a formula clause, the principles of Procter are applicable to this case. If formula clauses like the one at issue actually function to require payment of any increased value to the charitable donee, these clauses would be similar in effect to savings clauses in that they recharacterize the transaction in a manner that would render any adjustment nontaxable....Fair administration of the gift tax will become even more difficult if formula clauses are given effect, for scarce resources cannot reasonably be expended examining returns if the examination will have no tax effect.

Comments on the FSA position on formulae gifts

In light of the FSA, is use of a formula for transfer tax purposes still safe? A careful reading of the FSA clearly indicates that IRS is concerned only about the use of formulae for gift tax purposes, and maybe only where the exact tranche gift technique is used. Nevertheless, the IRS rationale for a blanket disregard of gift tax formulae for a defined value gift cannot withstand much intellectual scrutiny.

First, Congress as well as the Treasury both expressly allow formula usage for gift tax purposes, e.g., in the areas of charitable remainder trusts, inter vivos QTIP elections, disclaimers, and GRATs. Indeed, the Regulations expressly permit (and in some cases require) the use of a condition subsequent that would fail under Procter and its progeny. If IRS is calling for an end to formula or defined value gifts, then since these types of transfers are permitted and required in other areas of the law, nothing less than legislation or a published Ruling should be required to change the position. Furthermore, any such published Ruling should be applied only prospectively.

At this juncture, it also would be highly inappropriate for the courts to step in and halt the use of formulae for gift tax purposes, which simply are being used in an attempt to build some elusive valuation certainty into the gifting of hard-to-value assets. However, there always is a risk that the courts may determine that valuation is a taxpayer risk and that new Section 2001(f) (dealing with the valuation of gifts) is the only congressionally blessed route for taxpayers seeking to achieve finality of valuation for gift tax purposes. Section 2001(f) doesn't permit a cap on the amount of a gift, just a limit on the time for IRS to challenge the valuation of the gift. This won't solve the legitimate concerns of many clients, who want to give away only so much and no more.3

Second, IRS can have no realistic expectation that every gift tax audit will always result in a "tax effect" in the form of additional gift tax due. What does "tax effect" mean? It is a slippery slope. What about gift tax audits that simply result in more usage of the applicable credit amount? Pursuant to Section 2504(c) as amended in 1997, IRS now must audit more gift tax returns that won't generate any tax revenue or risk losing the ability to tax that gift. Such audits may not produce immediate dollars for the fisc. However, IRS' success in increasing mandatory usage of the applicable credit amount (as required by Rev. Rul. 79-398) via revaluation of lifetime gifts could possibly increase the IRS' take on the federal estate tax side when the donor dies, which should constitute "tax effect."

What about audits of gift tax returns where it is determined that the taxpayer's valuations were correct? Do these audits have "tax effect" in the form of a compliance check? What about audits of gift tax returns that result in no-change letters?

The primary purpose of the IRS audit is not to fatten the exchequer. One of the major purposes of an IRS audit is to test the accuracy of reporting positions taken by taxpayers. A prime purpose of IRS gift tax audits is to make sure that taxpayers properly report the gross value of taxable gifts, especially because it is not as easy for IRS to revalue lifetime gifts in light of Sections 2001(f) and 2504(c). IRS alluded to this situation in the FSA.

Third, the scarcity of IRS resources for audits really should play very little role in the administration of tax policy, but the courts have shown some sympathy toward this position. However, substantive tax positions brought on solely by budgetary concerns should not play a greater role than that of certainty in tax policy.

Fourth, the IRS' rationale, as stated in the FSA, seems equally applicable to a situation where the residuary donee is a spouse or a QTIPable trust. Any audit revaluation in such a situation also would not result in additional immediate gift or estate tax--hence a concern about such a formula also being invalidated for lack of "tax effect" (i.e., nothing to be gained on audit). Nevertheless, such a reading would fly in the face of clearly expressed, longstanding congressional intent that transfers between spouses be free from transfer tax. In Section 2523(f), Congress has expressly permitted lifetime QTIPs that have rules which differ very little from the rules applicable to testamentary QTIPs, with two exceptions.4 Isn't there possible "tax effect" to be ferreted out in audits of the estate tax return of the first spouse to die, even where there will be no additional estate tax revenue because of the presence of a self-adjusting QTIP formula election (e.g., valuation and income tax basis)?

Fifth, many of the policy justifications enunciated by the Fourth Circuit's 1944 decision in Procter have been eroded through changes in the law. In Procter , the ill-fated condition subsequent was a settlement of lawsuits between Mr. Procter and his mother over amounts that Mr. Procter owed her--hardly the backdrop of a gratuitous transfer. In Procter , the Fourth Circuit was concerned about the effect of what Mr. Procter was perceived to be doing--i.e., attempting to avoid gift tax treatment on property he was transferring to his children in excess of what he was receiving in return, by deeming that the excess property never was transferred. The concerns enunciated by the Fourth Circuit are stated below, and each concern is addressed in the italicized language that immediately follows:

The donees might not be bound by the Tax Court's decision concerning the gift tax and could independently attempt to enforce the gift even though, for tax purposes, the gift of the excess value was determined to have never been made. This happens every day in the real world. Estates get hit with estate tax on values of closely held interests which exceed the sales price of the interests in buy-sell agreements. Arguably, such a clause would be an enforceable condition on a gift under state law.

The effect of an attempt to enforce the tax would be to defeat the gift. In a defined value gift where the gift is irrevocable and the donor cannot get back any of the gift property, this concern is nonexistent.

The effect of the condition would be to require the court to pass on a moot case. If the defined value gift is irrevocable, a case involving its valuation would hardly be moot. Moreover, valuation litigation has come quite a ways since 1944 and could hardly be described as "trifling" today. The issues of the amounts of the gifts and charitable deductions (for gift and income purposes) also hardly fit the "moot" description.

Courts cannot issue declaratory judgments in tax cases. This is no longer the law.5

Finally, the same result sought by the defined value gift should be achievable via a timely and properly prepared disclaimer where the donation document itself provides for an alternate taker in the event of disclaimer.6 The Regulations clearly sanction pecuniary and fractional disclaimers without exception, provided that the disclaimer otherwise complies with the disclaimer rules. But disclaiming an interest in a family entity, in favor of a charity, may not be easily done, especially if the disclaimant is involved in the management of the entity since disclaiming all management rights in this regard also would likely be required in order to give the disclaimer tax effect and to prevent a gift by the disclaimant (and exposing the donor to gift tax on the original donation).7

Authorities supporting the defined value gift

There have been several thoughtful articles on the defined gift/sale technique, but each article has acknowledged that there in fact is little express authority for the technique. Proponents of the defined value gift point to the Regulations and published Rulings which expressly sanction the use of values as finally determined for tax purposes.8 Most of the proponents, though, tend to hang their hats on three primary arguments: IRS approved formula gifts in TAM 8611004, the distinction between a value readjustment clause (condition subsequent) and a value definition clause (condition precedent), and changes in the law since Procter undercut the policy rationale for that decision.

TAM 8611004 involved the timing of valuation of an annual series of donated limited partnership interests that were donated as follows: "[S]uch interest in X Partnership, an *** limited partnership, as has a fair market value of $13,000...."

TAM 8611004, which was not a favorable ruling for the taxpayer, concluded that the annual donations of $13,000 worth of limited partnership interests were to be valued as of the date of each donation. This meant that the donor's estate included more of the limited partnership interests actually donated pursuant to the formula, rather than the amount of partnership interests reflected as owned by the deceased donor pursuant to the partnership agreement and annual income tax returns. IRS justified its ruling on applicable state law--i.e., the donor's right to go back and adjust the ownership percentages under the formula to reflect what he'd actually donated.

Contrary to what some writers have suggested, TAM 8611004 really does not stand for the proposition that IRS will support a "stated value" formula donation: IRS simply did not affirmatively characterize the donative scheme as violative of Procter and its progeny. TAM 8611004 cites another case in the Procter line, Harwood,9 but the TAM cites Harwood only for the proposition that the business transaction exception rule of Reg. 25.2512-8 is inapplicable to the facts of the TAM (just as the Tax Court determined in Harwood ).

In TAM 8611004, the uncertainty of percentage of limited partnership interests was between the donor and one donee. Contrast that with the facts of the FSA and McCord: the uncertainty of division of the limited partnership interests owned was solely between the donees, and the donation formula itself styled the donation so that only one donee, the residuary charity, arguably could receive any benefit from any increased valuation by IRS.

The proponents of the defined value gift technique also assert what they view as a critical distinction between a "value adjustment clause" (and there are slight variations on that term), which is a condition subsequent, prohibited by Procter, and a "value definition clause," which they term a condition precedent. Some of the distinctions noted between the value adjustment gift and a value definition gift include the following: (1) the gift amounts to the lower tier donees are fixed; (2) the gift is irrevocable and the donor has no continuing interest or right, contingent or otherwise, with respect to the gift property; (3) the remainder donee and the upper tier donees are usually unrelated; (4) any subsequent sale by the charity of its interest is only done via an independent appraisal; and (5) the IRS has blessed formula bequests on the estate tax side for years, and not to do so now could call into question what has heretofore been a tried and true method of testamentary planning.

It is not completely clear whether the courts will buy the theory that there is a significant distinction between the condition subsequent and the condition precedent, especially if the differences in effect are slight. It seems equally uncertain whether what IRS has permitted on the estate tax side will translate over to the gift tax side. Will the newly legislated differentiation between gift and estate tax give rise to less "unification" in administration? Time will tell.

It also is unknown whether IRS will respect any gift tax formula donations not in the form of a disclaimer or in an amount other than a tax-related number such as annual exclusion, applicable credit amount, or GST exemption. Query whether IRS ever will respect any formula donation that shifts value between donees except where a tax-tied formula donation (e.g., unified credit/GST exemption) is involved. Until there is a decision squarely and solely on the merits and limits of the defined value technique, there are significant risks to this transaction. As discussed below, it also is unclear whether McCord will be decided on the merits of the defined value gift technique.

Most estate planners, including proponents of the defined value gift, believe that IRS is on solid ground when it comes to value adjustment clauses that are conditions subsequent and styled as savings clauses nullifying the donation (Procter ), or as reversions of the excess donated property back to the donor (Rev. Rul. 86-41), or as consideration paid to the donor making up the difference in value (Rev. Rul. 86-41, Harwood , and Ward10).

The IRS step-transaction argument

Advisors must acknowledge that an objective, disinterested observer could perceive as abusive fact patterns not too dissimilar to those of the FSA and McCord. Slight variations on the facts (such as requiring the charity to sell its interest for a pre-set price prior to the donation) may virtually guarantee a finding of abuse. Where the family (and in both the FSA and McCord , the donees) is in control of the partnership, and the donees have interests potentially adverse to those of the charity, as in any zero sum game valuation gift formula, courts may be more inclined to find abuse on the family's part, even with a fiduciary duty.

In both the FSA and in McCord, the family remained in control of the assets of the limited partnership interests, less what the charities received in redemption of their interests. Thus, it is entirely possible that the Tax Court could rule against the taxpayers in McCord without also prohibiting the defined value gift technique. The Tax Court could accomplish this either by relying on the step-transaction doctrine or by finding, as a matter of public policy, that a charitable deduction should be limited to what the charity actually receives in a sale of its interests--not a higher value as redetermined by IRS.

Designing defined gift transactions

In addition to tax uncertainty, formulae gifts are problematic with respect to ongoing operation of the entity pending final determination of the donees' ownership interests. The possibility for shifting interests on revaluation may necessitate recalculation of intervening distributions, filing of amended tax returns and the like, and it could cast some significant uncertainty on the ownership or marketability of the interests or entity assets. In light of the flurry of recent schemes attempting to exploit charitable vehicles,11 estate planners and their clients must understand that there will be heightened scrutiny when a charity is involved in estate planning with a family. The clients may well have to prove a negative--i.e., that the charity was not interposed for nefarious purposes--which can be difficult. In fashioning a defined value formula donation or sale, advisors should consider the following design suggestions:

  1. The charity should not be required to sell its interest, and if there is a sale price or a required sale set forth in the documents, the price must be for fair market value as finally determined, with input rights for the charity.
     
  2. Each charity and other donee should be represented by separate counsel.
     
  3. Some time should elapse between the donation and any sale.
     
  4. Appraisals must be obtained for both the original donation as well as any subsequent sale or redemption.
     
  5. Preferably, two separate appraisers should be used--one for the donation and one for the sale or redemption. Any sale or redemption by the charity, which is the remainder donee, would consist of an element (i.e., the contingent additional amount where there is any revaluation on audit) that was not considered in the first appraisal.12 This additional "bundle of rights" must be appraised using traditional valuation methods. The second appraiser would have to go back and carefully review the first appraisal of the partnership as of the date of donation in order to ascertain independently the likelihood that the first appraisal was correct. This could involve having to replicate totally the first appraisal. The second appraiser's role would involve, among other things, an analysis of the range of value involved in the first appraisal as of the original date of donation as well as a fresh review of the first appraisal's methodology and due diligence.

    The reason why a different appraiser should be used for the second appraisal is that the second appraisal involves reviewing, and, indeed, second-guessing, the first appraisal, which, arguably, is more objectively done by a different appraiser. Arguably, anything less than a full-fledged review of the first appraisal for redemption of the charity's interests risks the "patina of third-party reliance" argument made in the FSA.

  6. The charity or other residuary donee should sell its interest to another person rather than have the partnership redeem the interest in order to avoid having to face the argument by IRS that it is the donee family members--not charity--that benefitted. It seems far preferable that the donor-partner actually purchase the charity's interest (and be responsible for any additional amount on revaluation). Structuring the transaction as a sale rather than a redemption also avoids an argument that the charity's interests evaporated by operation of law, leaving only the family still in the partnership.
     
  7. As far as the timing of the purchase of the residuary donee's interest, prudence strongly dictates that--just as in the sale of a remainder interest in a QTIP trust--any sale not occur until after the gift tax value is finally determined. Even though this delay may please neither the charity (which has to hold on to its interest when it may prefer cash now) nor the client (who may want a chance at an increased income tax charitable contribution deduction if IRS raises the gift tax value), it seems imperative that the charity which holds the contingent remainder interest stay in the mix until the "tax smoke clears." If, however, the sale of the charity's rights occurs prior to gift tax finality, the residuary donee should not sell the contingent right but expressly retain it, which also avoids having to value the most difficult to value of the assets held by the charity.
     
  8. The charity should be admitted to the partnership as a partner, or the partnership agreement should grant the charity as an assignee certain express rights such as a right to partnership information and a right of the charity to avail itself of the fiduciary duty owed by the partnership and the general partners. If the charity does sell its interests prior to the point of gift tax finality, it is recommended that the charity expressly retain its contingent remainder rights. The partnership agreement should expressly extend the protective rights of the charity discussed above (even though the charity has no partnership percentage interest as either partner or assignee) pending gift tax finality.
     
  9. In the FSA, IRS argued that while the partnership agreement afforded certain protections to charitable partners, those protective provisions were inapplicable because the charities were only assignees. The documents must be consistent in this regard.
     
  10. If the partnership agreement requires the charity to sell, it seems prudent to insert some baseline rights for the charity relative to the appraisal and sale process. The charity could be given full access to entity information, the right to participate in selecting an appraiser as well as the right to seek alternative dispute resolution if there is a disagreement about the valuation. All other things being equal, in order to avoid arguments of conflicts of interest, a cautious advisor should insist that the donor, rather than the other donees (as was the case in the FSA as well as in McCord), be in control of the partnership at the time of the sale by the charity of its interest, particularly if the charity is required to sell its interest.

    Practice Notes:

    The charity or other residuary donee should sell its interest to another person rather than have the partnership redeem the interest in order to avoid facing the argument by IRS that the donee family members--and not the charity--benefitted. It seems far preferable that the donor-partner actually purchase the charity's interest (and be responsible for any additional amount on revaluation).


     
  11. If there is a sale of the charity's interests prior to gift tax finality, perhaps the donors should be the ones buying the charity's interests in order to establish a direct link between the donors and the consideration paid for the charity's interests. This could be important if the donors also seek an increased income tax charitable contribution deduction in the event of IRS revaluation.
     
  12. The amalgamation of donations to different people in the same formula increases the risk of "phantom value" being taxed, if the aggregate value of the donated interests exceeds the sum of the formula rights apportioned to the family donees, whose interests typically are fixed. This risk could go up substantially if the donated interests constituted voting control of an entity so as to create a premium for purposes of the gross gift value, a so-called two-values problem a la TAM 9403005. Clearly, in McCord, the interests of the sons, the GST trusts and the Shreveport Symphony were fixed in amount by the donation formula, and, to some extent, not really even formulaic at all (except that each was computed by aggregating values of the immediately preceding tranche(s) of donation value).

    In order to prevent a "phantom gift value" issue, perhaps it would be prudent to make a separate, subsequent donation to the charity or person who, in effect, will be the "residuary donee" in an amount equal to the total taxable gifts of partnership interests made during the calendar year, as finally determined for gift tax purposes, less the value of the other taxable gifts of partnership interests made during that taxable year, as finally determined for federal gift tax purposes. In that way, the gifts to the donees whose interests are fixed aren't aggregated with those of the residuary donee, and such language actually operates similarly to Section 2502(a).

  13. It is imperative that clients consistently report a defined value gift by formula. In Knight,13 the Tax Court disregarded the taxpayers' defined value donation of $300,000 apiece in limited partnership interests for the benefit of each of the taxpayers' two children (obviously intended to be a unified credit gift by each taxpayer). The Tax Court did so because the taxpayers' gift tax returns, contrary to the donation documents, reported each gift as a straight percentage amount (rather than a percentage which resulted from application of a gift formula) in the partnership, and then claimed that the percentage given to each donee had a value of only $263,165--less than the $300,000 per donee gift. Not only must the donation documents and partnership agreement be consistent, but the tax reporting must be consistent as well.


The intervening purchase of the charity's interests

It is no secret that charities prefer cash to partnership interests, especially since the good works of the charity (and the payment of compensation to its eager staff) cannot be well satisfied by K-1s and the occasional cash distributions. The question squarely raised in McCord is the effect on the charitable deduction of the intervening sale that occurs prior to the gift tax audit, especially where IRS proposes an increased valuation.

Proponents of the defined value gift technique argue that the charity sells its interests (which would include the contingent right to get more interests on IRS revaluation) for fair market value as determined by an independent, third-party appraiser. Thus, the acquirer of the charity's interest should stand in the shoes of the charity-assignor, so if there is any increase in value by IRS (even an amount that exceeds what the charity ultimately receives in the sale), the charitable deduction should go up even though a charity may not realize that excess. This point may well cause the courts to have heartburn, especially where the taxpayers (including those in McCord) also argue for an increased income tax charitable contribution deduction. Section 170 limits charitable deductions to the fair market value of the donated property.

Some planners analogize the desired result set forth above to the situation where a client donates Blackacre to charity at an appraised value of $1 million, and the charity turns right around and resells Blackacre less than one month later to an unrelated third party for $1.2 million. Few would argue that the donor would not be entitled to a charitable deduction of $1.2 million instead of the $1 million if nothing had changed with respect to the property between the time of donation and the sale. But is that what is happening in the multi-donee defined value gift?

One could argue that the defined value gift is entirely different. In the above example, the donor's increased deduction was based solely on what the charity actually realized for the donated property. This is justifiable because the charitable deduction is limited to the fair market value of what the charity received, which was more accurately measured by an actual sale of the interests as opposed to the appraised value. If the charity's interests are sold prior to gift tax finality, the increased value usually is realized by a person related to the donor (quite often a donee) or by the entity itself as the acquirer in a redemption (which occurred in McCord). This may trouble the courts.

The second question posed in the FSA

In FSA 200122011, IRS also addressed the following: "Whether the amount of a transfer may be reduced by the actuarial value of the estate taxes attributable to the potential section 2035(c) [now 2035(b)] inclusion in the donors' gross estates?"

Not surprisingly, IRS answered this question as follows: "The amount of the gift may not be reduced by the actuarial value of the potential estate taxes because the fact of inclusion and the amount of any estate tax attributable thereto is too speculative."

Section 2035(b) (formerly 2035(c)) includes in the gross estate any gift tax paid on transfers made within three years of death. In the FSA, IRS distinguished Rev. Rul. 75-72, which expressly sanctions net gifts, and Harrison.14 IRS noted that a court already had considered and rejected a potential discount for Section 2035(b) liability in Frank Armstrong Jr. Trust.15 The alleged discount for estate tax attributable to inclusion of the gift tax in the donor's gross estate is dubious at best because its effect on the hypothetical "willing buyer-willing seller" test is unclear.16 What about a discount for the possibility that the donor won't be able to pay the gift tax, thereby exposing the donees to liability therefor as transferees? Arguably, this would be just as dubious.

Conclusion

It is hoped that in fashioning its decision in McCord --whatever it may be--the Tax Court carefully considers the possible fallout of an ambiguous, open-ended ruling, which could cast unnecessary doubts on previously undoubted territory such as defined value formula gifts and bequests for annual exclusion/applicable credit amount/marital deduction/GST exemption purposes. It is hoped that the Tax Court also will provide estate planners with guidance as to whether formula gifts to multiple donees, including residuary donees, will pass muster even if done differently. If the Tax Court decides McCord based on the step-transaction doctrine, hopefully the Tax Court will provide guidance here as well.


This article is reprinted with the publisher's permission from ESTATE PLANNING, a monthly journal on strategies for saving taxes, building wealth, and managing assets published by RIA under the WGL imprint. Copying or distribution without the publisher's permission is prohibited. To subscribe to ESTATE PLANNING or other RIA journals please call 800.950.1216 or visit http://www.riahome.com/journals/. For information on ESTATE PLANNING, click here


  1. TC Docket No. 7048-00.back

  2. 142 F.2d 824, 32 AFTR 750 (CA-4, 1944), cert. den.back

  3. The author notes, anecdotally, that his clients' zeal for gift giving stops at what he calls the "unified credit county line."back

  4. The inter vivos QTIP election must be made on a timely filed gift tax return (the testamentary QTIP election must be made on the first filed estate tax return, whether or not timely filed), and the donor of an inter vivos QTIP trust can have an interest in the QTIP trust. Section 2523(f)(5).back

  5. See Section 7477.back

  6. Reg. 25.2518-3(d), Example 20.back

  7. See, e.g., Ltr. Ruls. 8624066, 9008011, and 9532027.back

  8. See, e.g., Regs. 25.2702-3(b)(1)(ii)(B) (GRATs) and 1.664-2(a)(1)(iii) (CRATs); Rev. Proc. 64-19, 1964-1 CB 682 (IRS blessed certain pecuniary marital deduction bequests funded at estate tax values as finally determined).back

  9. 82 TC 239 (1984), aff'd without published opinion, 786 F.2d 1174 (CA-9, 1986).back

  10. 87 TC 78 (1986).back

  11. Examples include the charitable remainder trust capital gains avoidance plan (which IRS proscribed in Notices 98-20, 1998-1 CB 776, and 99-17, 1999-1 CB 871, and Congress curtailed with the amendment of Sections 1(h), 664(d)(1)(A), and 664(d)(2)(A)); charitable split-dollar (which IRS proscribed in Notice 99-36, 1999-1 CB 1284, and Congress effectively eliminated in Section 170(f)(10)); and the charFLIP (the so-called charitable family limited partnership).back

  12. Query whether this additional element ought to be considered in the very first appraisal as well with respect to the gift. Analogizing to old "what's behind door no. 1" for those game show-ites, where's Monty Hall when you need him?back

  13. 115 TC 506 (2000).back

  14. 17 TC 1350 (1952).back

  15. 87 AFTR2d 2001-707 (DC Va., 2001).back

  16. Query whether an assumption that the donor wouldn't or couldn't pay the gift tax is contrary to the hypothetical "willing buyer-willing seller" test?back

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