June, 2012 Newsletter
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Katzenstein & Bowman: Tax Court Provides Road Map for Successful Defined Value Clause Planning in Wa
LISI recently provided members with commentary on the Wandry decision by Paul Hood in Estate Planning Newsletter #1941. We now wrap-up our focus on this most important case, first with commentary by Andy Katzenstein and Scott Bowman, followed by commentary in a separate newsletter by Steve Akers.
Andy Katzenstein is a partner in Proskauer's Personal Planning Department and practices in the firm's Los Angeles office. He is an ACTEC Fellow and former Chair of the Beverly Hills Bar Association's Probate and Trust Law Section as well as the Los Angeles County Bar Association's Estate and Gift Tax Section. Formerly an adjunct professor at UCLA School of Law, he currently serves as an adjunct professor at USC Law School where he teaches estate and gift tax. Andy also writes extensively on estate and gift tax issues. His practice focuses on estate, gift and generation-skipping tax planning, income taxation of trusts, post-death administration of trusts and estates, charitable foundations, and resolving disputes between fiduciaries and beneficiaries.
Scott Bowman is a member of Proskauer's Personal Planning Department and practices in the firm's Boca Raton office. He is an active member of the ABA Tax Section and the ABA Real Property, Trust and Estate law Section, of which he currently serves as a Fellow and as a member of its Membership and International Tax Planning Committees. Scott speaks and writes regularly on tax and estate planning topics.
Here is their commentary:
On March 26, the Tax Court issued a groundbreaking decision in Wandry v. Commissioner approving of the donors' use of a defined value clause. Wandry is the latest in a line of cases over the last few years, beginning with McCord v. Commissioner, that have approved of defined value clauses as a distinct estate planning technique apart from so-called "savings clauses" that were rejected long ago in Commissioner v. Procter. Yet the line of positive defined value clauses have all had an important fact in common – the donors included a charitable beneficiary in the gifting transaction in an effort to diffuse the IRS's Procter "public policy" arguments.
Wandry is groundbreaking in that it is the first case to approve of a defined value clause where no charitable donee was a party. In fact, no "residual" beneficiary was involved at all. Instead, IRS revaluation served to reallocate interests in excess of the defined value to the original donor, something that was previously thought to be aggressive. Even better, the Tax Court provided a "road map" of the points to follow when implementing a defined value clause.
The donors, Albert and Joanne Wandry, formed Norseman Capital, LLC ("Norseman") with their children in 2001. Norseman held cash and marketable securities. In 2004, the donors made significant gifts of their interests in Norseman. Their attorney advised that the number of Norseman membership units equal to the desired value of their gifts could not be known until a valuation of Norseman's assets could be made. Therefore, all gifts should be of a specific dollar amount, rather than specific numbers of Norseman membership units.
Based on this advice, each of the donors transferred $261,000 of Norseman membership units to each of their four children and $11,000 of Norseman membership units to each of their five grandchildren. The assignment provided as follows:
I hereby assign and transfer as gifts, effective as of January 1, 2004, a sufficient number of my Units as a Member of Norseman Capital, LLC, a Colorado limited liability company, so that the fair market value of such Units for federal gift tax purposes shall be as follows:
Name Gift Amount
Kenneth D. Wandry $261,000
Cynthia A. Wandry $261,000
Jason K. Wandry $261,000
Jared S. Wandry $261,000
Grandchild A $11,000
Grandchild B $11,000
Grandchild C $11,000
Grandchild D $11,000
Grandchild E $11,000
Total Gifts $1,099,000
Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date. Furthermore, the value determined is subject to challenge by the Internal Revenue Service ("IRS"). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted Units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.
The donors then had an appraisal completed by an independent appraiser, which the donors' accountant used to prepare a ledger for the Norseman capital accounts and the donors' gift tax returns. The capital account ledger reflected a decrease in the donors' capital accounts and an increase to the donees' capital accounts.
On the donors' gift tax returns, they reported gifts totaling $1,099,000 each and detailed the dollar amounts transferred to their children and grandchildren. However, the schedule describing the gifts stated that each child received a 2.39% interest in Norseman and each grandchild received a .101% interest in Norseman. The accountant backed into these percentages based on the dollar amounts transferred and the Norseman appraisal.
The IRS issued notices of deficiency asserting that the interests in Norseman were worth over 40% more than the value determined by the donors' appraiser.
In Tax Court, the IRS made three arguments against the transaction, rounding out its third with its long-standing public policy argument against savings clauses.
The IRS first argued that the gift descriptions, as part of the gift tax returns, were admissions that the donors transferred fixed Norseman percentage interests to the donees. This argument was based on the principle that statements made in a tax return signed by a taxpayer may be treated as admissions. The IRS relied on Knight v. Commissioner, where the donors stated they had transferred a fixed dollar amount of partnership interests to their children. At the Knight trial, however, the donors argued they had actually transferred less than the fixed dollar amount, thereby opening the door for the IRS to assert they had not transferred a fixed dollar amount, but rather a percentage interest. In Wandry, the Tax Court found that nothing the donors had done exposed them to such an argument. Although the schedules to the donors' gift tax returns listed percentage interests, the gifts were still reported as fixed dollar gifts. The donors' consistent intent and action proved that gifts of fixed dollar amounts were intended.
The IRS next claimed that the Norseman capital accounts controlled the nature of the gifts. Here, the IRS relied on case law that held that a completed gift occurred with respect to corporate stock when the corporate books were changed to reflect a change in ownership. The IRS argued that the same principle should apply with regard to a capital account. In other words, the percentage increase in the donees' capital accounts reflected the transfer of a percentage interest not merely a fixed dollar amount. The Tax Court rejected this argument as well, reasoning that there was no dispute about whether the gifts were completed, so the stock transfer cases were inapplicable. With regard to the capital accounts, the Tax Court found that the facts and circumstances of the gift determine the capital accounts of the donees; the capital accounts do not determine the nature of the gift.
Finally, the IRS reasoned that the gift documents themselves transferred fixed Norseman percentage interests to the donees because the defined value clause was void against public policy. Relying on Procter, the IRS argued that the donors' use of the defined value clause was contrary to public policy because (1) any attempt to collect the tax would defeat the gift, thereby discouraging efforts to collect tax, (2) the court would be required to pass judgment upon a moot case, and (3) the clause would reduce the court's judgment to a declaratory judgment.
The Tax Court noted King v. United States, a pre-McCord case upholding the use of a price adjustment clause. The clause at issue in King adjusted the purchase price of a specified number of corporate shares sold from a taxpayer to trusts created for the benefit of his children. The clause was triggered if the IRS determined the value of the shares to be different from the sales price. Under the Golsen rule, the Tax Court addressed King as Tenth Circuit precedent (the donors in Wandry lived in Colorado), but determined that it was not controlling precedent because the nature of the clause in King (a "price adjustment clause") differed from the Wandry clause (a "defined value clause") in that the King clause required additional consideration from the purchasing trusts.
Instead, the Tax Court rejected the IRS's public policy arguments by reconfirming the distinction between the type of savings clause used in Procter and the type of defined value clause used in more recent cases such as McCord, Estate of Christiansen v. Commissioner, Estate of Petter v. Commissioner and Hendrix v. Commissioner. A savings clause is void because it creates a transfer involving a "condition subsequent" in which the donor tries to "take property back" based on IRS redetermination. On the other hand, a defined value clause is valid because it relies on a "condition precedent" to transfer a "fixed set of rights with uncertain value."
The IRS countered that the Wandry clause differed from the McCord-type clauses because the Wandry clause would operate to return property to the donors. In McCord and its progeny, charitable beneficiaries were named as parties to the transactions, such that any revaluation by the IRS would result in increased value passing to the charities. In contrast, revaluation in Wandry would merely reallocate percentage interests among the donors and the donees.
The Tax Court dismissed this argument and held that there is no distinction between the McCord-type clause with a charitable donee and the clause used in Wandry. Nothing in McCord and its progeny required that the donors include charity in the planning.
Rather, according to the Tax Court, the essence of the case law concerns the property right that is transferred. The Tax Court expressly stated that "[i]t is inconsequential that the adjustment clause reallocated membership units among [the donors] and the donees rather than a charitable organization because the reallocations do not alter the transfers." Indeed, McCord and its progeny cut against the IRS's public policy arguments by including a charity as a favored donee under express public policy. But the standard for evaluating a public policy violation is not whether charity is involved. As the Tax Court confirms, there must be a "severe and immediate" threat to public policy to invoke an exception to the clear application of the Code. So long as the dollar amount passing to the donee is fixed by formula, it is immaterial that the percentage interests allocated to the donee may change as a result of IRS revaluation; the threat is neither severe nor immediate.
Wandry is a huge taxpayer victory. Practitioners should now feel much more comfortable advising clients with regard to defined value clause planning. Even if the IRS appeals, the appeal will lie in the Tenth Circuit, where King already serves as a taxpayer-friendly case, albeit the facts there were somewhat different from Wandry. With appellate level decisions in the Fifth (McCord), Eighth (Christiansen) and Ninth (Petter) Circuits, we anticipate that the Tenth Circuit will follow suit if called upon. Should the Tax Court decision stand as the final the word in Wandry, it will become a foundational case in defined value clause planning for several reasons.
1. It reconfirms the distinction between a savings clause and a defined value clause.
As most practitioners have long suspected, the viability of defined value clauses vis-à-vis the IRS's public policy arguments hinges on the distinction between a savings clause and a defined value clause. The former is invalid against public policy because it depends on a condition subsequent – namely, IRS revaluation serves to "undo" the gift and negate the donor's gift tax exposure. It is this type of clause that was understandably subject to defeat under Procter. The latter, however, transfers a far different set of legal rights – namely, the donee is entitled to a fixed dollar amount worth of property, notwithstanding the challenges of determining what percentage of that property may equate to the fixed dollar amount.
From a technical property law standpoint, the difference between to the two types of clauses is fundamental. Wandry is important because it reconfirms that this difference determines the gift tax consequences of the transaction. A donor's transfer of a fixed dollar amount worth of property fixes the value for transfer tax purposes. The challenge of translating that dollar amount into a percentage interest is not a risk the donor has to bear. The IRS is welcome to audit the transaction to make sure the percentage interests are divided properly, but that does not change the nature of the property right transferred.
2. It establishes that a charity is not a necessary party to the transaction. In fact, no "residual" beneficiary is required.
Subsequent to McCord, the ongoing concern was whether a charity must be a party to the defined value transaction in order to add to the bona fide nature of the transaction. Although Christiansen, Petter and Hendrix all added to the favorable body of case law supporting the use of defined value clauses, all also included charitable beneficiaries in the disputed transactions.
Many practitioners felt that a charity was a necessary party to the transaction in order to have it respected for gift tax purposes. Others felt that although a charity was not required, some type of "residual" beneficiary was required to receive any increase in value in the event of a redetermination. Many suggested using tax-preferred residual beneficiaries such as marital trusts, zeroed out GRATs or incomplete gift trusts.
To our knowledge, few felt comfortable using a clause where no residual beneficiary was named (what we call a "naked" defined value clause). Wandry is groundbreaking because it established not only that a charity is not required, but no residual beneficiary is required. Thus, "naked" defined value clauses now appear to be fair game.
3. It provides a road map for planning with defined value clauses.
The most significant outcome of the Wandry decision is that the Tax Court has essentially laid out a judicially approved road map for planning with defined value clauses. In applying Petter to the facts in Wandry, the Tax Court laid out four "landmarks" on the road to an effective defined value clause.
The donees must be entitled to a predefined percentage interest expressed a mathematical formula.
The defined value clause must provide that the donees are entitled to a percentage interest in the transferred entity equal to a defined value under a formula. The formula in Wandry transferred a percentage interest in Norseman equal to a fixed dollar amount divided by the fair market value of Norseman. The fair market value of Norseman was unknown, but the donees' interests were fixed by the formula.
The value of the transferred entity may be unknown at the time of the transfer, but that value must be a constant.
By selecting a specific date and a specific valuation method (i.e., value as finally determined for federal transfer tax purposes) the value of the transferred entity is constant for purposes of making the gift. That value may be unknown on the date of the transfer, but it is constant nonetheless.
Before and after an IRS audit, the donee must be entitled to the same percentage interest.
When using the "approved" formula, the percentage interest to which the donee is entitled does not change. This is because the percentage interest is defined as an interest worth a fixed dollar amount. As the denominator in the formula changes (in the event of a redetermination of the value of the transferred entity) the percentage interest papered in the donee's name may change, but the percentage interest to which the donee is entitled does not. That is because the donee's interest is a fixed dollar amount, not a fixed percentage.
An audit must merely ensure that the donees receive the percentage interest they were always entitled to receive.
The Tax Court in Wandry conceded that absent an audit, the donees might never have received the proper percentage interests to which they were entitled, but that does not mean that the transfers were dependent upon IRS audit. The audit simply ensured that the percentage interests were allocated consistent with what the donees were entitled to receive.
4. It contains a variety of interesting facts that merit further consideration.
The real take away from Wandry is the approval of the "naked" defined value clause without a charitable beneficiary. Additionally, we highlight some latent facts in the case that make it all the more interesting.
The donors obtained the appraisal (well) after the transfer. An appraisal before the transfer should be equally valid.
One of the reasons the Tax Court approved the defined value clause was because the value of the assets to be transferred was not yet determined. At the time the donors completed their gifts, there were two distinct uncertainties as to the value of Norseman. First was the value that an appraiser would assign to a Norseman membership interest (because the appraisal was not obtained prior to the gifts). Second was the value that the IRS would assign to a Norseman membership interest if the gift tax returns were audited. Accordingly, in defining the amount subject to the gift, the donors expressed that the number of membership units could not be known but must be determined after such date based on all relevant information as of that date and that the value determined by the appraiser may be subject to challenge by the IRS.
Does this mean that Wandry will only work if the transfer is made before the appraisal is complete? This could be a problem if true. For example, if the transaction involved a sale to a defective grantor trust and the planner recommended a 10% seed gift, how could the settlor know how much cash to give it if an appraisal had not been completed beforehand?
We do not believe that the appraisal must be postponed until after the gift (or sale) in order for the Wandry clause to be effective. Based on the Tax Court "road map," what is required is that some uncertainty as to valuation be present. In Wandry, the uncertainty was present both because an appraisal had not been completed and because the IRS might change the value for gift tax purposes. But even if the appraisal is completed before the gift (or sale), the uncertainty of IRS redetermination should provide enough uncertainty as to value to satisfy this aspect of the Tax Court "road map."
The transaction was a gift (with no sale). The reasoning should apply equally to a sale.
Although Wandry involved a gift and not a sale, the reasoning should be equally applicable to a transaction involving a sale or a seed gift followed by a sale. Just as Petter extended the McCord reasoning to a seed gift and sale transaction, we think that Wandry would be similarly extended, if such a challenge is ever brought. The theory is the same and should apply in either case; where there is uncertainty as to value, a defined value clause which is a condition precedent should be respected and avoid the imposition of gift tax.
The Wandry clause refers to adjustment in the same manner as a federal estate tax formula marital deduction would be adjusted for IRS redetermination. This reference is helpful, but not essential to the validity of the clause.
In describing the intended transfer, the donors in Wandry stated that the transferred Norseman membership interests should be adjusted "in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law." The inclusion of this statement was helpful to describe the type of transfer that the donors intended to make. Given the state of the law at the time of the transaction (pre-McCord), it makes sense that the donors' attorney would want to tie the transaction to other types of formula clauses that have widespread approval for transfer tax purposes.
The inclusion of such a clause was not essential to the Tax Court's holding. What was essential was the formulaic adjustment that IRS redetermination would effect. The Tax Court generously lays this out in its "road map." The formula should be expressed as:
x = defined value / fair market value of transferred entity
In this case, "x," which is the percentage interest that is intended to be transferred, is automatically adjusted with IRS redetermination of the fair market value. There is no condition subsequent because the fair market value is hard-wired into the formula that determines the percentage transferred.
Wandry cites King, a price adjustment clause case. Price adjustment clauses might be more widely approved in the future.
Although the Wandry court declined to rely on King because King involved a price adjustment clause, it is appears to have done so on the basis of a factual, not a legal, distinction. The Tax Court had the opportunity to remark that price adjustment clauses were somehow different and should not be respected, but it did not do so. A price adjustment clause, at least when drafted as a condition precedent, should also be effective to avoid the imposition of gift tax. (Whether the clause in King was drafted as a condition subsequent or condition precedent is not entirely clear from the facts of the case.) Although it is a different kind of clause, the theoretical basis is the same. To be clear, Wandry does not go so far as to say this – but it didn't slam the door on the potential effectiveness of price adjustment clauses either.
It is important to note that nothing escapes the estate and gift tax system through the application of a condition precedent clause. Although gift tax was avoided by the donors in Wandry, their estates will include the Norseman membership interests that were precluded from transfer to the children and grandchildren by the defined value clause. Estate tax will be imposed on those interests at that time. Similarly, nothing escapes the estate and gift tax system through the application of a condition precedent price adjustment clause. By requiring the purchaser to pay the seller (donor) more for what the purchaser is buying, the price adjustment clause keeps the estate of the seller (donor) "full." That additional value will be taxed at death.
There was an apparent inconsistency in the gift tax return. It is best to avoid this inconsistency in future planning.
The Tax Court noted that on the gift tax return, the donors stated they had transferred a fixed dollar amount in Norseman. On an attached schedule, however, the accountant had listed percentage interests based on the appraisals. Based on consistent testimony and other corroborating facts, the Tax Court found that the donors had transferred a fixed dollar amount, not a fixed percentage interest.
The testimony in Wandry was sufficient to keep the donors out of trouble. However, the fact that the Tax Court spent time addressing this argument should serve as a warning for future planning. Practitioners must carefully review the disclosure of the transaction on the gift tax return to make sure that the tax reporting is consistent with the tax planning. This includes stating on the Form 709 that the gift was intended as a fixed dollar amount, with a reference to the gift documents that could be attached to the return.
Norseman held cash and marketable securities.
The assets underlying the entity interests being transferred should have no bearing on the validity of a defined value clause. But given all of the case law in the Section 2036 area concerning the validity of family limited partnerships holding cash and marketable securities, we find it interesting (and ironic) that such an entity would be the subject of this groundbreaking taxpayer victory.
The Tax Court stated the value of Norseman "assets" was unknown.
The Tax Court's language concerning the valuation of Norseman is a bit odd. The opinion states that the donors hired an appraiser to value Norseman's "assets" and the "unknown" at the time of the transfer was the value of Norseman's "assets." Considering that Norseman held cash and marketable securities, the value of Norseman's assets should not have been difficult to determine. The challenge should have come in determining the discount to apply to the 1% membership interest that was subject to the valuation. We speculate that this may have been just a poorly written portion of the opinion, and, in any event, may be inconsequential. What matters is that the value of a membership interest was uncertain at the time of the transfer but the value being transferred was a constant fixed dollar amount.
The donors used Norseman membership interests to make annual exclusion gifts. It is fascinating that this wasn't challenged.
Given the recent decisions in Price v. Commissioner and Fisher v. United States, it is surprising that the donors' transfer of Norseman membership interests as annual exclusion gifts wasn't challenged. The opinion does not detail the restrictions on distributions, withdrawal of capital or transfers of interests, or the managing member's fiduciary duties (if there was one) – so perhaps these interests did qualify for the annual exclusion. We can only speculate.
The decision seems fair when comparing donors making gifts of assets with readily ascertainable values to donors making gifts of harder to value assets.
From a fairness perspective, Wandry makes sense. Why should a donor who wants to make a gift of cash, or securities for which there is a ready market, be better able to avoid gift tax than a taxpayer wanting to make a gift of a harder to value asset? Both donors intend to make gifts of a certain value and be able to assess the corresponding gift tax consequences. If the donor who makes a good-faith effort to value the gift is later found to have been wrong, it seems unfair for that donor to bear the brunt of a gift tax simply because the transferred asset was hard to value. Wandry solves that problem by providing consistent treatment for both types of donors.
Practitioners who wish to advise clients to engage in defined value clause planning would do well to understand the facts of Wandry and tailor their planning accordingly. Make sure your donors understand that they are transferring a fixed dollar amount, not a percentage interest, and review the gift tax returns to make sure the accountant has papered the gift appropriately. Hopefully, Procter is now just a speck in the rear view mirror as we follow the Wandry "road map" and are able to give our clients more confidence that they can make transfers and be protected from the immediate imposition of gift tax!
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
LISI Estate Planning Newsletter #1945 (April 9, 2012) at http://www.leimbergservices.com Copyright 2012 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.
Wandry v. Comr., 2012-88;, McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006); Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944); Knight v. Commissioner, 115 T.C. 506 (2000); Thomas v. Thomas, 197 P. 243 (Colo. 1921); King v. United States, 545 F.2d 700 (10th Cir. 1976); Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009); Estate of Petter v. Commissioner, 653 F.3d 1012 (9th Cir. 2011); Hendrix v. Commissioner, T.C. Memo 2011-133; Price v. Commissioner, T.C. Memo 2010-2; Fisher v. United States, 105 AFTR 2d 2010-1347.
 Wandry v. Commissioner, T.C. Memo. 2012-88, available at:
 McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006).
 Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944).
 Knight v. Commissioner, 115 T.C. 506 (2000).
 See Thomas v. Thomas, 197 P. 243 (Colo. 1921).
 King v. United States, 545 F.2d 700 (10th Cir. 1976).
 Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009).
 Estate of Petter v. Commissioner, 653 F.3d 1012 (9th Cir. 2011).
 Hendrix v. Commissioner, T.C. Memo 2011-133.
 Price v. Commissioner, T.C. Memo 2010-2.
 Fisher v. United States, 105 AFTR 2d 2010-1347.
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