Pen and paper


Many of our clients are taking advantage of the current environment of historically high exclusion amounts to initiate intra-family transactions prior to year-end. Effectuating those transactions so close to the end of the year when it involves a hard-to-value asset, such as a privately held business, can be problematic.  In fact, with just a few weeks left in the year, there may be insufficient time to obtain a robust and reliable appraisal.

At this point, many advisers will utilize a defined value clause, a type of formula clause, that enables the client to complete the transfer now, prior to the completion of the underlying asset appraisal.  Formula clauses of various shapes and sizes have been utilized for decades, with defined value clauses gaining added recognition with the 2012 Wandry[1] decision.  On the other hand, not all formula clauses have been accepted by the United States Tax Court, and the Internal Revenue Service has not publicly acquiesced to formula clauses generally, continuing to debate their use in light of public policy principles.  Therefore, taxpayers and advisers should be aware of the relevant issues and past decisions of the Tax Court.  Proper drafting of a formula transfer mechanism is paramount.

In various cases, the Tax Court held that a gift of stock-based upon a formula, where the gift is of a fixed dollar amount rather than a specific number of shares or a percentage interest, is entirely valid and has not accepted IRS’s public policy arguments.  This means that the taxpayer can make a gift that, even if successfully challenged by the IRS, will likely not result in gift tax or penalties being due.  In Wandry, the defined value clause called for any valuation adjustment to generate a re-allocation of shares between the transferor and the transferees (i.e., a portion of the equity thought to be transferred would effectively revert to the transferor).  In prior cases, including McCord,[2] Hendrix[3], Petter[4] and Christiansen,[5] formula transfer clauses called for any adjustment to generate a reallocation of the transferred interests between taxable transferees and non-taxable transferees (e.g., charities), thus insulating the transferor from potential gift tax and penalties.

Some practitioners have incorrectly drafted savings clauses stating that the gift transfer is for a set number of shares or percentage interest.  If it is later found by a court that the value of the transferred interest exceeds the transferor’s exclusion amount, the clauses call for the taxpayer to take back an amount of equity equaling the excess over the exclusion, such that no tax would be owed.  In Procter[6], the Fourth Circuit held that this type of clause was ineffective as it created a condition subsequent that could not become operative until a final judgment had been rendered, but once a judgment had been rendered, it could not become operative because the matter involved had already been concluded by such final judgment.  Taxpayers using these types of clauses have lost in court, as seen in Proctor and Ward.[7]

With defined value clauses, the key is to properly draft the clause to define the gift as a certain dollar amount of equity interests based on the fair market value of such interests as finally determined for gift tax purposes.  This language was cemented as critical by the Wandry and Petter cases and further confirmed by the recent Nelson[8] decision.  In Nelson, the Tax Court ruled against the taxpayer with respect to the use of a defined value clause, because such clause referred to a dollar amount as determined within 90 days by a qualified appraiser.  This language closed the door to any further adjustment because it effectively locked in the percentage of the equity that was transferred.

In addition, all legal documents and related tax returns should be consistent with respect to using a specified dollar amount.  If the legal documents specify a dollar amount and then the gift tax return refers to a specific number of shares or percentage interest, that may provide an opening for the IRS to argue the invalidity of the defined value clause in the legal transfer documents.

While losing on the defined value clause issue, the decision was very favorable to the Nelsons with respect to valuation discounts.  Discounts for lack of control and lack of marketability on the core underlying asset, an operating business, summing to 40.5% were determined.  Then, a total discount of 31.6% was determined at the family holding company level.  The Nelson case is another in a long line of cases supporting significant valuation discounts for non-controlling interests in closely held entities where the facts are supportive, and the valuation expert puts forth appropriate data and convincing analysis.

The use of a defined value clause may be an appropriate technique in cases in where the gift involves a hard-to-value asset with a tight window to the end of the tax year looming.  Clients should consult with their tax and legal advisors before utilizing this type of clause for tax purposes.

Authored by Todd G. Povlich and Tadd A. Lindsay

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[1] Wandry v. Commissioner, T.C. Memo 2012-88.

[2] McCord v. Commissioner, 461 F. 3rd 614 (Fifth Circuit).

[3] Hendrix v. Commissioner, T.C. Memo 2011-133.

[4] Petter v. Commissioner, T.C. Memo 2009-280.

[5] Christiansen v. Commissioner, 130 T.C. 1 (8th Circuit).

[6] Proctor v. Commissioner, 142 F.2nd 824 (4th Circuit).

[7] Ward v. Commissioner, 87 T.C. 78.

[8] James C. Nelson v. Commissioner, TC Memo 2020-81.


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