January 2012 | Issue 56
Introduction
The U.S. Court of Appeals for the Ninth Circuit, in Petter v. Commissioner, 653 F. 3d 1012, (8/4/11), found for the taxpayer in a case involving the use of a “formula clause” to reallocate gifts of property to heirs and charity. >
The Plan
Anne Petter lived in Washington State. After inheriting a large amount of United Parcel Service (“UPS”) stock, she worked with an estate planner to devise an estate plan which would give some of her wealth to charity and as much of her stock as she could to two of her children, without having to pay gift tax.
To accomplish this, Anne created the Petter Family LLC (“PFLLC”), a Washington limited liability company, and transferred approximately $22.6 million worth of UPS stock to it in exchange for membership Units. She then created defective grantor trusts for two of her children, the “Donna” trust for her daughter Donna, and the “Terry” trust for her son Terrance. It was her intention to transfer some of the PFLLC Units to these trusts.
Anne did not want to pay gift tax in connection with the transfer of PFLLC Units to the trusts. Therefore the transfers were coupled with simultaneous donations of Units to two tax-exempt public charities. The transactions were accomplished in two steps, a gift and a sale.
The Gifts
On March 22, 2002, Anne gave the trusts Units in PFLLC equal in value to the unused portion of her unified exemption, which at the time amounted to approximately $908,000, or $454,000 per trust. The gift documents for each trust provided that the trust and the charity, in the aggregate, would receive 940 Units. Of these, each trust would receive a number of Units equal in value to $454,000. Any additional Units would go to the charity. The Units had been valued by an outside appraiser at $536.20 per Unit. Using this value, the trusts each received 846 Units. The balance of 94 shares went to the charities. The documents provided that that if the value of the Units that the trust received initially was finally determined for federal gift tax purposes to exceed the $536.20 per Unit value, the trust would transfer the “excess” Units to the charity. If the value were lower, the charity would transfer the excess to the trusts.
The Sale
Three days later, on March 25, 2002, Anne assigned to each trust and to a charity 8,459 Units of PFLLC. The document again used a “defined value” formula clause setting forth how many shares would go to the trust and how many shares would go to the charity. Under the formula, Anne was assigning to each of the trusts a number of Units equal in value to $4,085,000, at the per Unit value that was finally determined for federal gift tax purposes. The rest of the Units were to be given to charity. The 7,619 Units assigned to each of the trusts in this step was paid for by the trusts with a note for $4,085,000.
Anne’s 2002 gift tax return reflected gifts of $454,000 each to the two trusts, on which no gift tax was due because of the availability of the remainder of Anne’s unified exemption. Also shown were the donations of Units to the charities, valued for charitable deduction purposes at the same $536.20 per Unit.
The IRS Weighs In
In November 2006, the IRS sent Anne a gift tax deficiency notice. The IRS said that Anne had undervalued the Units, which in their view were really worth $794.39 each. Accordingly, Anne’s gift to the two trusts exceeded her available gift tax exemption by over $400,000, and the sales to the two trusts represented a total gift of nearly $4 million (the amount by which the value of the Units sold to the trusts exceeded the value of the notes received in return).
Furthermore, the IRS said that the “defined value formula clause,” which reallocated excess units to charity if the “finally determined” gift tax value of the Units was higher than initially assumed, was void, as being against public policy.
The Parties go to Court
Shortly before trial in Tax Court, the parties stipulated that each PFLLC Unit was worth $744.74. The trusts therefore had too many Units and, under the reallocation agreement, had to transfer the excess Units to charity. The IRS denied an additional charitable deduction for this subsequent transfer, arguing that the charities would never have received the extra Units if it hadn’t been for the IRS audit.
The Estate prevailed over the IRS in Tax Court (T.C. Memo. 2009-280, 12/7/09) and also in the IRS’s appeal to the 9th Circuit Court of Appeals.
Concluding Comments
The defined value formula clause used by the Estate ultimately protected it from a “spillover” gift tax liability that would have occurred in its absence in the event that the IRS successfully challenged the per Unit valuation used for the gifts. It converted any potential spillover gift to the trusts into a charitable deduction.
It is worth noting that the planners in this case also successfully used two additional estate planning techniques.
One technique was the formation of a family limited liability company to hold the UPS shares. This permitted the use of a valuation discount from the net asset value of the underlying shares in valuing the PFLLC Units. This permitted, in effect, the transfer of more UPS shares.
The other technique was the employment of leverage by the trusts (the notes) to pay for the lion’s share (90%) of the PFLLC Units that they acquired. This multiplied by a factor of ten the number of Units that could be transferred to the trusts tax free within the amount of gift tax exemption that was available.
This was a complex transaction undertaken by someone who had a desire to benefit charity as well as her heirs. It is a method to permit maximum use of a gift tax exemption without triggering a significant gift tax liability in the event that the value of discounted or hard-to-value property is successfully challenged on audit.
Of course, such a transaction should not be undertaken without the employment of first rate legal, tax, and valuation advisors.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) addressed herein.
