Formula Clauses Receive IRS Scrutiny Despite a Favorable Tax Court Ruling

While a gift of closely-held business interests can be an effective wealth transfer technique, an IRS revaluation of the gifted interests can cause unintended gift tax consequences.  For example, if a donor makes a gift of $5 million of business interests in 2012 (when the lifetime gift tax exemption is $5 million), and upon audit the IRS determines that the business interests were really worth $6 million, the donor would be forced to pay gift tax on the excess $1 million in value.  In order to minimize this risk, estate planners have traditionally recommended that the gift documents distribute any excess gift following an IRS revaluation to charity, because a charitable gift is not subject to gift tax.   This strategy (called a formula clause) has been approved in several cases as consistent with public policy favoring charitable gifts.  However, many commentators believed that a formula clause would only pass muster if a charity was involved, due to those public policy considerations.

The Tax Court’s recent decision in Wandry v. Commissioner, T.C. Memo 2012-88, upended this conventional wisdom.  The Wandrys made gifts of a specific amount of LLC units to their children and grandchildren. However, the gifting documents stated if the value of the units is finally determined after an audit to be different from the appraised value, the number of gifted units would be adjusted so that the value gifted equals a specific amount (the formula clause).  The IRS audited the gift tax returns and found that the value was higher than the originally appraised value.  The Wandrys said that the gift amounts should be adjusted pursuant to the formula clause, but the IRS argued that the gifts were of the fixed percentage interests designated on the gift tax returns.  The Tax Court agreed with the Wandrys, holding that the formula clause was a valid reallocation of LLC units among the Wandrys and their children and grandchildren.  The Wandrys had transferred a fixed set of rights to a specified value, and were not trying to take property back from the donees.  The court stated that the charitable gift in other cases was a contributing factor, but not determinative.  Wandry thus increases the options for taxpayers interested in making gifts of hard-to-value assets.

The IRS appealed the Wandry decision, but then withdrew its appeal.  However, the IRS then announced in Action on Decision 2012-004 (November 13, 2012) that it believes the case was wrongly decided.  While the Tax Court’s decision is controlling authority, the IRS’s opposition means that careful analysis is required whenever gifts of closely-held business interests are made.  Our estate planning attorneys are experienced in evaluating all of the factors affecting such gifts, and can assist in determining whether taking advantage of the Wandry decision is the right choice in a particular situation.

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