The Quandary Over Wandry
Audit Risk and Use of Defined Value Clauses
Estate planning attorneys and their clients are aware of the risk of an audit. Despite knowing this risk, they seek certainty. Business valuation is as much art, as it is science. Estate planning attorneys have devised techniques to hedge the aforementioned risk and provide their clients with a greater degree of certainty. One such technique utilized by estate planners is the use of Formula or Defined Value Clauses. The merit of defined value clauses seeks to mitigate audit risk, while providing the client with the certainty of knowing, at the date of transfer, their ultimate gift tax liability. While defined value clauses seem to be the â€śmagic bulletâ€ť of providing certainty to clients, they have long been loathed by the IRS, and have been a â€śred flagâ€ť leading to an audit. This article discusses the use of defined value and formula clauses in high net worth estates.
When having an estate plan prepared, clients seek the greatest degree of certainty possible; namely certainty that the gifts are at the â€ścorrectâ€ť value and are thus free from audit risk.Â This places a great deal of pressure on the valuation analyst, as the valuation of the business enterprise is oftentimes the foundation of the estate plan.Â There is, however, always audit risk no matter how well researched and well articulated the valuation is.Â That is because, at its fundamental level, valuation is not a science.Â A large portion of valuation is subjective; as such, the IRS may have a materially different opinion as to the ultimate value of a business enterprise.
Estate planners have devised techniques to hedge the aforementioned risk and provide their clients with a greater degree of certainty.Â One such technique utilized by estate planners is the use of Formula or Defined Value Clauses.Â The merit of defined value clauses seeks to mitigate audit risk, while providing the client with the certainty of knowing, at the date of transfer, their ultimate gift tax liability.Â While defined value clauses seem to be the â€śmagic bulletâ€ť of providing certainty to clients, they have long been loathed by the IRS, and have been a â€śred flagâ€ť leading to an audit.Â When faced with the defined value issue, estate and gift tax examiners would give a very simple, short, one sentence response to formula clauses, â€śWe donâ€™t respect formulas.â€ťÂ This practice ended after Wandry v. Commissioner, T.C. Memo. 2012-88, in which the United States Tax Court (â€śTax Courtâ€ť) upheld a stated dollar value â€śformula transfer.â€ťÂ Some IRS examiners still state that they cannot take a defined value clause into consideration at the examiner level, but it could be considered at appeals.
It should be noted that the IRS appealed the Tax Courtâ€™s Wandry decision on August 28, 2012.Â The case was set to be heard by the United States Court of Appeals for the 10th Circuit (â€ś10th Circuitâ€ť), but the IRS subsequently filed a dismissal and dropped the appeal.Â It should be noted that the 10th Circuit approved a defined value clause (formula price adjustment clause) in King v. United States, 545 F.3d 700 (10th Cir. 1976).Â In King, a formula adjusted the purchase price of shares sold to a trust for children if the IRS determined the fair market value of the shares to be different than the sales price.Â The IRS filed a non-acquiescence in the Wandry caseâ€”I.R.B. 2012-46 (non-acquiescence relating to the courtâ€™s holding that taxpayers made a completed transfer of only a 1.98 percent membership interest in Norseman Capital, LLC).
By way of background, a defined value clause works in two different manners and each will be described in greater detail in the following sections of this article.Â In general, a defined value clause works to state that a fixed dollar amount is transferred (either by gift or sale), and the actual number of shares of units (membership or partnership) is based on a valuation.Â Consider the following example where the donor intends to make a one million dollar gift, and the fair market value of the business enterprise was determined, in an independent and qualified business appraisal, to be $10.0 million, on a non-marketable minority interest basis.Â As such, the percentage of the enterprise that was transferred is equal to a 10.0 percent non-marketable minority interest ($1.0 million transfer amount / $10.0 million non-marketable minority interest value of the business enterprise = 10.0%).
The IRSâ€™ primary concern with defined value types of clauses is that they may encourage taxpayers to use aggressively low valuations.Â If the IRS audits the transfer, the worst possible outcome is that a smaller number of shares (lower percentage of the subject enterprise) are transferred.Â Utilizing the above example, assume the IRS takes the position that the fair market value of the business enterprise is $15.0 million, the percentage interest associated with the transfer of one million dollars would now only be 6.7 percent ($1.0 / $15.0 = .6667).Â If there is no audit, then the taxpayer gets away with an abusive transfer.
After the IRS filed its non-acquiescence in the Wandry case, they informally indicated that they were looking for the â€śright caseâ€ť to mount another attack on Wandry-type clauses.Â The IRS seems to have found its case in True v. Commissioner (Tax Court Docket Nos. 21896-16 & 21897-16).Â It should be noted that the taxpayers, a husband and wife, made the split gift election, hence the separate Tax Court petitions for Mr. and Mrs. True.Â The interesting fact about this case is that the taxpayers were residents of Wyoming, and the case would be appealable to the 10th Circuit, which, as described, has already ruled in favor of such defined value clauses.
It should be noted that H.A. True III (the taxpayer in the abovementioned case) is the son of H.A. True, Jr., who was the taxpayer in True v. Commissioner, 390 F.3d 1210 (10th Cir. 2004) affâ€™g, T.C. Memo. 2001-167 (2001), involving, among other things, the value of closely held businesses and the effect of the price in a buy-sell agreement on the value for gift and estate tax purposes.
The following sections will provide a background and analysis of the True case, as well as other relevant cases.
The Trueâ€™s made gifts of interests in a closely held business to one of his daughters, and made sales of the business to all of his other children, as well as to a trust.Â All of the abovementioned transfers were made based on a valuation prepared by FMV Opinions, Inc. (â€śFMV Opinionsâ€ť), a nationally recognized valuation firm.
The gifted units were transferred to one of the Trueâ€™s daughtersâ€”Barbara True.Â The gift transfer agreement provided that if the transfer of those interests is determined, for federal gift tax purposes, to be worth more than $34,044,838 amount of the gift (which represented the defined value), â€ś(i) the ownership interest gifted would be adjusted so that the value of the gift remained at $34,044,838, and (ii) Barbara True would be treated as having purchased the ownership interests that were removed from her gift.â€ťÂ As evidenced in the above statement, the defined value gift, in this case in the amount of $34,044,838, provide the Trueâ€™s with the certainty of knowing their gift tax exposure, as a successful IRS audit would not change the value of the gift, only the size of the transferred interest and, in the True case, that excess would be purchased by Barbara True.
Sales of business interests were made to Barbara True, the other two children, and a trust.Â According to the petition, the transfer agreement for the sales to the children â€śprovided that if it is determined for federal gift tax purposes that the interests sold were undervalued by FMV Opinions, the purchase price would be increased to reflect the finally-determined fair market values.â€ť
The IRS alleged a gift tax deficiency of $16,591,418 by each of Mr. and Mrs. True.Â The taxpayers took the position that the valuations were correct, but if the transferred interests are determined to have a higher value, no gift should result because of the price adjustment provisions of the transfer agreement.
General Description of Defined Value Clauses and the Different Types of Defined Value Clauses
As noted at the beginning of the article, when clients are making transfers of hard to value assets, clients are concerned that gift taxes may result if the assumed value at the time of transfer ends up being lower than the value that is finally determined for gift tax purposes.Â This has given rise to two types of clauses to define what is transferred by formula in order to avoid (or hedge) the gift tax risk, those being:
- Formula Allocation Clauses, and
- Formula Transfer Clauses.
The agreement utilized in the True transfers was a hybrid of the two approaches.Â The following provides a description of each type of formula clause.
Formula Allocation Clauses
A â€śformula allocation clauseâ€ť allocates the amount transferred among various transferees.Â In general, an asset is transferred and allocated between taxable and non-taxable transferees, utilizing a formula allocation.Â Again, this type of formula clause serves the purpose of mitigating gift tax risk, as the actual dollar amounts transferred to taxable and non-taxable transferees remains constant, and upon a successful IRS audit, only the percentage interests allocated among the transferees changes.Â Examples of non-taxable transferees include: charities, spouses, QTIP trusts, â€śincompleteâ€ť gift trusts (where there is a retained limited power of appointment or some other retained power so that the gift is not completed for federal gift tax purposes), and a â€śzeroed-outâ€ť GRAT.Â With this type of clause, the allocation can be based on values as finally determined for gift or estate tax purposes, or the allocation can be based on an agreement among the transferees as to values.
The following cases have previously recognized formula allocation defined value clauses, all involving clauses with the â€śexcessâ€ť value passing to charity:
- McCord v. Commissioner, 461 F.3d 614 (5th 2006),
- Christiansen v. Commissioner, 130 T.C. 1 (2008), affâ€™d 586 F.3d 1061 (8th 2009),
- Petter v. Commissioner, T.C. Memo. 2009-280, affâ€™d, 653 F.3d 1012 (9th 2011), and
- Hendrix v. Commissioner, T.C. Memo. 2011-133.
Two of the cases relied on an agreement among the transferees as to valuation (McCord and Hendrix) and the other two cases relied on finally determined estate (Christiansen) or gift (Petter) tax values.
Formula Transfer Clause
In Wandry v. Commissioner, T.C. Memo. 2012-88 the Tax Court upheld a stated dollar value â€śformula transferâ€ť clause of, in effect, â€śthat number of units equal in value to $X as determined for federal gift tax purposes.â€ťÂ The court addressed the IRSâ€™ argument that the formula assignment was an invalid â€śsavings clauseâ€ť under the Procter Case.Â Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944).Â Judge Haines (the judge in Wandry) concluded that the transfers of units having a specified fair market value for federal gift tax purposes are not void under the savings clause rationale, as they do not operate to â€śtake property backâ€ť as a condition subsequent.
True Transfer Clause
The Procter clause was analyzed as a transaction with a â€ścondition subsequentâ€ť in which the â€śexcessâ€ť units were transferred back to the donor.Â The clause in Proctor stated the following:
Eleventh:Â The settlor is advised by counsel and satisfied that the present transfer is not subject to Federal gift tax.Â However, in the event it should be determined by final judgment or order of a competent federal court of last resort that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all parties hereto that in the event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance in trust hereunder and shall remain the sole property of Frederic W. Procter free from the trust hereby created.
The language of the Procter transfer literally states that counsel believes the transfer is not subject to gift tax, and that any property â€śhereby transferredâ€ť that would be subject to gift tax is â€śdeemedâ€ť not to be included in the conveyance.Â This is different from the clause in Wandry that only purported to transfer a specified dollar value of property and nothing else.Â Similarly, the clause used in True did not contemplate that any of the transferred shares would be returned to the donor.Â In contrast, if there were a difference in value, Barbara True would purchase the shares that would have been subject to gift tax.
The Wandry case provided the following:
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.
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.Â Furthermore, the value determined is subject to challenge by the Internal Revenue Service (â€śIRSâ€ť).Â 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.Â Nevertheless, if, and 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.
As discussed above, the Wandry clause had the effect of only transferring units equal to a specified monetary value.Â Some planners have observed that the effect of the Wandry clause is as in Procterâ€”the units in excess of the gift amount end up being owned by the donor.Â The clauses are different, literally, in that, the Procter clause actually transferred the larger amount and the excess was â€śdeemedâ€ť not to be included, whereas the Wandry clause never purported to transfer more than the specific dollar values.Â By contrast, the True clause makes a transfer of all of the units that were transferred to Barbara True in the gift transaction.Â To the extent that their value exceeds the specified amount, the excess is purchased by Barbara; none of the shares are returned to Mr. or Mrs. True.Â In that regard, the True clause is somewhat like a formula allocation clause, in that all of a certain block of units are transferred, and the formula describes how many units are gifted and how many units are sold.
Defined Value Transfers in Sale Transactions
The majority of this article has been committed to a discussion of defined value transfers in gift transactions; however, it is noteworthy to point out that sale transactions can also be structured with a defined value clause.Â Petter and Hendrix both involved combined gift/sale transactionsâ€”with formula allocation clauses allocating the â€śexcessâ€ť value over the standard purchase price to charity.
A sale could also be structured with the assignment being of the number of shares equal to the specified purchase price.Â The Woelbing cases involved sales transactions in which Mr. Woelbing sold to a grantor trust that number of shares of stock in a closely held company having a value equal to $59 million, in return for a $59 million note.Â The IRS contested the valuation (and also argued that IRC Code Sections 2702, 2036, and 2038 applied).Â Estate of Donald Woelbing v. Commissioner, Docket No. 30261-13; Estate of Marion Woelbing v. Commissioner, Docket No. 30260-13.Â The Woelbing cases were settled with the IRS reportedly giving effect to the Wandry provision in the sales agreement, but the IRS could assure any shares that were not transferred were subject to estate taxation in Mrs. Woelbingâ€™s estate (because she had died days after receiving the gift tax notice of deficiency).
Planners could also structure a formula clause similar to the one approved in King v. United States, 545 F.2d 700 (10th Cir. 1976).Â That case upheld a formula that adjusted the purchase price of shares sold to a trust for children if the IRS determined the fair market value of the shares to be different than the sale price.Â It should be noted that this is the approach utilized in the sale transactions in the True cases.)
The 5th Circuit rejected the price adjustment approach in a sale for a private annuity in Estate of McLendon v. Commissioner, T.C. Memo 1993-459, revâ€™d 77 F.3d 447 (5th Cir. 1995).Â Similarly, a â€śprice adjustmentâ€ť clause in a transaction was not given effect in Harwood v. Commissioner, 82 T.C. 239 (1984), affâ€™d without published opinion, 786 F.3d 1174 (9th Cir. 1986), gift transfer of limited partnership units with a provision that if the value was finally determined to exceed $400,000 for gift tax purposes, the trustee was to execute a note back to the donor for the â€śexcess value.â€ť
In conclusion, while defined value clauses have been a â€śhot buttonâ€ť issue for the IRS, do not be surprised to see them utilized in current estate plans.Â As valuation analysts, we must not succumb to the pressure to impugn our independence based on the flexibility provided by such clauses, as oftentimes, when estate planners utilize a variant of the above-discussed formula clauses, they are seeking an overly aggressive valuation slanted to the clientâ€™s benefit.
Peter H. Agrapides, MBA, CVA, is with the Salt Lake City, Utah, and Las Vegas, Nevada, offices of Western Valuation Advisors. Mr. Agrapidesâ€™ practice focuses primarily on valuations for gift and estate tax reporting. Mr. Agrapides has experience valuing companies in a diverse array of industries. These engagements have ranged from small, family owned businesses to companies over $1 billion.
Mr. Agrapides can be reached at (801) 273-1000 ext. 2, or by e-mail to firstname.lastname@example.org.