Guidance on Formula Gifts Between Family Members

Wandry v. Commissioner

In certain cases, formula-driven, gift-giving plans have proved to be successful. In other cases, they have not. What characteristics differentiate a formula gift-giving plan that can withstand the Internal Revenue Service (the “service”) scrutiny and be upheld in Tax Court from a plan that gets defeated?  The Wandry decision¹ provides insight into these questions and highlights issues that taxpayers and tax advisers should consider when structuring and implementing a gift-giving plan. This discussion summarizes: (1) the facts of the Wandry case; (2) the service’s arguments; and (3) the Tax Court decision.

Wandry v. Commissioner

In 1998, Albert and Joanne Wandry (“petitioners”) formed the Wandry Family Limited Partnership (“Wandry FLP”), a Colorado limited liability partnership.  Upon its formation, they contributed cash and marketable securities to the Wandry FLP.

The petitioners, along with their advisers, were contemplating a tax-free, gift-giving plan through transfers of Wandry FLP partnership interests up to their annual gift tax exclusions of (1) $11,000 per each donor under Section 2503(b); and (2) additional gifts in excess of their annual exclusion up to $1 million for each petitioner under Section 2505(a). On January 1, 2000, the petitioners implemented the gift-giving plan using the Wandry FLP partnership interests. 

The transfer of these interests is not at issue in this case. However, in August 2001, the petitioners formed Norseman Capital, LLC (“Norseman”), a Colorado limited liability company, to manage the business and affairs of a recently established family business. By 2002, all of Wandry FLP’s assets had been transferred to Norseman.

On January 1, 2004, the petitioners executed separate assignments and memorandums that gifted membership units of Norseman to their children and grandchildren. 

Although the petitioners did not have a completed valuation at the time of the gift, the assignment document contained the following language:

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 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.

This paragraph is called the ‘adjustment clause.’ 

The only gifts the petitioners ever intended to make were dollar amounts of Norseman membership units equal to their federal gift tax exclusions. The petitioners were advised by tax counsel that if a subsequent determination revalued the membership units, no units would be returned to them. Rather, accounting entries to Norseman’s capital accounts would reallocate each member’s membership units to conform to the actual gifts.

A valuation report was issued on July 26, 2005, which concluded that a one percent Norseman membership interest was worth $109,000. Gift tax returns were filed for Albert and Joanne for 2004. These gift tax returns reported net transfers from each donor of $261,000 to their children and $11,000 to their grandchildren.

The gift tax returns described the gifts to the children as a 2.39 percent Norseman membership interest ($261,000 ÷ $109,000), and the gifts to the grandchildren as a 0.101 percent Norseman membership interest ($11,000 ÷ $109,000). These membership interests were derived by dividing the total dollar value gifted to each descendant by the appraised value of a one percent interest.

In 2006, the Internal Revenue Service  (“service”) audited the petitioners’ gift tax returns.  The service determined that the values of the gifts exceeded the petitioners’ federal gift tax exclusions.  On February 4, 2009, the service issued deficiency notices related to these gifts.

The notice asserted that the petitioners’ 2006 gift tax returns were actually gifts of a 2.39 percent interest to each child and a 0.101 percent interest to each grandchild (rather than gifts of $261,000 and $11,000, respectively). The service increased the value of (1) the 2.39 percent Norseman membership interests from $261,000 (as reported on each donor’s gift tax return) to $366,000; and (2) the 0.101 percent Norseman membership interests from $11,000 (as reported on each donor’s gift tax return) to $15,400.

The petitioners and the service eventually agreed to increase the value of the 2.39 percent and 0.101 percent Norseman membership interests to $315,800 and $13,346, respectively.

The key issue in this case was whether the petitioners actually made gifts of a 2.39 percent and 0.101 percent Norseman membership interest to their children and grandchildren or whether they made a gift of a fixed dollar amount of Norseman membership interests.

If the petitioners gifted a fixed percentage of Norseman membership interests, then an increase in the value of the 2.39 percent and 0.101 percent membership interests would result in a tax on the gift amount in excess of the annual exclusion. However, if the gifts were fixed dollar amounts, then no gift tax would result. This is because the value of the gift would remain unchanged.

The Service’s Arguments

First, the service argued that the gift descriptions, as part of the gift tax returns, are admissions that the petitioners transferred fixed percentages of the Norseman membership interests.

Second, the service argued that Norseman’s capital accounts controlled the nature of the gifts, which they contended were adjusted after the gifts were issued to show the children and grandchildren as the owners of the 2.39 percent interest and 0.101 percent membership interests, respectively.

Third, the service maintained that the gift documents themselves transferred fixed percentages of the Norseman membership interests to the petitioners’ children and grandchildren.  The service reasoned that the adjustment clause does not save petitioners from the tax imposed by section 2501 because it creates a condition subsequent to completed gifts and is void for federal tax purposes as contrary to public policy.

In the first argument, the service cited Knight v. Commissioner,² where the taxpayers stated they had transferred gifts to their children of partnership interests with a fixed value of $300,000.  On the gift tax returns, the taxpayers reported gifts to each of their children of 22.3 percent interests in the partnership.

The taxpayers’ gift tax returns did not report a dollar value associated with the partnership interests, which opened the door for the service to assert that they had not transferred a fixed dollar amount, but rather a percentage interest in the partnership.

In the second argument, the service argued that Norseman’s capital accounts controlled the nature of the gifts and that Norseman’s capital accounts reflected gifts of fixed percentages.

The service cited Thomas v. Thomas,³ which held that a completed gift occurred with respect to corporate stock when the books of the corporation were changed to reflect a change in ownership.  The service claimed that Colorado law would view the partnership interests similarly and that Norseman’s capital accounts did control the transfer.

The service’s third argument raises an old issue that has evolved through a series of cases where the service challenged a taxpayer’s attempt to use a formula to transfer assets with uncertain value at the time of transfer.  The service reasoned that the gift documents themselves transferred fixed percentages of Norseman interests because the defined value clause was void against public policy.

The service relied on Commissioner v. Proctor,⁴ which has been described as the “cornerstone of a body of law.”  As in Proctor, the service argued that the use of the defined value clause was contrary to public policy for the following reasons:

1. Any attempt to collect the tax would defeat the gift, thereby discouraging efforts to collect the tax.
2. The court would be required to pass judgment upon a controversial case.
3. The clause would reduce the court’s judgment to a declaratory judgment.

Petitioners’ Response and the Court’s Decision

The petitioners responded to the service’s first argument by stating that at all times they understood, believed, and claimed to have made gifts equal to $261,000 and $11,000 to each of their children and grandchildren, respectively.

In Knight, the taxpayer’s gift tax returns did not report dollar value gifts. In the case of Wandry FLP, the Tax Court found that nothing the petitioners had done subjected them to that argument.  The petitioners’ gift tax returns included schedules that simply derived the percentages of the gifts based on the net dollar value transfers. The court concluded that the petitioners’ consistent intent and actions prove that dollar amounts of gifts were intended.

The Tax Court noted that capital account entries are always tentative until a final adjudication or the expiration of the statute of limitations. The Tax Court also reasoned that there was no dispute about whether the gifts were completed, so the stock transfer cases the service referred to were inapplicable.

The Tax Court noted King v. United States,⁵ a case that preceded McCord v. Commissioner,⁶ upholding the use of a price adjustment clause. The Tax Court mentioned that King is not exactly on point and therefore not controlling.

Notably, the “price adjustment” clause in King provided for an adjustment to the consideration the trusts paid in the sale, not the stock transferred. Furthermore, because the transaction was a sale, and not a gift, the Tenth Circuit did not address the public policy arguments.

The Tax Court further referenced Harwood v. Commissioner,⁷ Estate of Christiansen v. Commissioner,⁸ and Estate of Petter v. Commissioner⁹ to refute the service’s public policy arguments by reconfirming the distinction between the type of savings clause used in Proctor and the type of defined value clauses used in recent cases. 

A savings clause creates a transfer involving a “condition subsequent” in which the donor tries “to take property back.” A formula clause relies on a “condition precedent” and merely transfers a “fixed set of rights with uncertain value.” The difference depends on an understanding of just what the donor is trying to give away.

The service argued that the McCord-type clauses are different from Wandry since the petitioners transferred an uncertain set of rights of which the value exceeded their federal gift tax exclusions. The service argued that the Wandry clauses are savings clauses because they operate to “take property back” upon a subsequent condition.

The service concluded in McCord, and the cases that followed, that charitable beneficiaries were named as parties to the transactions, such that any service revaluation would result in increased value passing to the charities. Wandry, on the other hand, simply reallocates percentage interests among the petitioners and their children and grandchildren. 

The Tax Court dismissed the service’s arguments. There is no distinction between the McCord-type clause with a charitable donee and the clause that was used in Wandry. There was nothing in McCord and the cases that followed that required donors to include charity in the planning. 

Rather, under the terms of the gift documents, the petitioners were always entitled to receive predefined Norseman percentages, which the gift documents essentially expressed as a mathematical formula. For each of the petitioners’ children, this formula was expressed as: x = $261,000 ÷ the fair market value (FMV) of Norseman. Similarly, for the petitioners’ grandchildren, this formula was expressed as: x = $11,000 ÷ the FMV of Norseman.

Although the petitioners’ formula had one unknown variable: (the value of a LLC unit at the time the transfer documents were executed), that value was constant. The parties have agreed that as of January 1, 2004, the value of a 2.39 percent Norseman membership interest was $315,800. Accordingly, the total value of Norseman’s assets on January 1, 2004, was approximately $315,800 divided by 2.39 percent, or approximately $13,213,389. This value was constant at all times.

Before and after the audit, the donees were entitled to receive the same Norseman percentage interests. Each of the children was entitled to receive approximately a 1.98 percent Norseman membership interest (1.98 percent = $261,000 ÷ $13,213,389). Similarly, each of the grandchildren was entitled to receive approximately a 0.083 percent Norseman membership interest (0.083 percent = $11,000 ÷ $13,213,389). 

Even if the audit had not occurred, the donees may have never received the proper Norseman percentage interests they were entitled to. The audit simply ensured that the petitioners’ children and grandchildren would receive the 1.98 percent and 0.083 percent Norseman percentage interests they were entitled to receive, respectively. 

It is irrelevant that the adjustment clause reallocates membership units among the petitioners and the donees rather than to a charitable organization. This is because the reallocations do not alter the transfers. On January 1, 2004, each donee was entitled to a predefined Norseman percentage interest expressed through a formula.

The gift documents do not allow for petitioners to “take property back.” Rather, the gift documents correct the allocation of Norseman membership units among the petitioners and the donees because the valuation report understated Norseman’s value. The clauses at issue are valid formula clauses.

The Tax Court confirmed that there should be a “severe and immediate” threat to public policy to invoke an exception to the clear application of the code.  As long as the dollar amount passing to the donee is fixed by a formula, it is inconsequential that the percentage interests allocated to the donee may change as a result of a service audit, the threat not being either severe or immediate.

On November 12, 2012, the service released an Action on Decision (AOD) recommending nonacquiescence with the court decision, believing that the Tax Court had “erred in determining that the property transferred for federal gift tax purposes was anything other than the fixed percentage membership interest, that is, a 2.39 percent interest, transferred on the date of the gift to each donee.”¹⁰

On November 13, 2012, the service published an Acquiescence/Nonacquiescence (ACQ) stating that the commissioner did not acquiesce to the decision. Nonacquiescence means that “although no further review was sought, the Service does not agree with the holding of the court and, generally, will not follow the decision in disposing of cases involving other taxpayers.”¹¹ 

Conclusion

Wandry is the first case dealing with a formula clause that does not have a charitable element. It has the potential to be a landmark case that provides taxpayers and tax professionals with guidance on the use of formula gifts between family members. The decision also identifies the differences between “defined value” and “savings clauses” and describes the differences between formula gifting plans that are successful and ones that are not.

In this case, the gifts were predefined Norseman percentages expressed by a mathematical formula where the only variable was the FMV of Norseman. Taxpayers and tax professionals should be sure that the FMV of any entity subject to a formula gift-giving plan is defendable and developed according to sound valuation principals. 

This is because formula gifts will likely get the attention of the service, and there is the additional risk of the service challenging the FMV used in the formula. The best way to do this is to make sure that the FMV of the entity subject to the gifting plan is estimated by a qualified valuation analyst.