Structuring Defined Value Clauses in Trust Transfers

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Structuring Defined Value Clauses in

Trust Transfers: Formula Allocations

and Price Adjustment Clauses

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

TUESDAY, JULY 19, 2016

Presenting a live 90-minute webinar with interactive Q&A

Paige K. Ben-Yaacov, Partner, Baker Botts, Houston

Jonathan J. Rikoon, Partner, Loeb & Loeb, New York

Patrick J. Duffey, Attorney, Holland & Knight, Tampa, Fla.

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Background

Client wants to transfer hard-to-value assets to beneficiaries

• Assets selected for growth potential compared to current appraised

value

• Some of that is due to real business potential but with a trade-off in

volatility and risk

• But some of it may be due to a depressed valuation:

• Market conditions

• Special risks and exposures – regulatory, tax environment.

• Closely held business interest with no control or marketability

5

The Problem – What If the IRS Disagrees on Value?

• A plain gift may generate unexpected gift tax cost

• A GRAT avoids the gift tax risk but:

• Mortality risk – all in estate if grantor does not survive term

• Liquidity risk – GRAT has rigid formula for paying annuity

• Not readily available for generation-skipping planning

• A leveraged (installment) sale to a grantor trust can reduce gift tax cost

without the mortality or liquidity risk of a GRAT.

• But the risk of additional gift tax remains unchanged (same as a gift)

and unaffected by the leverage of the installment note.

• Exception to the extent use of the note saves gift tax exemption to

be available as an audit cushion

6

Can a Formula Save the Day?

• We know formulas work in some contexts:

• Marital deduction/credit shelter legacies

• GST exemption legacies

• Disclaimers

• Size of annuity/unitrust amount for charitable split interest trusts (CLATs,

CLUTs, CRATs, CRUTs)

• Why not just give (or sell) so much of the asset as is worth $X (e.g., gift tax

exemption), whatever percentage that turns out to be?

• Alternative: formula allocation clause – transfer entire asset but allocate the

transfer between completed-gift transferee (by gift or sale) and non-taxable

transferee.

• Or, sell the asset (or X% of it) for a price equal to its fair market value,

whatever that turns out to be?

7

No Surprise: IRS Hates Formula Clauses in Gifts or Sales

• Public Policy (takes away incentive to audit, requires courts

to decide moot cases)

• Technical arguments (condition subsequent: gift is already

complete by the time clause kicks in)

• Potential for gamesmanship or collusion

• Encourages overly aggressive appraisals – no down side?

• IRS won some early cases but has been losing lately as

practitioners learn lessons

8

Procter v. Comm'r (4th Cir. 1944)

Have to understand what DOESN'T work to structure

something that DOES work

Mr. Procter Remainder Interest *

* Clause provided that any "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. . . ."

Children

If any portion of transfer results in gift tax,

property automatically excluded from transfer

9

First Clause That Did Not Work – Procter (4th Cir. 1944)

• Trust document said that if a court later determines that any part of this

transfer is subject to gift tax, then that portion “shall automatically be

deemed not to be included in the conveyance . . . and shall remain the

sole property of” the transferor.

• Court: that’s a condition subsequent and the gift was already made and

taxable before we rule, too late to reverse gift.

• Violates public policy; “trifling with the judicial process.”

• Discourages collection of tax.

• Decision of court would deprive the court of jurisdiction: once the

final judgment fixes the gift tax liability, the gift (and the tax)

disappears.

• End-run around the prohibition on declaratory judgments for tax

cases.

10

Ward v. Comm'r (T.C. 1986)

Wards

Stock *

* Clause provided that "if it should be finally determined for Federal gift tax purposes that

the fair market value of each share . . . exceeds or is less than [$2,000 or $2,300,

respectively] an adjustment will be made in the number of shares constituting each gift . .

. ."

Sons

Assignment provided for "adjustment"

to number of shares of stock transferred based on

values as finally determined for gift tax purposes

11

Proctor Followed (For a While at Least)

• Ward (TC 1986)

• Gift of 25 shares of closely held stock, with the number of shares of the gift

to be adjusted if the finally determined fair market value is other than

$2,000/sh, such that each gift turns out to be $50,000.

• Donors argued they intended to give $50,000 worth of stock and the 25

shares was just “representative of the value.” But that’s not what the

documents said.

• 2 of 3 Proctor public policy arguments still applied: no incentive for IRS to

challenge valuation, and the donor cannot be compelled “to reclaim a

portion of the property” which would thus escape gift and estate taxation.

• Distinguishes King (below) as an arms-length sale, no donative intent; plus

in King the clause “operated to insure that no unintended gift was made”

while here the agreement “purports to retroactively alter the amount of an

otherwise completed gift.”

• Q: Does that mean if the gift had indeed been “so much stock as is

worth $50,000” it would have been OK? Form over substance – but a

critical drafting point.

12

McClendon v. Comm'r (TCM 1993)

Taxpayer

Sale of remainder

interest for annuity*

* Formula stated that if value "changed through a settlement process with the Internal

Revenue Service, or a final decision of the United States Tax Court, the purchase price

hereunder shall be adjusted accordingly ."

Son and

Trust

13

Proctor Followed (For a While at Least)

• McLendon (TC 1993)

• Private annuity sale agreement in closely held business provided

for adjustment of fixed dollar purchase price if final gift tax

valuation differs from appraisal.

• Analysis closely follows Ward.

• Q: If the sale price had been a King-style “whatever the fair market

value is” formula rather than a fixed dollar price to be subsequently

adjusted, would that have been OK?

14

King v. U.S. (10th Cir. 1976)

Mr. King

Sale of specific number

of shares of stock

* Formula stated that "if the fair market value . . . as of the date of . . . [the agreement] is

ever determined by the Internal Revenue Service to be greater than the fair market value

determined in the . . . manner described above, the purchase price shall be adjusted to

the fair market value determined by the Internal Revenue Service."

Trusts for

children at $1.25/share*

15

What About a Price Adjustment Clause?

• King (10th Circuit 1976):

• Sale price of closely held stock to family trust used formula of

similar sales to stock option plan. Ordinary course of business.

• Sale agreement provided that if the IRS determines the FMV of

this stock to be more or less than the sale formula, then purchase

price to be adjusted to IRS figure.

• Trial court had found that the parties really intended to pay FMV

but they recognized that it was difficult to ascertain.

• Actual price adjustment had real financial effect.

• No donative intent.

• Distinguished Proctor based on these facts.

• Plus: no diminution of seller’s estate

• Unlike clauses where a contingency would “alter, change, or

destroy the nature of the transaction.”

16

McCord v. Comm'r (5th Cir. 2006)

Community

Foundation

of Texas

First $6,910,932.52

of LP units

4 Sons

GST Trusts *

Shreveport

Symphony

Next $134,000

of LP units

Remainder

of LP units

Gift of 82.33%

LP units

- Formula not based on values as finally determined

- Sons, GST Trusts and Charities reached agreement post-transfer on number of units

each received (Confirmation Agreement)

* Remaining GST exemption

Mr. & Mrs. McCord

17

McCord Analysis

• Tax Court based analysis on Confirmation Agreement; not Assignment

Agreement

• Fifth Circuit overruled Tax Court based on:

• the plain language of the Assignment Agreement

• Taxpayers were not parties to the Confirmation Agreement or otherwise

involved in it

• “no evidence of any agreement-not so much as an implicit, ‘wink-wink’

understanding-between the Taxpayers and any of the donees” regarding

the percentage interest to which each donee was entitled"

18

Christiansen v. Comm'r (Tax Court 2008) (8th Cir. 2009)

Mrs. Christiansen's

Estate (principal assets

two 99% LP interests)

Christine

CLAT (75%)

Foundation (25%)

$6.35 million*

Disclaimed amount

above $6.35 million

* Based on values as finally determined for federal estate tax purposes.

19

Why Christiansen Worked

• No Condition Subsequent

• transfer to charity not contingent on value adjustment

• Not a moot issue; no problems with finality

• revaluation changed amount to charity

• No evidence of policy to maximize incentive for IRS to audit

• Strong public policy in favor of charity

20

Petter v. Comm'r (Tax Court 2009) (9th Cir. 2011)

Terry's Trust First $453,910

of units *

Remainder The Seattle Foundation

Gift of 940 Units Anne Petter

Terry's Trust

Sale of first

$4,085,190 of units *

The Seattle Foundation

Sale/Gift 8,459 Units Anne Petter

Gift of remainder

* Based on value of units as finally determined for federal gift tax purposes.

21

• All the same reasons as Christiansen

• IRS public policy arguments undermined by allowance of:

• Formula marital deduction clauses

• Formula GST transfers

• Split interest charitable trusts

• Formula transfers to a GRAT

Why Petter Worked

22

Hendrix v. Comm'r (Tax Court 2011)

Greater Houston

Community

Foundation

Set dollar amount

worth of stock

Remainder

of stock

Gift of

non-voting stock

- Formula not based on values as finally determined

- Trusts and Charity reached agreement post-transfer on number of units each received

(Confirmation Agreement)

Mr. & Mrs. Hendrix

Trusts

23

• McCord dispositive unless:

• not an arms-length transaction

• formula clause void as against public policy

• No evidence of collusion

• Public policy is one of encouraging gifts to charity

Hendrix Analysis

24

Wandry v. Commissioner of Internal Revenue

Wandry v. Comm’r., T.C. Memo 2012-88 (March 26, 2012)

» Background

˗ Taxpayers were Albert & Joanne Wandry

˗ Gift Tax deficiency for 2004 year based on gifts of LLC interests to children and

grandchildren

˗ LLC was Norseman Capital

• Key: Norseman was formed by TPs and their children in 2001

• Key: Court characterized Norseman as part of a “family business”

» Timeline

4/2001

Norseman Capital, LLC

Created

1/1/2004

Gifts Made

7/26/2005

Valuation Report

2006

IRS Audit

2/4/2009

IRS Deficiency

Notice

5/6/2009

Tax Ct. Petition

Filed

3/26/2012

Tax Ct. Decision Entered

25

» January 1, 2014 Gift

˗ Each Taxpayer executed a separate gift documents transferring:

• $261,000 worth of Norseman, LLC to each of four children ($1,044,000)

• $11,000 worth of Norseman, LLC to each of five grandchildren ($55,000)

• Total: $2,088,000 to children and $110,000 to grandchildren

» Key: dollars not units/percentages/shares/etc.

Gift of LLC units

equal to $1 million

exemption split

Mr. & Mrs. Wandry

among children

and grandchildren

Kenneth $261,000

5 grandchildren

$11,000 each

Cynthia $261,000

Jason $261,000

Jared $261,000


26

» Evidence of the Transfer

˗ Capital Account Ledger: reflected a downward adjustment of the TP’s capital

accounts and an upward adjustment of the children’s and grandchildren’s

capital accounts, but the adjustments did not reconcile with TP’s claimed gift

amounts.

˗ 2004 Partnership Tax Return (Form 1065 and K-1s): reflected capital

adjustments, generally but did not itemize adjustments that were attributable

to the gifts.

˗ 2004 Gift Tax Return: described the gifts as percentage interests, not dollar

amounts


27

» The Wandry Clause:


28

» Gift Tax Descriptions = Admissions

» Capital Accounts are Controlling

» DVC is Ineffective

IRS Arguments

» Gift Tax descriptions are admissions, but

the percentage interests were derived from

and consistent with the Gift documents.

» Capital Accounts are reflective of ownership,

not dispositive. They are frequently subject

to adjustment in other contexts.

» King (10th Cir.) not on point, Petter (9th Cir.)

controls. Passes “Petter” Test:

˗ Donees always “entitled to receive a predefined

number of units”

˗ Formula had one (1) unknown, which was a

constant (the value of an LLC unit)

˗ Pre-audit, the donees were legally entitled to

receive same number of units

˗ The audit only ensured that donees would

receive the units to which they were always

entitled.

The Tax Court

TAX COURT ANALYSIS


29

» Public Policy

˗ Proctor - operation of the clause would:

• disincentivize tax collection efforts by nullifying any gift in the event of audit;

• cause the Court to pass judgment on a moot case;

• reduce the Court’s judgment to a declaratory judgment.

» Tax Court: a Wandry Clause does not violate public policy

˗ “The Commissioner’s role is to enforce tax laws, not merely to maximize tax

receipts.”

˗ Operation of the clause would not “undo the gift” because the interests

transferred were always the same.

˗ The case is not moot and judgment not merely declaratory, because operation

of the clause would cause an adjustment (based on the stipulated value) with

“significant Federal tax consequences”

• Key: to the extent open, Taxpayers and Donees would need to amend prior tax returns

to adjust income upward (Taxpayers) or downward (Donees). Presumably income tax

consequences would result.


30

» Chart Title$

» Note: “Tax Cost” ignores, for simplicity, application of the applicable exclusion amount. Also for simplicity, the calculations above ignore GST tax implications as well as the potential application of the annual exclusion amount.

Valuation of Transferred Norseman Interest

Gift Tax Consequences

Taxpayers IRS Tax “Cost”

Date of Gift $2,088,000 - $835,200

Audit - $3,082,000 $1,232,800

Trial

Stipulation $2,659,860 $1,063,944

» Query: for an extra $228,744 in gift tax (plus interest and penalties), would taxpayers

have been better off conceding the Wandry clause at the audit stage?


31

TAKE-AWAYS

» Nature of the Asset

˗ “old and cold” (2001)

˗ operating business

» Transaction Documentation

˗ clear and well-drafted documents

» Consistency

˗ Consistently characterized gift as

pecuniary amount on the 709,

during audit, and at trial

» Jurisdiction

˗ Would have appealed to 10th Circuit

(King)

What Went Right

» Precise descriptions of the gift on the 709

˗ Consider using an attachment or continuation

sheet to describe the transfer as you might with

a GST severance.

» Record-Keeping

˗ Capital accounts should accurately reflect the

transfer

» Income Tax Reporting

˗ Ensure that the entity’s income tax reporting is

accurate and consistent w/ the transfer (likely

Form 1065 and K-1)

» Forum Shopping

˗ Tax Court is relatively friendly to formula

clauses, but Wandry was just a TC Memo.

˗ 5th, 8th, 9th, and 10th Circuits all have

favorable—but perhaps not dispositive—case

law.

Best Practices


32

» The Service strongly dislikes Wandry

˗ On November 13, 2012 the IRS announced its non-acquiescence to Wandry

˗ A Wandry clause is, anecdotally, an audit flag

» Query: does operation of defined value clause always benefit the client?

˗ Perhaps not. Consider:

• IRS strong aversion to DVC clauses; and

• Appreciation of the underlying asset(s).

˗ A DVC will partially undo the estate tax “freeze” aspect of such a transfer (gift or

sale)

˗ The IRS may be willing to “trade” operation of the DVC in exchange for a better

valuation discount

˗ Timing is also important: gift tax audit or estate tax audit?

AUDIT STRATEGY


33

» Taxpayers petition for a redetermination of an income tax deficiency arising from a disallowed

deduction for a contribution of a conservation easement.

» $10M deduction for a conservation easement failed because of a substitution power held by an

LLC owned by the Taxpayers.

» At trial (Tax Court) and on appeal, Taxpayers argued that the substitution power was negated

by a general “savings clause” in the easement that provided:

• “[T]he Trust ‘shall have no right or power to agree to any amendments ... that would

result in this Conservation Easement failing to qualify ... as a qualified conservation

contribution under Section 170(h) of the Internal Revenue Code and applicable

regulations.’”

» The Tax Court and 4th Circuit both rejected that argument.

Belk v. Comm’r., 774 F. 3d 221 (4th Cir. 2014)

Belk v. Commissioner of Internal Revenue

34

» Why is this case relevant to defined value clauses?

˗ The 4th Circuit cited to and extensively analyzed Proctor in its opinion.

˗ In fact, it held that the savings clause failed for the same reason as the buy-back clause in

Proctor:

• “[W]e note that were we to apply the savings clause as the Belks suggest, we would be

providing an opinion sanctioning the very same ‘trifling with the judicial process’ we

condemned in Procter.”

» The Court took issue with both the generality and operation of the clause

» Defined value clauses should be distinguishable since they are central to the transaction (gift or

sale) and produce meaningful tax consequences if they do, in fact, operate to adjust the original

transfer.

Belk v. Commissioner of Internal Revenue

35

Practicalities: Simpler Formula Transfer Clauses

• Stated value transfer clause (transfer of so many units as equals $X as

determined for gift tax purposes) (Wandry). Can be a sale or a gift.

• Not a condition subsequent, does not take back any property – just

defines how much is transferred, balance not in the transfer at all.

• Forgoes the charitable gift public policy argument

• Puts pressure on independence and fiduciary duties of transferee to

fight for full valuation.

• Alternative: gift of $X worth of assets and sale of excess for a note.

• Alternative: gift with a donee disclaimer of excess above $X worth.

36

• Stated price sale clause (transfer of X units, for whatever the fair market

value is) (King).

• Not a condition subsequent, does not alter the amount of property

transferred – just defines purchase price for what is transferred.

• Forgoes the charitable gift public policy argument

• Puts pressure on independence and fiduciary duties of transferee to

fight for full valuation.

Practicalities: Simpler Formula Transfer Clauses

37

Formula Allocation Clauses

• Allocates the transfer of a hard to value asset between a taxable gift portion

and a non-taxable portion

• The allocation may be based on agreement of transferees among

themselves, if they are true independent players (sometimes charities):

McCord (2006), Hendrix (2011)

• May need participation of independent party and counsel

• Or, it may be based on final determination of gift tax value (Petter 2009) or

estate tax value (Christiansen 2008), which takes it much closer to a true

formula clause

• Should a small portion (say, 5%) of the “non-taxable” portion also pass to

the taxable gift, to give the IRS an audit incentive and deal with one of the

Proctor arguments?

38

• The non-taxable gift portion of the allocation can be to:

• Charity (as in the four cases on the previous slide)

• Public vs. private?

• Beware of private foundation excise taxes – self-dealing,

jeopardizing investments, excess business holdings

• (Near) zeroed out GRAT

• Spouse

• QTIP trust

• Incomplete gift trust – e.g., retained power to consent to distributions to

others plus power of appointment.

• Recipient should be controlled by an independent trustee

• More complex to draft and administer than a Wandry or King formula; more

parties and counsel, possible AG oversight for charities.

• But, more cases as precedent.

Formula Allocation Clauses (continued)

39

• Gift tax return should include full explanation and “qualified” appraisal

– burden of proof, statute of limitations

• Should a return always be filed even for a sale?

• Red flag? Estate tax return disclosure on past transactions?

• Be wary of stating "no position taken on return is contrary to

revenue ruling"

Administration and Reporting

40

• If a post-audit adjustment to value will, under the formula clause, change how

much each owner really owns of the transferred asset as of the transfer date,

and if they are different taxpayers, how are profits and losses allocated and

reported in the interim?

• Wandry-type clause: issue is allocation between transferee and transferor

• Petter/Christianson-type clause: issue is allocation between or among

transferees.

• The allocation clauses with charities or charitable trusts (or other third

parties) may lead to the need to amend returns as well as actually

reallocate cashflow from operations or gains.

• State Attorney General filings may need amendment as well in this case.

Administration and Reporting

41

Potential solutions to avoid need to amend income tax returns after adjustment

under formula:

• Use a King-type price adjustment formula. No post-closing changes to

distributions, or to income tax returns.

• Use a Wandry-type defined value clause with a grantor trust transferee (or

other disregarded entity); although the cashflow from any distributions may

need to be reallocated, no income tax return amendments should be

needed because everything is reported on the grantor’s return.

• Use a formula allocation clause with a grantor trust as the taxable

transferee and either an incomplete gift trust, a GRAT feeding into a grantor

trust, or a QTIP (which is also a grantor trust) as the nontaxable transferee.

Again, cashflow may need reallocation but no amendment of returns.

Administration and Reporting (continued)

42

Impact of Structure of Transferred Asset on Formula

• If the client's entire interest in an asset is being transferred, then a Wandry

formula can be a problem because in theory the audit could reduce the

valuation and increase the percentage required to be transferred to more

than 100%.

• No similar issue with a King formula.

• Again in theory if an allocation clause transfers so much of the asset as

has a fixed value to the taxable gift donee (and the balance to a non-

gift transferee), and if the unit value is low enough, the same problem

could arise.

• Solution: formula should have an alternative (maximum transfer

percentage) of 100% of the asset if that turns out to be less than the target

dollar amount.

• Even though the final value is almost never below the appraised value, so

this shouldn’t be a problem in reality, because it could happen in theory

and we are trying to sustain a commercial-like formula, it can’t be unilateral

and should have the possibility of an adjustment in either direction.

43

Impact of Structure of Transferred Asset on Formula

(continued)

• When would client be transferring 100% anyway? That’s one way of using

a FLP or FLLC which is funded with only that portion of the underlying

asset or business that the client actually wants to transfer, and we don’t

want to see any retained interest in the FLP or FLLC due to estate tax

inclusion issues or practical issues of post-transfer administration.

• E.g., client may down the road want to withdraw funds/profits from the

asset/business but doesn’t want the transferee to do so. If client’s

interest is held in the same FLP or FLLC as the transferee's, there’s a

2701 issue if client can withdraw but the transferee can’t, as well as a

2036/2038 issue if the client has the right to decide about withdrawals

from the FLP/FLLC.

• No such issues if the client’s interest in the underlying asset/business

is held outside the FLP/FLLC – but that requires that the client

transferred 100%. Hence our fact pattern.

44

Paige K. Ben-Yaacov

Partner, Baker Botts L.L.P.

(713) 229-1474

[email protected]

Patrick J. Duffey

Attorney, Holland & Knight

(813) 227-6656

[email protected]

Jonathan J. Rikoon

Partner, Loeb & Loeb LLP

(212) 407-4844

[email protected]

Thank You

45

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Structuring Defined Value Clauses in Trust Transfers