That investment boilerplate matters, especially in blended families!!!

Posted on September 9, 2012 by

EXECUTIVE SUMMARY:

The Illinois appellate court affirmed the trial court’s granting of a motion for summary judgment on a claim for breach of fiduciary duty and unjust enrichment that a step-daughter brought against her step-mother, who was the income beneficiary of a QTIP trust that the step-mother-trustee had invested solely in municipal bonds. The appellate court was significantly swayed by the overall estate plan of the deceased father, who had created two other testamentary trusts for the benefit of his daughter and her descendants without including his surviving wife. The appellate court also was influenced by the language in the QTIP trust instrument that expressly negated the duty of investment diversification. The Illinois Supreme Court denied further appeal.

FACTS:

The decedent trust grantor, Luther, created a revocable living trust that divided into three trusts at his death, which occurred in 2003. Two of these resulting trusts solely provided for the decedent’s daughter, Tiffany, and her descendants. The QTIP trust benefitted the decedent’s surviving widow, Audrey, with Tiffany, Audrey’s step-daughter, and her descendants as the principal beneficiary. As trustee of the QTIP trust, which expressly negated the trustee’s duty to diversify trust investments, Audrey solely invested the trust corpus in municipal bonds. Luther didn’t give Audrey any right to make principal distributions for her own benefit from the QTIP trust.
Tiffany sued Audrey for breach of fiduciary duty and for unjust enrichment, alleging that the decision to solely invest the QTIP trust corpus in municipal bonds instead of in a diversified portfolio had damaged the value of the trust principal to the tune of approximately $300,000. Audrey filed a motion for summary judgment on all four counts, pointing to the express language in the trust instrument that negated the duty to diversify investments in the QTIP trust. In finding in Audrey’s favor, the trial court was swayed by the overall estate plan, which significantly benefitted Tiffany and her descendants, as well as the language in the QTIP trust that expressly negated the duty to diversify trust investments.
On appeal, Tiffany argued that the trial court had erroneously interpreted Luther’s intent regarding the QTIP trust and further that Audrey’s actions had violated the fiduciary duties of impartiality and prudent investment, neither of which had been negated in the QTIP trust. The appellate court disagreed and upheld the trial court’s granting of summary judgment in favor of Audrey on all counts. The Illinois Supreme Court denied further appeal.
COMMENTS:
It strikes me as somewhat surprising that neither court focused very much attention on the trustee’s duty of impartiality, which certainly would seem to have been violated by Audrey’s purposeful investment of 100% of the corpus of the QTIP trust in municipal bonds, which solely benefitted her at Tiffany’s expense. In my opinion, this decision could just as easily have gone the other way, but the Illinois Supreme Court denied further appeal.

It seems clear to me that the trust investment language was boilerplate. I would have probably gone the other way and found that the fact that Luther didn’t give Audrey any rights to principal from the QTIP trust to have been more important than either court found it to be. Instead, the courts seemed to be more significantly influenced by two facts other than that the trust instrument indeed negated the trustee’s duty to diversify the trust’s investments. The first fact was that Luther set up two other trusts in his estate plan for the sole benefit of Tiffany and her descendants, excluding Audrey. The second was that somehow the court believed Audrey’s testimony and that of her son that she actually sought out the best investment advice and was not wedded to tax-free municipal bonds.

Estate planning for blended families requires very fine distinctions as it is heavily nuanced in ways that typically aren’t required to be addressed or even considered in estate planning for single relationship couples. Even otherwise irrelevant boilerplate has to be carefully rethought and recalibrated in the blended family situation. In this case, it is hard to believe that the investment of 100% of the corpus of the QTIP trust in municipal bonds was somehow not a breach of the duty of impartiality. However, the boilerplate language concerning investment, which may not have even been considered important by Luther, was dispositive.

CITES:

Carter v. Carter, 2012 IL App (1st) 110855 (Feb. 7, 2012).

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Taxpayers hoisted by their own petard! Lex dura lex sed lex!!!

Posted on June 5, 2012 by

KEY WORDS: Valuation; Charitable Contribution Deductions

EXECUTIVE SUMMARY:

In a fact rich memorandum decision, Judge Holmes of the Tax Court decided that the taxpayers were properly denied charitable contribution deductions for very large and possibly undervalued pre-IRC Secs. 170(f)(11)(C) and (D) donations of real estate to a charitable remainder unitrust because they failed to comply with Treas. Reg. Sec. 1.170A-13(c), which is the regulation that spells out proper appraisals and documentation of charitable contributions of property that exceeds $5,000 in value. In so doing, the Tax Court expressly found Treas. Reg. Sec. 1.170A-13(c)(2) to be valid under the Chevron test. The Tax Court declined the taxpayers’ invitation to find the regulation invalid.

FACTS:

In 2003, the Mohameds donated five very valuable properties to a charitable remainder unitrust (“CRUT”) that they had established back in 1998. Mr. Mohamed, entrepreneur, a licensed real estate broker and a real estate appraiser, prepared his own 2003 joint income tax return, and he identified the 2003 donations on Form 8283, which he filled out both as donor and donee (he was the trustee of the CRUT), but he left the appraiser declaration blank because it called for an unrelated appraiser to sign that declaration. Mr. Mohamed attached two additional statements to the return that further identified the properties and set forth more information about their values. On one of the statements, entitled “Appraised Market Values,” he provided information about some of the property expenses and signed it “Real Estate Broker/Appraiser.”

In 2004, the Mohameds donated a shopping center to the CRUT. Mr. Mohamed filled out the joint income tax return and the Form 8283 in similar fashion to 2003. He attached a statement to the 2004 return on his letterhead, which reflected that he was a realtor. He attached a second statement that listed the income and expenses of the shopping center and used a 6.5% “cap rate” to determine the value. Mr. Mohemed signed this statement “owner and Licensed Real Estate Broker.”

The IRS audited the 2003 return and was displeased with the self-appraisals. In response, the Mohameds then obtained independent appraisals that were similar, but not identical, to Mohamed’s own, as shown below:

Year Donated Property Mohamed appraisal Independent appraisal Sales Price
2003 Rio Linda 1 $296,348.00 $296,000
2003 Rio Linda 2 325,000.00 315,000
2003 Rio Linda 3 125,000.00 140,000 $125,000
2003 Rio Linda 4 264,040.00 220,000 $265,000
2003 Calvine Road 14,873,921.00 16,380,000 23,000,000
2004 Shopping center 2,642,190.62 2,926,246 2,280,000
Totals: 18,526,499.62 20,277,246

At first in the Tax Court, the IRS argued that the Mohameds overstated the values of the properties. Later, the IRS amended his answer to deny all of the claimed deductions for failure to follow the deduction substantiation guidelines in the regulations. The Mohameds made two arguments. First, they claimed that such a harsh result meant that the regulation in question, Treas. Reg. Sec. 1.170A-13(c)(2), must be invalid. Second, they argued that they substantially complied with that regulation.

Judge Holmes first analyzed the contribution deduction substantiation regulation in question, Treas. Reg. Sec. 1.170A-13(c). Judge Holmes broke down each requirement in the regulation, finding the most important one being that an appraisal be done by a “qualified appraiser,” which Treas. Reg. Sec. 1.170A-13(c)(5) says can’t be either the donor (as it was in this case) or the donee (also as it was here). This precluded a finding that the Mohameds had used a qualified appraiser. Then Judge Holmes determined that the statements that Mr. Mohamed attached to their income tax returns weren’t “appraisal summaries” either, as required by Treas. Reg. Sec. 1.170A-13(c)(4). Therefore, Judge Holmes determined that the Mohameds had failed to comply with the contribution substantiation regulations.

What about the validity of that regulation?

The Mohameds made a very clever argument: they posited that Treas. Reg. Sec. 1.170A-13(c) was arbitrary and capricious because it literally allows a taxpayer who overvalues a gift to keep some of the deduction, while penalizing a taxpayer, like the Mohameds, who accurately valued the properties but who failed to follow the substantiation procedure. Judge Holmes began by noting that the Treasury Department had been delegated the authority to promulgate regulations that themselves were the sole arbiters of whether a deduction was properly substantiated, so Treas. Reg. Sec. 1.170A-13(c) was a legislative regulation. Therefore, Judge Holmes concluded that under the Chevron decision of the U.S. Supreme Court, no court can invalidate a regulation similar to Treas. Reg. Sec. 1.170A-13(c) unless the court finds that the regulation is arbitrary, capricious or manifestly contrary to the statute, in this case, IRC Sec. 170.

Judge Holmes began by noting that no court has directly addressed whether Treas. Reg. Sec. 1.170A-13(c) fails the Chevron test. He noted that in the Deficit Reduction Act of 1984 (“DEFRA”), the Congress exhibited clear intent that contributions of property that exceeded $5,000 in value be verified by a qualified appraiser in order to be deductible. Thus, Judge Holmes expressly found that the meaning of “verified” in DEFRA was accurately reflected in Treas. Reg. Sec. 1.170A-13(c). Even though under Chevron, that should have been the end of the analysis, requiring that the regulation be upheld, Judge Holmes also determined that Treas. Reg. Sec. 1.170A-13(c) was consistent with IRC Sec. 170(a)(1) in that it matched the congressional interpretation set out in DEFRA.

Judge Holmes then examined whether the Mohameds had substantially complied with the regulation. He then surveyed the case law that clearly showed that taxpayers who argued for substantial compliance usually lost, and he chronicled a list of “fatal mistakes.” Judge Holmes concluded that the case law required a qualified appraisal, which the Mohameds appraisals could not be because Mr. Mohamed, the taxpayer, did the appraisals himself. Nevertheless, Judge Holmes analyzed each of the various mistakes that the Mohameds made in their appraisals to see if those mistakes were insignificant (and therefore passable under Bond) or were fatal on a property-by-property basis. Judge Holmes concluded that the Mohameds had made fatal mistakes under the case law that precluded a finding of substantial compliance.

Finally, Judge Holmes addressed another clever argument that the Mohameds made: Form 8283 was confusing in that it didn’t indicate anywhere on its face that a taxpayer had to get independent appraisals of property worth more than $5,000, with the sole exception of artwork worth at least $20,000. Judge Holmes noted that while he was sympathetic to the Mohameds’ complaint here, and that the IRS had since modified its form to clarify that point, he brushed aside the argument and ruled in favor of the IRS. Judge Holmes concluded this way:

We recognize that this result is harsh–a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions–all reported on forms that even to the Court’s eyes seemed likely to mislead someone who didn’t read the instructions. But the problems of misvalued property are so great that Congress was quite specific about what the charitably inclined have to do to defend their deductions, and we cannot in a single sympathetic case undermine those rules.

COMMENTS:
Ouch! This is a high dollar case, so it wouldn’t surprise me if the Mohameds appeal, although I see little chance, if any, of success on appeal. Although it wasn’t discussed in the Tax Court’s opinion, how could anyone who holds himself out to be an appraiser, like Mr. Mohamed did, not be aware of the USPAP requirement that appraisers be independent? USPAP, which governs real estate appraisals, as well as appraisals of business interests and personal property, is replete with requirements of independence. For example, USPAP Standards Rule 2-3 requires the following certification (among others that are required) for a real estate appraisal report:

I have no (or the specified) present or prospective interest in the property that is the subject of this report and no (or the specified) personal interest with respect to the parties involved. [emphasis added]

How clearer does the rule need to be? I have a hunch that Mr. Mohamed thought that he was a better appraiser than anyone else who he could get, so why should he spend the money on an independent appraisal? This is the perfect case as the poster child to show stubborn, niggardly clients who are questioning your exhortations that they hire and pay for a qualified, independent appraiser to substantiate either gifts or charitable contributions of property.

What of Mr. Mohamed’s argument that the tax form misled him? He gets nowhere with me on that one. For starters, he admitted on the stand that he hadn’t read the instructions to the form, despite the fact that the top of Form 8283 says to refer to the instructions! If you’re going to be your own tax preparer, like Mr. Mohamed was, you’ve simply got to read the instructions or at least be familiar with them like professional return preparers. Was this too a case of “you get what you pay for?” I strongly suspect so.

There are a few takeaways from this decision, which was very methodical and well done by Judge Holmes. First, the contribution substantiation requirements in Treas. Reg. Sec. 1.170A-13(c) are rigid but are very specific; very little leeway is accorded taxpayers who attempt to comply but who fall short of the mark. The bottom line: follow Treas. Reg. Sec. 1.170A-13(c) to the letter.

Second, even though Mr. Mohamed was very close in most of his appraisals to the prices for which some of the properties sold not too long after the valuation date, according to Hood’s Rules of Appraisal No. 1: “actual value is irrelevant.” In every case, Hood’s Rules of Appraisal No. 3 (the last of three such rules) says “perceived, defensible value is everything.” And for those of you who are curious about Rule No. 2, it is “actual value is unknown at the valuation date.”

Finally, and this is incredible, one of the independent appraisals, which was of the shopping center, had serious questions about its real independence even though it was late and could not be considered a “qualified appraisal.” For starters, the appraiser wrote “[m]y valuation is per your instructions” on the report! The appraiser further indicated that instead of performing an independent analysis of the market and the property, which you would expect an independent appraiser to do, the report indicated that the appraiser got his information from Mr. Mohamed.

Mr. Mohamed also severely limited the scope of the appraiser’s work to that of performing an analysis of only the income approach, instead of considering all three approaches to valuation: market, cost and income. Mr. Mohamed obviously meddled in the appraiser’s work, thereby cutting off at the legs any chance that the appraiser’s work would be given any appreciable level of credibility. The bottom line: Clients need to chill out and let the professionals do their work and stay out of the way.

The common theme of today’s parable is that Mr. Mohamed was his own worst enemy by trying to do everything himself and control that which he didn’t do, and it cost him dearly. Resolve not to let one of your clients make similar mistakes.

CITES:

Mohamed v. Comr., T.C. Memo 2012-152 (May 29, 2012); IRC Secs. 170(a)(1); IRC Secs 170(f)(11)(C) and (D)(both added by the American Jobs Creation Act of 2004); Treas. Reg. Sec. 1.170A-13(c); Chevron, U.S.A., Inc. v. Natural Res. Def. Council, 467 U.S. 837 (1984); Mayo Found. For Med. Educ & Research v. United States, 562 U.S. ___, 131 S. Ct. 704 (2011); Deficit Reduction Act of 1984, Sec. 155.

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Recent Study from AICPA Sheds Insight on Why Couples Argue

Posted on May 7, 2012 by

http://www.journalofaccountancy.com/News/20125634.htm

While this is no big secret, it is compelling reading because AICPA commissioned Harris, the famous polling company, to conduct the study. In blended families, the issue of money is a crucial obstacle that couples simply must overcome if they are to stay together.

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Special article co-authored with Emily Bouchard

Posted on May 2, 2012 by

Estate Planning for the Blended Family: The Intersection of the Head and the Heart

Emily Bouchard and L. Paul Hood, Jr. © 2012

A prospective new client contacts you about working with him and his partner. Within minutes you learn that they are unmarried with each having children from prior relationships as well as one of their own together. Do you experience a thrill of excitement at having such a complex and fascinating potential couple to work with, or does this scenario strike fear in your heart? If you’re like most of the estate planners we work with, fear is the first response, and we also make it clear that the prospective client is most likely afraid as well, but for different reasons.

In Estate Planning for the Blended Family (Self-Counsel Press 2012), we identify and discuss 11 fears that clients can have when it comes to the estate planning process, which include everything from contemplating death to fear of the estate planning process itself. The biggest issue that is front and center in the estate planner’s mind (or should be if it’s not already) is the likelihood of conflict of interests within the blended family system.

The reality is that estate planners need to be able to manage their own emotions, as well as those of their clients, around these fears and conflicts. It’s not enough to understand the intricacies of estate planning vehicles to avoid taxes and transfer assets efficiently – it’s also necessary to make sure you are addressing the core concerns (and yes, fears) that are part of the process. These fears prevent people from doing estate planning, or cause them to procrastinate in their estate planning. Fears lead to avoidance strategies that cause delays in estate planning. More often than not, people tend to avoid those conversations due to a lack of awareness about how to have the conversations effectively.

Estate planning for the blended family client can present some of the most challenging work that an estate planner ever does. One of the reasons why this is so is that most professionals in the field of estate planning aren’t sufficiently trained or experienced in the “human side” of the process, which is the “heart” of estate planning. Most attorneys, accountants, and financial advisors are trained in the “head” side of estate planning. The key to successfully navigating the often treacherous waters of estate planning for the blended family is properly balancing the head and heart.

On May 8th we will present the first in a series of three webinars on Blended Family Estate Planning, diving into the key issues of the initial consultation and successful engagement of couples with a blended family. During this presentation, participants learn how to address emotionally charged issues and fears that keep the planning process from moving forward, as well has how to move when a client shuts you down or shuts you out. Specifics related to property ownership and distribution will be addressed along with who should be considered for key fiduciary roles. The training provides a comprehensive introduction to estate planning for the blended family, and in so doing, marries the “head” and the “heart” of estate planning. In the second session, attention is focused on the lifetime planning options that are available or advisable to blended family couples. In the final session, the various issues that are attendant to testamentary estate planning for blended family clients are addressed, as well as some post-death administration issues.

To sign up for this timely and important training, visit: http://ultimateestateplanner.com/lawyer/Teleconference_Registration_cp5747.htm

Send your questions to Paul: paulhood@acadiacom.net or Emily: emily@wealthlegacygroup.net.

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Helpful Testamentary Charitable Lead Annuity Trust Private Letter Ruling

Posted on April 30, 2012 by

KEY WORDS: Charitable Lead Trusts

EXECUTIVE SUMMARY: In this private letter ruling, the IRS held that a zeroed out testamentary charitable lead annuity trust (“T-CLAT”) that used an ascending (i.e., back-loaded) charitable payout was a qualified charitable lead annuity trust.

FACTS: The decedent set up a ten year testamentary charitable lead annuity trust in his revocable living trust in which a private foundation was the charitable beneficiary.  The T-CLAT payout was variable, but it was tied to zeroing out the value of the non-charitable interest in the T-CLAT.  The T-CLAT trustee filed a petition with the local probate court to construe a proposed ascending charitable payout as being consistent with the decedent’s intent and provided notice to the state attorney general.  The proposed T-CLAT payout would increase by 20% each year for the entire ten year T-CLAT term.

The trustee of the T-CLAT averred that a straight-line annuity payout risked not being able to honor the decedent’s testamentary intent that the T-CLAT would probably not be able to make the charitable payouts for all of the ten years.  The T-CLAT trustee attached illustrations to its petition showing both ways to set up the T-CLAT charitable payout.  The probate court agreed with the proposal, but the court conditioned its ruling upon the T-CLAT trustee obtaining a favorable private letter ruling from the IRS, hence the ruling request.

The IRS gave a favorable ruling on the ascending T-CLAT payouts, concluding:

The state court’s construction, an event that occurred after the date of Decedent’s death, does not affect the charitable qualification of the trust or the estate’s eligibility for a charitable deduction for that interest. Accordingly, based on the information submitted and the representations made, we conclude, on the date of Decedent’s death, the trust satisfied the requirements under § 2055(e)(2). Therefore, pursuant to § 2055(a), Decedent’s estate is entitled to the charitable deduction claimed on Decedent’s original Form 706 for the present value of the charitable interest established under the trust on the date of Decedent’s death. [Emphasis added]

COMMENTS: This ruling is welcome news and shows how flexible that T-CLATs can be made to be.  It is good to know that the IRS believes that setting up the T-CLAT payout in a writing other than the trust instrument doesn’t harm the qualification of the T-CLAT under IRC Sec. 2055(e)(2), which permits qualified reformations of a trust instrument.

The ruling is as interesting for what the IRS did not say because it wasn’t asked: what is the level of flexibility that the IRS will permit in having unequal T-CLAT payouts?  In the ruling, the T-CLAT trustee expressly asked for qualification of ascending payouts that increased by 20% each year, similar to the 20% increases that are expressly permitted in GRATs by Treas. Reg. Sec. 25.2702-3(b)(1)(ii)(A).  I don’t think that there is any restriction on the size of the increases that are possible in a T-CLAT.   In fact, I even think that a descending (i.e. front-loaded) charitable payout is possible to qualify a T-CLAT, but I doubt that such would find much utility as a practical matter.

From a drafting standpoint, the ruling may stand for the proposition that perhaps it is better to not be more specific in confecting the charitable annuity payout than to simply provide, like the T-CLAT in this ruling, for a payout that would “zero out” the non-charitable interest.  I say that because one of the hardest things to do in putting together a T-CLAT is dealing with the unknown AFR that will be in effect at the time of death.

There have been a number of private letter rulings in which the IRS has blessed various T-CLAT formulae, but each of those rulings involved a specific formula in the trust instrument.  Of course, the proposed payout would have to be consistent with the testator’s intent, and a court would have to go along with the strategy.  However, from a practical standpoint, the back-loaded ascending payout will almost always be better for preserving the non-charitable share than a straight-line payout.

CITES: PLR 201216045; IRC Sec. 2055; Treas. Reg. Sec. 20.2055-2(e)(2)(vi); PLRs 8946022, 9118040, 9128051, 9840036, 199947022 and 199927031; and Hood, “A Panacea or Potential Problem: T-CLATs-Beyond the Basics,” The Ultimate Estate Planner, Inc. (Nov. 17, 2011).

 

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Proposed Ante-Nuptial Agreement Fails to Qualify for the Marital Deduction

Posted on April 30, 2012 by

KEY WORDS: Marital Deduction; Tenancy by the Entirety; Marriage Contracts

EXECUTIVE SUMMARY: In this private letter ruling, the IRS held that an arrangement whereby two spouses proposed to limit what the survivor between them could do with the deceased spouse’s half interest would not qualify for the marital deduction. In so doing the IRS distinguished Rev. Rul. 71-51 by determining that under the proposed arrangement, unlike the facts in Rev. Rul. 71-51, the property would be passing by operation of law instead of pursuant to the agreement.

FACTS: Al and Beatrix, husband and wife, own a parcel of real estate as tenants by the entirety. They proposed to enter into an agreement that would restrict what the survivor between them could do with the deceased spouse’s half interest, thinking that such an arrangement would qualify for the estate tax marital deduction at the first spouse’s death.  However, to be on the safe side they sought guidance in the form of a private letter ruling from the National Office of the IRS.

In the arrangement, the agreement will provide that on the death of the first spouse to die, one half of the value of the property must be held in trust during the surviving spouse’s (“Survivor”) lifetime.  The Survivor may exchange his or her own separate property for the portion of the property to be held in the trust.  The Survivor will receive the other half of the property outright. The trust, in Article II, will provide for the Survivor to receive the trust income.  If the Survivor: (i) does not remarry, or (ii) remarries and certain conditions are met, he or she may receive principal in the trustee’s absolute discretion.  The remaining principal will be distributed to designated remaindermen at the Survivor’s death.

The couple argued that the proposed arrangement would qualify for the estate tax marital deduction under IRC Sec. 2056 by way of IRC Sec. 2040 and cited Rev. Rul. 71-51 as authority for their position.

The IRS disagreed.  The IRS pointed out that in Rev. Rul. 71-51, the spouses owned the subject property as joint tenants with rights of survivorship and decided to restrict the ultimate disposition of the property by entering into an irrevocable joint and mutual will in which the property would be held in trust for the benefit of the surviving spouse for his or her lifetime.  The issue in Rev. Rul. 71-51 was whether the arrangement met the marital deduction requirement in IRC Sec. 2056 that the property pass from one spouse to the other.  In Rev. Rul. 71-51, the IRS ruled that the arrangement would qualify for the estate tax marital deduction because the surviving joint tenant would take by virtue of the agreement that originally created the joint tenancy instead of by the joint and mutual will.

In the subject ruling, the IRS distinguished Rev. Rul. 71-51 by finding that:

[T]he Agreement and consequent Trust constitute a binding contract creating rights and interests that supersede and extinguish those of the tenancy by the entirety. At the death of the first spouse to die, the Property is nontestamentary in character and passes in accordance with State law. Thus, Rev. Rul. 71-51 is not applicable. For this reason, we are providing no further comment on the tax consequences of the transaction.

COMMENTS: The ruling is a little surprising given the lax attitude that has developed with respect to the marital deduction, which certainly has increased exponentially in the 41 years that has elapsed since Rev. Rul. 71-51.  However this ruling is altogether unexpected and seems to be correct. Caution is advised any time that a couple seeks to limit what the survivor between them can do with jointly owned property, which is common, particularly in blended family relationships.  Those who seek to get out of the taxation rain under the apparently small umbrella of Rev. Rul. 71-51 are urged to follow the facts of that ruling to the letter.

CITES: PLR 201216005; IRC Secs. 2040 and 2056; Awtry Est. v. Comr., 221 F. 2d 749 (2nd Cir. 1955); Rev. Rul. 71-51.

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Tax Court Deals the IRS Another Blow in a Defined Value Gift Case

Posted on April 1, 2012 by

Executive Summary: In this federal gift tax case, the Tax Court determined in a memorandum opinion that the taxpayers’ respective defined value gift clauses were enforceable under state law, were defined value gifts of LLC membership interests instead of gifts of percentage interests and were to be respected for federal gift tax purposes.
Facts: On January 1, 2004, Joanne and Dean executed separate assignments and memorandums of gifts (“gift documents”). Each gift document provided:
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:

Name Gift Amount

Kenneth D. Wandry $261,000
Cynthia A. Wandry 261,000
Jason K. Wandry 261,000
Jared S. Wandry 261,000
Grandchild A 11,000
Grandchild B 11,000
Grandchild C 11,000
Grandchild D 11,000
Grandchild E 11,000
Total Gifts 1,099,000

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 Internal Revenue Service (“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. [emphasis added]

Corresponding timely adjustments were made to the capital accounts of the members. The transfers were subsequently appraised by a qualified appraiser. The transfers were fully disclosed with all of the documentation on the federal gift tax returns of Joanne and Dean. There was a little discrepancy between the gifts as shown on the gift tax returns, which reflected gifts of interests worth a certain dollar amount, and the supporting schedules, which reflected gifts of percentage interests of 2.39% and .101%, respectively.
On audit of the federal gift tax return, the IRS argued for a higher unit value ($366,000 and $15,400, respectively) than that opined by the business appraiser. Additionally, the IRS argued that the defined value gift clauses granted percentage gifts (2.39% and .101%, respectively) rather than defined value gifts ($261,000 and $11,000) because of the schedules to the gift tax returns. The IRS also argued that the defined value gift clauses were unenforceable and violative of public policy.
Joanne and Dean obviously disagreed, and each filed a Tax Court petition. Subsequently, the parties agreed that the values of the gifts were $315,800 and $13,346, respectively, which would require subsequent downward adjustments to the membership interests pursuant to the defined value gift clauses.

In the Tax Court, Judge Haines began with the gift description issue. While the IRS cited Knight v. Comr. in support of its position on this issue, namely, that the schedules to the gift tax returns reflected what Joanne and Dean actually gave, Judge Haines distinguished Knight, noting:

Petitioners have not similarly opened the door to respondent’s argument. At all times petitioners understood, believed, and claimed that they gave gifts equal to $261,000 and $11,000 to each of their children and grandchildren, respectively. In Knight, the taxpayers’ gift tax returns did not report dollar value gifts. In the cases at hand, although respondent relies on the gift descriptions as the basis for the alleged admissions, petitioners’ gift tax returns were consistent with the gift documents. Petitioners’ gift tax returns reported gifts with a total value equal to $1,099,000, and the schedules supporting petitioners’ gift tax returns reported net transfers with a value of $261,000 and $11,000 to petitioners’ children and grandchildren, respectively. Petitioners’ C.P.A. merely derived the gift descriptions from petitioners’ net dollar value transfers and the [business appraiser] report.[Emphasis added]

Judge Haines then addressed the IRS argument, citing a Colorado (applicable law state) case, Thomas v. Thomas, that the capital account adjustments, rather than the gift documents, control and the former described percentage gifts. Judge Haines disagreed with the IRS, noting:

Respondent’s reliance on Thomas is misplaced. Thomas is a case about whether and when a gift of corporate stock is complete, and it has no bearing on the nature of petitioners’ gifts. We do not find respondent’s argument to be persuasive. The facts and circumstances determine [the LLC’s] capital accounts, not the other way around. Book entries standing alone will not suffice to prove the existence of the facts recorded when other more persuasive evidence points to the contrary.
…
In fact, the Commissioner routinely challenges the accuracy of partnership capital accounts, resulting in reallocations that affect previous years. If the Commissioner is permitted to do so, it can be said that a capital account is always “tentative” until final adjudication or the passing of the appropriate period of limitations. Accordingly, [the LLC’s] capital accounts do not control the nature of petitioners’ gifts to the donees.

Even if we agreed with respondent’s capital accounts argument, respondent has failed to provide any credible evidence that the [LLC] capital accounts were adjusted to reflect the gift descriptions. The only evidence in the record of any adjustments to [the LLC’s] capital accounts in 2004 is the capital account ledger and the [LLC’s] members’ Schedules K-1, neither of which provides credible support to respondent’s argument. The capital account ledger is undated and handwritten. There is no indication that it represents [the LLC’s] official capital account records, and it does not reconcile with any of petitioners’ or respondent’s determinations. The capital account ledger is unofficial and unreliable. [emphasis added]

With respect to the argument of the IRS that Petter Est. was distinguishable, Judge Holmes also disagreed, noting:

Respondent argues that the cases at hand are distinguishable from Estate of Petter. Rather than transferring a fixed set of rights with an uncertain value, respondent argues that petitioners transferred an uncertain set of rights the value of which exceeded their Federal gift tax exclusions. Respondent further argues that the clauses at issue are void as savings clauses because they operate to “take property back” upon a condition subsequent.

Respondent does not interpret Estate of Petter properly.

Judge Haines then went on to analyze the subject case documents under the Petter Est. rationale and noted several key points. First, he noted that the only unknown in the mix, i.e., the value of the LLC’s assets as of January 1, 2004, was a constant. Second, both before and after the IRS audit, the donees were entitled to receive the same percentages of LLC interests because the gifts were “essentially expressed as a mathematical formula, as follows:

Value of gift to child=$261,000
FMV of LLC assets

Value of gift to grandchild= $11,000
FMV of LLC Assets
After this analysis, Judge Haines concluded:

Absent the audit, the donees might never have received the proper [LLC] percentage interests they were entitled to, but that does not mean that parts of petitioners’ transfers were dependent upon an IRS audit. Rather, the audit merely ensured that petitioners’ children and grandchildren would receive the 1.98% and .083% [LLC] percentage interests they were always entitled to receive, respectively.

It is inconsequential that the adjustment clause reallocates membership units among petitioners and the donees rather than a charitable organization because the reallocations do not alter the transfers. On January 1, 2004, each donee was entitled to a predefined [LLC] 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 LLC membership units among petitioners and the donees because the [business appraiser] report understated [the LLC’s] value. The clauses at issue are valid formula clauses. [emphasis added]

Finally, with respect to the Procter public policy argument, Judge Haines also turned it back, expressly noting that “[t]he lack of charitable component in the cases at hand does not result in a ‘severe and immediate’ public policy concern.”

Comments: Congratulations to counsel to the taxpayers for a slam dunk taxpayer victory! You should read this opinion. It is an important extension of defined value gifts and proves that one doesn’t need a charitable or marital “wrapper” for these things to work properly as I have argued in published articles for almost ten years.

In my opinion, the bottom line is that properly designed and implemented defined value transfers are more legitimate now than ever before and should be accorded respect for tax purposes, and it is well past time for the IRS to accommodate them with formal guidance. Given the significant string of defeats in these cases (conjuring up memories of the armies of certain unnamed allies who never win wars), it is time for the IRS to start getting hit with attorney’s fees under IRC Sec. 7430 for continuing this fight.
Cites: Wandry v. Comr., 2012-88; Petter v. Comr., T.C. Memo 2009-290, aff’d 643 F. 3d 1012 (9th Cir. 2011); Christiansen v. Comr., 130 T.C. No. 1 (2008), aff’d 586 F. 3d 1061 (8th Cir. 2009); McCord v. Comr., 120 T.C. 358, 364 (2003), rev’d 461 F.3d 614 (5th Cir. 2006); Comr. v. Procter, 142 F. 2d 824 (4th Cir. 1944); King v. U.S., 545 F. 2d 700 (10th Cir. 1976); Knight v. Comr., 115 T.C. 506 (2000); Ward v. Comr., 87 T.C. 78 (1986); Harwood v. Comr., 82 T.C. 239 (1984); Rev. Rul. 86-41; and Hood, Defined Value Gifts and Sales Under the Microscope: What’s Possible and What’s Not-Revisited?, BNA Tax Management Estate, Gift and Trust Journal, July 11, 2011.

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