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.