Let’s talk this time about gift taxation.
Let’s say that you have a family-owned company. You desire to pass this on to your kids and grandkids. There are ways to do this, but the method best for you is annual gifts of $13,000, which is the amount of the gift tax annual exclusion. Both you and your spouse can give away $13,000 per beneficiary, so you are transferring $26,000 at a clip. Enough beneficiaries and this can add up.
You ask: what could go wrong?
What if the IRS challenged the value of the gift? Remember, partnership or LLC units generally do not have the same value as a direct and uninterrupted transfer of the asset(s) in the partnership or LLC.
Why is that? Well, if you are a limited member, you have to obtain the general member’s permission to asset. If you are my daughter and I am the general member, rest assured that permission is not happening for a while. My daughter may “own” $26,000 (2 annual gifts of $13,000) in the LLC, but is it really worth $26,000? Remember: you need my permission to get to the $26,000. Would you pay her $26,000 today on the hope and prayer that someday I will distribute $26,000 to you?
Let’s say that IRS comes in says that the LLC units are not worth $26,000. Instead the units are worth $40,000. What just happened? What happened is that I have to amend my gift tax return. I am now using my lifetime exemption so as not write a check to the IRS. Had I already used-up my lifetime exemption, I would be writing a check. I would not be happy.
What if I changed the terms of the gift? Instead of saying that my wife and I transferred X number of units, we say we transferred units (or fractions thereof) worth $13,000 to our daughter. If the IRS adjusts the gift value upward, then – as far as I am concerned - I “actually” gifted fewer units. Remember, I gifted $13,000 in value, NOT a set number of units. Brilliant!
Except that the IRS thought it too brilliant. This tax technique is called a “defined value clause,” and the IRS has pursued these cases on multiple grounds, including being against public policy.
One of the first cases was Proctor. There the donors gifted remainder interests using the following clause:
“In the event it should be determined … that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all parties hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance in trust hereunder and shall remain the sole property of the taxpayer.”
The Fourth Circuit of Appeals nixed the Proctor clause as being after-the-fact. It was a condition subsequent. The IRS continued its win streak with Ward and with Harwood.
Those cases are easy to understand: you cannot undo what has already been done. Let’s make it more challenging.
What if you are not trying to undo anything? What if you have two beneficiaries: your family and any excess going to charity? Think about this for a moment. If the IRS revalues the gift, the revaluation would be “excess” and go to the charity. There is no gift tax on transfers to charity. There would be little motivation for the IRS to pursue you. The IRS still did not like this and litigated the matter in Christiansen, McCord and Petter. This time, they were not as successful.
What if you like the result in McCord but it is not your intent to include a charitable beneficiary? Congratulations. You are Dean and Joanne Wandry. The Wandry’s gifted partnership units worth $1,099,000 on January 1, 2004. The actual number of units was not fixed, pending a later valuation. The valuation was completed July 26, 2005. The IRS examined the gift tax returns and issued the tax assessment in February, 2009.
The IRS argued that
· The descriptions on the gift tax returns sounded like a transfer of units and not dollars
· The entry the accountant made to the books sounded like a transfer of units and not dollars
· The attorney’s documents sounded like a transfer of units and not dollars
· It was against public policy to transfer dollars and not units, and
· In any event the taxpayers smelled funny.
The Wandry’s took the matter to Tax Court. They won their case this past March, and they are now famous as being the first taxpayers to win against the IRS using a formula clause that doesn’t have a charitable element. Granted, this is not the same as winning the Peyton Manning sweepstakes, but it is something.
My take: I expect to see Wandry clauses as standard boilerplate in FLP transfer documents from this point on.
