With very limited exceptions, estate, gift and GST (called "wealth transfer") taxes are imposed on property's fair market value (FMV). Only cash and publicly traded securities have definite values for estate and gift tax purposes. All other assets, such as closely held business interests, land, private equity and art, do not and their FMVs are equal to the price at which the property would trade hands between a willing buyer and willing seller, neither of whom is acting under a compulsion to buy or sell but both of whom have full knowledge of the "knowable" facts affecting value (e.g., the price of land is determined without regard to the fact that there is undiscovered gold under the ground).
In fact, the IRS is known to collect more additional wealth transfer taxes on account of challenges to values reported by taxpayers than all legal issues combined. Moreover, penalties of between 20% and 40% may be imposed on the amount of tax underpaid attributable to an undervaluation of property for wealth transfer tax purposes. Section 6662(g). A reasonable cause exception (subject itself to exceptions) to the penalty is provided under Section 6664(c). The requirements for this exception are fleshed out in Reg. 1.6664-4 and are very worthwhile studying. Among other requirements is that the taxpayer must obtain an independent appraisal of the property transferred.
Hence, one way to try to avoid penalties and an additional wealth transfer tax by reason of an undervaluation is to rely on a thorough and complete appraisal. However, that has not, in many cases, avoided an increase in tax even if it did avoid the Section 6662(g) penalty.
Transferring a Fixed Dollar Amount of Value: Price Adjustments Clauses
Another way individuals have tried to avoid the undervaluation penalty as well as any addition to tax is to attempt to ensure there is no undervaluation by use of a formula which eliminates any incorrect valuation. One method of using such a formula is to readjust the amount of property that could be transferred as a gift. This is sometimes called a "price adjustment clause." The efficacy of such a clause has, at least to a large degree, been unsuccessful. Probably, the leading case is Commissioner v. Proctor, 142 F.2d 824 (4th Cir. 1944). However, in King v. United States, 545 F.2d 700 (10th Cir. 1976), the court found that the transfer, even if undervalued, was not a gift because it fell under the ordinary course of business rule (which deems a transfer to be for full and adequate consideration in money or money's worth under Reg. 25.2512-8). Under these types of clauses, if more than what was desired to be transferred (e.g., more than the gift tax annual exclusion or the taxpayer's remaining transfer tax exemption) would be given away, a sufficient portion of the property is "returned" to the donor (or deemed never to have been transferred) so there is no gift (or extra gift). In large measure, such readjustment ("return to the donor") or “savings” clauses have been rejected by the court, although some practitioners report "good" settlements on the issue in audits.
Transferring a Specific Dollar Amount’s Worth
More recently, taxpayers, in attempt to avoid being deemed to have made a gift have defined the amount transferred (whether by gift or sale) by a dollar amount such as "I hereby transfer one million dollars’ worth of my stock in my company."
In Nelson v. Commissioner, TC Memo 2020-81, just decided by the United States Tax Court, the taxpayer claimed to have transferred (in one case by gift and in another by sale) limited partnership interests of a fixed dollar amount worth. While the court did not reject the notion of respecting such fixed dollar value transfers, it found the taxpayer in Nelson did not effectively transfer property worth the amount of the intended gift or sale. The good news for the taxpayer in the case is that the court allowed "layered" discounts for gift tax purposes, totally about 60%. The bad news is that it rejected the taxpayer’s contention that a dollar value of property (in part by gift and in part by sale) was transferred (Overall, the case seems to be a real winner for the taxpayer despite the adverse holding on the defined value clause). The key element here is that the taxpayer failed, in the claimed intent to transfer a dollar amount of property, to use the phrase “as finally determined for federal gift tax purposes” or the equivalent.
In Nelson, the deeds of transfer purported to transfer a fixed dollar amount of value of units in the case of the gift and the sale. It said value was to be “determined by a qualified appraiser within [a number of] days ...” (90 case in the deed of gift, and 180 days in the deed of sale). The deeds did not use the language “as finally determined for gift tax purposes” that was used in the other cases such as Petter v. Commissioner, T.C. Memo. 2009-280, Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008), aff’d, 586 F.3d 1061 (8th Cir. 2009), and Wandry v. Commissioner, T.C. Memo. 2012-88. In Succession of McCord v. Commissioner, 461 F.3d at 618, the Court of Appeals for the Fifth Circuit upheld a gift of an interest in a partnership expressed as “a dollar amount of fair market value in interest” reduced by a transfer tax obligation rather than a percentage interest that was determined in agreements subsequent to the gift. It held that “a gift is valued as of the date that it is complete; the flip side of that maxim is that subsequent occurrences are off limits.” Therefore, it seems a taxpayer should use “fair market value” or, perhaps, better yet, use “fair value as finally determined for gift tax purposes.” The taxpayer should not do what was done in Nelson: define value by reference to the conclusion of an appraiser.
The High Point for Taxpayers: Wandry
In Wandry v. Commissioner, supra, the taxpayer clearly defined the amount transferred by a fixed dollar amount on the date of the transfer as finally determined for federal gift tax purposes. However, the Commissioner of Internal Revenue has non-acquiesced in the decision meaning taxpayer can anticipate a potential challenge.
Overall, case law suggests that the IRS likely would be unsuccessful. See, e.g., Estate of Christiansen v. Commissioner, supra (upholding gift clause providing fair market value “as such value is finally determined for federal estate tax purposes”); Estate of Petter v. Commissioner, supra (upholding gift clause transferring the number of units of a limited liability company “that equals one-half the minimum * * * dollar amount that can pass free of federal gift tax by reason of Transferor’s applicable exclusion amount” along with a clause providing for an adjustment to the number of units if the value “is finally determined for federal gift tax purposes to exceed the amount described” in the first clause).
What Should Taxpayers Do to Limit Gift Tax Exposure?
There seem to be several things a taxpayer may consider doing to limit gift tax exposure when making a lifetime transfer by gift or sale. First, if the taxpayer is certain that, even if the IRS is completely successful in proving the value is much greater than the taxpayer has reported, no gift tax will be due if the higher value still would not result in gift tax by reason of the large gift tax exemption. For example, the taxpayer still has the $11.58 million exemption when transferring interests in a partnership holding marketable securities worth $10 million. The taxpayer reports the transfer based upon an appraisal of the partnership (taking into account lack of control and lack of marketability discounts) of $7 million. Even if the IRS could successfully establish the value was $10 million and not $7 million, no gift tax would be due.
Second, the taxpayer could structure the transfer so that a qualified disclaimer under Section 2518 would result in a “reversion” to the taxpayer so the amount disclaimed would be treated as never having been transferred. Presumably, the disclaimer could be phrased in terms of “as finally determined for federal gift tax purposes.”
And that bring us to a third possibility, discussed above. When attempting to transfer only a specific dollar amount (or worth) of property use the phrase “as finally determined for federal gift tax purposes.”
And Do a Little More
Regardless of which method is used to try to limit the amount transferred, in addition to using the phrase “as finally determined for federal gift tax purposes,” the taxpayer and the transferee should ensure they treat all subsequent reporting as consistent with the value. For example, if the taxpayer transfers “one million dollars’ worth of the partnership units as finally determined for federal gift tax purposes,” it may be appropriate to report the sale on the taxpayer’s income tax return even if the sale could not result in gain or loss because the buyer is a grantor trust. See Rev. Rul. 85-13, 1984-1 C.B. 184. But taxable income earned in the partnership will have to be allocated to the seller and buyer. Because, at least in initial years, gift tax value will not have been finally determined, it will not be certain the proper amount each party (the seller and the buyer) should report. This dilemma can be avoided if the transferee is a grantor trust as it all will be reported by the grantor. Otherwise, the parties should agree that each will report income based upon an appraisal but, in all events, each agrees to adjust the amount reported (and the amounts each may have received) if it turns out the percentage transferred as finally determined for federal gift tax purposes is different than the appraised value.
It seems sensible to report the transfer, even if purporting to be a full value sale, under Reg. 301.6501(c)-1(f) which should mean that, if the IRS does not challenge the value pursuant to Section 7477 or by the assessment of gift tax, the value will have been finally determined for federal gift tax purposes. Perhaps, the taxpayer should also make a gift of a portion of property sold and report it on a gift tax return which, presumably, would result in a final determination of the property’s value of federal gift tax purposes. Maybe, both should be done.
In addition, if the sale is to a grantor trust, it may be possible to structure the trust so that if the IRS determines the property was undervalued in the sale transaction, a substantial portion of the excess value is held in an incomplete gift trust for the benefit of the grantor, thereby minimizing the gift tax exposure with respect to the excess transfer. The details of that structure are beyond the scope of this discussion, but Wealth Transfer Planning subscribers will find an example in the Irrevocable Trust forms available in the program.
Can I Use an Appraised Value in a Transfer of a Dollar Amount?
There is a way one may use an appraisal. And, perhaps, it should be used. For example, the taxpayer wishes to transfer all non-management interest in a limited liability company (LLC) to a trust for descendants. The taxpayer engages an appraiser who determines the value of the interests to be $5 million. The taxpayer does not transfer all non-management interests but the “lesser of all non-management interests or that percentage of such management interests that have a fair market value as finally determined for federal gift tax purposes as of the date of this transfer of $5 million.”
Now suppose the value as finally determined for gift tax purposes of all the non-management interests is $10 million, not $5 million. Well, the lesser of all interests and those interests have a $5 million value is those having a value of $5 million. That means, presumably, only half of the units have been transferred. If the finally determined value is $4 million, then all the non-management units will have been transferred.
Although the Nelson decision is adverse to the taxpayer, in terms of the intended effect of the defined value clauses, it need not be read as adverse to the use of defined value gifts, in general. Of course, there is some risk in making defined value gifts, given the propensity of the IRS to challenge them. However, Wandry, Petter, and McCord should give estate planners a reasonable level of comfort that defined value gifts can be successful, if structured correctly. The lesson from Nelson is that defined value clauses must be drafted with careful attention, following the language established by precedent as closely as possible. Estate planning often requires creativity in planning and drafting, but when drafting a defined value clause, run-of-the-mill may be best.
Meet the Authors:
Jonathan G. Blattmachr has over 35 years of experience in trusts and estates law and is currently a Principal at Pioneer Wealth Partners, LLC. He is a retired member of Milbank Tweed Hadley & McCloy and the Alaska, California and New York Bars. Mr. Blattmachr writes and lectures extensively on estate and trust taxation and charitable giving and has authored or co-authored eight books and over 500 articles on estate planning topics. He also co-developed Wealth Transfer Planning™, an InterActive Legal software system published for lawyers that provides specific client advice and automated document assembly for wills, trusts, powers of attorney, and other estate planning documents.
Professor Mitchell M. Gans is the Steven A. Horowitz distinguished professor in taxation at Hofstra University School of Law, and an Adjunct Professor of Law at NYU Law School. He is an Academic Fellow at ACTEC and is the Academic Editor of the ACTEC Journal. Professor Gans is a leading scholar in the estate-and-gift tax area, teaching courses for the IRS on estate and gift tax and valuation methodology. He is a frequent lecturer for ALI-ABA, NYU, ACTEC, the ABA and other groups and has written numerous articles on estate tax planning topics, including a recent Leimberg Information Services article, co-authored with Jonathan Blattmachr, on the Proposed Section 2704 Regulations.
Vanessa Kanaga joined InterActive Legal in 2013, and serves as President and Director of Content Development. In her role, Vanessa oversees the development of InterActive Legal program content, in addition to working with CEO, Michael L. Graham, to guide the company in its future direction, and manage day-to-day operations.
Vanessa received her J.D. from Cornell Law School, Magna Cum Laude, in 2006, and holds a B.A. in Philosophy from Wichita State University, with a minor in Music, as well as an Advanced Professional Certificate from New York University School of Law. Following law school, Vanessa practiced in New York for several years, at Milbank, Tweed, Hadley & McCloy, LLP, and then Moses & Singer, LLP. In 2012, she returned to her home town of Wichita, Kansas, where she was an associate attorney in the estate planning and probate practice group at Hinkle Law Firm, LLC, before joining InterActive Legal.