DEFINED VALUE CLAUSES: DRAFTING & AVOIDING RED FLAGS

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1 DEFINED VALUE CLAUSES: DRAFTING & AVOIDING RED FLAGS First Run Broadcast: April 26, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) Formula and defined value clauses are used in estate planning to attempt to fix the value of property transferred in a lifetime gift, testamentary transfer, or in a sale. These clauses are also frequently used in marital deduction and credit shelter trusts, and in GST allocations. Carefully drafted formula clauses can withstand IRS scrutiny and optimize tax outcomes for a client s estate. But the IRS has recently issued new guidance in this area and has become more aggressive in challenging formula clauses as not reflecting economic reality and understating the value of property transferred. This program will provide you with an in-depth discussion of the uses of formula clauses in trust and estate planning, recent regulatory and case law developments, and practical guidance in drafting clauses to avoid red flags and withstand IRS scrutiny. Understanding the uses and risks of defined value clauses in trust and estate planning Types of clause formula allocation by subsequent agreement, final value for gift taxes, or price adjustment How clauses are used in marital deduction and credit shelter trusts, and in Generation Skipping Transfer Tax allocations Spotting red flags that may adverse IRS action and planning to avoid Recent case law and regulatory developments, including IRS Priority Guidance Plan Special considerations in de-coupled states Speaker: Jennifer A. Pratt is a partner in the Baltimore office of Venable, LLP, where she has assists client with estate planning, charitable giving, and estate and gift tax controversy matters. She has extensive experience with estate administration, the preparation of federal estate and gift tax returns, as well as fiduciary income tax returns. Earlier in her career, she worked with a major national bank and has particular expertise in adapting financial products to the estate planning needs of clients. She has been named in the 2011 edition of Maryland Super Lawyers Rising Stars Edition. Ms. Pratt received he B.A., summa cum laude, from the University of Baltimore, her J.D., magna cum laude, from the University of Baltimore School of Law, and her LL.M. in taxation from the University of Baltimore.

2 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Defined Value Clauses: Drafting & Avoiding Red Flags Teleseminar April 26, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER April 19, 2018 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

3 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: April 26, 2018 Seminar Title: Location: Credits: Program Minutes: Defined Value Clauses: Drafting & Avoiding Red Flags Teleseminar - LIVE 1.0 MCLE General Credit 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

4 Defined Value Clauses April 26, 2018 By Jennifer A. Pratt, Esquire Venable, LLP 750 East Pratt Street, Suite 900 Baltimore, Maryland (410) Fax: (410)

5 I. Types of Formula Clauses Value Adjustment Clauses. A value adjustment clause seeks to fix the amount of the gift or estate tax liability by either adjusting the amount that is being transferred or adjusting the consideration received by the donor in exchange for the transfer of the asset. The adjustment clause changes the elements of the transaction if there is a subsequent tax challenge. Defined Value Clauses. A defined value clause fixes the amount at the time of the transfer, and uses either a formula transfer clause or a formula allocation clause. The defined value clauses defines the transfer itself in terms of ultimate value for tax purposes intended to be transferred. This type of clause most closely resembles the pecuniary or fractional formula bequests used for estate tax purposes. II. Making the Gift Many clients were making significant gifts in 2012, trying to utilizing the anticipated vanishing unprecedented gift tax exemption of $5,120,000 per person. Not all clients had marketable securities or cash to make those gifts so they were gifting an asset or assets with an uncertain value. The valuation experts were swamped at the end of 2012 and were not able to get the valuations prepared in time for the looming 12/31/12 deadline. For clients that wanted to make the gift to utilize the $5,120,000 per person exemption without knowing the value of the assets being transferred, what could be done? Rather than transfer of a specified percentage of interests in the hard to value asset, clients could transfer a specified dollar amount. This type of gift is known as a defined-value gift. The defined-value gift approach was favorable at the end of 2012 for a number of reasons. First, for many clients it was not be possible to obtain a compete appraisal of the interests before the end of the year. Second, even if an appraisal were obtained, gift tax could be due if the IRS audited the return and disagreed with the appraisal. Third, the Tax Court had recently approved a defined-value transfer in a similar case. Now with the passage of the Tax Cuts and Jobs Act in 2017, each person has an approximately $11.18 million exemption and there will again be a sunset of the double exemption amount back to the $5 million per person indexed for inflation in The use of these defined value clauses will come back in to play over the next several years. III. Validity of Defined-Value Clauses Defined value clauses have an interesting history from Technical Advice Memorandum November 15, 1985 through the favorable decision in Wandry v. Comm r, T.C. Memo , nonacq., A taxpayer who made a defined-value gift scored a victory in the recent Tax Court case, Wandry, but this victory does not remove all doubt of the success of the strategy. In Wandry, the taxpayer made gifts of LLC units so that the fair market value of such Units for federal gift tax -2-

6 purposes equaled a specified dollar amount. Wandry v. Comm r, T.C. Memo , nonacq., The IRS challenged the defined-value gift, relying on the public policy analysis of the 1944 Fourth Circuit case, Procter. Comm r v. Procter, 142 F.2d 824 (4 th Cir. 1944). In Procter, the taxpayer included a savings clause in the language of the gift providing that if the gift were to generate gift tax, the taxable portion would be deemed not included in the transfer. The Fourth Circuit held the transfer void. The transfer was subject to a condition subsequent to the donor s gift, and allowing such a transfer would be against public policy because it would defeat any attempt by the IRS to collect tax on audit. The Wandry Court made a distinction between a transfer in which the donor attempts to return property to the donor and a transfer, as in Wandry, in which the donor transfers only a set amount. See also Petter v. Comm r, T.C. Memo The taxpayer in Wandry would not be taking any property back; rather, the gift was set but expressed as a formula. Additionally, the transfer did not violate public policy in this particular case because there was no severe and immediate threat to public policy. The IRS s role is to enforce the laws, and there are other mechanisms, such as the interest of the donee, to enforce the proper result of the formula. Because of the distinction made between these two cases, we were careful to document your defined-value gift using the language of Wandry rather than the language of Procter. Although the Wandry case is a promising precedent, it is not binding precedent. Additionally, the IRS has indicated through non-acquiescence that it intends to continue challenging defined-value gifts. The Procter case still hovers, particularly here in the Fourth Circuit. Therefore, there is still a risk that the gift will be invalid because of the defined-value clause. We remain optimistic, however, that definedvalue clauses will continue to be upheld by the courts, following the sound analysis of Wandry, so we suggest that the gift tax return be filed to take full advantage of the defined-value approach. IV. Audit Profile of Defined-Value Gifts Some practitioners have warned that a defined-value gift could raise the audit profile of a gift tax return. Defined-value gifts, particularly in 2012 after Wandry, are not uncommon, although they had been uncommon in prior years. The IRS non-acquiescence certainly does suggest that the IRS may have thrown down the gauntlet on defined-value clause gifts. However, a defined-value clause may appreciably raise the probability of audit for a large gift of hard to value assets, however the hard to value assets, like limited liability company interests or closely held business interests, are already of interest to the IRS. The IRS Priority Guidance Plan included the project to provide Guidance on the gift tax effect of defined value formula clauses under Sections 2512 and This was deleted in 2017 from the IRS Priority Guidance Plan and so practitioners are still left with some uncertainty in making defined value gifts. -3-

7 V. Reporting a Defined-Value Gift The key to the defined-value gift will be to report it correctly on a timely filed gift tax return. A defined-value gift should be reported as a transfer of a particular percentage of interests having the specified dollar value and not as a gift of a specific percentage of interests. Neither the taxpayer in Wandry nor the taxpayer in another defined-value case, Knight, reported the defined-value gift correctly: both taxpayers reported the gift as a specified percentage of interests. Knight v. Comm r, 115 T.C. 506 (2000). The IRS in Wandry did argue that the misreporting negated the defined-value clause and the Court stated that descriptions on a gift tax return can be a binding admission regarding how the parties viewed the gift. The Wandry gift was respected notwithstanding the incorrect reporting, because the Court stated that it was clear that the Wandrys always understood, believed and claimed that they gave gifts equal to a stated dollar amount. The taxpayer in Knight was not as fortunate: the misreporting, together with an inconsistent argument that the value of the interests was less than the defined value, invalidated the defined-value clause. Correct reporting will avoid the IRS argument that the defined value clause is meaningless. In order to report a defined-value gift correctly, the description of the gift should provide that the gift is of a sufficient percentage of membership interests in Family Holdings, LLC, a limited liability company, so that the fair market value of such percentage as finally determined for federal gift tax purposes, shall be $5,120,000. The return should then go on to state, According to the attached appraisal, the percentage transferred pursuant to the gift would be x%; nevertheless, the ultimate percentage is based on the value as finally determined for federal gift tax purposes. This method of reporting clarifies that the defined-value clause is to take effect if the return is later audited. -4-