FORMULA AND DEFINED VALUE CLAUSES IN ESTATE PLANNING: AN UPDATE

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1 FORMULA AND DEFINED VALUE CLAUSES IN ESTATE PLANNING: AN UPDATE First Run Broadcast: March 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 formula and defined value clauses and how they are used in estate and trust planning How clauses are used in marital deduction and credit shelter trusts, and in Generation Skipping Transfer Tax allocations Formula clauses with gifts involving charity (Christiansen) and not involving charity (Wandry) Recent regulatory and case law developments Red flags for IRS challenges and new lines of IRS attack Special considerations in de-coupled states Speakers: Blanche Lark Christerson is a managing director at Deutsche Bank Private Wealth Management in New York City, where she works with clients and their advisors to help develop estate, gift, tax, and wealth transfer planning strategies. Earlier in her career she was a vice president in the estate planning department of U.S. Trust Company. She also practiced law with Weil, Gotshal & Manges in New York City. Ms. Christerson is the author of the monthly newsletter Tax Topics." She received her B.A. from Sarah Lawrence College, her J.D. from New York Law School and her LL.M. in taxation from New York University School of Law. 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. 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. Renee M. Gabbard is a partner the Irvine, California office of Bryan Cave, LLP, where her practice includes all aspects of income, capital gains, gift and estate tax planning, charitable planning, and advanced wealth and business succession planning. She has written and spoken widely on estate and trust planning topics. Ms. Gabbard received her B.A. from the University of Southern California and her J.D. from New York University School of Law.

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: I will be attending: Formula & Defined Value Clauses in Estate Planning: An Update Teleseminar March 26, 2013 Early Registration Discount By 03/19/13 Registrations Received After 03/19/13 VBA Members: $70.00 Non VBA Members/Atty: $80.00 VBA Members: $80.00 Non-VBA Members/Atty: $90.00 NO REFUNDS AFTER March 19, 2013 PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association): $ Credit Card (American Express, Discover, MasterCard or VISA) Credit Card # Exp. Date Cardholder:

3 Vermont Bar Association ATTORNEY CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: March 26, 2013 Seminar Title: Location: Credits: Formula & Defined Value Clauses in Estate Planning: An Update Teleseminar 1.0 General MCLE 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 FORMULA AND DEFINED VALUE CLAUSES IN ESTATE PLANNING: AN UPDATE First Run Broadcast: March 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 formula and defined value clauses and how they are used in estate and trust planning How clauses are used in marital deduction and credit shelter trusts, and in Generation Skipping Transfer Tax allocations Formula clauses with gifts involving charity (Christiansen) and not involving charity (Wandry) Recent regulatory and case law developments Red flags for IRS challenges and new lines of IRS attack Special considerations in de-coupled states Speakers: Blanche Lark Christerson is a managing director at Deutsche Bank Private Wealth Management in New York City, where she works with clients and their advisors to help develop estate, gift, tax, and wealth transfer planning strategies. Earlier in her career she was a vice president in the estate planning department of U.S. Trust Company. She also practiced law with Weil, Gotshal & Manges in New York City. Ms. Christerson is the author of the monthly newsletter Tax Topics." She received her B.A. from Sarah Lawrence College, her J.D. from New York Law School and her LL.M. in taxation from New York University School of Law. 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. 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. Renee M. Gabbard is a partner the Irvine, California office of Bryan Cave, LLP, where her practice includes all aspects of income, capital gains, gift and estate tax planning, charitable planning, and advanced wealth and business succession planning. She has written and spoken widely on estate and trust planning topics. Ms. Gabbard received her B.A. from the University of Southern California and her J.D. from New York University School of Law.

5 by Blanche Lark Christerson 01/23/ Defined value clauses. Last summer saw yet another taxpayer victory involving a defined value formula clause and gifts of discounted property to heirs and charity. Estate of Petter v. Commissioner showed once again just how effective these clauses can be, and now adds the 9 th Circuit Court of Appeals to the ranks of courts approving them (653 F.3d 1012, 8/4/11). Before getting into the particulars of defined value clauses, here is some background: The facts. Anne Petter lived in Washington State. In the early 80 s, she inherited her uncle s stock in United Parcel Service (UPS). Despite this multi-million dollar windfall, Anne kept her day job as a schoolteacher, and stayed in the same house she d lived in for years. By the late 90 s, she undertook some complex estate planning to benefit her children, grandchildren and charity, without incurring gift tax. To get as much mileage as possible from her $1 million gift tax exclusion (of which about $900,000 was left), Anne s attorney recommended a part gift, part sale transaction involving a limited liability company (LLC) and trusts for two of her children, Donna and Terry. The planning was put on hold when UPS announced in late 1999 that it was going public. By May 2001, when the lock-up period after the initial public offering was over, Anne s UPS stock was worth about $22.6 million. She moved to complete her planning. The LLC and the trusts. Later in 2001, Anne, Donna and Terry signed the operating agreement for the Petter Family LLC. Anne contributed her UPS stock to the LLC in exchange for membership units divided into different classes: A (for Anne), D (for Donna) and T (for Terry). (Class A had effective control over the LLC.) Defective grantor trusts were also created for each of Donna and Terry. (These trusts would not be includible in Anne s estate at her death, but Anne was responsible for paying their income taxes; in addition, because the trusts were treated as Anne s alter ego for income tax purposes, transactions between Anne and the trusts (such as a sale) were not currently taxable.) Part I of the transaction the gift. On March 22, 2002, Anne executed a document that said she was giving 940 Class T Units to Terry s Trust and to the Seattle Foundation. The document used a defined value formula clause to describe how many units would be allocated to Terry s Trust and to charity: Terry s Trust would receive units equal to one-half of Anne s remaining gift tax exclusion (an amount she understood to be $453,910), and the Seattle Foundation would (and did) receive the balance. If the value of the initial units the trust received was finally determined for federal gift tax purposes to exceed that amount, the trust would transfer those excess units to the Seattle Foundation; if the value as finally determined was lower than that amount, the Seattle Foundation would transfer its excess units to the trust. (Donna s Trust had a similar document, but used Class D Units; the Kitsap Foundation was the charity.) Part II of the transaction the sale. On March 25, 2002, Anne executed another document that said she was assigning 8,459 Class T Units to Terry s Trust and to the Seattle Foundation. The document again used a defined value formula clause to describe how many units would be allocated to the trust and to charity: Anne was selling to the trust the number of units equal to $4,085,190 as finally determined for federal gift tax purposes, and was giving the balance to the Seattle Foundation. If the value of the units the trust received was finally determined to

6 01/23/ exceed the specific dollar amount, the trust would transfer its excess units to the Seattle Foundation; the Seattle Foundation would do the same for the trust if the value proved lower. (Donna s Trust had a similar document using Class D Units; this time, the Seattle Foundation was the charity.) In exchange for the units, each trust gave Anne a 20-year promissory note for $4,085,190, payable in quarterly installments of interest and principal, at 5.37% interest. The allocation. On April 15, 2002, the formal appraisal of the Class T and Class D Units was completed. The units were valued at $ each, and reflected a 46% non-marketability discount and a 13.3% net asset value adjustment. Based on the appraisal and the defined value formula clauses described above, Anne s attorney made the appropriate allocations of units to the two trusts and the two charities. (The charities used outside counsel to review the gifts and to make sure their interests were adequately represented.) The gift tax return and audit. Anne s 2002 gift tax return fully disclosed the transactions, and listed the following totals for the units she gave away: $453,910 to each of Donna and Terry s Trusts; $951,364 to the Seattle Foundation; and $50,128 to the Kitsap Foundation. The IRS began auditing the return in 2005, and by November 2006, sent Anne a gift tax deficiency notice. The IRS said that Anne had undervalued the units, which were really worth $ each. Accordingly, Anne s gift to the two trusts exceeded her available gift tax exclusion by over $400,000, and the sales to the two trusts represented a total gift of nearly $4 million (the difference between the increased value of the units transferred to the trusts and the sale price). The IRS also said that Anne s defined value formula clause, which reallocated excess units to charity if the finally determined gift tax value of the units was higher than initially believed, was void as against public policy. About two weeks before trial, Anne and the IRS stipulated that each LLC unit was worth $ The trusts therefore had too many units and, under the clause s reallocation language, had to transfer that excess to the charities. The IRS denied an additional charitable deduction for this subsequent transfer, arguing that the charities never would have received the extra units if it hadn t been for the audit. Anne therefore owed about $2.1 million in gift tax. Anne disagreed and filed a petition in the Tax Court, which had to decide whether Anne s defined value formula clause was valid. What the Tax Court said. The Tax Court examined the IRS s public policy argument, which was based on a th Circuit Court of Appeals case called Commissioner v. Procter (more on this below). The gist of Procter was that taxpayers couldn t insulate themselves from potential gift tax by using adjustment language to undo a transfer that later turned out to be subject to gift tax. Such a clause was contrary to public policy because, in part, it discouraged enforcement of the revenue laws and made courts address a moot issue. Because the Tax Court found Anne s language sufficiently different from Procter, it said there was no need to address the public policy argument. Furthermore, Anne s language didn t undo the initial transfers, but simply ensured that the charities received what they should have gotten originally: In the end, we find it relevant only that the shares were transferred out of Anne s name and into the names of the intended beneficiaries, even though the initial allocation of a particular number of shares between those beneficiaries later turned out to be incorrect and needed to be fixed. The Tax Court therefore upheld Anne s defined value language, and found that she had no additional gift tax liability (T.C. Memo , 12/7/09). The IRS appealed the decision. What the 9 th Circuit Court of Appeals said. The 9 th Circuit Court of Appeals reviewed the Tax Court s findings of fact for clear error, and took a fresh (or de novo ) look at its conclusions of

7 01/23/ law. Because the IRS dropped its Procter/public policy argument on appeal, the 9 th Circuit was left to focus on the following IRS contentions. First, the charities only received the additional units because of the audit. These additional transfers thus depended on an impermissible condition precedent, and under the relevant Treasury regulations, such post-event transfers were not entitled to a charitable deduction. Second, Anne had transferred a particular number of units with a pre-defined value of $ per unit. This amount, which was reported on Anne s gift tax return, was the value as finally determined for gift tax purposes, and thereby limited the charities to the number of units set forth in the return; they were entitled to no more. The 9 th Circuit looked carefully at both arguments. Even though it was true that the charities would not have received the extra units without the audit, this reallocation did not rely on an impermissible condition precedent, since the charities rights arose when Anne executed the initial transfer documents. At that time, the only unknown was the value of the transferred units, not the transfers themselves. Accordingly, the post-audit reallocation merely gave the charities their promised number of units, which was capable of mathematical determination from the outset, once the fair market value [of the units] was known. As to whether the per unit value of $ reported on the gift tax return was the value as finally determined for federal gift tax purposes, the 9 th Circuit rejected that contention as well: although Anne transferred a set number of units (940 per trust in the gift transaction, and 8,459 per trust in the sale transaction), she did not specify the value of a unit in her transfer documents. Rather, she described giving (and selling) to the trusts units equal to stated dollar amounts as finally determined for federal gift tax purposes, with the balance of the transferred units to charity. In other words, the units fair market value would need to be determined through a qualified appraisal, and that value could later be challenged on audit. Although the reported value could therefore change, charity was still entitled to receive the units remaining after the requisite transfers to the trusts. Furthermore, the value as finally determined for federal gift tax purposes meant the value reported on the gift tax return unless that value was successfully challenged, which it was here. The 9 th Circuit thus upheld Anne s defined value clause, stating this was consistent with the decision of the 8 th Circuit Court of Appeals in Estate of Christiansen v. Commissioner (586 F.3d 1061, 11/13/09), which dealt with another defined value clause. Although the IRS tried to distinguish Anne s case from Christiansen, its efforts were unavailing: Anne was entitled to the additional charitable deduction for the extra units passing to charity. Echoing some recent cases, the 9 th Circuit invited the Treasury Department to change its relevant regulation regarding charitable deductions if troubled by the consequences of our resolution of this case. Comments. As complicated as this case sounds, it is really a straightforward proposition: Anne wanted to pass as much property as she could to her family and charity, without incurring gift tax. She had a lot of UPS stock and about $900,000 of her $1 million lifetime gift tax exclusion left. To give away more of that stock and ensure a management structure for what her children would ultimately receive, she transferred her stock to an LLC. Because of restrictions on a member s interest, valuation discounts were applicable to the LLC units. Could reasonable people differ on the value of those units? Of course. And that was the crux of the problem: if an audit increased the value of the units, Anne could face a significant gift tax liability. The defined value formula clause addressed this problem by capping, at a specific dollar amount, the number of units Anne transferred (by gift and sale) to Donna and Terry s Trusts. If

8 01/23/ the fair market value of these transferred units ultimately proved higher and the trusts received too many units, the trusts were required to transfer that excess to charity. So did this reallocation, as the IRS argued, undo some of the gift and sale of the units to the trusts, or did it simply ensure that charity received its due? As this case illustrates, the latter interpretation prevailed. What makes this transaction so taxpayer-favorable is that it freezes what goes to the taxpayer s beneficiaries and gives any excess to charity. That is the frustration for the IRS, and explains their focus on Procter: why bother auditing returns if the valuation increase won t generate any gift tax revenue? Yet courts are loath to deny a charitable deduction for property that indeed goes to charity, and are cognizant of the public policy that favors charitable gifts; they also tend to be wary of Procter claims, which at heart argue this just isn t fair. Is this transaction for everyone? Of course not. It is a complex structure that involves significant planning dollars and a genuine desire to benefit charity, along with heirs. Done properly, however, it addresses a taxpayer s goal of giving away what she can, gift-tax free, without triggering a significant gift tax liability if the value of the discounted or hard-to-value property is successfully challenged on audit. What was Procter all about? Procter is complicated, and had five court appearances between 1943 and 1945 (three in the Tax Court and two in the 4 th Circuit Court of Appeals). In addition, a related 1952 Tax Court case involving Frederic Procter s mother, Lillian, provides fascinating background on the family situation (19 T.C. 387). Here is the upshot: Frederic Procter was a great-grandson of one of the founders of Procter & Gamble, which started in 1837 as a candle and soap business. An only child, Frederic was born in His grandfather created four trusts for Lillian, which would pass to Frederic if he survived his mother (he did not, and died in 1947 of leukemia; his remainder interests thus never came to fruition). Frederic married Marjorie in 1920, and had a boy and a girl. Marjorie divorced him in Paris in 1927, and got custody of the children. When Marjorie died in a car crash in 1933, Frederic was already on Marriage #3 (his second wife had divorced him); Lillian then took charge of his children, and legally adopted his daughter in Frederic s third marriage also ended in divorce, as did his fourth marriage. He married for a fifth (and final) time in As to Lillian, she was constantly advancing Frederic money, and helping him pay alimony to his ex-spouses in addition to looking after his children. She and her son had a strained relationship. By 1939, Frederic owed Lillian, with interest, about $686,000, evidenced by seven promissory notes. In 1939, Frederic in effect consolidated these debts, and created an irrevocable trust that would pay him income for life, with the remainder to his surviving descendants. To fund this trust, he transferred remainder interests in two of Lillian s trusts that were worth nearly $1 million each (at Lillian s death, the remainder interests would first pay her estate any outstanding debts, with the balance flowing into Frederic s trust). As a result of the transfer, the IRS said that Frederic owed about $36,500 in gift tax. Yet a provision in Frederic s trust stated that the parties involved did not believe that Frederic s transfer was subject to gift tax, but if it was so decreed by a Federal Court of last resort, any such property was automatically not included in the original transfer, and would remain Frederic s sole property. Litigation ensued. The Tax Court held that Frederic did not owe gift tax because the present value of his two remainder interests was less than what he owed his mother (2 T.C.M. 429, 7/6/43). The IRS appealed.

9 01/23/ The 4 th Circuit Court of Appeals reversed the Tax Court. It held that Frederic did owe gift tax because the Tax Court had employed the wrong methodology for calculating the present value of Frederic s remainder interests. In addition, the 4 th Circuit addressed Frederic s argument that even if a court held the transfer was subject to gift tax, language in his trust undid the offending transfer, thereby precluding its treatment as a gift. The 4 th Circuit disagreed: We do not think that the gift tax can be avoided by any such device as this. Taxpayer has made a present gift of a future interest in property. He attempts to provide that, if a federal court of last resort shall hold the gift subject to gift tax, it shall be void as to such part of the property as is subject to the tax. This is clearly a condition subsequent and void because contrary to public policy. [such] trifling with the judicial process cannot be sustained. Stated another way, the 4 th Circuit wasn t about to let Frederic put the toothpaste back in the tube (142 F.2d 824, 4/11/44). Condition precedent and condition subsequent. What s the distinction, then, between a condition precedent (pronounced preseedent ) and a condition subsequent? Procter illustrates the condition subsequent : taxpayer does something, but if it later turns out to be a problem, he didn t do it. A condition precedent is what the IRS argued in Petter: that charity ONLY received additional LLC units because of the audit. In other words, before charity would receive those units, something (as in the audit) had to happen, which barred the deduction. As discussed above, however, the 4 th Circuit did not agree with the IRS, and viewed the charities rights as arising from the initial transfer. How did Anne know how much to give and sell? Anne gave each trust units worth $453,910 and then sold each trust units worth $4,085,190. Where did these numbers come from? As indicated above, $453,910 represented half of Anne s remaining gift tax exclusion of $907,820. If she gave away any more than that, she would trigger gift tax. But what about the $4 million+? The answer lies in how these part gift, part sale transactions are typically structured. It is common practice to first give the trust property equal to at least 10% of the property that will be sold to the trust. Here, the gift equaled 10% of the trust s eventual corpus, with the sale price being the other 90%. ($453,910 plus $4,085,190 = $4,539,100.) January and February 7520 rates issued. The IRS has issued the January and February rates: for both months, it is 1.4%, a drop of 0.20% (20 basis points) from the December % 7520 rate. January s mid-term rates are 1.27% (annual, semiannual, quarterly and monthly), a 0.10% (10 basis points) drop from December s mid-term rates of 1.27% (annual, semiannual, quarterly and monthly); February s mid-term rates are 1.12% (annual, semiannual, quarterly and monthly), a further drop from the January and December mid-term rates. Blanche Lark Christerson is a managing director at Deutsche Bank Private Wealth Management in New York City, and can be reached at blanche.christerson@db.com. The opinions and analyses expressed herein are those of the author and do not necessarily reflect those of Deutsche Bank AG or any affiliate thereof (collectively, the "Bank"). Any suggestions contained herein are general, and do not take into account an individual s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. No warranty or representation, express or implied, is made by the Bank, nor does the Bank accept any liability with respect to the information and data set forth herein. The information contained herein is not intended to be, and does not constitute, legal, tax, accounting or other professional advice; it is also not intended to offer penalty protection or to promote, market or recommend any transaction or matter addressed herein. Recipients should consult their applicable professional advisors prior to acting on the information set forth herein. This material may not be reproduced without the express permission of the author. Deutsche Bank means Deutsche Bank AG and its affiliated companies. Deutsche Bank Private Wealth Management refers to Deutsche Bank s wealth management activities for high net worth clients around the world

10 by Blanche Lark Christerson 06/11/ Another defined value victory. On March 26 th, the Tax Court handed down another taxpayer victory involving a defined value formula clause. Wandry v. Commissioner illustrates that it is possible to use such clauses to limit potential gift tax exposure without including charity as part of the mix (T.C. Memo ). Although this case is good news for taxpayers, caution may still be in order. What is a defined value clause? Before going further, some background is necessary. Taxpayers wishing to give their family hard-to-value property, such as units in a limited liability company (LLC), often face a conundrum: because reasonable people (and qualified appraisers) can differ about how much such property is worth, donors can face significant gift tax liability if the IRS successfully argues on audit that the property they gave away is worth more. What to do? The short answer is that taxpayers using defined value clauses that give transferred property to both family members and charity have been winning their cases. Here s an example of such a clause: Mom wants to give units of her LLC to a trust for her child and is charitably inclined. She phrases her gift memorandum carefully, and provides that the trust will receive LLC units equal to a fixed dollar amount, with charity receiving the balance; if it later turns out that the units are worth more (or less), they will be reallocated, so that charity receives what it should have gotten all along. This is a simplified version of Estate of Petter, a taxpayer homerun that the 9 th Circuit Court of Appeals decided last summer (see below); it is similar to Wandry, except that charity played no part in Joanne and Albert Wandry s largesse. The facts. In 2001, Joanne and Albert started a family business with their children, and formed Norseman Capital, LLC. As with their previous family limited partnership, they wanted to give units of the LLC to their children and grandchildren. On January 1, 2004, they executed separate (but identical) gift memorandums to accomplish this. Joanne s memorandum provided that she was transferring a sufficient number of units to equal the following: $261,000 for each of her four children $1,044,000 $11,000 for each of her five grandchildren $ 55,000 $1,099,000 (In 2004, the lifetime gift tax exclusion was $1.5 million, and the annual exclusion (which does not erode the lifetime exclusion) was $11,000 per donee.) Each memorandum also provided that the number of units transferred on the gift date was fixed, and was based on a unit s then fair market value, which a qualified appraiser would determine later. Because that value could be challenged, if the IRS or a court of law made a different final determination of it, then 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

11 06/11/ tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law [the adjustment clause ]. An undated and handwritten ledger from the LLC s accountant indicated that to reflect the gifts, Joanne and Albert s combined capital accounts in the LLC decreased in 2004 by a little over $3.6 million; the capital accounts of each child and grandchild increased by about $855,000 and $36,000, respectively. The LLC s 2004 income tax return also reflected the capital account adjustments. In July of 2005, the qualified appraiser issued its report, and said that a 1% LLC unit was worth $109,000 as of January 1, 2004 (apparently about a 40% discount). Based on this value, Joanne s 2004 gift tax return reported total gifts of $1,099,000, and described each $261,000 gift as 2.39% of Norseman, and each $11,000 gift as.101% of Norseman. (Albert s gift tax return did the same; collectively, they gave $2,198,000.) In 2006, the IRS audited the gift tax returns of Joanne and Albert. On February 4, 2009, the IRS issued deficiency notices, maintaining that each of the 2.39% and.101% LLC interests were undervalued, and were really worth $366,000 and $15,400, respectively. Because Joanne and Albert had each exceeded their gift tax exclusions, they owed gift tax. Joanne and Albert disagreed, and went to Tax Court. Joanne, Albert and the IRS stipulated the facts, and agreed that each 2.39% and.101% LLC interest was worth $315,800 and $13,346, respectively. The Tax Court, then, was essentially left to decide whether Joanne and Albert had made gifts of fixed percentage interests, as the IRS contended, or whether they had made gifts of percentage interests equal to a fixed dollar amount. The specifics. The IRS argued that: 1) Joanne and Albert were bound by the percentage descriptions reported on their gift tax returns; 2) the change in Norseman s capital accounts controlled the nature of the gifts; 3) the gift documents themselves transferred fixed percentage interests; and 4) the adjustment clause was void as against public policy under Procter (a seminal 1944 case that barred a taxpayer from undoing a completed transfer that was later held subject to gift tax). Joanne and Albert argued that they had given percentage interests equal to the dollar values set forth in the gift documents, and that the public policy concerns did not apply to their adjustment clause. What the Tax Court said. Judge Haines heard the case. Although he acknowledged that descriptions on a gift tax return can be binding admissions of how a taxpayer views the gift, Joanne and Albert always understood, believed, and claimed that they gave gifts equal to $261,000 and $11,000 to each of their children and grandchildren, respectively. In preparing their gift tax returns, their accountant merely derived the gift descriptions from the net dollar value set forth in each gift memorandum and the appraised value; Joanne and Albert s consistent intent and actions prove that dollar amounts of gifts were intended. As to whether the LLC s capital account controlled the nature of the gifts Joanne and Albert transferred, that was not so: the facts and circumstances determine Norseman s capital accounts, not the other way around. Furthermore, the IRS had failed to provide any credible evidence that the capital accounts were adjusted to reflect the gift descriptions the ledger was unofficial and unreliable, and did not reconcile with any of the parties determinations. In

12 06/11/ addition, the annual Schedule K-1s that the LLC members received to help prepare their income tax returns only showed a member s beginning and end-of-year capital account balances, and did not account for the adjustments attributable to the gifts. Therefore the IRS s argument fails in both law and fact. As to the gift documents transferring fixed percentage interests, and the adjustment clause being void as against public policy, Judge Haines dismissed those contentions. Joanne and Albert were merely trying to limit the value of their gifts, not undo them, and used formulas similar to what the Tax Court approved in 2008 and 2009 in Estate of Christiansen and Estate of Petter, respectively. (Both cases were affirmed on appeal, and involved gifts to family members as well as charity.) Indeed, Judge Haines carefully matched up Joanne s and Albert s transfers with those in Petter, which the IRS tried to distinguish. Joanne and Albert s children and grandchildren were always entitled to receive predefined Norseman percentage interests; these were essentially expressed as a mathematical formula. Although unknown when the gifts were made, the value of those interests was a constant at all times, since before and after the audit, the children and grandchildren were entitled to receive the same percentage interests. Furthermore, it was inconsequential that membership units were reallocated among Joanne and Albert and their children and grandchildren, rather than charity (as occurred with Petter); this did not alter the transfers, and Joanne and Albert could not take property back. The readjustment clause was valid. Finally, the Procter/public policy argument was inapplicable. A judgment for Joanne and Albert would not undo their gifts, and the reallocation could have significant Federal tax consequences by changing what Joanne, Albert, the children and grandchildren should have reported as their share of Norseman s profits and losses. The court s judgment was therefore not moot (one of the concerns expressed in Procter). Although the charitable component in Petter contributed to a favorable taxpayer outcome, it was not determinative ; the lack of it in this case did not result in a severe and immediate public policy concern. Comments. Wandry is a real taxpayer victory. The Tax Court emphatically supported defined value/readjustment clauses, and was untroubled that charity played no role in the transaction. This is big if it holds. So what are some of the caution signs? First, we don t know if the IRS is going to appeal. If the Service doesn t appeal, then the case stands but it still might be vulnerable for some of the reasons mentioned below. If the IRS appeals, the 10 th Circuit Court of Appeals will hear Wandry. The 10 th Circuit is bound by its prior decisions, at least one of which could be problematic for the Wandrys. Decided in 1976, King v. U.S. involved a price adjustment clause: if the IRS ever revalued the closely held stock that John King sold to multi-generational trusts for each of his four children, the stock s purchase price would be adjusted to reflect that revised value (thereby avoiding any potential gift tax). The IRS increased the stock s value from $1.25 per share to $16 per share; it said that King had made a gift, and that the adjustment clause was invalid under Procter, as it violated public policy. In an unreported decision, a district court rejected the IRS s position, holding that King had intended to sell the stock for full and fair consideration, and had no donative intent. The

13 06/11/ transaction was made in the ordinary course of business at arms length, and the price adjustment clause, which was a proper way to address the stock s valuation uncertainty, insulated the transfers from gift tax. The 10 th Circuit agreed, and held that the district court s factual finding that the transaction was a sale and not a gift was not clearly erroneous (the standard necessary for reversal). The 10 th Circuit also stated that Procter didn t apply because there was never an attempt to negate the valuation clause, and no attempt to reconvey the stock to King ; indeed, only if the transaction be construed as undertaken to reduce King s estate (emphasis in original), would the price adjustment clause violate public policy. (A sharp dissent observed that donor intent doesn t determine whether there s been a gift: this intra-family transaction was not in the ordinary course of business, and was designed to pass some of King s wealth to his children; it presumably was a gift, and on its face, is not and cannot be a sale. ) Given what the 10 th Circuit said about why Procter didn t apply, and its aside that the price adjustment clause would violate public policy ONLY if King had been trying to save gift and estate taxes, how was the Tax Court able to hold for Joanne and Albert, who were trying to limit their gift tax exposure? Because Judge Haines said we do not believe that King is squarely on point, and therefore do not believe it is controlling. If the current 10 th Circuit hears Wandry, will it agree? Second, what of Judge Haines s conclusion that just as in Petter, the adjustment clause did not allow Joanne and Albert to take property back, but merely ensured that their children and grandchildren received what they should have gotten in the first place? Let us review some facts: 1. Joanne and Albert gave each child and grandchild Norseman units equal to fixed dollar amounts. 2. If the value of those units was increased on audit, the gifted units would be reallocated so that the gifts still equaled the fixed dollar amounts. 3. The only people to whom the units could be reallocated were Joanne and Albert. 4. Joanne, Albert and the IRS agreed on the appropriate values for the 2.39% and.101% interests that were reported on the gift tax returns. 5. Judge Haines stated that even though Norseman s value was unknown when the gifts were made, it was constant ; before and after the audit, the children and grandchildren were always entitled to receive the same LLC interests of 1.98% and.083%, respectively. But wait! Those percentages are different from the ones that were reported on the gift tax return: 2.39% versus 1.98%, and.101% versus.083%. How are they the same? The answer presumably lies with the adjustment language, which reallocates excess units elsewhere, to ensure that the gifts still equal the stated dollar amounts, or the same percentages. In Petter, that excess went to charity and ensured that it received what it should have gotten originally. In Wandry, that excess went to the only place it could go: back to Joanne and Albert. In other words, although the reallocation ensured that children and grandchildren didn t get too much, it

14 06/11/ wasn t protecting an additional third party (like charity) from getting too little; rather, it returned property to the donors. It is hard to see how this result differs from the taking back Procter proscribes. Is this a problem? That depends. As mentioned above, if the IRS doesn t appeal Wandry, the case stands. Note, however, that this is a Tax Court memorandum opinion, as opposed to a regular Tax Court opinion that is reviewed by the entire court. This means that Wandry represents persuasive authority, but is not binding on the Tax Court or any other Tax Court judge (there are over 19). Thus the IRS could still object to a Wandry-type defined value clause and find itself relitigating the issue in the Tax Court and possibly obtain a different result. If the IRS appeals Wandry, the outcome could depend on whether the 10 th Circuit feels bound by King; if so, the court s decision may not be favorable for the Wandrys. Although it can be argued that taxpayers should be able to limit their potential gift tax exposure when giving hardto-value property, the Service is not happy with taxpayer attempts to do so, and could well feel that there is enough of a substantive difference between Petter and Wandry that the game s not over yet. The bottom line. While Wandry is a huge step forward in the use of defined value clauses, unless and until it is blessed by the 10 th Circuit, the Petter approach, which includes charity and gives it any valuation overflow, seems safer. The problem, of course, is that many donors do not necessarily have charitable intent, and want to give their family as much as possible, while keeping the balance. (See the 1/23/12 Tax Topics for more on Petter and Procter.) June 7520 rate issued. The IRS has issued the June 7520 rate. It is 1.2%, a new historic low. (The May rate was 1.6%, and the January through April rates were 1.4%.) June s mid-term rates are all 1.07% (annual, semiannual, quarterly and monthly). (May s mid-term rates were all 1.3% (annual, semiannual, quarterly and monthly).) As a reminder, these low interest rates are very favorable for certain planning techniques such as grantor retained annuity trusts (GRATs), charitable lead annuity trusts (CLATs) and Sales to Defective Grantor Trusts, and far less favorable for techniques such as qualified personal residence trusts (QPRTS) and charitable remainder annuity trusts (CRATs). As a further reminder, the generous $5.12 million gift tax exclusion will expire at the end of this year unless Congress acts. Donors wishing to take advantage of this exclusion may find themselves creating trusts and various entities, such as LLCs, and may need qualified appraisals. Such planning takes time, and should not be left to the last minute. Blanche Lark Christerson is a managing director at Deutsche Bank Private Wealth Management in New York City, and can be reached at blanche.christerson@db.com. The opinions and analyses expressed herein are those of the author and do not necessarily reflect those of Deutsche Bank AG or any affiliate thereof (collectively, the "Bank"). Any suggestions contained herein are general, and do not take into account an individual s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. No warranty or representation, express or implied, is made by the Bank, nor does the Bank accept any liability with respect to the information and data set forth herein. The information contained herein is not intended to be, and does not constitute, legal, tax, accounting or other professional advice; it is also not intended to offer penalty protection or to promote, market or recommend any transaction or matter addressed herein. Recipients should consult their applicable professional advisors prior to acting on the information set forth herein. This material may not be reproduced without the express permission of the author. Deutsche Bank means Deutsche Bank AG and its affiliated companies. Deutsche Bank Private Wealth Management refers to Deutsche Bank s wealth management activities for high net worth clients around the world

15 by Blanche Lark Christerson 10/31/ Countdown. The election is next week, and it is hard to imagine a closer contest. Regardless of who wins the Presidential race, it seems likely that about half of the country will be sorely disappointed, given how evenly split the electorate appears to be. Nevertheless, let us hope that the President whoever that may be will be able to work successfully with the new Congress to tackle the many serious issues facing the nation, including the deficit and our tax laws. Indeed, the 2001 and 2003 Bush tax cuts that expire at the end of this year, along with mandatory spending cuts that are slated for next year, constitute the so-called fiscal cliff. Let us also hope that this cliff is addressed after the election and before the end of the year. The difficulty, of course, is that President Obama has said that he will not sign legislation that extends the Bush tax cuts for the top 2% of taxpayers (individuals making more than $200,000 and married couples making more than $250,000), and Republicans have balked at raising taxes on anyone. The bottom line: to avoid going over the cliff, someone has to blink. The question is whether that will happen inflation-adjusted numbers in part. Because of the expiring Bush tax cuts and the ongoing uncertainty regarding what the tax law will be next year, the IRS is limited as to the 2013 inflation-adjusted numbers it can provide. Nevertheless, information recently has been issued addressing parts of the tax law that are unaffected by the expiring tax cuts (see Revenue Procedure , IR , and a fact sheet from the Social Security Administration). Here, then, is a selected overview of some of these inflation-adjusted numbers for 2013: Contributions to retirement accounts in 2013: IRAs. The contribution limit for IRAs will be $5,500 (up from $5,000). Taxpayers who are at least 50 can make catch-up contributions of $1,000 (this number is frozen). Roth IRAs. Roth IRAs are funded with after-tax dollars, and have the same contribution limits as the IRAs mentioned above. Taxpayers can t contribute to a Roth, however, if they have too much MAGI (modified adjusted gross income, generally the same as adjusted gross income (AGI)). In 2013, contributions will be phased-out at the following income levels: $178,000-$188,000 for married taxpayers filing jointly, and $112,000-$127,000 for single taxpayers. Note: because any taxpayer can now convert a traditional IRA into a Roth, regardless of income level and filing status, taxpayers can still create a Roth IRA, as long as they do a two-step process: create a traditional IRA and convert it. (Taxpayers need not do this two-step process, however, if they are rolling over an existing retirement plan (such as a 401(k)) into a Roth a move that will trigger current income tax.) 401(k) contributions and other elective deferrals. The contribution limit for deferred plans such as 401(k)s will be $17,500 (up from $17,000). Taxpayers who are at least 50 can make catch-up contributions of $5,500 (this number is unchanged). Kiddie tax. The kiddie tax applies to children under age 18 and, as of 2008, children who don t earn more than half of their own support and are either age 18 or full-time students, ages

16 10/31/ This means that if these children have more than $2,000 of unearned income (up from $1,900), it will be taxed at their parent s top rate. ( Unearned income refers to items such as interest, dividends and capital gains.) Estate and gift taxes in 2013: Annual exclusion gifts: rise to $14,000 per donee, or $28,000 if the taxpayer s spouse joins in the gift (this number is up from $13,000/$26,000). Annual exclusion gifts to non-citizen spouses: rise to $143,000 (up from $139,000). Other things to remember for the waning days of 2012, and for 2013: Transfer taxes. Transfer taxes estate and gift taxes and the generation-skipping transfer tax (GST) are set to revert to pre-bush tax levels on January 1 st. These were: $1 million gift and estate tax exclusions $1 million GST exemption indexed for inflation ($1.43 million?) Top rate of 55% rate on taxable transfers over $3 million, and A 5% surcharge on taxable estates between $10 million and $ million. Contrast those numbers with what is currently in place: $5.12 million gift and estate tax exclusions $5.12 million GST exemption 35% rate on taxable transfers over $5.12 million Portable spousal exclusions (these let a surviving spouse inherent what s left of the deceased spouse s estate tax exclusion) Thus, unless Congress acts, transfer taxes will be very different next year. Taxpayers who wish to take advantage of the generous $5.12 million gift tax exclusion have very little time left in which to do so (some of the easiest gifts involve cash, publicly traded securities and loan forgiveness; gifts that involve hard-to-value property or the creation of trusts or other entities are unlikely to be accomplished between now and year end). Enhanced AMT exemptions have lapsed. The alternative minimum tax (AMT) was originally designed to ensure that a handful of wealthy taxpayers paid income tax; it now reaches deep into the middle class. Congress regularly patches the AMT by indexing its exemption for inflation; its most recent patch expired at the end of This means that some 34 million taxpayers are currently affected by the AMT about 30 million of whom have probably never even heard of the tax. Another AMT patch is therefore on Congress s post-election to-do list, along with the fiscal cliff mentioned above. What will happen? No one knows. In the meantime, the 2012 AMT exemptions are where they were in the mid- 90 s: $45,000 for joint filers and $33,750 for single filers. Estimated tax payments. Given the current reach of the AMT in 2012, and the requirement that taxpayers be current with their income tax liabilities, many taxpayers should probably have been paying quarterly estimated tax payments to cover their AMT liability (understanding that Congress may yet again gallop to the rescue). How large should