Structuring Defined Value Clauses in Trust Transfers: Formula Allocations and Price Adjustment Clauses

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Structuring Defined Value Clauses in Trust Transfers: Formula Allocations and Price Adjustment Clauses TUESDAY, JULY 19, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Paige K. Ben-Yaacov, Partner, Baker Botts, Houston Jonathan J. Rikoon, Partner, Loeb & Loeb, New York Patrick J. Duffey, Attorney, Holland & Knight, Tampa, Fla. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 Background Client wants to transfer hard-to-value assets to beneficiaries Assets selected for growth potential compared to current appraised value Some of that is due to real business potential but with a trade-off in volatility and risk But some of it may be due to a depressed valuation: Market conditions Special risks and exposures regulatory, tax environment. Closely held business interest with no control or marketability 5

6 The Problem What If the IRS Disagrees on Value? A plain gift may generate unexpected gift tax cost A GRAT avoids the gift tax risk but: Mortality risk all in estate if grantor does not survive term Liquidity risk GRAT has rigid formula for paying annuity Not readily available for generation-skipping planning A leveraged (installment) sale to a grantor trust can reduce gift tax cost without the mortality or liquidity risk of a GRAT. But the risk of additional gift tax remains unchanged (same as a gift) and unaffected by the leverage of the installment note. Exception to the extent use of the note saves gift tax exemption to be available as an audit cushion 6

7 Can a Formula Save the Day? We know formulas work in some contexts: Marital deduction/credit shelter legacies GST exemption legacies Disclaimers Size of annuity/unitrust amount for charitable split interest trusts (CLATs, CLUTs, CRATs, CRUTs) Why not just give (or sell) so much of the asset as is worth $X (e.g., gift tax exemption), whatever percentage that turns out to be? Alternative: formula allocation clause transfer entire asset but allocate the transfer between completed-gift transferee (by gift or sale) and non-taxable transferee. Or, sell the asset (or X% of it) for a price equal to its fair market value, whatever that turns out to be? 7

8 No Surprise: IRS Hates Formula Clauses in Gifts or Sales Public Policy (takes away incentive to audit, requires courts to decide moot cases) Technical arguments (condition subsequent: gift is already complete by the time clause kicks in) Potential for gamesmanship or collusion Encourages overly aggressive appraisals no down side? IRS won some early cases but has been losing lately as practitioners learn lessons 8

9 Procter v. Comm'r (4th Cir. 1944) Have to understand what DOESN'T work to structure something that DOES work Mr. Procter Remainder Interest * Children If any portion of transfer results in gift tax, property automatically excluded from transfer * Clause provided that any "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...." 9

10 First Clause That Did Not Work Procter (4 th Cir. 1944) Trust document said that if a court later determines that any part of this transfer is subject to gift tax, then that portion shall automatically be deemed not to be included in the conveyance... and shall remain the sole property of the transferor. Court: that s a condition subsequent and the gift was already made and taxable before we rule, too late to reverse gift. Violates public policy; trifling with the judicial process. Discourages collection of tax. Decision of court would deprive the court of jurisdiction: once the final judgment fixes the gift tax liability, the gift (and the tax) disappears. End-run around the prohibition on declaratory judgments for tax cases. 10

11 Ward v. Comm'r (T.C. 1986) Wards Stock * Sons Assignment provided for "adjustment" to number of shares of stock transferred based on values as finally determined for gift tax purposes * Clause provided that "if it should be finally determined for Federal gift tax purposes that the fair market value of each share... exceeds or is less than [$2,000 or $2,300, respectively] an adjustment will be made in the number of shares constituting each gift...." 11

12 Proctor Followed (For a While at Least) Ward (TC 1986) Gift of 25 shares of closely held stock, with the number of shares of the gift to be adjusted if the finally determined fair market value is other than $2,000/sh, such that each gift turns out to be $50,000. Donors argued they intended to give $50,000 worth of stock and the 25 shares was just representative of the value. But that s not what the documents said. 2 of 3 Proctor public policy arguments still applied: no incentive for IRS to challenge valuation, and the donor cannot be compelled to reclaim a portion of the property which would thus escape gift and estate taxation. Distinguishes King (below) as an arms-length sale, no donative intent; plus in King the clause operated to insure that no unintended gift was made while here the agreement purports to retroactively alter the amount of an otherwise completed gift. Q: Does that mean if the gift had indeed been so much stock as is worth $50,000 it would have been OK? Form over substance but a critical drafting point. 12

13 McClendon v. Comm'r (TCM 1993) Taxpayer Sale of remainder interest for annuity* Son and Trust * Formula stated that if value "changed through a settlement process with the Internal Revenue Service, or a final decision of the United States Tax Court, the purchase price hereunder shall be adjusted accordingly." 13

14 Proctor Followed (For a While at Least) McLendon (TC 1993) Private annuity sale agreement in closely held business provided for adjustment of fixed dollar purchase price if final gift tax valuation differs from appraisal. Analysis closely follows Ward. Q: If the sale price had been a King-style whatever the fair market value is formula rather than a fixed dollar price to be subsequently adjusted, would that have been OK? 14

15 King v. U.S. (10th Cir. 1976) Mr. King Sale of specific number of shares of stock at $1.25/share* Trusts for children * Formula stated that "if the fair market value... as of the date of... [the agreement] is ever determined by the Internal Revenue Service to be greater than the fair market value determined in the... manner described above, the purchase price shall be adjusted to the fair market value determined by the Internal Revenue Service." 15

16 What About a Price Adjustment Clause? King (10 th Circuit 1976): Sale price of closely held stock to family trust used formula of similar sales to stock option plan. Ordinary course of business. Sale agreement provided that if the IRS determines the FMV of this stock to be more or less than the sale formula, then purchase price to be adjusted to IRS figure. Trial court had found that the parties really intended to pay FMV but they recognized that it was difficult to ascertain. Actual price adjustment had real financial effect. No donative intent. Distinguished Proctor based on these facts. Plus: no diminution of seller s estate Unlike clauses where a contingency would alter, change, or destroy the nature of the transaction. 16

17 McCord v. Comm'r (5th Cir. 2006) First $6,910, of LP units 4 Sons GST Trusts * Mr. & Mrs. McCord Gift of 82.33% LP units Next $134,000 of LP units Shreveport Symphony Remainder of LP units Community Foundation of Texas - Formula not based on values as finally determined - Sons, GST Trusts and Charities reached agreement post-transfer on number of units each received (Confirmation Agreement) * Remaining GST exemption 17

18 McCord Analysis Tax Court based analysis on Confirmation Agreement; not Assignment Agreement Fifth Circuit overruled Tax Court based on: the plain language of the Assignment Agreement Taxpayers were not parties to the Confirmation Agreement or otherwise involved in it no evidence of any agreement-not so much as an implicit, wink-wink understanding-between the Taxpayers and any of the donees regarding the percentage interest to which each donee was entitled" 18

19 Christiansen v. Comm'r (Tax Court 2008) (8th Cir. 2009) Mrs. Christiansen's Estate (principal assets two 99% LP interests) $6.35 million* Disclaimed amount above $6.35 million Christine CLAT (75%) Foundation (25%) * Based on values as finally determined for federal estate tax purposes. 19

20 Why Christiansen Worked No Condition Subsequent transfer to charity not contingent on value adjustment Not a moot issue; no problems with finality revaluation changed amount to charity No evidence of policy to maximize incentive for IRS to audit Strong public policy in favor of charity 20

21 Petter v. Comm'r (Tax Court 2009) (9th Cir. 2011) First $453,910 of units * Terry's Trust Anne Petter Gift of 940 Units Remainder The Seattle Foundation Anne Petter Sale/Gift 8,459 Units Sale of first $4,085,190 of units * Gift of remainder Terry's Trust The Seattle Foundation * Based on value of units as finally determined for federal gift tax purposes. 21

22 Why Petter Worked All the same reasons as Christiansen IRS public policy arguments undermined by allowance of: Formula marital deduction clauses Formula GST transfers Split interest charitable trusts Formula transfers to a GRAT 22

23 Hendrix v. Comm'r (Tax Court 2011) Set dollar amount worth of stock Trusts Mr. & Mrs. Hendrix Gift of non-voting stock Remainder of stock Greater Houston Community Foundation - Formula not based on values as finally determined - Trusts and Charity reached agreement post-transfer on number of units each received (Confirmation Agreement) 23

24 Hendrix Analysis McCord dispositive unless: not an arms-length transaction formula clause void as against public policy No evidence of collusion Public policy is one of encouraging gifts to charity 24

25 Wandry v. Commissioner of Internal Revenue Wandry v. Comm r., T.C. Memo (March 26, 2012)» Background Taxpayers were Albert & Joanne Wandry Gift Tax deficiency for 2004 year based on gifts of LLC interests to children and grandchildren LLC was Norseman Capital Key: Norseman was formed by TPs and their children in 2001 Key: Court characterized Norseman as part of a family business» Timeline 4/2001 Norseman Capital, LLC Created 1/1/2004 Gifts Made 7/26/2005 Valuation Report 2006 IRS Audit 2/4/2009 IRS Deficiency Notice 5/6/2009 Tax Ct. Petition Filed 3/26/2012 Tax Ct. Decision Entered 25

26 Wandry v. Commissioner of Internal Revenue» January 1, 2014 Gift Each Taxpayer executed a separate gift documents transferring: $261,000 worth of Norseman, LLC to each of four children ($1,044,000) $11,000 worth of Norseman, LLC to each of five grandchildren ($55,000) Total: $2,088,000 to children and $110,000 to grandchildren» Key: dollars not units/percentages/shares/etc. Mr. & Mrs. Wandry Gift of LLC units equal to $1 million exemption split among children and grandchildren Kenneth $261,000 Cynthia $261,000 Jason $261,000 Jared $261,000 5 grandchildren $11,000 each 26

27 Wandry v. Commissioner of Internal Revenue» Evidence of the Transfer Capital Account Ledger: reflected a downward adjustment of the TP s capital accounts and an upward adjustment of the children s and grandchildren s capital accounts, but the adjustments did not reconcile with TP s claimed gift amounts Partnership Tax Return (Form 1065 and K-1s): reflected capital adjustments, generally but did not itemize adjustments that were attributable to the gifts Gift Tax Return: described the gifts as percentage interests, not dollar amounts 27

28 Wandry v. Commissioner of Internal Revenue» The Wandry Clause: 28

29 Wandry v. Commissioner of Internal Revenue TAX COURT ANALYSIS IRS Arguments» Gift Tax Descriptions = Admissions The Tax Court» Gift Tax descriptions are admissions, but the percentage interests were derived from and consistent with the Gift documents.» Capital Accounts are Controlling» Capital Accounts are reflective of ownership, not dispositive. They are frequently subject to adjustment in other contexts.» DVC is Ineffective» King (10 th Cir.) not on point, Petter (9 th Cir.) controls. Passes Petter Test: Donees always entitled to receive a predefined number of units Formula had one (1) unknown, which was a constant (the value of an LLC unit) Pre-audit, the donees were legally entitled to receive same number of units The audit only ensured that donees would receive the units to which they were always entitled. 29

30 Wandry v. Commissioner of Internal Revenue» Public Policy Proctor - operation of the clause would: disincentivize tax collection efforts by nullifying any gift in the event of audit; cause the Court to pass judgment on a moot case; reduce the Court s judgment to a declaratory judgment.» Tax Court: a Wandry Clause does not violate public policy The Commissioner s role is to enforce tax laws, not merely to maximize tax receipts. Operation of the clause would not undo the gift because the interests transferred were always the same. The case is not moot and judgment not merely declaratory, because operation of the clause would cause an adjustment (based on the stipulated value) with significant Federal tax consequences Key: to the extent open, Taxpayers and Donees would need to amend prior tax returns to adjust income upward (Taxpayers) or downward (Donees). Presumably income tax consequences would result. 30

31 Wandry v. Commissioner of Internal Revenue Valuation of Transferred Norseman Interest Gift Tax Consequences» Chart Title$ Taxpayers IRS Tax Cost Date of Gift $2,088,000 - $835,200 Audit - $3,082,000 $1,232,800 Trial Stipulation $2,659,860 $1,063,944» Query: for an extra $228,744 in gift tax (plus interest and penalties), would taxpayers have been better off conceding the Wandry clause at the audit stage?» Note: Tax Cost ignores, for simplicity, application of the applicable exclusion amount. Also for simplicity, the calculations above ignore GST tax implications as well as the potential application of the annual exclusion amount. 31

32 Wandry v. Commissioner of Internal Revenue TAKE-AWAYS» Nature of the Asset old and cold (2001) operating business» Transaction Documentation clear and well-drafted documents» Consistency Consistently characterized gift as pecuniary amount on the 709, during audit, and at trial» Jurisdiction What Went Right Would have appealed to 10 th Circuit (King)» Precise descriptions of the gift on the 709 Consider using an attachment or continuation sheet to describe the transfer as you might with a GST severance.» Record-Keeping Capital accounts should accurately reflect the transfer» Income Tax Reporting Ensure that the entity s income tax reporting is accurate and consistent w/ the transfer (likely Form 1065 and K-1)» Forum Shopping Best Practices Tax Court is relatively friendly to formula clauses, but Wandry was just a TC Memo. 5 th, 8 th, 9 th, and 10 th Circuits all have favorable but perhaps not dispositive case law. 32

33 Wandry v. Commissioner of Internal Revenue AUDIT STRATEGY» The Service strongly dislikes Wandry On November 13, 2012 the IRS announced its non-acquiescence to Wandry A Wandry clause is, anecdotally, an audit flag» Query: does operation of defined value clause always benefit the client? Perhaps not. Consider: IRS strong aversion to DVC clauses; and Appreciation of the underlying asset(s). A DVC will partially undo the estate tax freeze aspect of such a transfer (gift or sale) The IRS may be willing to trade operation of the DVC in exchange for a better valuation discount Timing is also important: gift tax audit or estate tax audit? 33

34 Belk v. Commissioner of Internal Revenue Belk v. Comm r., 774 F. 3d 221 (4 th Cir. 2014)» Taxpayers petition for a redetermination of an income tax deficiency arising from a disallowed deduction for a contribution of a conservation easement.» $10M deduction for a conservation easement failed because of a substitution power held by an LLC owned by the Taxpayers.» At trial (Tax Court) and on appeal, Taxpayers argued that the substitution power was negated by a general savings clause in the easement that provided: [T]he Trust shall have no right or power to agree to any amendments... that would result in this Conservation Easement failing to qualify... as a qualified conservation contribution under Section 170(h) of the Internal Revenue Code and applicable regulations.» The Tax Court and 4 th Circuit both rejected that argument. 34

35 Belk v. Commissioner of Internal Revenue» Why is this case relevant to defined value clauses? The 4 th Circuit cited to and extensively analyzed Proctor in its opinion. In fact, it held that the savings clause failed for the same reason as the buy-back clause in Proctor: [W]e note that were we to apply the savings clause as the Belks suggest, we would be providing an opinion sanctioning the very same trifling with the judicial process we condemned in Procter.» The Court took issue with both the generality and operation of the clause» Defined value clauses should be distinguishable since they are central to the transaction (gift or sale) and produce meaningful tax consequences if they do, in fact, operate to adjust the original transfer. 35

36 Practicalities: Simpler Formula Transfer Clauses Stated value transfer clause (transfer of so many units as equals $X as determined for gift tax purposes) (Wandry). Can be a sale or a gift. Not a condition subsequent, does not take back any property just defines how much is transferred, balance not in the transfer at all. Forgoes the charitable gift public policy argument Puts pressure on independence and fiduciary duties of transferee to fight for full valuation. Alternative: gift of $X worth of assets and sale of excess for a note. Alternative: gift with a donee disclaimer of excess above $X worth. 36

37 Practicalities: Simpler Formula Transfer Clauses Stated price sale clause (transfer of X units, for whatever the fair market value is) (King). Not a condition subsequent, does not alter the amount of property transferred just defines purchase price for what is transferred. Forgoes the charitable gift public policy argument Puts pressure on independence and fiduciary duties of transferee to fight for full valuation. 37

38 Formula Allocation Clauses Allocates the transfer of a hard to value asset between a taxable gift portion and a non-taxable portion The allocation may be based on agreement of transferees among themselves, if they are true independent players (sometimes charities): McCord (2006), Hendrix (2011) May need participation of independent party and counsel Or, it may be based on final determination of gift tax value (Petter 2009) or estate tax value (Christiansen 2008), which takes it much closer to a true formula clause Should a small portion (say, 5%) of the non-taxable portion also pass to the taxable gift, to give the IRS an audit incentive and deal with one of the Proctor arguments? 38

39 Formula Allocation Clauses (continued) The non-taxable gift portion of the allocation can be to: Charity (as in the four cases on the previous slide) Public vs. private? Beware of private foundation excise taxes self-dealing, jeopardizing investments, excess business holdings (Near) zeroed out GRAT Spouse QTIP trust Incomplete gift trust e.g., retained power to consent to distributions to others plus power of appointment. Recipient should be controlled by an independent trustee More complex to draft and administer than a Wandry or King formula; more parties and counsel, possible AG oversight for charities. But, more cases as precedent. 39

40 Administration and Reporting Gift tax return should include full explanation and qualified appraisal burden of proof, statute of limitations Should a return always be filed even for a sale? Red flag? Estate tax return disclosure on past transactions? Be wary of stating "no position taken on return is contrary to revenue ruling" 40

41 Administration and Reporting If a post-audit adjustment to value will, under the formula clause, change how much each owner really owns of the transferred asset as of the transfer date, and if they are different taxpayers, how are profits and losses allocated and reported in the interim? Wandry-type clause: issue is allocation between transferee and transferor Petter/Christianson-type clause: issue is allocation between or among transferees. The allocation clauses with charities or charitable trusts (or other third parties) may lead to the need to amend returns as well as actually reallocate cashflow from operations or gains. State Attorney General filings may need amendment as well in this case. 41

42 Administration and Reporting (continued) Potential solutions to avoid need to amend income tax returns after adjustment under formula: Use a King-type price adjustment formula. No post-closing changes to distributions, or to income tax returns. Use a Wandry-type defined value clause with a grantor trust transferee (or other disregarded entity); although the cashflow from any distributions may need to be reallocated, no income tax return amendments should be needed because everything is reported on the grantor s return. Use a formula allocation clause with a grantor trust as the taxable transferee and either an incomplete gift trust, a GRAT feeding into a grantor trust, or a QTIP (which is also a grantor trust) as the nontaxable transferee. Again, cashflow may need reallocation but no amendment of returns. 42

43 Impact of Structure of Transferred Asset on Formula If the client's entire interest in an asset is being transferred, then a Wandry formula can be a problem because in theory the audit could reduce the valuation and increase the percentage required to be transferred to more than 100%. No similar issue with a King formula. Again in theory if an allocation clause transfers so much of the asset as has a fixed value to the taxable gift donee (and the balance to a nongift transferee), and if the unit value is low enough, the same problem could arise. Solution: formula should have an alternative (maximum transfer percentage) of 100% of the asset if that turns out to be less than the target dollar amount. Even though the final value is almost never below the appraised value, so this shouldn t be a problem in reality, because it could happen in theory and we are trying to sustain a commercial-like formula, it can t be unilateral and should have the possibility of an adjustment in either direction. 43

44 Impact of Structure of Transferred Asset on Formula (continued) When would client be transferring 100% anyway? That s one way of using a FLP or FLLC which is funded with only that portion of the underlying asset or business that the client actually wants to transfer, and we don t want to see any retained interest in the FLP or FLLC due to estate tax inclusion issues or practical issues of post-transfer administration. E.g., client may down the road want to withdraw funds/profits from the asset/business but doesn t want the transferee to do so. If client s interest is held in the same FLP or FLLC as the transferee's, there s a 2701 issue if client can withdraw but the transferee can t, as well as a 2036/2038 issue if the client has the right to decide about withdrawals from the FLP/FLLC. No such issues if the client s interest in the underlying asset/business is held outside the FLP/FLLC but that requires that the client transferred 100%. Hence our fact pattern. 44

45 Thank You Jonathan J. Rikoon Partner, Loeb & Loeb LLP (212) Paige K. Ben-Yaacov Partner, Baker Botts L.L.P. (713) Patrick J. Duffey Attorney, Holland & Knight (813)