Planning With Defined V alue Clauses (With S ample Provisions)

Transcription

1 Planning With Defined V alue Clauses (With S ample Provisions) David G. S haftel David G. S haftel is the principal of S haftel Law Offices, P.C David G. S haftel. All rights reserved. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA online at A. Introduction 1. Whenever a client desires to cap gift tax exposure, planners should consider using a defined value clause implemented by use of an escrow trust. T his outline explores this strategy, and analyzes how to structure and draft an escrow trust. 2. A defined value clause limits the quantity of assets gifted or sold until a final determination of value is made. T he 2003 T ax C ourt decision in McC ord and the S ervice s recent rulings have focused concern on whether the courts will respect these formula clauses. Succession of McC ord v. C omm r, 1 20 T.C. 358 (2003), rev d, 461 F.3d 61 4 (5th Cir. 2006); T AM ; T AM ; and FS A On the one hand, these clauses may be lumped together with price adj ustment clauses which have already been j udicially condemned. 4. On the other hand, a defined value clause used to limit gift tax exposure in gift and sale transactions may be validated, as are other value definition formulas which are used in similar tax contexts. 5. The theme of this outline is that appropriately implemented defined value clauses are a reasonable, non abusive method to limit gift tax liability. However, proper implementation of a defined value clause will perhaps be crucial to whether such clauses will be accepted by the courts. C areless use of this technique creates confusion with respect to basic state law property ownership concepts. Worse yet, without proper implementation, a defined value clause in operation appears dangerously similar to the price

2 adj ustment clauses that have already been condemned by most courts as against public policy. 6. This outline suggests that an escrow trust be used to implement a defined value clause. S uch escrow trust implementation is consistent with state law property ownership concepts and clearly differentiates such clauses from price adj ustment clauses. B. Background O n Price Adjustment Clauses 1. It is important to understand the reasoning behind the courts condemnation of price adj ustment clauses. T hese formula clauses were the first attempts to cap gift tax liability in gift or sale transactions. T his type of clause provided that if it was determined that a portion of the transfer would be subj ect to payment of gift tax, then the transaction would subsequently be adj usted by either transferring the excess which produced the gift tax back to the donor or seller, or by requiring the donee to pay for the excess. 2. In C ommissionerv. Procter, 1 42 F.2d 824 (4th C ir ), cert. denied, 323 U.S. 756 (1 944), the Fourth C ircuit invalidated a price adj ustment clause stating, [t]his is clearly a condition subsequent and void because contrary to public policy. Id. at 827. T he court was concerned that the adj ustment might not be respected by the parties and stated: [s]uch holding, however, being made in a tax suit in which the donees of the property are not parties, would not be binding upon them and they might later enforce the gift notwithstanding the decision of the Tax C ourt. Id. a. The Fourth C ircuit concluded that the adj ustment clause was contrary to public policy for three reasons: i. First, the clause discourages the collection of tax by the tax agency because the only effect of an attempt to enforce the tax would be to defeat the gift. ii. S econd, the effect of the clause would be the obstruction of the administration of j ustice by requiring the courts to pass on a moot case. iii. Third, the court stated that the final j udgment of a court would be rendered meaningless because of the consequence of the clause. The court pointed out that it is not possible to obtain a declaratory j udgment from a federal court concerning whether the gift in question is subj ect to the gift tax. 3. The condition subsequent defect, which requires the after the fact adj ustment of the transaction by a transfer of assets back to the donor or seller, or requires the donee to pay for the excess, has been at the core of additional court decisions invalidating price adj ustment

3 clauses. a. Estate of McLendon v. C omm r, 66 T.C.M. (CCH) 946 (1 993), rev d on another issue, 96-1 U.S. T ax C as. (CCH) 60,220 (5th C ir ). b. Ward v. C omm r, 87 T.C. 78 (1 986). c. Harwood v. C omm r, 82 T.C. 239 (1 984), aff d without op., 786 F.2d (9th C ir.), cert. denied, 479 U.S (1 986). d. There is only one case that has sustained a price adj ustment clause: King v. United States, 545 F.2d 700 (1 0th C ir ), which involved an arm s-length sale transaction. 4. The IRS has focused on this condition subsequent characteristic in its rulings that challenge the validity of price adj ustment clauses: a. TAM ; b. TAM ; c. Rev. Rul , C.B. 300; d. Pvt. L etter Rul ; e. Pvt. L etter Rul i. The above cases and rulings in paragraphs 3 and 4 are thoroughly discussed in McC affrey, TaxTuning the Estate Plan by Formula, 33 U. Miami Inst. on E st. Plan. 4 7 through (1 999); Benford, Valuation Principles and Recent Developments, S pecial S ession Materials, App. A, 33 U. Miami Inst. on E st. Plan. (1 999); and Practical Drafting, J uly 2006, pp (U.S. Trust). C. Defined Value Formula Clauses: Theory 1. In contrast to the above described price adj ustment clauses, a properly implemented defined value cause avoids the condition subsequent adj ustment of the transaction. Instead of fixing both value and quantity up front, a defined value clause fixes only the value of the gift or sale transaction. T he exact quantity of assets transferred remains uncertain until values are finally determined for federal gift tax purposes. a. Defined value formula clauses for gift and sale transactions were apparently first proposed by C arlyn S. McC affrey and Mildred Kalik in Using Valuation C lauses to Avoid G ift Taxes, 1 25 T r. & E st. 47 (Oct ). Use of such clauses has subsequently been discussed by the following commentators: Moore and Buchanan, Valuation Readjustment C lauses: What s Possible?, 45 N.Y.U. Ann. Inst. on Fed. T ax n ch. 31 (1 987); Peterson, Savings C lauses in Wills and Trusts, 1 3 T ax Mgm t E st. Gifts & T r. J. 83, 89 (1 988); C ornfeld, Formulas, Savings C lauses and Statements of Intenț 24 U. Miami Inst. on E st. Plan. ch. 1 4 (1 990); Moore, Attempting to Achieve Finality in

4 Potentially Open Transactions, 29 U. Miami Inst. on E st. Plan (1 995); Trapp, Thinking AboutValuationAdjustmentC lauses, AC T E C Annual Meeting, HT II 9 J MT ; McC affrey, Tax Tuning the Estate Plan by Formula, supra, ch. 4; Abbin, Is Valuation the Best Planning G ame Remaining?, AL I ABA C ourse of S tudy: Planning T echniques for L arge E states. (Nov ); Hood, Defined Value G ifts: Does IRS Have It All Wrong?, 28 E st. Plan. 582 (Dec ); S haftel, How to Use an Escrow Trust to Implement a Defined Value Formula C lause, 31 E st. Plan (Mar. 2004); PracticalDrafting, J uly 2006 and Oct (U.S. T rust). 2. FinalDeterminationofQ uantity a. This finality is achieved when either the federal gift tax statute of limitations expires or when the IRS challenges the value and this challenge is resolved. T he gift tax limitation period runs for three years from the filing of the gift tax return Resolution of an IRS challenge may occur through negotiation, Appellate Division review, or litigation, which may take longer than the expiration of the limitations period. T reas. Reg (c); see also T reas. Reg (b). When the value for the asset is finally determined, the correct quantity is transferred. If the transfer is properly implemented, there is no after the fact change of the transaction, either theoretically (the value transferred) or practically (the implementation of the transfer). 3. Excess Beneficiaries a. The excess beneficiary is the beneficiary who receives any excess of assets transferred greater than the value specified in the defined value formula. T ypes of excess beneficiaries for a defined value clause include the following: i ii. C harity; Inter vivos QT IP trust; iii. Incomplete gift trust; iv. S pouse; v. GRAT; vi. Revocable trust; and vii. Donor/seller. b. A transfer to one of these excess beneficiaries will either produce an equivalent deduction, or will be non taxable. A transfer to a charity, QT IP trust, incomplete gift trust, or spouse avoids the appearance of the donor retaining the interest. S uch retention is arguably somewhat similar to the transfer back to the donor as a result of the condition subsequent in the condemned price adj ustment clauses. 4. Double TaxProblem a. Transfers to charity or an inter vivos QT IP trust avoid a

5 potential double tax problem, as has been described in Practical Drafting, (Oct. 2006). Assume that the S ervice and the courts refuse to recognize the validity of the defined value clause and treat the entire amount transferred as a gift to the taxable beneficiaries. Although this would be the result for federal gift tax purposes, state law might still require that the defined value clause beneficiaries be recognized. As a result, the excess beneficiaries would receive that beneficiary s appropriate share. If that excess beneficiary is a charity or a QT IP trust, then this share will not again be taxed at the donor s or donor s spouse s deaths. Id. (No amount will be included in the spouse s gross estate under section 2044(b)(1 )(B) because no marital deduction was allowed for this amount.) However, if that beneficiary is an incomplete gift trust, the spouse, a zeroed out grantor-retained annuity trust ( GRAT ), or a revocable trust, then that excess beneficiary s share will again be taxed when either future gifts are made or at the donor s or donor s spouse s deaths. T his is the double tax portion. b. Practical Drafting, 8690 (Oct. 2006) suggests adding the following type of dispositive language: The taxable donee gets a fractional share of the transferred property having a value of $ X, and the nontaxable donee gets a fractional share of the transferred property having a value equal to the value of the transferred property less $ X. Notwithstanding the preceding sentence, however, if a transfer in accordance with the preceding sentence is finally determined for federal gift tax purposes to result in a taxable gift greater than $ X, an additional fractional share of the transferred property having a value equal to such excess shall pass to the taxable donee and the share passing to the nontaxable donee shall be correspondingly reduced. c. This additional dispositive provision may present marital deduction qualification issues. T herefore, it should probably not be used if the excess beneficiary is the spouse or a marital trust. 5. Add a Taxable G ift a. To create an additional argument to counter the Procter public policy reasoning, commentators have suggested adding a taxable gift whenever using a defined value clause. McC affrey, Tax Tuning the Estate Plan by Formula, 33 U. Miami Inst. on E st. Plan. at (1 999); Practical Drafting, Oct. 2006, at For example, see E xhibit 3, which includes a taxable gift equal to three percent of the excess amount. D. Approved Uses O f Defined Value Concepts 1. Defined value concepts are established and accepted in the transfer tax area. C onsider the following formulas authorized by regulations and rulings: a. Bypass/ MaritalTrusts. Defined value formulas dividing assets between a bypass trust and the marital share or trust in a manner to avoid any out of pocket estate tax liability have been administratively accepted