McCord: defined-value gifts at the crossroads.
In the seminal case in this area, Procter, (1) the taxpayer transferred property to a trust for his children's benefit; the trust agreement provided that the transfer, or a portion of it, would be nullified if a Federal court found any portion subject to gift tax. Although the provision was not included to save taxes, the Fourth Circuit, clearly troubled by the implications of approving such a proviso, held it to be against public policy, because (1) public officials would be discouraged from attempting to collect the tax, as the effect of such an attempt would be to defeat the gift; (2) it would tend to obstruct the administration of justice, by requiring the courts to address a moot case; and (3) it would defeat a judgment rendered by the court.
In recent years, taxpayers have tried to distinguish a prohibited value-adjustment clause from a value-definition clause. The latter does not call for adjustment of values based on IRS audit results or court decisions, but simply defines a gift via formula (e.g., the gift is expressed as $x of the value of an interest to one beneficiary, with the remainder of the value to a charity). The differences, according to the proponents, include the fact that the transfer is unconditional and irrevocable as of the transfer date and no portion of the property reverts back to the donor under any circumstances. They also point out that such provisions are no different from the typical credit shelter/marital formulas commonly used in estate planning.
Despite the differences, the Service has argued vehemently for disregarding defined-value gift formulas on multiple fronts, including the substance-over-form and violation-of-public-policy doctrines. (2) The Fifth Circuit's recent pro-taxpayer decision in McCord (3) provides an excellent analysis of the issues involved, but leaves many unanswered questions.
On June 30, 2005, Charles T. McCord, Jr. and Mary S. McCord contributed equal and identical interests in assets valued at $12,294,384 ($6,147,192 each) to a Texas limited partnership (LP), McCord Interests, Ltd., L.L.P. (MIL); in exchange, each received roughly 41.17% of the class B LP interests? The taxpayers subsequently gifted all of their MIL interests irrevocably and unconditionally to several nonexempt and exempt donees via an assignment agreement (AA), on Jan. 12, 1996.
The gifts were not listed in the AA in terms of percentages of MIL interests, but defined in terms of dollar amounts of MILs net fair market value (FMV). Specifically, the nonexempt donees (the taxpayers' four sons and four generation-skipping transfer (GST) tax trusts established for their benefit) were to receive LP interests with an aggregate FMV of up to $6,910,933. (5) If the net FMV of the gifted LP interests exceeded that amount, the first exempt donee, Shreveport Symphony, Inc. (Symphony), was to receive a portion of the excess, up to $134,000. If the net FMV exceeded $7,044,933 ($6,910,933 + $134,000), the excess was to be transferred to the Community Foundation of Texas, Inc. (CFT). The nonexempt donees also assumed the taxpayers' Federal and state gift tax liabilities, and any future payment of Federal estate taxes that might be assessed on the taxpayers' gift taxes under Sec. 2035. In a nutshell, the transfers to the nonexempt donees and, thus, the gifts, were limited to $6,910,933 (before other reductions for assumed gift and estate tax liabilities).
As of Jan. 12, 1996, the appraised value of a 1% MIL LP interest was determined to be $89,505. Under the AA's defined formula, the taxpayers' sons and the GST trusts received interests valued at $6,910,933; Symphony and CFT received interests valued at $134,000 and $324,345, respectively. In March 1996, all the donees entered into a confirmation agreement (CA) that translated the dollar value of the gifts they received into percentages of MIL interests. Thus, the sons and GST trusts received 77.2128095%, Symphony 1.49712307% and CFT 3.62376573%.
On June 29, 1996, MIL redeemed the LP interests held by the charities at FMV as of that date. The FMV ($93,540 per 1% LP interest) was determined by an updated appraisal that the charities reviewed and accepted. The stipulated facts did not indicate any involvement or prearrangement by the taxpayers as to the pricing or timing of the redemption transaction. Also, the charities had the right under the AA to reject the appraisal and request arbitration.
On the McCords' 1996 gift tax returns, the gifts' taxable values were based on the gross FMV transferred to the nonexempt donees ($6,910,933), reduced by the total Federal gift taxes payable and the actuarially determined present value of their obligations for additional estate taxes under Sec. 2035. The IRS issued deficiency notices stating that the taxpayers (1) understated the FMV of the donated interests in MIL (6) and (2) erred in discounting the FMV value of those interests by the Sec. 2035 liability.
In addition to disputing the valuation, the Service attacked the defined-value gift formula on multiple fronts. It contended that the formula violated the public-policy doctrine, as it constituted a condition subsequent. It further argued that the formation of the partnership, transfers to the children and charities and redemption of the charitable interests, were a single integrated transaction that should be disregarded under the substance-over-form doctrine. According to the IRS the petitioners' sons were at all times in control of the transactions, and remained in control of the transferred interests after the transactions. Even if the formula were upheld, the Service argued against an increase in the charitable deductions based on the doctrine of reasonable probability of receipt, because the charities' interests had already been redeemed at a significantly lower price.
The court held for the taxpayers, stating that the IRS (which, according to the parties' stipulations, had the burden of proof under Sec. 7491) had failed to meet the burden of proof on any contested issue of fact or law. Approximately two years after the trial, the Tax Court chief judge issued an unusual order that resulted in a retroactive reassignment of the case to another judge, who, on the same day, fried an opinion on behalf of a splintered majority that vacated the original judge's decision and held for the Service.
Unfortunately, the Tax Court majority's holding was not based on the arguments advanced by the IRS at trial. Instead, the court crafted a method based on an interpretation of the AA and an application of the CA that the Service never raised. First, it independently revalued a 1% LP interest in MIL at $120,046. (7) It then applied that value to the percentage interests attributed to each donee under the CA (i.e., the percentages to which the donees agreed, based on the value of $89,505 per LP interest), to determine the gifts' value. As the original trial judge stated in a stinging dissent:
The majority's analysis of the assignment agreement requires the petitioners use the Court's valuation to determine the value of the transferred interests, but the donees' appraiser's valuation to determine the percentage interests transferred to the charitable organizations. There is no factual, legal, or logical basis for this conclusion.
The Tax Court also ruled that the value of the gifts should not be reduced for the Sec. 2035 liability, because it is not a fixed liability (estate tax law and rates may change, estate tax may be abolished, etc.). All the Tax Court judges seemed to agree on this point.
On appeal, the IRS did not advance its original arguments (violation-of-public-policy, form-oversubstance/integrated transaction and reasonable-probability-of-receipt doctrines). Instead, it focused on defending the method crafted by the Tax Court majority.
In a stinging rebuke, the Fifth Circuit reversed the Tax Court, calling the method used "imaginative but flawed." It stated that the gift occurred on Jan. 12, 1996, when the AA was executed, regardless of how the interests were described (i.e., in dollars or percentages). It noted further that the stipulated facts did not evidence collusion or side deals between the parties as to the original gifts or the conversions of the dollar values into percentages in March 1996. The CA merely put forth the LP interests that each donee would accept as equivalents of the dollar values irrevocably and unconditionally given by the taxpayers on Jan. 12, 1996. By using the percentages provided in the CA to determine the gift, the Tax Court, according to the Fifth Circuit, "in essence suspended the valuation date of the property that the Taxpayers donated in January until the date in March on which the disparate donees acted" According to the Fifth Circuit, this "violated the immutable maxim that post-gift occurrences do not affect, and may not be considered in, the appraisal and valuation process." Because the Tax Court majority's legal method was flawed, and the Service failed to meet its burden of proof, the Fifth Circuit accepted the taxpayers' valuations.
The court also held that the taxpayers could reduce the gifts' value by the Sec. 2035 liability. It stated that the test is not whether a liability is speculative (because all future liabilities are, to some extent), but more of a subjective determination as to how speculative. The court ruled that the liability, while not a certainty at the time of the gifts, was not too speculative that a willing buyer would ignore it.
Unfortunately, neither the Tax Court nor the Fifth Circuit addressed the merits of the substance-over-form or the violation-of-public-policy doctrine in the defined-value gift context. Even more interesting (and critical) is whether the reasonable-probability-of-receipt doctrine prevents the increased charitable deduction if the charity's interest is redeemed before the increase in value. The following can be inferred from the case as to how the courts may rule on the above doctrines:
1. The initial trial judge did not rule that the doctrines were inapplicable, only that the IRS failed to meet the burden of proof as to applicability. Thus, nothing prevents the doctrines' application if there is sufficient proof of collusion or side deals (i.e., redeeming a charity's interest at an artificially low or prearranged price).The shifting of the burden of proof from the taxpayers to the IRS (under Sec. 7491) helped significantly in McCord.
2. The Fifth Circuit's comment, in dicta, that the above doctrines were "overarching," and the careful consideration it gave to the facts (or rather, the lack of facts evidencing anything other than an arm's-length agreement) seem to indicate that that court will not explicitly ban the use of formula clauses under the violation-of-public-policy or the substance-over-form doctrine, but will review the facts in each case for evidence of nonarm's-length or abusive transactions.
3. The courts may be more likely to apply the reasonable-probability-of-receipt theory to disallow the increased charitable deduction when the charity's interest is redeemed at a much lower rate than the value established for gift tax purposes on audit. In McCord, the CA did not call for a reallocation of the interests between the donees based on the values as finally determined for gift tax purposes. Such a provision in a post-gift sharing agreement may make it more palatable for the courts to allow an increased charitable deduction.
4. There is little assurance that the courts will consistently decline to find undesired implied agreements in similar cases in the future, especially if there is a substantial difference between the reported transfer tax value and the actual FMV.
5. Even though the court permitted a valuation deduction for the donees' promise to pay the additional estate taxes if death occurred within three years of the transfer, practitioners should be cautious. If the donor fails to survive for three years, the promise's value might be included in his or her taxable estate.
Until the courts explicitly address these issues, taxpayers and tax advisers should tread very carefully. Clauses should be patterned closely to the one used in McCord. Tax practitioners should consider further strengthening the clause by requiring the charity to obtain its own appraisal (as opposed to merely allowing it to review and reject the taxpayer's appraisal and request arbitration). Donees should consider including the item discussed in #3 above in their post-gift sharing agreement. In addition, taxpayers must take care to avoid any facts that may imply the existence of anything other than an arm's-length transaction.
Additional litigation can be expected, given the significance of these issues to Federal gift tax administration. While the concept of defined-value gifts will continue to be controversial for the near future, the decision provides a glimmer of hope that such transactions--if properly structured and carefully implemented--may be allowable in gift tax planning.
BY VINU SATCHIT, SENIOR TAX MANAGER, BDO SEIDMAN, LLP, HIGH POINT, NC, AND MEMBER, AICPA TAX DIVISION'S PARTNERSHIP TAX TECHNICAL RESOURCE PANEL
(1) Frederic W. Procter, 142 F2d 824 (4th Cir. 1944).
(2) See IRS Letter Rulings (TAMs) 200245053 (11/8/02) and 20(1337012 (9/12/03), and IRS Field Service Advice (FSA) 200122011 (6/4/01).
(3) Succession of Charle's T. McCord, Jr., 461 F3d 614 (5th Cir. 2006), rev'g and remd'g 120TC 358 (2003).
(4) The taxpayers' four sons contributed $40,000 each in exchange for roughly 0.27% general partnership interests each .At the same time, McCord Brothers, a partnership owned equally by the four sons, contributed assets valued at $2.478 million in exchange for the remaining LP interests (approximately 16.6%).The taxpayers also contributed $10,000 each, for which they received class A MIL LP interests.
(5) Specifically, the GST trusts were to receive a dollar amount of FMV of MIL equal to the taxpayers' net remaining GST tax exemption, reduced by the dollar value of any transfer tax obligation owed by the trusts by virtue of their assumption thereof. The sons were to receive $6,910,933 worth of FMV of MIL interests, reduced by the dollar value of the MIL interests given to the trusts and any transfer tax the sons owed by virtue of their assumption thereof.
(6) The deficiency notices valued the interests at $171,749 per 1% LP interest. At trial, the IRS's expert argued for a value of $150,656.
(7) The taxpayers' appraiser valued a 1% LP interest at $89,505, the Service's expert at $150,665. The Tax Court majority's valuation, as the Fifth Circuit noted, was the precise median between the values computed by the two experts; see 461 F3d 614, at n. 23.
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|Title Annotation:||Estates, Trusts & Gifts|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2007|
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