Defined Value Provision Upheld
In Estate of Petter, 1 the Tax Court held for the taxpayer with respect to a gift that was made pursuant to a defined value formula.
In 2001, Mrs. Petter transferred to a limited liability company (“LLC”) approximately $22 million of UPS stock that she had inherited. The LLC had three classes of ownership units: Class A, Class D, and Class T. Also in 2001, Mrs. Petter created two grantor trusts—one for the benefit of each of her two children, with each child serving as trustee of his or her trust. In 2002, Mrs. Petter made gifts and sales to the two grantor trusts. Both the gift and the sale transactions were made using a defined value formula.
In the gift transactions, Mrs. Petter gave 940 Class D LLC units to her daughter's grantor trust and a charitable community foundation, and gave 940 Class T units to her son's grantor trust and another charitable community foundation. Each of the two gift documents allocated the 940 units between the grantor trust and the charitable foundation pursuant to a formula provision that provided that Mrs. Petter assigned to each grantor trust a number of units equal to one-half of the maximum dollar amount that could pass free of federal gift tax by reason of
Mrs. Petter's applicable exclusion amount allowed by Section 2010(c).
At the time of the gift, Mrs. Petter understood that one-half of her unused applicable exclusion amount was $453,910. The gift documents also provided that Mrs. Petter assigned to the charitable foundation a number of units equal to the difference between 940 units and the number of units assigned to the grantor trusts. Moreover, the gift documents contained reallocation provisions pursuant to which the grantor trust and the charitable foundation agreed to transfer units to the other if a party initially received more units than it was entitled to receive based on values as finally determined for federal gift tax purposes.
A few days following the gifts, Mrs. Petter assigned 8,459 Class D units in the LLC by sale to her daughter's grantor trust and by gift to a charitable foundation. She also assigned 8,459 Class T units in the LLC by sale to her son's grantor trust and by gift to the same charitable foundation. Each of the two sale documents allocated the units between the grantor trust and the charitable foundation in accordance with a formula provision. The grantor trusts received units worth $4,085,190 as finally determined for federal gift tax purposes and the charitable foundation received the excess units. In exchange for the units received by the grantor trusts, each trust gave Mrs. Petter a secured promissory note for $4,085,190 with interest and principal payable quarterly. The sale documents contained reallocation provisions pursuant to which the grantor trust and the charitable foundation agreed to transfer units to the other if a party initially received more units than it was entitled to receive based on values as finally determined for federal gift tax purposes.
A formal appraisal was obtained a few weeks later that valued the units in the LLC by applying a discount of approximately 53%. Based on that appraisal, the units were allocated for both the gift and the sale transactions between the grantor trusts and the charitable foundations.
Mrs. Petter filed a gift tax return reporting the gift and sale transactions. The IRS audited the gift tax return and valued the units in the LLC by applying a discount of approximately 30%. In addition, the IRS asserted that the defined value provisions would not be respected for gift tax purposes even if additional units were actually transferred from the grantor trusts to the charitable foundations pursuant to the defined value provision. The IRS further contended that a gift tax charitable deduction was not allowed in the year of the initial transfer for the units reallocated as a result of the audit from the grantor trusts to the charitable foundations.
Mrs. Petter filed a petition in the Tax Court. Prior to trial, Mrs. Petter and the IRS agreed to value the units in the LLC applying a discount of 30%. There were two issues before the court. The first was whether the defined value provisions would be respected for gift tax purposes. The second issue was whether an increased gift tax charitable deduction is allowed for the year of the original transfer because of the reallocation of units from the grantor trusts to the charitable foundations on account of the IRS audit.
The court began its opinion with a brief summary of the law regarding defined value provisions beginning with the Fourth Circuit's decision in Procter 2 and ending with the Eighth Circuit's decision in Christiansen 3 (which is discussed in this column). The Petter court rejected the IRS's argument that the defined value provisions in this case violated public policy. The court stated that there is a general public policy in favor of encouraging gifts to charities. According to the court, the facts of this case demonstrate that the charitable foundations looked after their interests, and did not just passively help Mrs. Petter reduce her tax bill. The charitable foundations conducted arm's-length negotiations, retained their own counsel, and won changes to the transfer documents to protect their interests, including insisting on becoming substituted members in the LLC with the same voting rights as all the other members. The court noted that by becoming substituted members, rather than mere assignees, the charitable foundations made sure that the LLC managers owed them fiduciary duties. The court found that these facts made the court confident that the gift was made in good faith and in keeping with Congress's overall policy of encouraging gifts to charities.
In addition, the court observed that the directors of the charitable foundations owed fiduciary duties to their organizations to make sure that the appraisal was acceptable before signing off on the gift and they also had a duty to bring a lawsuit if they later found that the appraisal was wrong. Further, the court stated that while it could envision a situation in which a charity would hesitate to sue a living donor, and thus risk losing future donations or the donor's goodwill, the gifts in this case were irrevocable once completed, and the charitable foundation's cause of action most likely would have been against the trusts, rather than against Mrs. Petter because the grantor trusts held the additional units which the charitable foundations would be seeking. Moreover, the court noted that the Service could revoke the charitable foundations' Section 501(c)(3) tax exemptions if it found they were acting in concert with a tax-dodging donor. The state attorney general was also responsible for enforcing the rights of the charitable foundations.
The court stated that it did not believe that it was deciding a moot case because it believed that a judgment adjusting the value of each unit would actually trigger a reallocation under the formula provision of the number of units between the grantor trusts and the charitable foundations.
Mrs. Petter also pointed out several other instances in which the IRS and Congress specifically allow formula clauses like this one. These included the CRAT and CRUT provisions of the Regulations, marital deduction formulas, IRS Regulations permitting allocation of the GST exemption based on a formula, IRS Regulations allowing disclaimers based on a formula, and the GRAT and GRUT provisions of the Regulations. Therefore, Mrs. Petter argued that if Congress allows these clauses in other contexts, there cannot be a general public policy against using formula provisions. The court disagreed with the arguments that the IRS presented in attempting to distinguish these formulas from that used by Mrs. Petter.
The court concluded by stating that Mrs. Petter's transfers amounted to gifts of an aggregate and set number of units, to be divided at a later date based on appraised values. The court found that the formulas used to effect these transfers were not void as contrary to public policy because there was no frustration of public policy as a result, and indeed no overarching public policy against these types of arrangements in the first place.
With respect to the second issue, the IRS argued that a gift tax charitable deduction should not be allowed for the year of the original gift and sale transactions with respect to the value of the additional units that passed to the charitable foundations when the units were reallocated using the finally determined gift tax value. The court relied on Reg. 25.2511-2(a), which provides that a gift is not necessarily determined by the measure of the donee's enrichment. Similarly, the court stated that a donor's tax treatment should not change based on the later discovery of the true measure of enrichment by the two parties, one of whom is a charity. Furthermore, Mrs. Petter's transfer could not be undone by any subsequent events. The fact that the charitable foundations “booked” the value or amounts of the units on a later date and initially “booked” a lower value did not matter because Mrs. Petter had no control over the internal accounting practices of the charitable foundations. The court disagreed with the IRS on this second issue and allowed a charitable deduction for the year of the initial transfer for the increased units reallocated to the charitable foundation as a result of the IRS audit.
Petter is a major victory for taxpayers and approves with rather strong language the appropriate use of defined value provisions. The IRS will most likely appeal this case to the Ninth Circuit. Supporting the court's decision in this case were very favorable facts. These facts included that the charitable foundations actively participated in the transaction, that the charitable foundations were members of the LLC and not mere assignees, there was full disclosure of the transaction on the donor's gift tax return, and the parties to the transaction included entities which were not related or controlled by the taxpayer, and which had their own fiduciary duties.
1 TC Memo 2009-280, RIA TC Memo 2009-280, 98 CCH TCM 534.
2 32 AFTR 750, 142 F2d 824, 44-1 USTC 10110, 44-1 USTC 10123 (CA-4, 1944).
3 104 AFTR 2d 2009-7352, 586 F3d 1061, 2009-2 USTC 60585 (CA-8, 11/13/2009).
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.