Tax Court Upholds Use of Formula Clauses for Gifts of Stock
Hendrix, TC Memo 2011-133 , RIA TC Memo ¶2011-133 , 101 CCH TCM 1642 .
In Hendrix, 1 the Tax Court upheld the use of defined-value formula clauses in a transaction where the taxpayer transferred stock in a family-owned corporation to trusts for the benefit of their children and a community foundation.
John and Karolyn Hendrix, husband and wife, were the majority stockholders of John H. Hendrix Corp. (JHHC), an S corporation. The others stockholders of the corporation were their three daughters and trusts for their benefit. The taxpayers discussed with their attorney their interest in making gifts of stock in the corporation to trusts for their daughters and to a charitable entity. The attorney advised the taxpayers to establish a donor-advised fund at a community foundation. The taxpayers decided to establish their donor-advised fund with the Greater Houston Community Foundation. The taxpayers authorized their attorney to contact the foundation, and the foundation and the attorney negotiated the agreement establishing the donor-advised fund. The taxpayers established the donor-advised fund with $20,000.
Each of the taxpayers executed trust agreements forming two trusts. Two of the trusts were referred to as the GST trusts and two of the trusts were referred to as the issue trusts. Each trust consisted of three separate and equal shares for the benefit of the taxpayers' three daughters.
Each of the taxpayers, the trustees of the GST trusts, and the foundation executed assignment agreements pursuant to which each of the taxpayers assigned approximately 288,000 shares of JHHC nonvoting stock to the GST trust and to the foundation. The assignment agreements contained a formula under which:
- A portion of the assigned shares having a fair market value as of the effective date equal to approximately $11 million was assigned by each taxpayer to the trustees of his or her respective GST trust.
- Any remaining portion of the assigned shares was assigned to the foundation for the benefit of the donor-advised fund.
The assignment agreements defined fair market value as the price at which those shares would change hands as of the effective date between a hypothetical willing buyer and a hypothetical willing seller, neither under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The assignment agreements required that the GST trusts pay proportionally any gift taxes imposed as a result of the transfers. The assignment agreements required the trustees of the GST trusts to sign promissory notes obligating the trustees to pay approximately $9 million to each taxpayer. The notes were secured by the corresponding shares transferred to the trusts.
On the same day, a second set of assignment agreements were executed containing the same terms as the first assignment agreements, except that each taxpayer transferred approximately 116,000 shares of JHHC nonvoting stock to his or her respective issue trust and to the foundation, and the fair market value of the stock for the benefit of the daughters was set at approximately $4.2 million. The second set of assignment agreements directed the trustees to deliver to each taxpayer a note in the amount of approximately $3.6 million.
The trustees of the four trusts retained a valuation company to value the shares as of the date of the gift. The foundation retained another appraisal company to review the appraisal report prepared by the valuation company retained by the trusts. The foundation's appraiser agreed that the valuation report was fair and reasonable. Thereafter, the foundation and the trustees entered into confirmation agreements that allocated amongst them the JHHC nonvoting stock according to the fair market value of the stock set forth in the valuation report. The taxpayers were not parties to the confirmation agreements.
Each of the taxpayers filed a gift tax return and each claimed a charitable contribution deduction of $50,000 and total taxable gifts of approximately $1.4 million.
The court began its analysis by noting that this case would be appealable to the Fifth Circuit which decided Succession of McCord. 2 In McCord, the Fifth Circuit upheld the use of a formula clause similar to the formula clause used in this case. The Fifth Circuit noted in its opinion in McCord that the IRS had relied on the doctrine of violation of public policy while the case was before the Tax Court, but that the IRS had waived that doctrine on appeal to the Fifth Circuit.
The IRS argued that McCord was not controlling precedent for purposes of this case because the Fifth Circuit did not consider the IRS's argument that formula clauses are invalid because they are not reached at arm's length and because such clauses are void as contrary to public policy. The court agreed with the IRS and held that McCord did not control this case to the extent that the IRS puts forth arguments not decided by the Fifth Circuit.
The court then proceeded to address the arm's-length transaction argument put forth by the IRS. The IRS argued that the formula clauses were not agreed to at arm's length for the following reasons:
- The taxpayers and their daughters were close and lacked adverse interests.
- The daughters benefited from the taxpayer's estate plan.
- The formula clauses were not thoroughly negotiated.
The court rejected the IRS's argument. The court stated that the mere fact that the taxpayers and their daughters were close and that the taxpayers' estate plan was beneficial to their daughters does not necessarily lead to the conclusion that the formula clauses were not agreed to at arm's length. The court also stated that a finding of negotiation or adverse interest is not an essential element of an arm's-length transaction. The court did, however, take note that the daughters' trusts and the foundation had adverse interests because the daughters' trusts could receive less stock for their required payment if the JHHC stock was overvalued for purposes of the confirmation agreement.
The IRS also argued that the formula clauses failed to be reached at arm's length because collusion existed between the taxpayers and the foundation. The court rejected this argument as well. The court noted that the foundation accepted various potential risks incident to its receipt of the taxpayers' gift of the JHHC stock. These risks included:
- A loss of the foundation's tax-exempt status if it failed to exercise due diligence as to the gift.
- The foundation exercised bargaining power when its counsel insisted that the taxpayers pay local taxes and penalties as well as federal and state taxes and penalties if JHHC failed to distribute sufficient income to pay those taxes.
- The foundation was represented by counsel independent of the taxpayers and their counsel.
- The foundation conducted an independent review of the valuation report.
- The foundation had a fiduciary obligation under federal and state law to ensure that it received the number of shares it was entitled to receive under the formula clauses.
The court next turned to the IRS's argument that the formula clauses are void as contrary to public policy. The court rejected the IRS's argument and held that the formula clause was not contrary to public policy. The court stated that the formula clause supports the fundamental public policy of encouraging gifts to charity. The court also distinguished this case from that of Proctor 3 and its progeny. The court stated that in this case, unlike Proctor, the formula clauses impose no condition subsequent that would defeat the transfer. Finally, the court noted the recent case of Estate of Christiansen, 4 where the Tax Court held that an essentially similar dollar-value formula disclaimer was not contrary to public policy. The court stated that it knew of no legitimate reason to distinguish the formula clause from that formula disclaimer.
This case is an important taxpayer victory, and it sets forth the steps that should be taken in structuring transactions involving formula clauses. Some important points that practitioners should take away from this case include the importance of having an independent party with an adverse interest and a fiduciary duty (in this case it was the foundation) review and agree to the conclusions contained within the valuation report. Related to this point is that it would be best if the amount passing to the charitable organization be meaningful and have true economic substance. Finally, the formula clause should contain no condition subsequent that would defeat the transfer and return it to the taxpayer.
It will be interesting to see if this case is appealed by the IRS and whether the IRS continues to litigate these types of formula clauses if the case is affirmed on appeal.
1 TC Memo 2011-133 , RIA TC Memo ¶2011-133 , 101 CCH TCM 1642 .
2 98 AFTR 2d 2006-6147 , 461 F3d 614 , 2006-2 USTC ¶60530 (CA-5, 2006), rev'g 120 TC 358 (2003).
3 32 AFTR 750 , 142 F2d 824 , 44-1 USTC ¶10110 , 44-1 USTC ¶10123 (CA-4, 1944).
4 130 TC 1 (2008), aff'd 104 AFTR 2d 2009-7352 , 586 F3d 1061 , 2009-2 USTC ¶60585 (CA-8, 2009).
Frank S. Baldino is an estate planning attorney at Lerch, Early & Brewer in Bethesda, Maryland. 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. For more information about transferring stock, contact Frank at (301) 657-0715 or email@example.com.