Wandry – A Significant Step Forward for Defined Value Clauses

Authored by: Neeli G. Shah

On March 26, 2012, the United States Tax Court issued a memorandum opinion in Wandry v. Commissioner, which was an important taxpayer victory in the world of defined value clauses (“DVC”).[ref]This article only focuses on certain aspects of the Wandry case.  Clients and taxpayers must fully review the entire case or consult at tax professional prior to using DVCs for personal estate and gift tax planning purposes.[/ref]  A DVC is a formula clause that allows the taxpayers to determine a gift’s fair market value, for federal gift tax purposes, by referencing a fixed dollar amount rather than transferring a fixed quantity of property.

In this case, the donors, Albert and Joanne Wandry, each transferred interests in their family LLC directly to their four children (worth $261,000 to each child) and five grandchildren (worth $11,000 to each grandchild) without any residual beneficiary to take in the event of an IRS redetermination.  There were no trusts or charities.  Although the donors did not have an appraisal at the time of the gift, the instrument contained the following language:

“I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted [membership units] is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted [membership units] shall be adjusted accordingly so that the value of the number of [membership units] gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.”

Approximately a year and half after the transfer, the appraiser issued his valuation, which the accountant used to prepare a ledger for the LLC’s capital accounts and the donors’ gift tax returns.  A schedule attached to the gift tax returns, however, showed that each child received a 2.39 percent interest in the LLC and each grandchild received a 0.101 percent interest in the LLC, based on the appraised value.

The IRS audited the donors’ gift tax returns and disputed the valuation and the use of the DVC to transfer fixed dollar amounts worth of LLC interest.

The IRS asserted three arguments as follows:

  1. Based on the terms of the schedule attached to the donors’ gift tax returns, they had transferred a fixed number of LLC interests rather then a fixed dollar amount;
  2. The capital accounts maintained on the LLC books and records should control the gift tax treatment, based on the argument that a percentage change in the capital accounts of the LLC corresponded to a transfer of a percentage interest in the LLC and to hold otherwise would create an administrative burden in amending years of income tax returns; and
  3. The DVC contained in the transfer document was void against public policy.

The Tax Court disagreed with all of IRS’s arguments and ruled the membership percentage interests reported on the gift tax return were not controlling since they were merely based on the appraisal and the fixed dollar value reported by each donor.  Most importantly, the Tax Court explained that there is no public policy against formula clauses that merely define the rights transferred without undoing prior transfers.  The Tax Court concluded that the prior case law approving DVCs was based on the nature of the property right transferred and not the existence of charitable beneficiaries.  This is significant as Wandry is the only case in a series of prior successful DVC cases that does not include a charitable residual beneficiary in the event of a revaluation by the IRS.

Historically, the IRS has successfully challenged similar clauses based on public policy.  However, recent case law has developed a distinction between “saving clauses,” which are void because they operate to undo prior completed transfers based on an event that occurs after the completion of the gift, and “DVCs,” which are gaining acceptance.  The Tax Court noted the reference to adjustments for valuation “in the same manner as a federal estate tax formula marital deduction” as important.  This formula ensures that there is no condition subsequent because, by definition, the FMV controls the percentage transferred.

In light of this taxpayer friendly decision and only 6 months remaining before the gift tax exemption is scheduled to drop from $5,120,000 to $1 million beginning in 2013, DVCs may become very popular for last minute 2012 gifts.  While Wandry is a huge taxpayer victory, taxpayers should be cautious in aggressively implementing DVCs.  It is important to note that while the donors in Wandry were lucky enough to successfully avoid this risk, any inconsistency on the gift tax returns will allow the IRS to argue that a fixed percentage, not a fixed dollar amount, was transferred.    Gift tax returns should be consistent with formula gifts.  Any filings, records, or tax returns must always document the transfer expressed as a fixed dollar amount, not as a percentage.  If the interest needs to be expressed as a percentage, it is important for taxpayers to highlight that the stated percentage is subject to the original terms of the gift or sale, as the case may be, expressed as a fixed dollar amount.

While the IRS lost this argument in Wandry, there is in fact a significant administrative burden associated with DVCs because the percentage interests of each donee may not be known for several years and amendments to each party’s income tax returns may be necessary.  As an alternative, consider using a grantor trusts as donees so that the donors can report the income allocable to the transferred interests on their income tax returns.

Finally, keep in mind that Wandry is a Tax Court memorandum opinion, subject to an appeal by the IRS.  While it is unclear whether the IRS will appeal the decision, it is highly unlikely that the IRS will acquiesce in this decision.

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