In James C. Nelson v. Commissioner,1 a donor transferred limited partnership (LP) interests equal to percentage interests that were calculated by an appraiser following a gift and a sale to a trust. The LP’s primary asset was common stock of a family-owned holding company. The holding company owned 100% of seven operating subsidiaries.
The donor made two transfers of LP interests to the trust created for her children and husband. The first transfer was a gift that was described in a memorandum of gift as having a fair market value (FMV) of $2 million as of the date of the gift, as determined by an appraiser within 90 days of the effective date of the assignment. The second transfer was structured as a sale and was memorialized by a memorandum of sale as having a value of $20 million as determined by an appraiser within 180 days of the effective date of the assignment. The appraiser concluded that the transfers were equal to 6.14% and 58.65% LP interests, respectively.
A dispute arose over whether the donor transferred LP interests equal to fixed dollar amounts or percentage interests. The Tax Court determined that to decide this issue, the transfer documents and not subsequent events controlled. Unfortunately for the taxpayer, the documents were fatally flawed. Neither the memorandum of gift nor memorandum of sale and transfer contained the key language of using a valuation as finally determined for federal gift (or estate) tax purposes.
Named Charities Get More
While Nelson didn’t involve charitable transfers, its conclusion on how to document a value adjustment clause models how to receive favorable treatment. Under a charitable lid plan, the transferor, whether during lifetime or at death, leaves a fixed amount to non-charitable beneficiaries with the remainder passing to a qualified charitable organization. The result is a “lid” that can be taxed as part of the gross estate or as an adjusted taxable gift. The goal of the charitable lid plan is meant to address the possibility of the Internal Revenue Service challenging an estate or gift valuation on audit by ignoring or reducing the discounts for lack of marketability or minority interest. Any reductions in the valuation discount result in named charities receiving more at the expense of the non-charitable beneficiaries. What’s owed to the IRS remains unchanged.
Let’s illustrate with a common fact pattern:Sally gifts an interest in a limited liability company (LLC) appraised at $1 million, reflecting valuation discounts for lack of marketability and minority interest of 33.3%. On audit, the IRS reduces the discount from $500,000 to $375,000. The deed of transfer provides the amount of the reduction in the discounting valuation “as finally determined for federal gift tax purposes” and it’s added to the share passing to charity. The charitable lid formula avoids a gift tax of $50,000 (40% of $125,000) while the charity receives an allocation of an additional $125,000.
The lid to charitable gift planning was raised in decisions from the Tax Court and U.S. Court of Appeals for the Eighth Circuit in Estate of Christiansen v. Comm’r2 and the Tax Court in Estate of Petter v. Comm’r.3 Both cases denied the IRS’ public policy argument that such clauses remove the incentive to audit transfer tax returns. The decisions allowed charitable lid strategies to limit a donor’s transfer tax liability while fulfilling charitable goals. Christiansen approved the use of a charitable lid estate plan activated by a formula clause disclaimer. Petter approved a dollar formula clause for lifetime transfer of LLC interests to family trusts with remainder interests to a family foundation.
The taxpayers in Nelson argued the governing instruments transferred specific dollar amounts of approximately $2.1 and $20 million. The IRS concluded there was a transfer of percentage interests of 6.14% and 58.65% in the LP. Although the IRS permitted formula clauses in Christiansen and Petter even though the percentage amounts became known only when FMV was determined, the court didn’t find them applicable here. Rather, it interpreted the clause as an impermissible “savings clause,” creating an impermissible condition subsequent. It noted Comm’r v. Procter,4 which rejected a clause that adjusted part of a gift to “automatically be deemed not be included in the conveyance in trust and shall be the sole property of the taxpayer.”5
Planning Implications
Having survived over a decade of legal challenges, the charitable lid technique is an effective tool for the estate and charitable gift planner. A minimum of three key requirements should be followed.
First, the documents of transfer must indicate the donor has relinquished all dominion and control. The substance of any transfer should impose economic risk to the transferor. To the extent the IRS prevails with a higher valuation, then the interests of the non-charitable beneficiaries are decreased with the resulting increase to the charitable beneficiaries. Petter stressed the role of the foundation in assuring the appraisal was acceptable before accepting the gift. The court felt the risk of revocation of the Internal Revenue Code Section 501(c)(3) status of the foundation was sufficient incentive for the charity to avoid being a part of a fraud. Additionally, the state attorney general stood as a backstop to enforce the rights of the charity.
Second, define “valuation” as determined for federal gift and estate purposes. While an appraisal, of course, is needed, avoid “as determined by a qualified appraiser within [blank] days of the effective date of this Assignment.”6
Third, avoid any possibility of the transfer creating a condition precedent. Treasury Regulations Section 5.2522(c)-3(b)(1) denies a gift tax charitable deduction, otherwise allocable, if, as of the date of gift, the transfer depends on the occurrence of an act or event for the transfer to be effective.
With the prospect of a dramatically reduced exemption from federal gift and estate taxes being discussed by the current front-runner in the U.S. presidential race, the charitably inclined with hard-to-value assets, including business interests and real estate, can put a lid on their transfer taxes.
Endnotes
1. James C. Nelson v. Commissioner, T.C. Memo. 2020-81 (June 10, 2020).
2. Estate of Christiansen v. Comm’r, 130 T.C. 1, aff’d, 586 F.3d 1061 (8th Cir. 2009).
3. Estate of Petter v. Comm’r, T.C. Memo. 2009-280.
4. Comm’r v. Procter, 142 F.2d 824 (1944).
5. Ibid., at p. 827.
6. Nelson, supra note 1, at p. 20.