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Tuesday, April 3, 2012

Another Taxpayer Win on Defined Value

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 The March 26, 2012 Tax Court decision in Wandry v. Comr., T.C. Memo 2012-88, was yet another win for taxpayers in a long-simmering dispute between taxpayers and the IRS on the issue of defined value gifts. In 2004, the Wandrys entered into a tax attorney-advised gifting plan by which they were to give interest, based on specific dollar amounts rather than percentages, in an LLC to their children and grandchildren.

The gift documents stated that each child would receive a membership interest equal to $261,000 and each grandchild would receive a membership interest equal to $11,000 (the same as the 2004 annual exclusion amount). The documents further stated that if it was ultimately determined that the value of the units gifted differed from the amounts listed, the units would be adjusted to gift the intended amounts, in the same manner that a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination.

In preparing the Wandrys’ 2004 gift tax returns, their CPA noted the amount of the gifts to the Wandrys’ children and grandchildren as $261,000 and $11,000, respectively. However, in preparing the gift tax returns, the CPA relied on an independent appraisal of the LLC that valued the assets of the LLC and concluded that a 1% interest in LLC was worth $109,000. Accordingly, on the schedules of the gift tax returns the CPA described the interests transferred as 2.39% and .101% interests. The IRS issued a notice of deficiency stating that interests of 2.39% and .101% were gifted to the Wandrys’ children and grandchildren, and that the actual value of the interests were $366,000 and $15,400, respectively.

The IRS argued that: (1) the description on the gift tax returns were admissions by the Wandrys that they transferred fixed percentage interests in the LLC; (2) the LLC’s capital accounts control the nature of the gifts, and were adjusted to reflect the gift descriptions; (3) the formula clause in the gift documents created a condition subsequent to completed gifts, and is void as a matter of public policy.

On the first issue, the IRS cited Knight v. Comr., 115 T.C. 506 (2000), in which the taxpayers entered into a similar gift-giving plan. The Tax Court, however, distinguished Knight because in that case: (1) the gift returns, in Knight, did not report a dollar amount associated with the interests transferred, only the percentages; and (2) the taxpayer, in Knight, argued at trial that the value of the interests transferred was lower than the reported amount, opening the door for the IRS’s argument that percentage interests, rather than dollar value interests, were actually transferred. The court highlighted the fact that the Wandrys always claimed that the value of the gifts were $261,000 and $11,000, and were reported as such on the gift tax returns.

On the second issue, the Tax Court explained that capital accounts do not control the nature or value of gifts. The court pointed out that the IRS Commissioner routinely challenges the accuracy and validity of capital accounts. Thus, “a capital account is always ‘tenatative’ until final adjudication or the passing of the appropriate period of limitations.” The court additionally noted that there was no evidence that the LLC’s capital account ledger, which was handwritten and undated, were official capital account records, and there was also no evidence that the donees capital accounts were adjusted to reflect the gift descriptions.

On the third issue, the Tax Court compared the case to Estate of Petter v. Comr., 653 F.3d 1012 (9th Cir. 2011) aff’g T.C. Memo 2009-280, in which the Ninth Circuit held valid a clause that transferred a number of units equaling a specific dollar amount to a trust, and the remainder to a charitable foundation. The court explained that although, absent the IRS’s audit, the donees might never have received the proper percentage interests, the transfers were not dependent upon the audit because though the value of the LLC unit may have been unknown, as with the transfers in Petter, the value of the gift was constant. The court further explained the formula clause was not contrary to public policy because it did not undo the gifts, but merely reallocated the membership units to properly reflect the intended gift amounts. The court also noted that it was “inconsequential” that the formula clause reallocated units among the taxpayers and donees, rather than a charitable organization (as has been the case in other recent taxpayer wins on defined-value issues).

Until now, the leading defined-value decisions have been cases where the formula clause designated that the remainder ultimately go to a spouse or charitable organization. Here, the Tax Court extended its previous positions by expressly stating that the “lack of a charitable component” is “inconsequential” and does not result in a “’severe and immediate’ public policy concern.” It is likely that we will see this case revisited in the Tenth Circuit. But until then, the taxpayers can celebrate one more win in the long fight for the validity of defined-value gifts.

Tara C. Jackson, J.D., LL.M.
Federal Tax Law Editor
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