Formula Clauses After Christiansen v. Commissioner: Gift Tax Hedge or Future Liability? - August 2008 - Trust and Estate Law

• Publication year: 2008
• Pages: 89
• Citation: Vol. 37 No. 8 Pg. 89

37 Colo.Law. 89 Colorado Lawyer 2008.

2008, August, Pg. 89. Formula Clauses After Christiansen v. Commissioner: Gift Tax Hedge or Future Liability? - August 2008 - Trust and Estate Law

The Colorado Lawyer
August 2008
Vol. 37, No. 8 [Page 89]

Articles
Trust and Estate Law
Formula Clauses After Christiansen v Commissioner: Gift Tax Hedge or Future Liability?
by Kami A. Pomerantz

Trust and Estate articles are sponsored by the CBA Trust and Estate Section. Topics include trust and estate planning and administration, probate litigation guardianships and conservatorships, and tax planning.

Article Editors

David W. Kirch, of David W. Kirch, P.C., Aurora - (303) 671-7726, dkirch@qwest.net; Constance D. Smith, of Rothgerber Johnson & Lyons LLP - (303) 623-9000 csmith@rothgerber.com

About the Author

Kami A. Pomerantz is an associate in the Private Client Group with Holland & Hart, LLP - (303) 295-8095, kpomerantz@hollandhart.com.

This article explains the use of formula valuation clauses in assignment documents transferring difficult-to-value assets for gift and estate tax purposes. It also reviews the Internal Revenue Service's position regarding such clauses and analyzes the recent case of Christiansen v. Commissioner, where the Tax Court validated the use of a formula valuation clause in certain circumstances, and provided some guidance for using formula clauses to transfer assets.

Taxpayers desire certainty regarding the amount of transfer tax they will have to pay as a result of a transfer of assets. However, in the estate and gift tax context, where taxpayers often transfer assets that are difficult to value, this certainty can be elusive. For example, a taxpayer making a gift or sale of closely held business interests valued at an amount that would not require payment of transfer tax takes a risk. Many years after the transfer, the Internal Revenue Service (IRS or Service) could revalue the transferred asset, creating a substantial tax liability.

To mitigate this risk of revaluation, practitioners have suggested using formula valuation clauses in assignment documents. These clauses employ a formula to define the amount transferred at a level that would not trigger transfer tax even if the IRS succeeds in revaluing the assets at a later date.

The IRS consistently has rejected the use of such clauses, claiming they subvert public policy. The IRS claims that the clauses discourage audits, because any revaluation of assets on audit does not result in the collection of additional tax. Generally, the IRS has been successful when challenging valuation clauses in court. Recently, however, the Tax Court in Christiansen v. Commissioner,(fn1) a case involving a disclaimer of assets to charity, upheld a formula valuation clause and provided a measure of hope to taxpayers that such clauses might be available to limit exposure to future gift and estate tax liabilities.

This article reviews the general use and operation of formula valuation clauses, specifically valuation adjustment clauses and valuation definition clauses. It describes the traditional response of the IRS and the courts to such clauses. The article also analyzes the Christiansen case and its implications. Finally, recommendations are offered concerning how practitioners might proceed when transferring assets that are difficult to value for gift and estate tax purposes.

Formula Clauses

Formula clauses commonly are used in estate planning documents simply because it often is difficult to predict or ascertain the value of assets at the expected time of transfer. The most commonly used formula is the marital deduction formula. It provides that the surviving spouse will receive a defined amount of the decedent spouse's residuary estate that will qualify for the marital deduction.(fn2)

The marital deduction formula can be expressed either as a pecuniary amount or a fractional amount of a decedent's estate. The formula may define the marital share as the amount that will produce the minimum marital deduction necessary to eliminate or produce the lowest possible federal estate tax in the decedent's estate. The marital share typically passes to either the decedent's spouse or to a trust for the spouse's benefit that qualifies for the marital deduction, and thereby generates no estate tax. Alternatively, the formula may define the credit share, or the taxable share of the estate, as the largest amount equal to the decedent's remaining exemption from estate tax, so as to create a tax equal to the decedent's remaining credit against estate tax.

When the marital share is defined, the remaining assets in the estate after funding the marital share pass to the credit share. If the credit share is defined, the opposite occurs and the remaining assets pass to the credit share. After application of either formula, no estate tax is imposed on the estate.

Generally, these formulas, regardless of how expressed, specifically incorporate the value of assets as finally determined for federal estate tax purposes. Use of the phrase "finally determined for federal estate tax purposes" in estate documents allows the fiduciary to determine the amount passing to the marital share or the credit share using the value of the decedent's assets as of the date of death. It also allows for readjustment of such amount in the event the IRS audits the estate tax return and revalues the estate assets. Thus, if the IRS increases the value of the decedent's assets on audit, the formula clauses direct the additional value to the marital share, which, in turn, increases the marital deduction claimed.

Under the marital share formula, an increase in value of the estate assets results in an increase of the minimum amount necessary to eliminate or produce the lowest possible federal estate tax. With respect to the credit share formula, an increase in asset value reduces the percentage of the estate passing to the credit share, because this amount is limited to the decedent's remaining exemption, with overage passing to the remainder marital share. Thus, despite the revaluation on audit, no additional estate tax becomes due, because any increase in the value of assets is offset by an increase in the marital deduction. The IRS has specifically allowed the use of this kind of formula.(fn3)

The Treasury Regulations (Regulations) also authorize, and in some cases even require, adjustment formulas with respect to certain estate planning techniques. For example, the Regulations governing charitable remainder trusts allow such trusts to express the annuity amount to be paid to an income beneficiary in terms of a fixed fraction or percentage of the value of assets transferred to the trust as finally determined for federal tax purposes.(fn4) Furthermore, the Regulations require the fiduciary to adjust such annuity payments if the fair market value of the assets transferred to the trust is modified on audit or appraisal.(fn5)

Likewise, with respect to testamentary charitable remainder trusts created under a will or trust, the Regulations allow a fiduciary to defer the payment of an annuity interest until values are finally determined for federal estate tax purposes.(fn6) The effect of these Regulations is that on adjustment of the value of assets transferred to the trust, either by the IRS or by an appraisal, the formula clauses will revalue the amounts allocated to the income and remainder beneficiaries without disqualifying the trust.

Such Regulations, and the associated Service rulings, implicitly recognize the uncertainties that attend asset valuation, by providing mechanisms to reallocate assets if adjustments occur. However, as discussed below, the Service has not always been so accommodating. The IRS has been decidedly less flexible with respect to value adjustment and value definition clauses in other contexts.

Formula Clauses in the Transfer Tax Context

Building on the sanctioned uses of formula clauses like the marital deduction formula described above, practitioners have sought to employ formulas to limit a transferor's exposure to transfer tax in other circumstances. Two such situations are particularly noteworthy. The first involves a transferor's attempt to transfer assets worth a specified dollar amount...