Formula clauses: adjusting property transfers to eliminate tax.

• Author: Skarbnik, John H.

When drafting dispository documents--whether they involve lifetime gifts or testamentary bequests--attorneys often use formula clauses to designate the value of property passing by gift or bequest. Often, the formula refers to the donor's or decedent's available federal unified credit. For example, an individual testator might make a bequest to a designated beneficiary of the maximum amount of property that can pass free of estate tax. Similarly, a donor might gift a number of shares in a closely held business whose total value will not result in tax after the application of the donor's remaining unified credit. Formula clauses adjust the amount of property transferred to maintain a specified value.

In 2011, the maximum amount of property that could pass free of gift and estate tax to a beneficiary other than the transferor's spouse was $5 million. (1) In 2012, as a result of an inflation adjustment, the estate and gift tax unified credit sheltered up to $5.12 million of property from federal tax. (2) For lifetime transfers, the transferor may also shelter from gift tax the amount of the annual gift tax exclusion, in addition to the remaining unused gift tax unified credit amount. (3) Generally, no marital deduction is allowed for gifts and bequests to a non--U.S. citizen spouse. (4) However, if property passes into a qualified domestic trust for the benefit of the surviving non--U.S. citizen spouse, it may qualify for the marital deduction. (5) Also, the annual tax gift exclusion is increased to $100,000, adjusted for inflation ($143,000 for 2013), for gratuitous transfers to a non--U.S. citizen spouse. (6)

For estates of decedents dying and gifts made after Dec. 31, 2012, the American Taxpayer Relief Act of 2012 (7) permanently extended the $5 million exclusion as adjusted for inflation, but increased the top tax rate from 35% to 40%. The act also extended other features of the estate and gift tax regime under the Economic Growth and Tax Relief Reconciliation Act of 2001, (8) as amended by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. (9)

To ensure that revaluations of gifts or estate assets by the IRS or a court will not result in additional taxes, taxpayers may want to use a formula adjustment clause that explicitly adjusts the quantity of the property transferred in the event the IRS challenges the taxpayer's valuation and there is a final determination for tax purposes of the value of the property. By using a formula adjustment clause, testators can specify that their estate should pass in a manner that will not result in any federal estate tax.

Recently, the Tax Court in Wandry (10) upheld a formula adjustment clause that provided for fixed dollar amounts of interests in a limited liability company (LLC) to pass to noncharitable beneficiaries, with a clause stating that any redetermination of the interests' value would adjust the number of membership units passing to each beneficiary to conform to the specified dollar amounts. In an audit, the IRS increased the value of the membership interests and on that basis recalculated the value of the gifts. The court held that as a result of the adjustment clause, a reduced percentage of LLC interests passed to the noncharitable beneficiaries, and a greater percentage of membership interest remained with the donors. The IRS withdrew its appeal of the case and later announced that it would not follow the Tax Court's holding. (11)

Wandry breaks new ground as the first case to uphold a formula clause where a charity was not involved as a potential recipient. This suggests new and expanded planning opportunities for employing formula adjustment clauses in situations that had not been previously sanctioned judicially. This article explores the Wandry case and its implications, along with some of the cases arising before it.

The use of a formula allocation clause may at first appear simple. If a testator provides that an amount equal to the maximum amount that can pass free of federal tax will pass to designated individuals or in trust, the dollar amount of the bequest can be relatively easy to determine, especially if the transfer is made in cash or marketable securities. Planning is more complex for assets that are difficult to value, such as interests in closely held businesses, real estate, or any other nonmarketable or hard-to-value assets. Even where the taxpayer obtains qualified appraisals of the interests, the IRS may contest the value.

To avoid the adverse tax consequences of a revaluation by the IRS or a court, a will, trust, memorandum and assignment of gift, or other transfer document evidencing the inter vivos or testamentary transfer may contain a formula clause. For example, assume that a donor plans on gifting stock in his wholly owned C corporation to his daughter. The donor could execute an assignment that provides:

I hereby transfer to my daughter such number of shares of ABC Corp. stock that have a value equal to my available remaining applicable exclusion amount for the purpose of determining my unified credit for gift tax, as such value is finally determined for federal gift tax purposes. If, as a result of an audit, the final determination results in an increase in the value of such shares, the number of gifted shares shall be adjusted accordingly so that the value of the total shares gifted does not exceed my available applicable exclusion amount for the purpose of determining my unified credit for gift tax purposes. Although the IRS strenuously argues that such clauses are void as against public policy and should be disregarded, the Tax Court has recognized their validity in some circumstances. Therefore, practitioners need to carefully draft such clauses to achieve the desired result.

The Facts in Wandry

In Wandry, a married couple, Joanne and Albert Wandry, each executed a separate assignment and memorandum of gifts of interests in their family business, Norseman Capital LLC, to their four children and five grandchildren. Each transfer document defined the gifts as a sufficient number of Norseman membership units so that the units' fair market value (FMV) for federal gift tax purposes would be equal to $261,000 for each of the Wandrys' children and $11,000 for each of their grandchildren, for a total of $1,099,000 given by each donor. Each document then stated:

Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date. Furthermore, the value determined is subject to challenge by the [IRS]. 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 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 Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula...