Recent regs rekindle debate on savings clauses.

• Author: Strobel, Caroline D.
• Position: IRS regulations

EXECUTIVE SUMMARY

* Taxpayers have turned to savings clauses to establish the value of property transferred between related parties.

* Despite the courts' apprehensions, Regs. Sec. 25.2702-3(b)(2) and (c)(2) require taxpayers creating certain types of qualified interests to include an adjustment clause.

* The adoption of a unified transfer tax system renders moot whether the government collects gift or estate tax.

Savings clauses are used to establish the value of property transferred between related parties. The courts and Treasury have clashed on the proper use of such clauses; the courts have often struck them down, while regulations have required their use. This article explains why the courts should reconsider their negative stance.

The valuation of property is one of the most difficult tasks a taxpayer, together with his adviser, may ever be required to undertake. Valuation is an art, not a science, and is important whenever an individual either sells or gifts property. Errors in valuing illiquid property often leave taxpayers with unintended economic and tax consequences.

Many transactions intended as sales between related parties inadvertently result in taxable gifts. Often, this results when a taxpayer is unable to accurately ascertain the fair market value (FMV) of a closely held business asset. Either on examination of a gift tax or estate tax return, the IRS may assert that the transferred asset was under- or overvalued. Lack of donative intent in the transfer of property does not preclude the finding of a taxable gift. For example, Sec. 2512(b) provides that whenever there is a sale, exchange or other transfer for less than full and adequate consideration, the excess of the value of the property transferred over the value of consideration received is a taxable gift. Typically, transactions in the ordinary course of business are excluded from this rule, because it is assumed that unrelated parties dealing at arm's length transfer property only for full and adequate consideration. If an unrelated party is buying a hard-to-value asset, it is assumed the cash or other readily valued consideration must be equal to the closely held asset's value; however, the Service does not apply this assumption when analyzing sales between related parties, regardless of stated intent.

To overcome this, taxpayers have turned to savings clauses to establish the value of property transferred between related parties. There are two kinds of savings clauses--adjustment dames and definitional clauses.

Adjustment Clauses

Adjustment clauses attempt to adjust the amount of (1) a transferred asset or (2) consideration given in exchange for a transferred asset once the asset's value has been conclusively determined. Adjustment clauses adjust the transaction as of the date of the original...