"I hereby make a gift of a portion of my LLC interests worth $X to my son, BUT, if the IRS audits me and says that this gift is worth much more than $X, than I really gave much less of my LLC interests so that this gift will not incur gift tax."
While the above headline and gifting statement is an oversimplification, a recent Tax Court case, Wandry v. Commissioner, has opened up a realm of possibilities for those interested in making gifts of business interests to their children. Normally, a person can make a tax free gift of $13,000 annually (for 2012) to as many recipients as they wish. Thus, a business owner could give away large portions of his business piece-by-piece ($13,000 each year) without suffering any adverse gift tax consequences. However, the hardest thing to determine when dealing with family businesses is how much of that ownership interest actually equals the tax free gift amount of $13,000. While appraisals are normally acquired, the IRS can always challenge the appraised value and argue that the gifts of interests you made were really worth much more than $13,000, leaving you with a potential gift tax liability.
The Wandry case is promising because the Tax Court allowed the use of a formula value clause in a gift agreement which means that if there were ever an audit and the appraised value of the business were increased, then the percentage of ownership interests deemed gifted would be changed to ensure no gift tax would be incurred. In short, while the IRS could audit you and challenge the value of the gift, there would be no incentive to do so as if the value increased, there would still be no increase in gifts. Understandably, the IRS has challenged formula value clauses on public policy grounds as it creates a situation where taxpayers can make aggressive low-ball valuations without any fear of audit consequences if those valuations are disregarded.
Prior to Wandry, the best advice was for a family to designate a charity to receive any excess value after audit adjustments--no extra tax would be due but the family would lose some control. Wandry really opens up possibilities for strategic giving, particularly for those families using FLPs or FLLCs to make gifts to their children.
