Year-End Gift Planning: How Valuation Clauses Can Get Around a Late Appraisal

With the abnormally high gift/estate tax exemption amounts of $5.12 million set to sunset at the end of this year, many attorneys, CPAs and tax-advisors are rushing to help their clients take steps to make significant gifts.  For those who wish to take advantage of this unique opportunity, the clock is winding down.  For the gifts to be effective this year, the transfer must be completed by December 31.

Unfortunately, many planners are now realizing that scheduling appraisals this late in the year means that they will likely not have the appraisal figures back until next year.  Thus, a donor is left to wonder, if I want to make a gift of say, exactly $5.12 million to my children, how do I know how many shares of stock or LLC units to transfer this year if I won't know the value until next year.

Fortunately, due to the availability of defined value clauses and some recent Tax Court cases, the donor (and his/her advisers) can make large gifts with confidence.

In short, a donor need not specificy the exact number of LLC units given, all that needs to be specified is that value to be transferred, expressed in a mathematical formula.

A good example of such a formula clause is found in the recent Wandry decision, and reads as follows:

I hereby assign and transfer as gifts, effective as of January 1, 2004, a

sufficient number of my Units as a Member of Norseman Capital,

LLC, a Colorado limited liability company, so that the fair market

value of such Units for federal gift tax purposes shall be as follows:

                   Name                             Gift Amount

                   Kenneth D. Wandry        $261,000

                   Cynthia A. Wandry           261,000

                   Jason K. Wandry              261,000

                   Jared S. Wandry               261,000

                   Grandchild A                     11,000

                   Grandchild B                     11,000

                   Grandchild C                     11,000

                   Grandchild D                     11,000

                   Grandchild E                     11,000

                                                          1,099,000

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

Internal Revenue Service (“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 marital deduction amount would be adjusted

for a valuation redetermination by the IRS and/or a court of law.

In short, while it would be preferrable to get the value before making the gift, a formula clause like the above gives the donor, and other professionals some breathing room.

Of course, one big caveat is to ensure that when the gift tax return is filed that the language on the return matches the language on the gift.  If the return just lists the exact number of shares, units, or percentage interest transferred the donor exposes himself to a potential challenge from the IRS alleging that a formula clause was not utilized. 

How Mitt Romney's Use of a "Defective" Trust Saves Him Taxes

A tax and estate planning attorney has a wide array of tools that can be implemented to help individuals and families save when it comes to gift and estate taxes.  Often, these tools come in the form of complex trusts with even more complex sounding acronyms.  For instance, Charitable Lead Annuity Trust ("CLAT"), Grantor Retained Annuity Trust "("GRAT"), Qualified Personal Residence Trust ("QPRT"), and the Irrevocable Life Insurance Trust ("ILIT").

On tool, however, is extremely effective and unique--the Intentionally Defective Grantor Trust ("IDGT").  Despite the use of the term "defective", this trust has a tremendous capacity to allow for the maximization of wealth transfers to younger generations with minimal gift/estate taxes.

Not surprisingly, Mitt Romney (one of many politicians) has benefited greatly from the implementation of an IDGT.

From the San Fransisco Chronicle:

Romney’s vehicle is known as an “intentionally defective grantor trust” or by the acronym IDGT -- hence the nickname: “I Dig It.” Such trusts permit donors to give potentially unlimited amounts to children free of estate and gift taxes.

Here’s how they work: the person setting up the trust, like Romney, contributes assets such as an interest in a fund or shares in a company. If he makes that contribution before those assets appreciate -- particularly when they are privately held and difficult to value -- he can claim the gift tax obligation is low or non-existent since the declared value is low or zero.

If the trust generates any income -- such as by selling stock -- the eventual tax bill is the responsibility of Romney, not the trust. By paying the capital gains tax, which was 20 percent in the late 1990s and is now 15 percent, he can avoid depleting the funds in the trust -- in essence making an additional donation that’s free of gift taxes.

That benefit in particular makes this type of trust “a more powerful driver of wealth transfer in estate planning than almost anything else,” ....

Gift Tax Appraisers--The Potential Bottleneck For Year End Gifts

Currently, federal law provides a lifetime gift tax exemption of $5.12 million, per person.  If Congress takes no action, beginning 2013, the exemption will drop to just $1 million.

Because of this impending change in the gift tax exemption, alot of estate planners are recommending that their clients make significant gifts of assets, real property and business interests to their children and grandchildren. 

However, appraisers, in particular those that specialize in valuation discounts for gifts of business interests, are getting swamped with requests.  Often the turn around time of one to two months is being doubled.  While a gift tax return for a 2012 gift won't be due until April of 2013, it is preferred to know that exact value of the gifted interest to maximize planning opportunities.

What's the FMV of artwork that cannot be sold? IRS says $65 million

From the NY Times:

The object under discussion is "Canyon," a masterwork of 20th-century art created by Robert Rauschenberg that Mrs. Sonnabend’s children inherited when she died in 2007.

Because the work, a sculptural combine, includes a stuffed bald eagle, a bird under federal protection, the heirs would be committing a felony if they ever tried to sell it. So their appraisers have valued the work at zero.  But the Internal Revenue Service takes a different view. It has appraised “Canyon” at $65 million and is demanding that the owners pay $29.2 million in taxes.

...

At the moment, tax experts note that the I.R.S.’s stance puts the heirs in a bind: If they don’t pay, they would be guilty of violating federal tax laws, but if they try to sell “Canyon” to zero-out their bill, they could go to jail for violating eagle protection laws.

Mr. Lerner said that since the children assert the Rauschenberg has no dollar value for estate purposes, they could not claim a charitable deduction by donating “Canyon” to a museum. If the I.R.S. were to prevail in its $65 million valuation, he said the heirs would still have to pay the $40.9 million in taxes and penalties regardless of a donation.

Then, given their income and the limits on deductions, he said, they would be able to deduct only a small part of the work’s value each year. Mr. Lerner estimated that it would take about 75 years for them to absorb the deduction.

“So my clients would have to live to 140 or so,” he said.

NY Times: Wealthy Turn to Family Limited Partnerships

New York Times:  In an Unusual Tax Year, the Wealthy Turn to Partnerships:

A Family limited partnership was once a rather esoteric way for wealthy families to centralize the management of real estate and various pots of money. But this is not a normal tax year.

The arcane device has suddenly become popular because of the scheduled expiration of the $5.12 million gift tax exemption at the end of this year. ... But wealth advisers cautioned that the rush to set up a partnership in order to use the tax break could lead families to do something that is not right for them.

For some families, a partnership is attractive. It is a way to combine money to reach the higher investment requirements that hedge fund and private equity managers require. But its most alluring feature may be the ability to discount the value of the assets put into the partnerships because the shares distributed from it are less liquid since only another family member can buy them.

A discount of 25% generally does not attract scrutiny from the IRS, and that could allow someone to increase a $5.12 million gift exemption to $7 million. Since the partnerships are not overly expensive to administer, several advisers said they have seen people starting them with as little as $2 million. But affluent families on the lower end of that range also risk running afoul of the IRS by being too aggressive in what they put into a partnership and how much they discount it. As families look for ways to get the most out of this year’s gift tax break, many of the advisers I spoke with said they were worried that less sophisticated families would be misled into thinking that they could put everything they had into a family limited partnership and never worry about taxes.

 (See also Family Limited Partnership Video Presentation)

Do My Gifts of Limited Partnership Interests Qualify for the Annual Exlusion?

Under current law, a person has a right to give away $13,000 of assets to as many people as they see fit--free of gift tax.  This is commonly referred to as the "annual exclusion". 

One question that has developed over the years has been whether annual gifts of a family limited partnerships are eligible to qualify for the annual exclusion.  The hiccup was that in order to be considered a gift eligible for the annual exclusion, the gift has to be a gift of a present interest, and not just some future right or benefit. (Reg. 25.2503-3(b).)  The courts have held that in order to qualify as a present interest, the gift must confer a present economic benefit by reason of the use, possession, or enjoyment  i) of property or ii) of income from the property.

The tricky part with gifts of family limited partnership interests is that most of their partnership agreements provide restrictions on transfers--so as to ensure the business interests remain in the family.  The only problem is that the courts view these transfer restrictions as precluding the donees from having the right to use or enjoy the interest in a meaningful way.  Thus, courts are left to consider whether there is income that is of use or benefit to the donee.

The recent case of the Estate of George  H. Wimmer, TC Memo 2012-157, recently considered such a question and reiterated that for gifts of limited partnership interest to qualify for the annual exclusion under the argument that the donee received income, they must prove three things:

1. That the partnership would generate income,
2. That some portion of the income would flow steadily to the donees, and
3. That a portion of the income could be readily ascertained. 

Often, partnership agreements contain language granting the general partners full discretion as to whether or not distributions will be made to the partners--which would not appear to satisfy the second requirement.  In Wimmer, the Court noted that the general partners owed fiduciary duties to the donee limited partners, and that because the donee limited partners were actually irrevocable trusts, the only way such trusts would be able to pay their share of income tax would be for the partnership to make a distribution of income.  Based on these unique facts, the court held that the income would in fact flow steadily to the donees.

In short, before deciding whether to make annual gifts of family limited partnerships, the partnership agreement should be read carefully so as to ensure that it contains language that will ensure such gifts will be treated as present interests and eligible for the annual exclusion. 

Formula Value Gifts--How to Make a Gift That is Essentially Audit Proof

"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.

Family Limited Partnerships Video Presentation

So I've toyed with the idea of creating short videos discussing various estate and tax planning techniques for quite some time.  I'm more of a visual learner myself and so I tried to figure out if I could create a video that would visually convey some key aspects of the various planning opportunities that are available.  My first video discusses how family limited partnerships can be used to transfer value in a business to your children while still retaining control and how to reap some pretty generous gift and estate tax benefits along the way.  The video is below.  I realize the production quality is a little low-grade but considering it's my first in a series, I think it's not too bad.