In this federal gift tax case, the Tax Court, in a memorandum opinion, upheld the taxpayer’s position regarding the respect to be given a defined value gift clause. The case is appealable to the U.S. Fifth Circuit Court of Appeals.
In Hendrix, yet another John Porter and Baker Botts success, John and Karolyn Hendrix transferred, partially by net gift and partially by sale, non-voting common shares of John H. Hendrix Corporation, a closely held Texas corporation. The shares were transferred by formula, which read as to one of the transfers as follows:
a. that portion of the Assigned Shares having a fair market value as of the Effective Date equal to $10,519,136.12 is assigned to Michael L. Klein and Leslie H. Wood, as trustees of the John H. Hendrix Issue GST Trusts, to be held in equal shares for the John H. Hendrix Issue GST Trust for Leslie H. Wood, the John H. Hendrix Issue GST Trust for Kristin L. Hendrix, and the John H. Hendrix Issue GST Trust for Karmen M. Hendrix; and
b. then, any remaining portion of the Assigned Shares is assigned to the [Greater Houston Community] Foundation, for the benefit of the John H. Hendrix Family Fund.
Therefore, since the family transferees were obligated to pay all gift tax arising out of the transfers, the amount of each family gift was the value of the shares transferred, less the principal amount of the notes, less all gift taxes. The formula gift allocated all excess value to the foundation. The shares were appraised in connection with the transaction, and the per share value reached by that appraisal was $36.66.
While the foundation, which was represented by competent counsel, did not authorize a full-blown appraisal (although it clearly had the right to do so), it did authorize an appraiser to review the appraisal, and that review indicated agreement with the methods and results of the appraisal. Approximately five months after the transactions, family donees and the foundation entered into a confirmation agreement, which formally divided the shares amongst themselves. The taxpayers were not involved in the confirmation agreement.
In the Tax Court, the parties stipulated prior to trial that the per share value of the shares was $48.60. The taxpayers took the position that the excess value created by the stipulated value accreted to the foundation, thereby increasing the gift tax charitable deduction. Not surprisingly, the IRS took the position that the taxable gifts to the family donees increased substantially. In response to the taxpayer’s position that the stipulated value simply passed to the foundation, the IRS argued that the charitable deduction is only available for amounts actually paid to charity. Since the foundation essentially forfeited its rights to an additional allocation of shares pursuant to the formula, no increased charitable deduction beyond that as to the shares that the foundation actually received should be permitted.(1)
The IRS also argued that the charitable transfers were “an incidental, but necessary aspect of the transaction.”(2) I wonder why this is an issue at all in light of the mountain of evidence presented at trial that the taxpayers had exhibited significant charitable intent and involvement. As such, I believe that this argument is nonsensical and contrary to the facts of the case.
In Hendrix, the IRS attempted to make much out of its allegations that neither the original assignments nor the confirmation agreements were confected at arm’s length and specifically alleged that the Foundation somehow was not acting at arm’s length because it failed to obtain a full-blown appraisal of the units prior to accepting the assignments or the confirmation agreements. The IRS unbelievably went so far as to accuse the Foundation of being selected because it was “ willing to work with [the taxpayers] in their aggressive tax avoidance scheme….”(3)
The facts are that the Foundation was represented by competent tax counsel, and that the Foundation made a judgment call that, in light of the value of the gifts to it, a review of the appraisal by a qualified business valuation professional would satisfactorily protect its interests and satisfy its due diligence needs. I submit that the business judgment rule should apply, such that the Foundation clearly acted at arm’s-length with the trusts.
Enter the Tax Court!
The first news that the opinion gave the IRS was a harbinger of things to come. The Tax Court shifted the burden of proof to the IRS. The Tax Court determined that the case was to be determined in significant part by the Fifth Circuit (the circuit to which any appeal would lie) in McCord. The two issues outside of McCord were the IRS arguments that either the formula clause was not the product of an arm’s-length transaction or was void as contrary to public policy. The Tax Court found against the IRS on both scores.
It is impossible to speculate what took the Tax Court so long to issue its decision in Hendrix. The Hendrix case will be appealable to the Fifth Circuit, which, in view of the McCord decision, does not, in my opinion, portend well for the IRS. Clearly, the facts were against the IRS. It is inexplicable that they even chose this one to litigate.
The opinion underscores the importance of doing everything correctly and above board.
Hendrix v. Comr., T.C. Memo 2011-133; Succession of McCord v. Comr., 461 F. 3d 614 (5th Cir. 2006), revg. 120 T.C. 358 (2003); Comr. v. Procter, 142 F. 2d 824 (4th Cir. 1944).
1 Contrast this to the government’s position in Petter, where, on appeal, the government argues that no charitable deduction should obtain, even as to the original units transferred to charity, citing Treas. Reg. Sec. 25.2522(c)-3(b)(1).
2 Respondent’s Answering Brief, p. 62.
3 Respondent’s Answering Brief, p. 85.