In this federal gift tax case, the Ninth Circuit unanimously affirmed the Tax Court’s determination that the taxpayer’s defined value gift clause was enforceable under state law and was to be respected for federal gift tax purposes.
Anne, a lifelong school teacher, inherited millions of dollars of then closely held stock in UPS. She lived a modest lifestyle, continuing to live in the same house after she inherited the UPS stock. She sought out estate planning assistance from a competent estate planner, who assisted her in the establishment of an insurance trust, a charitable remainder trust and a family LLC, together with some intentionally defective grantor trusts (“IDGT’s”). In the meantime, UPS went public, and the value of Anne’s stock roughly doubled in value.
Anne did a part-gift/part sale of her interests in the LLC to the intentionally defective grantor trusts, as follows:
- March 22, 2002: Anne gives the two IDGT’s LLC units equal to 10% of the value of the total LLC units to provide “seed capital” [Judge Holmes noted in a footnote that the estate planning attorney testified that he advised that this level of seed capital was required to meet the IRS “rule of thumb” for respect to the transaction]
- March 25, 2002: Anne sells the IDGT’s the remaining 90% of the LLC units
- At the same time, Anne also gave LLC units to two public charities.
- The division between the charities and the trusts was accomplished via formula as follows:
Transferor * * *
1.1.1 assigns to the Trust as a gift the number of Units described in Recital C above that equals one-half the minimum dollar amount that can pass free of federal gift tax by reason of Transferor’s applicable exclusion amount allowed by Code Section 2010©. Transferor currently understands her unused applicable exclusion amount to be $907,820, so that the amount of this gift should be $453,910; and 1.1.2 assigns to The Seattle Foundation as a gift to the A.Y. Petter Family Advised Fund of The Seattle Foundation the difference between the total number of Units described in Recital C above and the number of Units assigned to the Trust in Section 1.1.1.
1.2: The Trust agrees that, if the value of the Units it initially receives is finally determined for federal gift tax purposes to exceed the amount described in Section 1.1.1, Trustee will, on behalf of the Trust and as a condition of the gift to it, transfer the excess Units to The Seattle Foundation as soon as practicable.
There were similar clauses in the sale and pledge documents. Both trusts actually paid their note obligations. The charities were effectively represented by separate counsel. The transfers were appraised by a qualified appraiser. The transfers were fully disclosed with all of the documentation on Anne’s federal gift tax return.
Enter the Tax Court
On audit of the federal gift tax return, the IRS argued for a higher unit value than that opined by Anne’s appraiser. Additionally, the IRS argued that the defined value gift clause was unenforceable and violated public policy. Anne obviously disagreed.
In the Tax Court, Judge Holmes went through a history of the defined value gift/sale jurisprudence, beginning with Comr. v. Procter back in 1944 and continuing until the Eighth Circuit’s recent affirmance of the Tax Court (discussed by Steve Akers in LISI Estate Planning Newsletter, No. 1556) in Christiansen v. Comr. Judge Holmes made the following distinction in light of the jurisprudence:
A shorthand for this distinction is that savings clauses are void, but formula clauses are fine.
He then analyzed the transaction documents in order to determine what type of clause was included in those documents. The IRS also argued what Anne actually did was give an actual number of units instead of a formula gift. Judge Holmes disagreed with the IRS, noting:
The plain language of the documents shows that Anne was giving gifts of an ascertainable dollar value of stock; she did not give a specific number of shares or a specific percentage interest in the [LLC].
With respect to the public policy argument of the IRS, Judge Holmes also disagreed, noting:
And the facts in this case show charities sticking up for their interests, and not just passively helping a putative donor reduce her tax bill. The foundations here conducted arm’s-length negotiations, retained their own counsel, and won changes to the transfer documents to protect their interests. Perhaps the most important of these was their successful insistence on becoming substituted members in the [LLC] with the same voting rights as all the other members. By ensuring that they became substituted members, rather than mere assignees, the charities made sure that the [LLC] managers owed them fiduciary duties.
The opinion also addressed the other situations in the IRC and the Regulations where the IRS expressly blesses formula clauses, e.g., disclaimers, charitable remainder trusts and marital deductions. The opinion further held that the charitable deduction was properly taken on the date of the original transfer, March 22, 2002, even though there were subsequent revaluations and reallocations.
On appeal, the IRS raised the following points of contention:
- The transfers as originally computed pursuant to the original appraisal are not deductible pursuant to Treas. Reg. Sec. 25.2522©-3(b)(1);
- The “additional gifts” (as viewed in the eyes of the government) to the charities caused by the mutually agreed to revaluation of the LLC units also are not deductible pursuant to Treas. Reg. Sec. 25.2522©-3(b)(1);
- Treas. Reg. Sec. 25.2522©-3(b)(1) denies deduction of amounts that charities are not certain to receive;
- Christiansen Est. is not persuasive authority with respect to proper application of Treas. Reg. Sec. 25.2522©-3(b)(1);
- Christiansen Est. is wrong;
- The Tax Court ignored the IRS argument that Treas. Reg. Sec. 25.2522©-3(b)(1) applied to deny the gift tax charitable deductions;
- The Tax Court erroneously decided that the “additional gifts” (in the eyes of the government) were not subject to conditions precedent under Washington law; and
- The Tax Court erroneously decided that the defined value clauses were not contrary to public policy, i.e., a Procter/Ward argument.
- IRC Sec. 2001(f)(2) means that the amount shown on the tax return is correct unless the IRS conducts an audit, making it a condition precedent.
On appeal, the government asserted that the Tax Court ignored its argument that Treas. Reg. Sec. 25.2522©-3(b)(1) precluded the deduction for the “additional” LLC units.1 While the Tax Court in Petter did not expressly reference that section of the regulations, the government’s claim arguably misrepresents the truth, which was that the Tax Court expressly found that the transfers that Anne made were set back on the dates of the transactions (March 22 and 25, 2002), could not be undone and were not subject to any condition precedent.2 This finding arguably expressly adopted a finding by the Tax Court that Treas. Reg. Sec. 25.2522©-3(b)(1) was inapplicable on its face.
Enter the Ninth Circuit
In Steve Leimberg’s Estate Planning Newsletter, No. 1838, Steve Akers covered the oral arguments in Petter. The Ninth Circuit arguably telegraphed its ultimate decision through its comments during oral argument.
With respect to the IRS argument that the “excess units to the foundation” clause in the transaction documents left the gifts undefined when made, the Ninth Circuit directly stated:
We disagree. Although the reallocation clauses require the trusts to transfer excess units to the foundations if it is later determined that the units were undervalued, these clauses merely enforce the foundations’ rights to receive a pre-defined number of units: the difference between a specified number of units and the number of units worth a specified dollar amount. And that particular number of LLC units was the same when the units were first appraised as when the IRS conducted its audit because the fair market value of an LLC unit at a particular time never changes. Thus, the IRS’s determination that the LLC units had a greater fair market value than what [Anne’s] appraisal said they had in no way grants the foundations rights to receive additional units; rather, it merely ensures that the foundations receive those units they were already entitled to receive. The number of LLC units the foundations were entitled to was capable of mathematical determination from the outset, once the fair market value was known.
 Ultimately, the IRS argues that because the foundations would not have received the additional units but for the IRS audit, the additional transfer of units to the foundations was dependent upon a condition precedent. Adopting the IRS’s “but for” test would revolutionize the meaning of a condition precedent. [Emphasis added]
The Ninth Circuit deftly turned aside the IRS’s IRC Sec. 2001(f)(2) argument by pointing out the obvious: that the documents didn’t specify the value of an LLC unit. The Ninth Circuit further noted that the “court” in IRC Sec. 2001(f)(2) is broad enough to include a state court, and that the foundations clearly had a right under applicable state law (Washington) to contest the valuation.
The Ninth Circuit further determined that its holding-Treas. Reg. Sec. 25.2522©-3(b)(1) does not bar the charitable deduction for the units, “is consistent with” the Eighth Circuit’s decision in Christiansen Est. v. Comr. The Ninth Circuit politely refused the IRS’s request that Christiansen Est should be disregarded. Moreover, the Ninth Circuit expressly noted that the IRS had expressly abandoned its public policy arguments against defined value gifts, finding the above regulation to be clear and unambiguous. Finally, the Ninth Circuit invited the IRS to amend its regulations if it is troubled by the decision.
Congratulations to John Porter and his team for another slam dunk taxpayer victory! As I noted in my earlier commentary on this case, the transaction facts were, in my opinion, much stronger than the documents. I would have structured the documents much differently, but you cannot minimize or stress too much the need for the arm’s-length nature between the family and the charities. This case presents an absolute roadmap for how to organize and structure the transaction facts.
I argue that the government’s argument that Christiansen Est. was inapplicable because it involved Treas. Reg. Sec. 20-2055-2(b)(1), not Treas. Reg. Sec. 25.2522©-3(b)(1), is wrong pursuant to the maxim that the estate and gift tax regulations are to be read in pari materia3. Without saying so, the Ninth Circuit obviously agreed. Moreover, the government’s case on this point simply could not prevail by a simple comparison of the language of the two regulations subsections, which are set out in full below:
Treas. Reg. Sec. 25.2522©-3(b)(1). If, as of the date of the gift, a transfer for charitable purposes is dependent upon the performance of some act or the happening of a precedent event in order that it might become effective, no deduction is allowable unless the possibility that the charitable transfer will not become effective is so remote as to be negligible. [Emphasis added]
Treas. Reg. Sec. 20.2055-2(b)(1). If, as of the date of the decedent’s death, a transfer for charitable purposes is dependent upon the performance of some act or the happening of a precedent event in order that it might become effective, no deduction is allowable unless the possibility that the charitable transfer will not become effective is so remote as to be negligible. [Emphasis added]
The underlined language above presents the only differences between the two regulations subsections, which otherwise are identical. In my opinion, this totally undercut the government’s argument that Christiansen Est. is distinguishable because it involved the estate tax regulation instead of its gift tax regulation virtually identical “twin.” When one considers the fact that the same Tax Court judge (Judge Holmes) wrote both Christiansen Est. and Petter, I assert that one can make a very compelling argument that he considered virtually the same regulation expressly discussed in Christiansen Est. in Petter and expressly found it to be inapplicable. The Ninth Circuit agreed and noted the following:
The result that we reach—that Treasury Regulation § 25.2522©-3(b)(1) does not bar the charitable deduction at issue in this case—is consistent with the Eighth Circuit’s decision in Estate of Christiansen v. Comm’r, 586 F. 3d 1061 (8th Cir. 2009), which involved an estate tax regulation similar to § 25.2522©-3(b)(1). [Emphasis added]
Whichever side one takes about the applicability vel non of the pertinent regulations subsections to the facts in Christiansen Est. and in Petter, I argue that there exists absolutely no tax policy justification for different results under the two essentially identical regulations subsections. Since I believe that the result in Christiansen Est. is correct on the inapplicability of Treas. Reg. Sec. 20.2055-2(b)(1), it follows that I believe that the result in Petter also is correct on the inapplicability of Treas. Reg. Sec. 25.2522©-3(b)(1). The Ninth Circuit obviously agreed with me.
As the losses continue to mount up for the IRS, it is high time for the IRS to permit defined value gift transactions. In my opinion, it is time for a court to assess attorney’s fees under IRC Sec. 7430 against the IRS if it wrongheadedly persists in its erroneous losing position.
1 Brief for the Appellant, p. 29
2 Petter T.C. slip op at p. 43
3 See, e.g., Harris v. Comr., 340 U.S. 106 (1950).
Petter v. Comr., T.C. Memo 2009-290, aff’d No. 10-71854 (9th Cir. Aug. 4, 2011); Christiansen v. Comr., 130 T.C. No. 1 (2008), aff’d 586 F. 3d 1061 (8th Cir. 2009); McCord v. Comr., 120 T.C. 358, 364 (2003), revd. 461 F.3d 614 (5th Cir. 2006); Comr. v. Procter, 142 F. 2d 824 (4th Cir. 1944); King v. U.S., 545 F. 2d 700 (10th Cir. 1976); Knight v. Comr., 115 T.C. 506 (2000); Ward v. Comr., 87 T.C. 78 (1986); Harwood v. Comr., 82 T.C. 239 (1984); Rev. Rul. 86-41; and Hood, Defined Value Gifts and Sales Under the Microscope: What’s Possible and What’s Not?-Revisited, BNA Tax Management Estate, Gift and Trust Journal, July 14, 2011.