Making large gifts can be a challenge if they consist of illiquid, difficult-to-value assets, such as interests in a business or family limited partnership (FLP). They must be supported by a business valuation, and there’s a risk that the IRS will claim, years later, that a gift was undervalued for tax purposes.
A defined-value gift — which is essentially a gift of assets that equal a specific dollar amount, rather than a fixed percentage of a business or a set number of FLP units — protects against unexpected taxes down the road. Although the IRS has a distaste for defined-value gifts, in recent years some have been upheld by the U.S. Tax Court.
How does a defined-value clause work?
Let’s look at an example. Susan sets up an FLP to consolidate the management of her real estate holdings and other investments and to facilitate the transfer of fractional interests to her children while maintaining control. She transfers 30% limited partnership interests to each of her three children, retaining a 10% general partnership interest.
Susan hires a professional appraiser, who determines that the fair market value of the FLP’s assets is $5 million. The appraiser values each gift at $900,000 by taking 30% of $5 million ($1.5 million) and deducting a 40% discount for lack of control and lack of marketability. Assuming a 40% gift tax rate and an unused $1 million exemption (and ignoring the annual exclusion), Susan’s gift tax liability is $680,000.
Now, suppose the IRS challenged the valuation of the FLP interests and applied a discount of only 20%. In that case, each gift would be valued at $1.2 million, and Susan’s gift tax liability would jump to $1.04 million.
If Susan wants to limit her gift tax exposure and is charitably inclined, she could use a defined-value gift that provides for any excess value to go to a charity. Rather than give her kids 30% interests in the FLP, she would give each child a $900,000 interest.
If her valuation holds up, each child receives a 30% interest. But if the IRS limits the valuation discount to, say, 20%, each child receives a 22.5% interest. The remaining interest — also 22.5% [90% - (3 × 22.5%)] — goes to charity and, therefore, doesn’t trigger any additional gift tax liability. To avoid losing control of that interest, the FLP may be able to buy it back at fair market value.
How can it withstand IRS challenge?
Defined-value gifts require careful planning to withstand an IRS challenge. One reason the IRS doesn’t like them is that they allow a donor to “undo” a portion of a gift if it turns out to be taxable.
The U.S. Tax Court has sided with the IRS in some cases where a taxpayer used a defined-value clause to reverse completed gifts in excess of gift tax exemptions and exclusions. However, the court has drawn a distinction between a savings clause, which a taxpayer can’t use to avoid gift tax, and a formula clause, which is valid. Savings clauses are void because the taxpayer essentially tries “to take property back.” Formula clauses merely transfer a “fixed set of rights with uncertain value.” The pivotal question is just what the donor is trying to gift.
In one case, Wandry v. Commissioner, once the value of the entity was determined, the percentage interests in the entity were reallocated among the donor and donees in accordance with the specified dollar amounts. Therefore, the court concluded that the couple’s defined-value clause was a valid formula clause.
Notably, previous cases that upheld formula clauses generally involved clauses that reallocated interests among the donees, with any transfers in excess of the specified dollar amount going to a charity. According to the Tax Court in Wandry, however, it’s “inconsequential” that a clause doesn’t reallocate the units to a charity if the reallocations don’t alter the transfers.
A smart choice for your family?
Defined-value gifts can be a smart choice for families who intend to make large, hard-to-value gifts. But for them to work as planned, an attorney must draft the gift language carefully to ensure that it’s interpreted as a formula clause rather than a savings clause.
If you have any questions regarding this article, please contact Friedman LLP at firstname.lastname@example.org or 877-538-1670.