Joanne M. Wandry and Albert D. Wandry, Donor, Petitioner vs. Commissioner Of Internal Revenue, Respondent, Filed 3/26/12
John Walker, Chris D. Treharne, ASA, and John G. Mack, ASA[1]
In an important gift tax case involving transfers among family members, the Tax Court determined that transfers of closely-held business interests were specific dollar amount transfers rather than transfers of fixed percentage interests. Further, the court ruled that the Petitioners intent was not contrary to public policy and their transfer documents were not void for federal tax purposes.
TAKEAWAY
The Wandry ruling has the potential to be a landmark case that provides taxpayers and planners with exceptional guidance on the use of formula gifts between family members. The ruling also carefully identifies the differences between “defined value” and “savings” clauses.
THE FACTS
In August 2001, Albert D. Wandry (“Mr. Wandry”), Joanne M. Wandry (“Ms. Wandry”, collectively with her husband, the “Wandrys” or the “Taxpayers”) and their children formed an LLC with assets of cash and marketable securities. The cash and securities had previously been held in a limited partnership.
In both entities, the Wandrys’ tax attorney advised them of the following:
- make fixed dollar amount gifts rather than fixed percentage interests,
- the number of units equal to the dollar amount transferred could not be known on the date of transfer until a valuation could be performed, and
- so a mid-year closing of the entities’ books was not required, December 31 and January 1 valuation dates were advisable.
On January 1, 2004, the Wandrys executed nine separate assignments and memorandums of gifts, four to their adult children for units totaling $261,000 each, and five to grandchildren for units totaling $11,000 each. The gift documents were drafted by the Wandrys’ tax attorney and included the following clause:
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.
The Taxpayers believed the gifts were for specified dollar values, not percentage interests. Their tax attorney advised them that should a revaluation occur, no units would be returned to the Wandrys. However, the entity’s capital accounts would be adjusted to reallocate each member’s units to conform to the gifts.
The Taxpayers engaged an outside appraiser to value the January 1 gifts, which were valued at $109,000 per 1.0% interest. The Wandrys’ CPA filed their Form 709 gift tax returns, which described the gifts as 2.39% interests and 0.101% interests in the LLC. The percentage interests were derived from the dollar values of the gifts and the value determined by the appraiser.
Using the description of the gifts on Form 709, the IRS asserted the Taxpayers intended to transfer specific percentage interests of the LLC, the value of the percentage interests transferred exceeded the Wandrys’ gift tax exclusions, and the adjustment clause in the gift assignments were contrary to public policy (and therefore void for federal tax purposes).
DISCUSSION
The IRS audited the Wandry’s returns in 2006 and valued the respective interests at $366,000 and $15,400. However, prior to the start of the trial, the parties stipulated the value of the children’s interests to be $315,800 and the value of the grandchildren’s interests to be $13,346.
The IRS argued that the completed gifts of Norseman interests were in excess of the exclusion amounts and that gift tax and interest was payable. The IRS argued that the gifts were of specific interests in Norseman (2.39% and 0.101%) and not gifts of a specified dollar amount. The IRS pointed to the fact that the description of the gifts on the gift tax returns indicated the specified interests and the Norseman capital accounts had been amended to reflect the specified interests. The IRS also argued that the adjustment clause was a “condition subsequent” that did not reduce the gift value to the applicable exclusion limit.
After review of each of the IRS’s arguments, the Court determined that the description of the gifts did not show a specific intent to gift a percentage of Norseman, but instead showed the intent to gift $261,000 to each child and $11,000 to each grandchild. The Court also determined that the capital accounts were “unofficial and unreliable” because the capital accounts and the K-1s were not clear and did not control the gifted items and were deemed immaterial. Lastly, the Court determined that the gift documents did not state the specific percentages gifted. Under the Estate of Petter v. Commissioner, T.C. Memo 2009-280, a formula clause of indicating a specific value to family with a gift over to charity of excess amounts was upheld. The Court indicated that in the Wandry case, while there is no gift of excess value to charity like in Petter, the formula clause does not create a condition subsequent “to take property back” based on the valuation. The formula has only one unknown, the value of Norseman at the time of the transfer. Furthermore, while that value was unknown, it was a constant as the parties had agreed on the value. The Court determined that “it is inconsequential that the adjustment clauses reallocated membership units among petitioners and the donees rather than a charitable organization because the reallocations do not alter the transfers. On January 1, 2004, each donee was entitled to a predefined Norseman percentage interest expressed through a formula. The gift documents do not allow for petitioners to “take property back. Rather, the gift documents correct the allocation of Norseman membership units among petitioners and the donees because the K&W report understated Norseman’s value. The clauses at issue are valid formula clauses.”
CONCLUSION
Thanks to effective record-keeping and a clear history of consistent and competent estate planning advice, the Taxpayers’ use of a formula clauses was valid and enforceable.
Endnotes
[1] This article was excerpted from the following two sources: http://perkinsaccounting.com/wp-content/uploads/FCG-Valuation-Case-Eflash-14-1-Wandry-v-Commissioner.pdf and http://www.mackbusinessappraisals.com/images/Wandry%20Case%20for%20Website%20March%202012.pdf
