A Huge Taxpayer Win in Favor of Formula Clauses

Demystifying Valuation, Economic Damages + Forensic Accounting

A recent U.S. Tax Court case (Wandry v. Commissioner, T.C. Memo 2012-88, March 26, 2012) highlights the usefulness of formula clauses in gift transactions. The taxpayers, husband and wife, made gifts to their children and grandchildren of interests in a family limited liability company. Their tax attorney advised them to make all gifts as a specific dollar amount, rather than a specific number of LLC units or a specific percentage interest

The gift document provided the following terms:

“I hereby assign and transfer as gifts…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:”   

The document specified the dollar amount of the gifts to their four children and five grandchildren in amounts totaling the annual exclusion and the lifetime exemptions of $11,000 and $1,000,000, respectively. The document also contained an adjustment clause consistent with transferring a specific dollar amount and, in the event the units are revalued by the IRS, a subsequent adjustment of the number of units transferred.

The attorney also advised that if a subsequent revaluation of the LLC units occurred, no LLC units would be returned. Rather, accounting entries would reflect the reallocation of each member’s LLC units to conform to the actual gifts.

Upon audit, the IRS and the taxpayer agreed that the value per LLC unit was greater than the amount reflected in the original appraisal. The IRS sought to impose gift tax on the additional value per LLC unit for a gift of fixed percentage LLC units. The taxpayers’ argued that they made gifts of specific dollar amounts.

The IRS made various arguments all of which the Tax Court rejected. The taxpayers never attempted to revalue the gifts and believed they made gifts of specific dollar amounts. The capital account records do not change the nature of the gifts. Each donee was entitled to receive a predefined number of LLC units expressed as a formula; the formula had only one unknown (value per Unit); both before and after the IRS revaluation each donee was entitled to the same interest; and, the revaluation resulted only in the donees receiving the interest to which they were entitled.

The Tax Court also noted that the IRS’s role is to enforce tax law, not maximize tax receipts. There were competing interests in place to solve the valuation question. Any judgment would not undo any of the gifts, only reallocate the capital accounts. Therefore, it also rejected the public policy argument.

Consider using a formula clause for gifts of equity interests in family limited partnerships and other business equity interests. This may be a powerful tool to maximum the use of current lifetime exemption of $5,000,000, while it still exists.

Steve Koons, CPA, ABV, ASA, CFF