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Tax court rules on formula clause case

The United States Court of Appeals for the Fifth Circuit recently upheld the Tax Court’s ruling in the Nelson v. Commissioner case. On the surface this may appear to be a win for the IRS, and for the Nelsons it probably feels that way, but let’s dive a little deeper into the facts and circumstances. The two most pertinent issues to this case revolve around the use of a formula clause and the determination of the fair market value of the interests gifted.

The first issue – the formula clause, may strike fear in some estate planning attorneys. The use of these clauses seems to always be subject to IRS scrutiny, but the most well-known case (Wandry v. Commissioner) from 2012 favored the taxpayer. So what went wrong in Nelson? The transfer agreement is what went wrong.

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The agreement states that [Mary Pat] desires to make a gift and to assign to [the trust] her right, title and interest in a limited partner interest having a fair market value of Two Million Ninety-Six Thousand Dollars ($2,096,000) as of December 31, 2008 (the “Limited Partner Interest”), as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.”

Based on an appraisal of $341,000 for a 1% limited partner interest, the attorney used percentages of 6.14% for the gift and 58.65% for a subsequent sale in the company’s records, amended partnership agreement and the Nelson’s gift tax returns.

Under IRS audit, a higher value was proposed by the IRS for a 1% interest. The Nelsons argued that even if the valuation was adjusted, that they had sought to transfer specific dollar amounts through a formula clause and therefore a reallocation of interests was necessary.

The Tax Court found that the transfer documents did not contain language for a valid formula clause and could not support reallocation. The court found that the percentages were fixed once the valuation was complete based on the wording contained in the transfer documents. The appeals court affirmed this finding. Per the appeals court, the use of the language as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment, “expressly qualifies the definition of “fair market value” for the purposes of determining the interests transferred.”

The appeals court further stated that “most formula-clause cases featured transfer instruments that defined the interests transferred as the fair market value as determined for federal-gift or estate-tax purposes”. The appeals court also noted the need for specific language regarding what should happen to additional shares should the valuation change. The Nelson transfer agreement lacked any such language.

While a loss for the Nelsons, the ruling can serve as significant guidance regarding the writing of formula clauses.

Some good news:

The Tax Court in the case determined a value of the shares gifted using both the petitioner’s and the respondent’s expert reports. The Limited Partnership from which interests were gifted/sold owned a 27% interest in a corporation. Judge Pugh of the tax court accepted the petitioners’ expert use of both a lack of control discount and a lack of marketability discount in determining the value of the 27% interest in the corporation. The judge adjusted the lack of control discount from 20% to 15% but the lack of marketability discount remained at 30%.

With regards to the interest in the limited partnership which owned the 27% interest, Judge Pugh applied a 5% lack of control discount and a 28% lack of marketability discount.  There appears to be no discussion questioning the application of the tiered discounts. The door may have been opened for the consideration of multi-tiered discounts.

The appeals court affirmed the tax court’s gift tax deficiency but did not comment of the ultimate valuation conclusion or the use of the tiered discounts.

If you have any questions on this subject, please contact your Henry+Horne advisor.

Melissa E. Loughlin-Sines, CPA, CFE, CVA, CFF, ABV

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