Using Formula (Defined Value) Provisions

2021-8

Formula (defined value) provisions have been used in trusts and estates for many years beginning with the creation of an estate tax marital deduction in 1948.  In recent years, their use also involved gift dispositions where the gift’s value was uncertain.  The most recent case was Nelson v. Comm’r, 17 F.4th 556 (5th Cir. 2021), aff’g T.C. Memo. 2020-81.  The Fifth Circuit opinion cites many of the prior cases, including Tax Court cases which were previously discussed in Practical Drafting. 

Mr. and Mrs. Nelson (Mary Pat and James) had four daughters.  They formed a limited partnership, Longspar Partners, Ltd., in 2008.  The general partners were Mary Pat and James, each with a .5 percent general partnership interest; the limited partners were Mary Pat and several trusts and accounts that had been created for their daughters.  The major asset of the partnership was shares of stock in Warren Equipment Company, a holding company for several businesses created by Mary Pat’s father.  Mary Pat and James also formed a trust in 2008.  She was the settlor and he was the trustee.  The beneficiaries were James and the four daughters.  In 2008 and 2009, Mary Pat transferred her limited partnership interest in Longspar to the trust in two separate transactions, one a gift and then a sale.  The transfer agreement for the gift provided:

[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 AND NO/100THS DOLLARS ($2,096,000.00) 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.

The agreement for the sale used similar language transferring “a limited partner interest having a fair market value of $20,000,000” and providing for a determination by appraisal within 180 days.

The circuit court opinion described additional facts as follows:

As called for by the transfer documents, Mary Pat and James (through their attorney) contracted with an accountant to appraise the value of a 1% limited partnership interest in Longspar.  On September 1, 2009 (outside of the time period required by each transfer document), the accountant provided a report valuing a 1% limited partner interest in Longspar at $341,000.  The Nelsons’ attorney then used the fair market value as determined by the accountant to convert the dollar values in the transfer agreements to percentages of limited partner interests — 6.14% for the gift and 58.65% for the sale.  Those percentages were then listed on Longspar’s records, included in Longspar’s amended partnership agreement, and listed on the Nelsons’ Form 709 gift tax returns.

The IRS audited the gift tax returns and issued substantial gift tax deficiencies for 2008 and 2009.  The Tax Court rejected the Nelson’s contention that the value of the gifts could be adjusted to the values finally determined for gift tax purposes.  The opinion stated:

When determining the amount of gift tax, if any, that applies to a transfer, the nature of that transfer is ascertained by looking to the transfer document and its language, rather than subsequent events.  Succession of McCord, 461 F.3d at 626-27; Est. of Petter v. Comm’r, T.C. Memo.2009-280, 2009 Tax Ct. Memo LEXIS 285, at *36 (citing Ithaca Tr. Co. v. United States, 279 U.S. 151, 155 (1929)), aff’d, 653 F.3d 1012 (9th Cir. 2011).  The language that the Nelsons used in the gift instrument stated that they were transferring:

[Mary Pat’s] right, title, and interest in a limited partner interest having a fair market value of TWO MILLION NINETY-SIX THOUSAND AND NO/100THS DOLLARS ($2,096,000.00) 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.

This additional (i.e., emphasized) language expressly qualifies the definition of “fair market value” for the purposes of determining the interests transferred.  By its plain meaning, the language of this gift document and the nearly identical sales document transfers those interests that the qualified appraiser determined to have the stated fair market value — no more and no less.

The specific qualification added by the Nelsons separates their agreement from the formula clauses considered in other cases.  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.  See Est. of Petter v. Comm’r, 653 F.3d 1012, 1015-16 (9th Cir. 2011); Est. of Christiansen v. Comm’r, 586 F.3d 1061, 1062 (8th Cir. 2009); Wandry v. Comm’r, T.C. Memo. 2012-88, 2012 Tax Ct. Memo LEXIS 89, at *4-5, nonacq., 2012-46 I.R.B. 543 (Nov. 13, 2012).  Those that did not defined fair market value through reference to the “willing-buyer/willing-seller” test that is used to define fair market value in the relevant Treasury regulation.  Succession of McCord, 461 F.3d at 619 (citing 26C.F.R. §25.2512-1 (2005)); Hendrix v. Comm’r, T.C. Memo. 2011-133, 2011 Tax Ct. Memo LEXIS 130, at*8.  The Nelsons defined their transfer differently; they qualified it as the fair market value that was determined by the appraiser.  Once the appraiser had determined the fair market value of a 1% limited partner interest in Longspar, and the stated dollar values were converted to percentages based on that appraisal, those percentages were locked, and remained so even after the valuation changed.

Additionally, this case is not like Succession of McCord, where the definition of fair market value was unqualified.  See McCord v. Comm’r, 120 T.C. 358, 419 (2003) (Foley, J., concurring in part and dissenting in part), rev’d sub nom. Succession of McCord, 461 F.3d at 614.  Instead, the transfer agreement specifically qualified fair market value by reference to the appraiser, rather than to a final determination or to gift tax principles.  Following the Nelsons’ reading of the clause would give effect only to the first part (referencing fair market value) and not the second (referencing a qualified appraiser).  Such a reading does not comport with the plain meaning of the language used.

Moreover, the transfer documents in every other formula-clause case contained crucial language that the Nelsons’ instruments lacked: specific language describing what should happen to any additional shares that were transferred should the valuation be successfully challenged. Some cases provided for excess interests to go to charity.

See Est. of Petter, 653 F.3d at 1016; Succession of McCord, 461 F.3d at 619; Hendrix, 2011 Tax Ct. Memo. LEXIS 130, at *8. Another case involved an instrument that stated that “the number of gifted Units shall be adjusted . . . so that the value of the number of Units gifted to each person equals the amount set forth above.”  Wandry, 2012 Tax Ct. Memo LEXIS 89, at *6.  The Nelsons’ agreements contain no such language.  Nothing in the agreements compels the trust to return excess units, or do anything with excess units, should the valuation change.  The fact that the trust did return excess units is irrelevant; that fact is the type of “subsequent occurrence[ ]” that this court has said was “off limits” when determining the value of a gift.  Succession of McCord, 461 F.3d at 626.

As the government well-analogized, if a farmer agrees to sell the number of cows worth $1,000 as determined by an appraiser, and the appraiser determines that five cows equals that stated value, then the sale is for five cows.  If a later appraisal determined that each cow was worth more, and that two extra cows had been included in the sale, nothing in the agreement would allow the farmer to take the cows back.  The parties would be held to what they agreed — a transfer of the number of cows determined by the appraiser to equal $1,000.  So too here.  No language in the transfer agreements allows the Nelsons to reopen their previously closed transaction and reallocate the limited partner interests based on a change in valuation.

While the formula-clause cases might give the appearance of reopening a transaction in just such a fashion, that is not the case.  A gift is considered complete, and thus subject to the gift tax, when “the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or the benefit of another.” 26 C.F.R. §25.2511-2(b) (2021).  For tax purposes, the “value . . . at the date of the gift shall be considered the amount of the gift.” 26 U.S.C §2512(a).  With a formula clause, the transaction is still closed even if a reallocation occurs.  That reallocation simply works to ensure that a specified recipient “receive[s] those units [he or she was] already entitled to receive.”  Est. of Petter, 653 F.3d at 1019.  Similarly, the value of the gift existed and could be determined at the time of the transfer.  “The number of . . . units” transferred is “capable of mathematical determination from the outset, once the fair market value[is] known.”  Id.  The reallocation clauses thus allow for the proper number of units to be transferred based on the final, correct determination of valuation.

The Nelsons did not include such a clause.  Instead, the trust has already received everything it was entitled to — the number of units matching the stated value as determined by a qualified appraiser.  Both parties agree with the Tax Court’s conclusion that the gift was complete, and that Mary Pat parted with dominion and control, on the date listed in each transfer agreement.  On those dates, Mary Pat irrevocably transferred the number of units the appraiser determined equaled the stated values.  No clause in the transfer documents calls for a reallocation to ensure the trust received a different amount of interests if the final, proper valuation was different than the appraiser’s valuation.  The percentage of interests was transferred on the listed dates, even if those percentages were indefinite until the appraisal was completed.  Cf. Robinette v. Helvering, 318U.S. 184, 187 (1943) (holding that a gift was complete even in the face of “indefiniteness of the eventual recipient”).  The gift tax is assessed as of the date of the transfer and on the value of those percentages, whatever that value may be.  Simply put, while the Nelsons may have been attempting to draft a formula clause, they did not do so.

The interpretation of the transfer documents is not changed by looking to any objective facts outside of the language the Nelsons used.  First and foremost, under Texas law, “extrinsic evidence may only be used to aid the understanding of an unambiguous contract’s language, not change it or ‘create ambiguity.’”  URI, Inc. v. Kleberg Cnty., 543 S.W.3d 755, 757 (Tex. 2018) (quoting Cmty. Health Sys. Pro. Servs. Corp. v. Hansen, 525 S.W.3d 671, 688 (Tex. 2017)). “If a written contract is so worded that it can be given a definite or certain legal meaning when so considered and as applied to the matter in dispute, then it is not ambiguous.”  Id. at 765.

Here, the transfer agreements are not ambiguous; the meaning of the language prescribing that an appraiser will determine the percentage of interests to be transferred is definite and certain.  “An ambiguity does not arise simply because the parties advance conflicting interpretations of the contract[;]” “for an ambiguity to exist, both interpretations must be reasonable.”  Columbia Gas Transmission Corp. v. New Ulm Gas, Ltd., 940 S.W.2d 587, 589 (Tex. 1996).  Given the clarity of the language of the contracts as written, the Nelsons’ interpretation is not reasonable as a matter of law; as stated earlier, that interpretation would read out the reference to the appraisal in its entirety.  “Surrounding facts and circumstances can inform the meaning of the language but cannot be used to augment, alter, or contradict the terms of an unambiguous contract.”  URI, 543S.W.3d at 758 (citation omitted).  The Nelsons’ reading, based on their subjective intent, would go beyond elucidating contractual language to changing and overriding it.  Texas contract law does not allow for that.

Even if the contracts are ambiguous, there are no objective facts or circumstances surrounding the transfer that counsel a different result.  Under federal gift tax law, “the application of the tax is based on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor.”  26 C.F.R. §25.2511-1(g)(1) (2021).  Texas contract law commands the same.  URI, 543 S.W.3d at 767 (“[T]he parol evidence rule prohibits extrinsic evidence of subjective intent that alters a contract’s terms. . . .”).  The evidence the Nelsons point to all concerns their subjective intent; we cannot look to what the Nelsons had in their minds when drafting the contracts.  Rather than subjective intent, it is “objective manifestations of intent [that] control, not ‘what one side or the other alleges they intended to say but did not.’”  Id. at 763-64 (citation omitted) (quoting Gilbert Tex. Constr., L.P. v. Underwriters at Lloyd’s London, 327 S.W.3d 118,127 (Tex. 2010)).  Objective considerations include the “surrounding circumstances that inform, rather than vary from or contradict, the contract text.”  Hous. Expl. Co. v. Wellington Underwriting Agencies, Ltd., 352 S.W.3d 462, 469 (Tex. 2011).

Nelson indicates the importance of focusing on the desired result.  If an adjustment is to be made in the price based upon a final valuation for gift or estate tax purposes, the formula disposition should state that desire.

The IRS reliance on Comm’r v. Procter, 142 F.2d 824 (4th Cir. 1944), in which the Fourth Circuit Court of Appeals determined that a provision reversing a gift transfer which would have produced a gift tax was invalid because it was against public policy.  The Tax Court and some appeals courts rejected the use of Procter and other arguments in the cases referred to in the quoted paragraph beginning “The specific qualification” on page 2 of this issue.  In many of these cases the instrument directed that if the IRS asserted that a tax was payable, the “increased” amount should pass to charity.  The courts held that the amount of the gift was fixed on the transfer date irrespective of whether part of the gift passed to charity. 

However, in Wandry, 103 TCM 1472 (2012), the facts were different because the amount of the gift did not include a “contingent” gift to charity and, as noted above, the IRS has nonaquiesced in the decision.  A “contingent” gift could also be made to a spouse which qualifies for a marital deduction, but it would potentially be subject to tax no later than the spouse’s death.

The Wandrys capitalized the LLC using the then lifetime gift tax exemption of $1 million and the then gift tax annual exclusion of $11,000.  They executed separate assignments and memoranda of gifts.  Each gift document stated:

I hereby assign and transfer as gifts, effective as of January 1, 2004, 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:

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.

On audit, the IRS increased the value of the LLC and asserted a deficiency.  It contended that the adjustment provision quoted above was ineffective and contrary to public policy.  The opinion said:

We have since invalidated other attempts to reverse completed gifts in excess of the Federal gift tax exclusions.  See Ward v. Commissioner, 87 T.C. 78 (1986) (invalidating a clause that provided for a retroactive adjustment to the completed transfer of a fixed number of shares of corporate stock to escape any imposition of gift tax); Harwood v. Commissioner, 82 T.C. 239 (1984) (giving no effect to a clause requiring an adjustment to a completed gift of an 8.89% partnership interest if it is “finally determined” for gift tax purposes that the gift was worth more than $400,000), aff’d without published opinion, 786 F.2d 1174 (9th Cir. 1986).

On the other hand, Federal Courts have held valid formulas used to limit the value of a completed transfer. See Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008) (holding valid a clause disclaiming a beneficiary’s rights to the value of her mother’s estate in excess of $6,350,000, with the disclaimed amounts going to charitable organizations), aff’d, 586 F.3d 1061 (8th Cir. 2009); Estate of Petter v. Commissioner, T.C. Memo. 2009-280; see also McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006) (holding that a gift is valued on the date of the gift and subsequent events are off limits, the Court of Appeals for the Fifth Circuit respected the plain language of a clause transferring partnership interests to the taxpayers’ children having a “fair market value” of $6,910,933; anything in excess of that up to $134,000 to a local symphony, and the remainder to a charity), rev’g 120 T.C. 358 (2003).

In King v. United States, 545 F.2d 700 (10th Cir. 1976), the Court of Appeals for the Tenth Circuit held for a taxpayer who used a formula similar to the one used in Procter.  The clause at issue in King adjusted the purchase price of a specified number of corporate shares sold from a taxpayer to trusts created for the benefit of his children if the IRS determined the fair market value of those shares to be different from that determined on the sale date.  Under the rule laid down in Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971), we must follow Tenth Circuit precedent.  However, we do not believe that King is squarely on point, and therefore we do not believe it is controlling in the cases at hand.  Most notably, the “price adjustment” clause in King provided for an adjustment to the consideration the trusts paid in the sale, not the stock transferred.  Further, because the transaction was a sale, and not a gift, the Court of Appeals did not address the public policy arguments.

In focusing on defined value provisions and the Petter case [discussed on pages 10621-10624 of the October 2011 issue and pages 9978-9982 of the January 2010 issue], the court said:

Respondent argues that the cases at hand are distinguishable from Estate of Petter.  Rather than transferring a fixed set of rights with an uncertain value, respondent argues that petitioners transferred an uncertain set of rights the value of which exceeded their Federal gift tax exclusions.  Respondent further argues that the clauses at issue are void as savings clauses because they operate to “take property back” upon a condition subsequent.

Respondent does not interpret Estate of Petter properly.  The Court of Appeals described the nature of the transfers and the reallocation provision of the clause at issue in Estate of Petter as follows:

Under the terms of the transfer documents, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula.  This formula had one unknown: the value of a LLC unit at the time the transfer documents were executed.  But though unknown, that value was a constant, which means that both before and after the IRS audit, the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the Taxpayer’s transfer was dependent upon an IRS audit.  Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive. * * *

Id. at 1023.

*     *     *

Absent the audit, the donees might never have received the proper Norseman percentage interests they were entitled to, but that does not mean that parts of petitioners’ transfers were dependent upon an IRS audit.  Rather, the audit merely ensured that petitioners’ children and grandchildren would receive the 1.98% and .083% Norseman percentage interests they were always entitled to receive, respectively.

It is inconsequential that the adjustment clause reallocates 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.

Under a heading “Public Policy” the court states:

Respondent argues that the public policy concerns expressed in Procter apply here.  We disagree.  As we have previously stated, the Supreme Court has warned against invoking public policy exceptions to the Code too freely, holding that the frustration caused must be “severe and immediate”.  See Commissioner v. Tellier, 383 U.S. 687, 694 (1966). In Estate of Petter v. Commissioner, T.C. Memo. 2009-280, we held that there is no well-established public policy against formula clauses.  The Commissioner’s role is to enforce tax laws, not merely to maximize tax receipts.  See Estate of Christiansen v. Commissioner, 586 F.3d at 1065.  Mechanisms outside of the IRS audit exist to ensure accurate valuation reporting. Id.  For instance, in the cases at hand the donees and petitioners have competing interests because every member of Norseman is entitled to allocations and distributions based on their capital accounts.  Because petitioners’ capital accounts were understated, the donees were allocated profits or losses that should have been allocated to petitioners.  Each member of Norseman has an interest in ensuring that he or she is allocated a fair share of profits and not allocated any excess losses.

With respect to the second and third Procter public policy concerns, a judgment for petitioners would not undo the gift.  Petitioners transferred a fixed set of interests to the donees and do not seek to change those interests.  The gift documents do not have the power to undo anything.  A judgment in these cases will reallocate Norseman membership units among petitioners and the donees.  Such an adjustment may have significant Federal tax consequences.  We are not passing judgment on a moot case or issuing merely a declaratory judgment.

In Estate of Petter we cited Congress’ overall policy of encouraging gifts to charitable organizations.  This factor contributed to our conclusion, but it was not determinative.  The lack of charitable component in the cases at hand does not result in a “severe and immediate“ public policy concern.

For a detailed criticism of Wandry, see Gerzog, Not All Defined Value Clauses are Equal, 10 Pitt. Tax Rev. 1 (2014).

Based upon shepardizing Wandry, other than Nelson, no defined value provisions have been litigated in reported cases.  From the IRS standpoint, litigation would, in general, be required in a court of appeals to overrule Wandry.  This may explain a reluctance by the IRS to pursue the matter further.  On the other hand, taxpayers desiring to use a defined value provision should pattern it after what was done in Wandry.  A possible reason for the reluctance of the IRS to test Wandry-like cases is that significant amounts of potential gift tax may have not been at issue. 

The primary issue now in an uncertain valuation case turns upon the amount of two discounts involved which are for a minority interest and for a lack of marketability.  Both of these discounts were involved in Smaldino v. Comm’r, T.C. Memo., 2021-127.  The Tax Court determined the value of a gift of 49 percent of the Class B membership interest in a limited liability company (LLC) to a trust for his children and grandchildren; experts testified for both the petitioner and the IRS.  The court held that the combined discount for lack of control and marketability was 36 percent, which was the same as the one suggested by the IRS expert and 2.43 percent less than the one suggested by petitioner’s expert.  Using Smaldino as a guide, the percentage combined discount should be in the range of 30-40 percent. 

Smaldino also discussed other valuation issues, including guaranteed payments and the effect of IRC Sec. 2701 which was enacted in 1990.  Smaldino is the first Tax Court case dealing with this provision and the amount of a taxable gift.  Petitioner contended that under IRC Sec. 2701, guaranteed payments rights are not to be disregarded in the valuation process.  The court stated:

Neither party has otherwise argued the applicability of chapter 14 to this case, and we surmise that petitioner does not mean to suggest that chapter 14 should apply to this case other than to support his favored treatment of guaranteed payments.  It is instructive, however, to consider the valuation methodology of chapter 14 more comprehensively.  For those situations in which section 2701 applies, the value of the junior interest transferred is generally calculated by subtracting the value of the senior interests (including rights to distribution of income or capital that are preferred to rights of the transferred interest) from the aggregate value of all family-held equity interests and then allocating the remaining value among the transferred interest and other interests of the same or junior classes. sec. 25.2701-3(b)(1) through (3), Gift Tax Regs.  The amount thus allocated to the transferred interest is then reduced to take into account minority and similar discounts, as appropriate. Id. subpara. (4); Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts, para. 136.2.8 (2021), Westlaw FTXIEG (describing subtraction method under section 2701).

We conclude that it is appropriate, in valuing the transferred class B units for gift tax purposes, to subtract from the LLC’s NAV (before applying any discounts) the value of the class A units retained by petitioner, including the value of his priority claims, i.e., the guaranteed payments; to then allocate the remaining value among the transferred and retained class B units; and to then apply appropriate minority and marketability discounts to the transferred class B units.  That approach is consistent not only with chapter 14 but also with this Court’s decision in McCord v. Commissioner, 120 T.C. at 376 — a case that did not involve the application of chapter 14.  McCord involved the valuation for gift tax purposes of gift class B limited partner interests in a limited partnership.  The class A limited partners’ sole economic interest consisted of a guaranteed payment for the use of their capital. Id. n.12.  In valuing the gift class B limited partner interests, the Court first subtracted from the partnership’s NAV (before applying any discounts) the class A limited partners’ priority claims against the partnership’s assets under the terms of the partnership agreement.  Id. at 376.

In keeping with this methodology, we agree with petitioner that the guaranteed payments should be taken into account in valuing the gift class B interests.  We are unable, however, to agree with Mr. Biedenbender’s [the petitioner’s] methodology in all respects. For one thing, as respondent points out, Mr. Biedenbender has not meaningfully explained why his calculation applies the risk-free AFR rate.  On brief, petitioner suggests that the AFR rate is appropriate because, he says, “[t]he guaranteed payment is payable in all circumstances, whether the LLC has cash flow or profit or not.”  Petitioner’s argument ignores, however, that under the terms of the operating agreement, if the LLC is unable to make any guaranteed payments because of insufficient funds, the class A voting member (i.e., petitioner) “shall promptly make Additional Capita! Contributions sufficient to enable the Company to make such payments on a timely basis.”  In effect, then, petitioner bore the risk of the LLC’s inability to make guaranteed payments because of insufficient funds.

Comment

In our next issue, changes in the tax legislation which is now before the Senate in H.R. 5376, known as The Build Back Better Act, will be discussed. 

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