Presenting a live 90-minute webinar with interactive Q&A Structuring Defined Value Clauses in Trust Transfers: Formula Allocations and Price Adjustment Clauses TUESDAY, JULY 19, 2016 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: Paige K. Ben-Yaacov, Partner, Baker Botts , Houston Jonathan J. Rikoon, Partner, Loeb & Loeb , New York Patrick J. Duffey, Attorney, Holland & Knight , Tampa, Fla. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 . NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no longer permitted.
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Background Client wants to transfer hard-to-value assets to beneficiaries • Assets selected for growth potential compared to current appraised value • Some of that is due to real business potential but with a trade-off in volatility and risk • But some of it may be due to a depressed valuation: • Market conditions • Special risks and exposures – regulatory, tax environment. • Closely held business interest with no control or marketability 5
The Problem – What If the IRS Disagrees on Value? • A plain gift may generate unexpected gift tax cost • A GRAT avoids the gift tax risk but: • Mortality risk – all in estate if grantor does not survive term • Liquidity risk – GRAT has rigid formula for paying annuity • Not readily available for generation-skipping planning • A leveraged (installment) sale to a grantor trust can reduce gift tax cost without the mortality or liquidity risk of a GRAT. • But the risk of additional gift tax remains unchanged (same as a gift) and unaffected by the leverage of the installment note. • Exception to the extent use of the note saves gift tax exemption to be available as an audit cushion 6
Can a Formula Save the Day? • We know formulas work in some contexts: • Marital deduction/credit shelter legacies • GST exemption legacies • Disclaimers • Size of annuity/unitrust amount for charitable split interest trusts (CLATs, CLUTs, CRATs, CRUTs) • Why not just give (or sell) so much of the asset as is worth $X (e.g., gift tax exemption), whatever percentage that turns out to be? • Alternative: formula allocation clause – transfer entire asset but allocate the transfer between completed-gift transferee (by gift or sale) and non-taxable transferee. • Or, sell the asset (or X% of it) for a price equal to its fair market value, whatever that turns out to be? 7
No Surprise: IRS Hates Formula Clauses in Gifts or Sales • Public Policy (takes away incentive to audit, requires courts to decide moot cases) • Technical arguments (condition subsequent: gift is already complete by the time clause kicks in) • Potential for gamesmanship or collusion • Encourages overly aggressive appraisals – no down side? • IRS won some early cases but has been losing lately as practitioners learn lessons 8
Procter v. Comm'r (4th Cir. 1944) Have to understand what DOESN'T work to structure something that DOES work Remainder Interest * Mr. Procter Children If any portion of transfer results in gift tax, property automatically excluded from transfer * Clause provided that any "excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance. . . ." 9
First Clause That Did Not Work – Procter (4 th Cir. 1944) • Trust document said that if a court later determines that any part of this transfer is subject to gift tax, then that portion “shall automatically be deemed not to be included in the conveyance . . . and shall remain the sole property of” the transferor. • Court: that’s a condition subsequent and the gift was already made and taxable before we rule, too late to reverse gift. • Violates public policy; “trifling with the judicial process.” • Discourages collection of tax. • Decision of court would deprive the court of jurisdiction: once the final judgment fixes the gift tax liability, the gift (and the tax) disappears. • End-run around the prohibition on declaratory judgments for tax cases. 10
Ward v. Comm'r (T.C. 1986) Stock * Wards Sons Assignment provided for "adjustment" to number of shares of stock transferred based on values as finally determined for gift tax purposes * Clause provided that "if it should be finally determined for Federal gift tax purposes that the fair market value of each share . . . exceeds or is less than [$2,000 or $2,300, respectively] an adjustment will be made in the number of shares constituting each gift . . . ." 11
Proctor Followed (For a While at Least) • Ward (TC 1986) • Gift of 25 shares of closely held stock, with the number of shares of the gift to be adjusted if the finally determined fair market value is other than $2,000/sh, such that each gift turns out to be $50,000. • Donors argued they intended to give $50,000 worth of stock and the 25 shares was just “representative of the value.” But that’s not what the documents said. • 2 of 3 Proctor public policy arguments still applied: no incentive for IRS to challenge valuation, and the donor cannot be compelled “to reclaim a portion of the property” which would thus escape gift and estate taxation. • Distinguishes King (below) as an arms-length sale, no donative intent; plus in King the clause “operated to insure that no unintended gift was made” while here the agreement “purports to retroactively alter the amount of an otherwise completed gift.” • Q: Does that mean if the gift had indeed been “so much stock as is worth $50,000” it would have been OK? Form over substance – but a critical drafting point. 12
McClendon v. Comm'r (TCM 1993) Sale of remainder interest for annuity* Taxpayer Son and Trust * Formula stated that if value "changed through a settlement process with the Internal Revenue Service, or a final decision of the United States Tax Court, the purchase price hereunder shall be adjusted accordingly ." 13
Proctor Followed (For a While at Least) • McLendon (TC 1993) • Private annuity sale agreement in closely held business provided for adjustment of fixed dollar purchase price if final gift tax valuation differs from appraisal. • Analysis closely follows Ward . • Q: If the sale price had been a King- style “whatever the fair market value is” formula rather than a fixed dollar price to be subsequently adjusted, would that have been OK? 14
King v. U.S. (10th Cir. 1976) Sale of specific number of shares of stock Trusts for Mr. King children at $1.25/share* * Formula stated that "if the fair market value . . . as of the date of . . . [the agreement] is ever determined by the Internal Revenue Service to be greater than the fair market value determined in the . . . manner described above, the purchase price shall be adjusted to the fair market value determined by the Internal Revenue Service." 15
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