Estate planners’ have long-sought a way to avoid IRS’ challenges to valuation of lifetime gifts or sales of hard-to-value property between family members. Wouldn’t it be nice to be able to sell or give that family business stock or family limited partnership interest to kids and grandkids or trusts for their benefit and be able to sleep easy, knowing that the IRS can’t successfully challenge your valuation?
Taxpayers have tried for decades to attain valuation nirvana – a way to inoculate a gift from valuation attack. Early approaches involved retroactive adjustment agreements, meaning that the donor and donee agree to adjust the gift based upon a successful IRS valuation challenge. For example, “I hereby give you 10 shares of family business stock that I think is worth $12,000. If the IRS ever successfully asserts that the shares had a higher value, you’ll give the excess back to me.” Suppose IRS later asserted a date-of-gift value of $18,000. The kids would give a third of the shares back. Alternatively, the kids might have agreed to pay the excess asserted value ($6,000) to the donor.
Advisors hoped the IRS wouldn’t even bother to examine the return because it would be frustrated from collecting any taxes. Sensing the frustration, the courts generally concluded that these agreements violate public policy by preventing the IRS from enforcing the gift tax. Result? Agreement ignored and tax extracted from the taxpayer. Consequently, most advisors have given up on retroactive adjustment clauses.
In more recent years, taxpayers have tried a different tact in their gift or sale agreements. “I hereby transfer 10 shares of family business stock. That portion of the shares having a value of $12,000 goes to my children. Any portion of the shares having a value ultimately determined to be in excess of $12,000 goes to my spouse.” The expectation is that the excess value, if the IRS bothers to assert it, passes gift-tax free to the spouse under the marital deduction.
Variations on this theme include having the excess pass to charity (sheltered by the charitable deduction) or to a zero-out GRAT (see my June 2006 column – transfers to these entities incur no taxable gift). Alternative, the gift is simply defined as “that number of shares ultimately determined to have a value of $12,000.”
In 2006, the Fifth Circuit Court of Appeals overturned the Tax Court and approved an agreement in which the excess value passed to charity. The facts were complex, but the court apparently was impressed that the charity made an effort to get its fair share. Thanks to the Court, the IRS got nothing.
Do They Work?
Frankly, the jury is still out on definitional clauses. IRS hates them with a passion, although agents have varying reactions in the field. I fully expect more court challenges.
In the meantime, do you have anything to lose by including some form of definitional clause? Some say the worst result is that the clause simply is ignored. You incur the same gift tax consequences that you would have had in the absence of the clause. In the meantime, it might deter an examination or ultimately be sustained by the courts as effective.
Perhaps, but the answer many not be so clear. I think the most likely to succeed is a clause in which some unrelated party (like a charity) actually fights to enforce the provision. Use that type and the charity might get more than you want or expect. Further, you don’t know who has how many shares for a very long time, if ever, depending upon when or whether the IRS examines the transaction. How do you deal with the resulting uncertainty? And, what happens if the IRS successfully ignores the clause? Aren’t you still bound to transfer the excess as the clause requires (e.g., to charity) even though you have to pay gift tax?
Don’t have the stomach for any of this but still want to transfer hard-to-value assets? Strangely, the IRS’ own regulations permit valuation adjustment language in GRATs. (Again, see my June 2006 column.) They’re certainly not perfect, but work well for the IRS phobic. Or, invest in a solid appraisal. Of course, the IRS is not bound by it, but it is the best defense for those who like to address issues head on rather than living with uncertainty.
Ross Nager is Senior Managing
Director of Sentinel Trust Company of
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