• Keeping the Farm in the Family: Gift Planning by Defined Valuation Clauses
  • June 6, 2014 | Author: George F. Bearup
  • Law Firm: Smith Haughey Rice & Roegge, P.C. - Traverse City Office
  • We regularly counsel our clients on their desires to keep the farm in the family. Farms tend to embody a lot of family history and hard work that their owners want to pass on to their kids and grandchildren. Although there are numerous ways to pass it on, one of the ways often contemplated is by a gift during the farmer’s lifetime, for many reasons including tax planning or to encourage family members to pursue farming as a profession and lifestyle. When giving a lifetime gift, it is critical that the gift transaction be properly documented and structured to prevent negative consequences, including taxes, interest and penalties.

    Farmland is often difficult to value, as it is a closely held business interest. The risk is that if the donor of such an asset is wrong in the reported value of the gift, the IRS on audit can assess additional gift taxes, interest, and perhaps an understatement of gift tax penalty. Thus, when farmland or a closely held business interest is the subject of a gift or sale, serious consideration should be given to the use of a defined valuation clause, which has the effect of preventing unexpected gift tax liability arising on an IRS audit.

    The IRS has historically viewed with hostility the transfer of assets, particularly farmland and closely held business interests, when the donor uses a value adjustment clause to document that transfer. However, the 2012 Tax Court decision (Wandry) formally upheld a defined value gift of a closely held LLC that was subsequently challenged by the IRS on audit.

    For many years, donors tried to use value allocation formulae by which assets were allocated at a certain value to the donee; if the value was subsequently successfully challenged by the IRS on audit, part of the transferred assets would be shifted elsewhere (e.g., to a donor advised fund or charity), which would not result in a gift tax owed. These transfer clauses were structured so that any amount of a gift in excess of a specified amount was instead transferred to an entity that was not subject to a gift tax, like a charity, or to the donor’s spouse, which would qualify for the federal gift tax marital deduction. The IRS was quick to challenge these formula allocating gifts claiming they were contrary to public policy. The IRS claimed that the formula frustrated its ability to collect taxes - its view of public policy!

    But along came Wandry, which successfully structured the lifetime gift in a slightly different manner. A value definition clause does not operate to subsequently reduce or increase the size of a gift, or the amount of consideration that is paid for the purchase of a hard to value asset. Rather, excess value beyond a certain dollar amount remains with the donor. Restated, there is no subsequent “shift” of part of the transferred asset to another. An example of a value definition clause is the following:

    I transfer to the Trustees of the Trust that I established for my children a fractional share of property that is listed on Schedule A to this transfer instrument. The numerator of that fraction is $5.34 million dollars. The denominator of that fraction is the value of such property as finally determined for federal gift tax purposes after audit by the IRS, or in judicial proceedings that challenge the transferred property’s value.

    This clause will always produce a gift that is $5,340,000, currently the largest federal gift tax exemption available to a donor. If the IRS values the transferred property at $8 million, then only 66.75% of the property will be transferred to the donee, which produces a gift of $5,340,000 covered by the donor’s then available federal gift tax lifetime exemption.

    In light of the Wandry case, serious consideration should be given to the use of a value definition formula gift rather than estimating the value of the gift coupled with the hope that the reported value is sustained on a subsequent IRS audit. However, relying upon a value definition clause is not a complete safe harbor. The Wandry decision is only a Memorandum Decision of the Tax Court, which is given less weight than a regular decision of that Court. Moreover, the IRS subsequent to the Wandry decision, announced its “non-acquiesence” with that result. [IRS Announcement 212-46 IRB 3] But with those risks known, reliance upon a value definition clause should allow a donor to transfer a set dollar amount of an interest in illiquid or a hard-to-value asset without having to worry about potential gift tax liability arising from an IRS audit.

    Because of the nature of the formula, which is dependent upon whether the value is accepted by the IRS, it is sometimes better to transfer the hard-to-value asset to a Trust which is classified for federal income tax purposes as a grantor trust, for which the transferor is required to pay the income tax. The income tax reporting issues that cause administrative headaches in the years that follow the use of a defined value gift (How much was actually transferred? How much was actually retained by the transferor?) can be alleviated if the beneficiary of the gift is a grantor trust, where all of the income derived from the transferred interest will be allocated to the donor no matter how the interest is ultimately determined to be owned between the donor and the donee.

    Once the three year IRS statute of limitations on IRS audits passes, the grantor trust classification can then be terminated, thus causing all future income derived from the gifted asset to be taxed either to the Trust or to the trust beneficiaries.

    With the gift of hard to value assets like real estate or closely held business interests, there always lurks the risk of large gift tax liability from an IRS challenge to increase the value of the gifted assets. Relying upon a defined value gift (or sale) clause like that used in Wandry is a viable method to reduce the gift tax exposure to the donor, notwithstanding the IRS’ noted hostility to the formula based transfers.