• Tax Court Upholds Use Of “Defined Value Clause” On Transfer Of Closely Held Stock To Family Trusts And Charitable Foundation - Hendrix v. Commissioner, T.C. Memo 2011-133 (June 15, 2011)
  • August 9, 2011
  • Law Firm: Proskauer Rose LLP - New York Office
  • In Hendrix v. Commissioner, the taxpayer scored yet another victory in a growing line of cases finding favorably for the use of defined value clauses. Hendrix involved the transfer of stock in a closely held corporation to two trusts for the donors’ family and to a charitable foundation. The transfer included a so-called “defined value clause” which stated that the donors were transferring a specified number of shares in the company, and that the trusts were to receive $10.5 million and $4.2 million worth of stock, respectively, and any stock over such amount was to pass to a charitable foundation. The terms of the transfer permitted the trusts and the charitable foundation to determine the fair market value of the stock and divide it accordingly among them. Subsequently, the trusts obtained an appraisal valuing the stock, which the charitable foundation further reviewed through its independent appraiser. Approximately five months after the initial transfer, the trusts and the charitable foundation divided the transferred stock based on the appraisal. The IRS challenged the transaction on the basis that the defined value clause was void as against public policy and not reached at arm’s length.

    As to the public policy argument, the IRS argued that based on the 1944 case of Procter v. Commissioner, 142 F.2d 824 (4th Cir.), the use of the clause violated public policy on the grounds that it discouraged the collection of tax by defeating the gift, that it required the court to pass on a moot case, and that a final judgment would be self-defeating. The Tax Court reviewed a recent line of cases upholding the use of defined value clauses.  It reasoned, consistent with the recent cases, that where a defined value clause, such as the one in Hendrix, does not rely on a condition subsequent to defeat a gift, it is not susceptible to the same public policy concerns as advanced in Procter. To the contrary, where the residual beneficiary of the transfer is a charity, public policy actually favors the transfer.

    As to the arm’s length argument, the Tax Court applied a relatively low standard to determine that the parties had negotiated fairly and at arm’s length. Notwithstanding the relationship between the donors and the trust beneficiaries, the Tax Court found that the economic and business risk assumed by the trusts placed the family members at odds with the donors and the charitable foundation. Additionally, the charitable foundation demonstrated arm’s length negotiation in its dealings with the donors and the trusts by retaining independent counsel, being actively involved in negotiating the terms of the agreement, and being bound by its fiduciary duty to advance its charitable purpose.