August 19, 2011

Appeals Court Greenlights Charitable Formula Clause

A charitable freeze technique that used a complex contribution formula was considered by the 9th U.S. Circuit Court of Appeals in Petter v. Commissioner, No. 10-71854 (2011). The charitable freeze is a technique that readjusts a simultaneous gift/charitable contribution combo if the IRS successfully challenges a valuation of the gift, shifting additional value from the gift component to the charitable contribution component to eliminate any gift taxation resulting from the challenge.

The Estate Plan

Anne Petter, a schoolteacher, received a large amount of UPS stock from her uncle.

At the advice of her attorney she created a sophisticated estate plan, including an irrevocable life insurance trust holding a $3.5 million policy and a charitable remainder unitrust (CRUT) that she funded with $4 million of her UPS stock. The CRUT paid her 5% a year for the remainder of her life.

Her estate plan also included Petter Family LLC (PFLLC)—the subject of the case. She funded the LLC with her remaining UPS stock, which had risen in value to $22.6 million. The estate plan then created a charitable freeze.

Under the charitable freeze, ownership of LLC units was gifted in part and sold in part to two trusts. The total value of all these units came to 90% of the total value of the PFLLC. As consideration for the sale component of the transfer, each trust executed a 20-year promissory note. In conjunction with the transfers, gifts of LLC interests also were made to two charities, totaling over $1 million. The part gift, part charitable contribution, part sale arrangement was intended to avoid gift tax on the transfers.

The charitable freeze worked as follows: The gift component would utilize in full Petter’s charitable exclusion amount. If the IRS successfully challenged the valuation of the gifted units, and the units were found to be worth more than indicated on Petter’s gift tax return, the charitable contribution would adjust upward and eat the excess value, eliminating any gift tax liability. In that event, the charity and not the IRS—or the U.S. government—would benefit from an IRS challenge.

PFLLC units were valued at $536.22 per unit shortly after the transfers. The valuation included a 46% nonmarketability discount and a 13.3% net value adjustment. Based on the appraisal, the two charities were allocated a particular number of PFLLC membership units.

The IRS Challenge

Unsurprisingly, the IRS challenged the taxpayer’s valuation, determining that the units were worth $794.39 each. The valuation differential would have two consequences from the IRS’ perspective: (1) the gift would exceed Petter’s lifetime exclusion amount and she would owe gift tax; and (2) the sale of PFLLC units to the trusts would be for “less than full and adequate consideration,” resulting in an additional taxable gift to each of the trusts.

The Tax Court and Court of Appeals Holdings

Petter petitioned the Tax Court for a redetermination of the deficiency.

Prior to trial, the IRS and Petter agreed that the correct valuation of PFLLC units was $744.74 per unit. The IRS claimed that the formula clause was invalid, but the Tax Court upheld the gift formula clause. The IRS appealed the Tax Court’s decision.

Under the regulations, a charitable deduction is not permitted "[i]f, as of the date of the gift, a transfer for charitable purposes is dependent upon the performance of some act or of the happening of a precedent event in order that [the transfer] might become effective." Treas. Reg. § 25.2522(c)-3(b)(1).

The IRS contended that subsequent gifts under the formula clause were dependent on a condition precedent—a successful IRS challenge—and were invalid under the regulations.

The Court of Appeals disagreed, holding that the transfer to the charities was not dependent on a condition precedent since the value of units gifted to the trusts was fixed at the time of the gift. Only the total number gifted units was subject to adjustment to match the fair market value of LLC at the time of the gift. As a result, the court upheld the validity of the freezing formula clause.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s partner, AdvisorFX, for a free trial.

See also The Law Professor's blog at AdvisorFYI.

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