Taxpayers sometimes employ a so-called “defined value clause” (“DVC”) in connection with a gift of property that is difficult to value, such as an equity interest in a closely-held business.  In the case of such a gift, the value of the business interest – the amount of the gift – is never really “established” for tax purposes unless the IRS audits the gift tax return.  DVCs are aimed at such audits.

What is it?

A DVC may be used where the donor seeks to keep the value of the gift at or below his remaining gift tax exemption amount.  In the event the IRS successfully determines that the value of the shares of stock (or partnership units) gifted by the taxpayer exceeds the taxpayer’s available exemption amount, a DVC provides that some of these shares or units would be “returned” to the taxpayer, as if they had never been transferred.

The IRS has challenged DVCs as being against public policy, on the grounds that they enable the donor-taxpayer to retroactively adjust the number of shares transferred, depending upon an IRS challenge years after the transfer. However, a number of courts have found that DVCs are acceptable where the “excess” amount was not returned to the donor but, rather, was redirected to a charity.  (Alternatively, some taxpayers have directed that the excess be used to fund a zeroed-out GRAT.)

The IRS very recently announced its intent to issue regulations on the use of defined value clauses by estate planners. The use of defined value clauses to mitigate gift tax impact on the transfer of hard to value assets has long been an item of IRS scrutiny. While the Service has lost a number of tax court challenges to defined value clauses, the Service’s decision to include these clauses on the 2015-2016 Treasury Priority Guidance Plan Project nevertheless demonstrates its intent to continue to pursue limits on their use.

Several different types of defined value clauses commonly used have nevertheless withstood IRS scrutiny, utilizing both formula allocations and price adjustment clauses. Critical to structuring a defined value clause is ensuring that the transfer was implemented properly and that no pre-arrangement exists between the transferor and the transferee.

More recently, however, the Tax Court in Wandry, T.C. Memo. 2012-88, approved a DVC where the “excess” was returned to the donor, and not to a charity.  In that case, the taxpayers gifted LLC interests to their issue, but instead of stating the number of LLC units being transferred, they phrased the gift in terms of “that number of units which had a value equal to the taxpayers’ remaining exemption amount” (in other words, a fixed dollar amount).  If the appraised value of the LLC interests was successfully challenged by the IRS as too low, then the number of units originally calculated as having been gifted (on the basis of the taxpayer’s appraisal) would be adjusted downward, to reflect the greater value per unit determined by the IRS, and the donor’s relative interest in the LLC (post-gift) would increase.  The Tax Court ruled that what the taxpayers had gifted was LLC units having a specific dollar value – the exemption amount – and not a specific number of LLC units.

The Wandry decision may encourage more taxpayer-donors to employ DVCs, notwithstanding that the IRS did not acquiesce in the decision.  Before doing so, however, it is important that taxpayers look beyond the immediate transfer tax consequences of such an arrangement.  They also need to consider various income and other gift tax consequences that may result from an adjustment triggered by a DVC.

Closely-held businesses, the transfers of interests in which are the usual target of DVCs, are often formed as pass-throughs such as partnerships, LLCs or S corporations.  A gift transfer of an interest in such an entity carries with it certain “tax attributes.” For example, every member, including the recipient of the gift, must include his allocable share of the partnership’s income on his income tax return, whether or not the entity distributes such income.  If the donor-member had contributed built-in gain property to the partnership, a portion of the donor’s income tax liability as to such built-in gain shifts over to the donee-member as a result of the gift; on a subsequent sale of the property, a portion of the built-in gain would be taxed to the donee.  In addition, if the pass-through entity makes cash distributions to its owners, the donor and the donee would each receive an amount in accordance with their respective pro rata shares (before any Wandry-adjustment).  What if the original transfer was treated as a part-sale/part-gift because it resulted in a reallocation of partnership debt among the members?

Because the Service will likely move forward in scrutinizing the construction and implementation of defined value clauses, estate planners must ensure such clauses are properly constructed and strictly implemented according to the terms. Accordingly, some of the questions to ask your estate planning professional when structuring defined value formula clauses in order to avoid gift tax consequences on asset transfers, are set forth below. Simply, you want to avoid transfers that will trigger gift tax imposition.

  • What are the grounds for IRS challenges of defined value clauses?
  • What types of defined value clauses have failed to withstand IRS challenges?
  • How to best structure defined value clauses
  • How to structure defined value clauses involving non-taxable entities other than public charities

The foregoing highlights some of the issues that need to be considered before embarking on a gifting program which depends upon the use of DVCs. While a DVC is a useful estate planning tool, it does not lessen the need for a solid appraisal.  Moreover, as with all estate planning in the context of a closely-held business for example, the donor and his beneficiaries have to consider the possible ancillary consequences of their gifting decisions.