"Glom On" To This Good News About Defined Value Clauses and IDGT Sales

by Carter Ruml on February 19, 2010

KYEstates strives to provide fair and balanced commentary. No, truly, we do.

Image: U.S. Tax Court Website

So, when we are biased, we’ll let you know. Please be advised that KYEstates is biased in favor of the taxpayer. For that reason, KYEstates is happy to report on the facts, arguments, and taxpayer victory in Estate of Petter v. Comm’r, T.C. Memo. 2009-280, 2009 WL 4598137 (U.S. Tax Ct. 2009).

The Tax Court described the overall background as follows:

Anne Petter inherited a large amount of valuable stock and set up a company to hold it. She divided ownership of the company among herself, trusts for her children’s benefit, and charities. She performed this division by allocating a fixed number of units in the company to herself, a fixed dollar amount to the trusts, and the rest to the charities.

Because this case is in the Tax Court, it’s not surprising that the taxpayer (Mrs. Petter’s Estate) and the IRS weren’t able to agree on the value of the LLC:

Her estate and the Commissioner now agree that the value of the company was higher than she first reported. That has triggered the obligation to reallocate more shares in the company to the charities. The question is how to measure the size of the gift on which tax is owed: We have to multiply the new value of the shares by the number of shares going to the charities, but is it the number of shares before or after the reallocation?

The facts are interesting and not entirely unfamiliar to KYEstate$ readers in and near Louisville, with its large UPS presence.

Mrs. Petter was a niece of an early investor in UPS who lived modestly as a schoolteacher.

By 1998 (pre-UPS IPO), Mrs. Petter realized her net worth of approximately $12 million might require some estate planning, and she obtained transfer tax counsel, who created an ILIT and a charitable remainder unitrust.

The estate planner began designing and implementing a relatively standard gift/sale transaction. The attorney then formed a single member LLC, Petter Family LLC (PFLLC) and two intentionally defective grantor trusts, a separate one for each child.  Each child was trustee of the grantor trust for such child.  (Mrs. Petter had a third child, but this child is disabled and was not involved in the transactions at issue.)

PFLLC was formed in late 1998, and the attorney intended for it to be funded at a later date.  UPS announced it was going public in November 1999, which froze Mrs. Petter’s block of UPS stock and prevented the stock from being transferred to the LLC until after the IPO.  The IPO-related lock-up period expired in May, 2001.  When the period expired, Mrs. Petter’s stock was worth $22.6 million.

The attorney continued the transactions.  Mrs. Petter contributed over 400,000 shares of UPS stock then worth over $22.6 million to PFLLC, to capitalize the company.  PFLLC had a three-class capital structure.  The members owning each class voted as a class.  Each class elected one member to PFLLC’s three-person board of managers.  The managers, in turn, acted by majority vote.  The manager elected by vote of the “Class A” members, however, could exercise a veto over the board of managers.  Mrs. Petter controlled the “Class A” units, giving her effective veto power over all of PFLLC’s decisions.

PFLLC’s operating agreement contained relatively standard restrictions against transfer of PFLLC units without approval of the managers, and that transferees would be treated as assignees only, without voting rights, unless and until they were admitted by the members as substituted members.

After PFLLC had been capitalized, it was time to transfer Mrs. Petter’s units to the grantor trusts.  The Tax Court ought to go into the business of writing client memos, because they provide a lucid explanation of the reasons for the trusts being structured as they were:

In late 2001, LeMaster set up two intentionally defective grantor trusts. (Although specialists call them “defective,” these types of trusts are widely used by sophisticated estate planners for honest purposes.) Anne’s trusts were defective because they allowed the trustee of either trust to purchase and pay premiums on a life insurance policy on the life of the grantor (Anne), in contravention of section 677(a)(3). This meant that for income-tax purposes-though not for any other purpose-Anne would be treated as the owner of the assets even though they were legally owned by a trustee, and she herself would remain liable for income taxes on the trust’s income for the rest of her life. This arrangement did, however, remove those assets held in trust from Anne’s estate, reducing her estate-tax liability. It also allowed her to make income-tax payments for the trusts without the IRS’ treating those payments as additional gifts to her children.

The transfer of PFLLC units to to the trusts was structured as a gift, followed by a sale.  On March 22, 2002, Mrs. Petter gave units to the trusts intended to make up 10% of the trusts’ assets.  Three days later, she sold units worth 90% of the trusts’ assets in exchange for promissory notes.  (In a footnote, the Tax Court discussed, but did not explicitly endorse, the 10% seeding “rule of thumb” for grantor trust transactions.)  The notes had 20-year terms and provided for quarterly interest-only payments and a single balloon repayment of principal.  Payment of the promissory notes was secured by pledge agreements against the PFLLC units held by each trust.

In connection with the transfers, Mrs. Petter also gave units to donor advised funds established at two community foundations.  [Attention Kentucky T&E Community - if you want to "try this transaction at home", consider working with our state's community foundations in Louisville or Lexington.]

The Tax Court then identified the key question: value….

The division of PFLLC’s units among gifts to the trusts and community foundations, and gifts and sales to the trusts, meant that Anne had to value what she was giving and selling. LeMaster used a formula clause dividing the units between the trusts and two charities, to ensure that the trusts did not get so much that Anne would have to pay gift tax.

The transaction documents for the gift and sale contained several defined value clauses that were similar in substance, but slightly different in wording.  You can read each of the different clauses in the full opinion linked above; one example is below:

Transferor * * *

1.1.1 assigns to the Trust as a gift the number of Units described in Recital C above that equals one-half the minimum dollar amount that can pass free of federal gift tax by reason of Transferor’s applicable exclusion amount allowed by Code Section 2010(c). Transferor currently understands her unused applicable exclusion amount to be $907,820, so that the amount of this gift should be $453,910; and

1.1.2 assigns to The Seattle Foundation as a gift to the A.Y. Petter Family Advised Fund of The Seattle Foundation the difference between the total number of Units described in Recital C above and the number of Units assigned to the Trust in Section 1.1.1.

The transaction documents also provided for the community foundations to return units to the trusts if the value of the units was “finally determined for federal gift tax purposes” to be less than the target gift amount.  [KYEstate$ note: it's hard to imagine a fact pattern under which this foundation "give back" clause would ever be triggered; if one comes to the mind of any reader, please let us know.]

The trusts faithfully performed their obligations under the transaction documents and promissory notes:

The parties agree that Donna’s and Terry’s trusts have made regular quarterly payments since July 2002. The trusts were able to make payments because the PFLLC paid quarterly distributions to all members, crafted so the amounts paid to the trusts covered their quarterly payment obligations.

Having discussed the transaction structure, the Tax Court gives a hint of the pro-taxpayer outcome ahead with the following observation about Mrs. Petter’s intent:

We have no doubt that behind these complex transactions lay Anne’s simple intent to pass on as much as she could to her children and grandchildren without having to pay gift tax, and to give the rest to charities in her community.

The Tax Court discussed the role of the community foundations in the transactions.  One foundation was “tiny” compared to the other, and “did not have the expertise to independently vet the paperwork, so it glommed onto the same agreements the Petters negotiated with the other [foundation]” [Count not your day a loss: you have now read the phrase glommed onto in a Federal court's opinion.  Find that phrase in another published Federal court decision predating the Petter opinion and KYEstates will happily buy you lunch if you are local, or if you are not, send you a gift card from the local independently-owned coffee shop nearest you.]

A Seattle lawyer provided separate representation for the foundations and negotiated protections for them in the transaction documents, including admisssion as substitute members, rather than assignees, and rights to tax distributions to cover taxes on unrelated business taxable income.

The transaction was planned before an appraisal was available.  In planning the transaction, the attorney used a 40% discount on the market value of the UPS stock.  The Tax Court, with classy understatement, observed that:

Such a discount is a major goal, and often a major problem, of contemporary estate planning. Anne could of course have just transferred and sold her UPS stock outright. But doing so would’ve enabled the Commissioner to tax her on its full value-UPS stock is publicly traded and easy to price. But a gift of membership units in an LLC is harder to value because provisions in the operating agreement restrict members’ rights to sell, and typically no single member is allowed to sell LLC assets without approval of the managers. This creates the possibility of a more taxpayer-friendly valuation.

As events would have it, the actual appraisal results came in with a total combined discount (lack of control plus lack of marketability) of approximately 46.5%

Mrs. Petter timely filed a gift tax return, that made comprehensive disclosures about the transaction, including the formula clauses, the transaction documents, PFLLC’s organizational documents, the appraisal, letters of intent with the community foundations, and statements of account for the UPS stock.  An audit commenced, and the taxpayer was quite cooperative in the audit process.  Nonetheless, issues were not resolved during the examination, and the IRS issued a notice of deficiency, claiming the correct discount was only 21.5%.

This revaluation of the PFLLC units would trigger a reallocation of shares from the grantor trusts to the charities.  The attorney hoped this reallocation would result in a greater charitable deduction for Mrs. Petter, but no additional gift tax.  The IRS claimed the reallocation clauses were invalid.  The Tax Court observed that:

If [the IRS is correct], the units might still be reallocated to the charities, but Anne would not get an additional charitable deduction. This also would mean that the shares sold to the trusts were sold for “less than full and adequate consideration,” and thus were transferred partly by sale and partly by an additional $1,967,128 gift to each trust, computed by deducting the price of the installment notes from the fair market value of the shares transferred.

Before trial at the Tax Court, the parties agreed on a discount of approximately 25.3%.  (Note that in this instance, the valuation battle was largely conceded to the IRS.)  Having set forth all the facts, the Tax Court restated the core questions:

We are asked to decide whether to honor the formula clause for the gift and the sale; if we honor them, we must also decide when Anne may take the charitable contribution deduction associated with the additional units going to the Foundations.

The Tax Court then provided a useful overview of the long-running controversy between taxpayers and IRS relating to defined value clauses in the transfer tax context, as developed in 142 F.2d 824 (4th Cir. 1944), King v. U.S., 545 F.2d 700 (10th Cir. 1976), Knight v. Comm’r, 115 T.C. 506 (2000), Ward v. Comm’r, 87 T.C. 78 (1986), Harwood v. Comm’r, 82 T.C. 239 (1984). Rev. Rul. 86-41, 1986-1 C.B. 300, McCord v. Comm’r, 461 F.3d 614 (5th Cir. 2006), and Christiansen, __ F.3d __ (8th Cir., Nov. 13, 2009).

After this review of precedent, the Tax Court summarized as follows:

To reach a reasonable conclusion in this case, we start with two maxims of gift-tax law: A gift is valued as of the time it is completed, and later events are off limits….And gift tax is computed at the value of what the donor gives, not what the donee receives. The Fifth Circuit held in McCord that what the taxpayer had given was a certain amount of property; and that the appraisal and subsequent translation of dollar values (what the donor gave each donee) into fractional interests in the gift (what the donees got) was a later event that a court should not consider. In Christiansen, we also found that the later audit did not change what the donor had given, but instead triggered final allocation of the shares that the donees received….The distinction is between a donor who gives away a fixed set of rights with uncertain value-that’s Christiansen – and a donor who tries to take property back-that’s Procter. The Christiansen formula was sufficiently different from the Procter formula that we held it did not raise the same policy problems.
A shorthand for this distinction is that savings clauses are void, but formula clauses are fine
[emphasis added].

The Tax Court then applied these rules to the specific facts in Petter:

But figuring out what kind of clause is involved in this case depends on understanding just what it was that Anne was giving away. She claims that she gave stock to her children equal in value to her unified credit and gave all the rest to charity. The Commissioner claims that she actually gave a particular number of shares to her children and should be taxed on the basis of their now-agreed value….The plain language of the documents shows that Anne was giving gifts of an ascertainable dollar value of stock; she did not give a specific number of shares or a specific percentage interest in the PFLLC. Much as in Christiansen, the number of shares given to the trusts was set by an appraisal occurring after the date of the gift. This makes the Petter gift more like a Christiansen formula clause than a Procter savings clause.

The Tax Court observed that it was confident the gift had been made in good faith and in keeping with Congress’s overall policy of encouraging gifts to charities:

….the facts in this case show charities sticking up for their interests, and not just passively helping a putative donor reduce her tax bill. The foundations here conducted arm’s-length negotiations, retained their own counsel, and won changes to the transfer documents to protect their interests. Perhaps the most important of these was their successful insistence on becoming substituted members in the PFLLC with the same voting rights as all the other members. By ensuring that they became substituted members, rather than mere assignees, the charities made sure that the PFLLC managers owed them fiduciary duties….In McCord, the taxpayers built into the partnership agreement restrictions on charitable interests in the partnership (i.e., limited voting rights and the right of other partners to buy out the charitable interests at any time)….In contrast, Anne’s gift made the charities equal members in the PFLLC, giving the charities power to protect their interests through suits for breach of the operating agreement or breach of a manager’s fiduciary duties, as well as through the right to vote on questions such as amending the operating agreement and adding new members.

In a footnote, the Tax Court noted with favor that at the time of trial, the taxpayer was in the process of reallocating PFLLC units between the trusts and the community foundations in conformity with the adjusted appraisal.

The Tax Court did not view the IRS’s public policy arguments favorably, instead agreeing with the taxpayer that “if Congress allows [defined value] clauses in other contexts, there can’t be a general public policy against using formula provisions.”  These “other contexts” include charitable remainder annuity trusts, marital deduction bequests, allocation of GST exemption, and tax-qualified disclaimers.

The Tax Court summarized its application of the Petter facts to the applicable law as follows:

In summary, Anne’s transfers, when evaluated at the time she made them, amounted to gifts of an aggregate and set number of units, to be divided at a later date based on appraised values. The formulas used to effect these transfers were not void as contrary to public policy, as there was no “severe and immediate” frustration of public policy as a result, and indeed no overarching public policy against these types of arrangements in the first place.

The Tax Court then had to determine when Mrs. Petter might claim a deduction for her gift of the additional [i.e., reallocated] units to the foundations: for the original gift year of 2002, or later, when the revaluation and reallocation occurred?  On this question, the Tax Court found favorably for Mrs. Petter:

Anne made a gift for which, at the time of transfer, the beneficiaries could be named but the measure of their enrichment could not yet be ascertained….we see no reason a donor’s tax treatment should change based on the later discovery of the true measure of enrichment by each of two named parties, one of whom is a charity. In the end, we find it relevant only that the shares were transferred out of Anne’s name and into the names of the intended beneficiaries, even though the initial allocation of a particular number of shares between those beneficiaries later turned out to be incorrect and needed to be fixed.

Accordingly, the Tax Court held that the correct date for the additional charitable gift upon reallocation of the units to the foundations was March 22, 2002 (the original gift date).

In addition to being a comprehensively favorable outcome for the taxpayer, Petter is notable for its comprehensive description and discussion of the IDGT gift/sale technique.  At KYEstates, we welcome Petter‘s good news, and hope to bring you reports of similar good news in the future.

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{ 1 comment… read it below or add one }

Ronald Larson September 29, 2010 at 1:11 pm

I would be interested to learn of mechanisms to protect the Trust Protector from liability (inc. insurance), and case law (particularly re a South Dakota trust) concerning the validity of Trust provisions relieving the Trust Protector from liability.

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