In a recent case, the Tax Court has approved the use of a defined value formula clause to limit the amount of any gift for which the taxpayer could be subject to the payment of a gift tax. In Hendrix v. Commissioner (June 15, 2011), the taxpayers wanted to transfer stock of an S corporation to trusts for their daughters. Transfers of interests in closely held businesses are inherently difficult to value, and there is always a risk that the IRS will argue for a higher value than assumed by the taxpayer, yielding an unwelcome gift tax liability. In an attempt to remedy this problem, taxpayers have attempted to make gifts of a specific dollar amount of shares, rather than a specific number of shares. The number of shares given is adjusted based upon the value for the shares that is ultimately determined following any IRS review of the transaction.

Mr. and Mrs. Hendrix transferred a fixed number of shares in a family owned corporation to trusts for their daughters and to a charity, as tenants-incommon. Under the transfer agreement, the trusts for the daughters were to receive a fixed dollar amount of the stock, and the charity was to receive the balance. The trustees of the trusts and the charity were to agree on the value of the shares in order to determine how many shares each received. An arbitration procedure was set out in case they could not agree. Mr. and Mrs. Hendrix, took no part in the determination of the value of the stock. Their expectation was that if the IRS determined a higher value for the shares, the charity would get more shares and the trusts for the daughters would get less shares. The taxpayers would not have made a taxable gift because the only value kept by the trusts was the value of shares that the taxpayers intended to give.

The IRS asserted that the stock was worth more than the amount agreed to by the trusts and the charity. The IRS also asserted that the formula gift provision was not effective to control the amount transferred to the trusts, and accordingly assessed a significant gift tax against Mr. and Mrs. Hendrix. The IRS argued that the formula clause was not valid because it was not reached at arms’ length and also was void as being contrary to public policy.  

The court found the agreement was reached at arms’ length, and also found that the formula clause did not violate any public policy. In fact, the court noted that a clause such as this had the effect of encouraging gifts to charity because a charity would receive any excess value of the stock above the amount that the donors intended to transfer to the trusts for their daughters. The court found that this case was similar to the prior McCord case, in which the United States Court of Appeals for the Fifth Circuit had upheld a similar formula clause.

The IRS relied on two prior cases, Commissioner v. Procter and Commissioner v. Ward, but in those cases any value ultimately determined to be above the stated amount that was to be transferred to the donee was to be returned to the taxpayer. The courts in those cases determined that the formula clauses did violate public policy because they removed any incentive for the IRS to challenge the donors’ valuation, because any increase in valuation would simply be returned to the donor and no taxable gift ever would result. The McCord and Hendrix cases differ in that any excess value goes to a charity rather than reverting to the donor. This is a fine distinction because any effort by the IRS to increase the value of the transferred asset still will not result in any gift tax being collected; only a transfer to a charity. One could still argue that where such a clause is used, the IRS has no incentive to audit the transaction and challenge the valuation used by the donor. A similar case, Petter v. Commissioner, was also decided in December, 2009 in favor of the donor taxpayer. The case was heard by the Court of Appeals for the Ninth Circuit in June, 2011 and a decision is pending.