In Wandry, a groundbreaking Tax Court case, the court approved a donor’s use of a defined value clause (a clause where the donee is entitled to a fixed dollar amount worth of property) which, upon an IRS revaluation of LLC membership interests, resulted in a reallocation of LLC interests to the original donor. Wandry is the latest in a series of recent cases that have approved of defined value clauses. What makes Wandry unique is that it is the first case to approve of a defined value clause where there was no charitable donee to receive part of the property.
The donors, Albert and Joanne Wandry, formed Norseman Capital, LLC (the “LLC”) with their children in 2001. The family members contributed cash and marketable securities to the LLC. In 2004, the donors gifted specific dollar amounts of membership interests in the LLC. They gave $261,000 of interests to each of their four children and $11,000 of interests to each of their five grandchildren. The assignments provided that the donors were transferring a sufficient number of units in the LLC so that the fair market value of the units for federal gift tax purposes would be $261,000 per child and $11,000 per grandchild. The assignments provided further that the donors intended to have a good faith determination of the value of the units made by an independent appraiser, and that if the IRS challenged such valuation and a final determination of a different value were made by the IRS or a court of law, the number of gifted units would be adjusted accordingly, so that the value of the number of units gifted to the children and grandchildren equaled the amounts set forth above.
The donors then had an appraisal completed by an independent appraiser, which the donors’ accountant used to prepare a ledger for the LLC capital accounts and the donors’ gift tax returns. On the donors’ gift tax returns, the donors reported a gift of $261,000 to each child and $11,000 to each grandchild. However, the schedule describing the gifts stated that each child received a 2.39% interest in the LLC and each grandchild received a .101% interest in the LLC. The accountant backed into the percentages based on the dollar amounts transferred and the LLC appraisal.
The IRS asserted that the appraisal undervalued the interests by more than 40%. In Tax Court, the IRS made three arguments.
First, the IRS argued that the descriptions of the gifts in the gift tax returns were admissions that the donors transferred fixed LLC percentage interests, rather than fixed dollar amounts. The IRS relied on Knight v. Commissioner, 115 T.C. 506 (2000). In Knight, the donors stated they had gifted a fixed dollar amount of partnership interests, but, at trial, the donors argued they had actually transferred less than the fixed dollar amount. This opened the door for the IRS to assert they had not transferred a fixed dollar amount, but rather a percentage interest. In Wandry, the Tax Court found that while the schedules to the donors’ gift tax returns listed percentage interests, the gifts were still reported as fixed dollar gifts. Thus, the donors always intended to gift fixed dollar amounts.
The IRS next argued that the LLC capital accounts, which reflected gifts of fixed percentages interests, controlled the nature of the gifts. The IRS relied on case law that held that a completed gift occurred with respect to corporate stock when the corporate books were changed to reflect a change in ownership. The Tax Court rejected this argument as well, reasoning that the stock transfer cases were inapplicable, because, here, there was no dispute as to whether the gifts were completed. The Tax Court believed that the facts and circumstances of the gift determine the capital accounts of the donees, rather than the capital accounts determining the nature of the gift.
Lastly, the IRS reasoned that the assignment documents transferred fixed LLC percentage interests because the defined value clause used in the assignments was void against public policy. Relying on Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944), the IRS argued that the donors’ use of the defined value clause was contrary to public policy because (1) any attempt to collect the tax would defeat the gift, thereby discouraging efforts to collect tax, (2) the court would be required to pass judgment upon a moot case, and (3) the clause would reduce the court’s judgment to a declaratory judgment.
The Tax Court rejected the public policy arguments by reconfirming the distinction between the type of savings clause used in Procter (which is void because it involves a “condition subsequent” in which the donor tries to “take property back” based on IRS redetermination) and the type of defined value clauses upheld in more recent cases such as McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009), Estate of Petter v. Commissioner, 653 F.3d 1012 (9th Cir. 2011), and Hendrix v. Commissioner, T.C. Memo 2011-133 (which relies on a “condition precedent” to transfer a “fixed set of rights with uncertain value”).
The IRS claimed that the clause in Wandry differed from the types of clauses used in the more recent cases because the Wandry clause would operate to return property to the donors. In the recent cases, charitable beneficiaries were named as parties to the transactions, so that any revaluation by the IRS would result in business interests passing to the charities. On the other hand, revaluation in Wandry would merely reallocate percentage interests among the donors and their children and grandchildren.
The Tax Court dismissed this argument and held that there is no distinction between the Wandry-type clause and clauses that use a charitable donee. Thus, the court held for the donors, finding the defined value clause valid.