104 AFTR 2d 2009-7352 (8th Cir. 2009)

In a unanimous decision, the Eighth Circuit upheld over the IRS’ public policy objections a formula disclaimer which passed property to charity. This is an important case, as its holding might be broadly applied not just to formula disclaimers passing property to charity, but to defined value clauses in general, including those used in conjunction with gifts or sales of business interests to intentionally defective grantor trusts.

In her will, a decedent left her entire estate to her daughter. The will provided that any disclaimed assets were to pass 75% to a CLAT and 25% to a private foundation. The daughter made a formula disclaimer, in effect disclaiming a fractional share of the decedent’s estate exceeding $6.35 million. The decedent’s estate tax return reported the estate’s value at just over $6.5 million. Based on that value, about $120,000 was to pass to the CLAT and about $40,000 was to pass to the foundation. On audit, the IRS and the estate agreed to increase the gross estate from $6.5 million to $9.6 million (based largely on adjustments to discounts that the estate took on limited partnership interests). Pursuant to the disclaimer, the additional $3.1 million of estate tax was to pass to the CLAT and foundation as if there were no additional tax.

The Tax Court held that the 75% disclaimer to the CLAT was not a qualified disclaimer due to technical violations of the Disclaimer Regulations. That finding was not at issue in the appeal.

With respect to the 25% passing to the foundation, the IRS allowed the $40,000 charitable deduction for the pre-adjustment disclaimer amount, but not for the additional amount passing to the foundation as a result of the adjustment. The IRS made two arguments against the increased deduction. First, it argued that any increased amount passing to the foundation was not deductible because it was contingent on the determination of the final estate tax value, and the Regulations provide that a charitable deduction is not available where it is “dependent upon the performance of some act or happening.” The court rejected that argument, finding that while the transfer must be complete at the date of the decedent’s death, there does not necessarily need to be an agreement on the value of the transfer at that time. In this case, the foundation’s right to receive 25% of the disclaimed amount was certain; the only thing that was uncertain was the value of that 25%.

The IRS’s second argument was the same argument that the IRS made successfully in Proctor v. Commissioner, 142 F.2d 824 (4th Cir. 1944)—that is, that the transfer violated public policy because it reduced the IRS’ incentive to audit the return. The court rejected this argument as well, even though the formula disclaimer “may marginally detract from the incentive to audit” and, in some situations, would permit a charitable deduction equal to the entire increase in the value of the estate. The court gave three reasons for its holding. First, it noted that the IRS’ role is not merely to maximize tax receipts, but to enforce the tax laws. Second, there is no evidence of a clear Congressional intent suggesting a policy to maximize incentives for the IRS to audit returns; on the other hand, there is a clear policy of encouraging charitable donations by allowing charitable deductions. Third, there are other mechanisms that offset the decreased incentive to audit, including (a) the executor’s fiduciary duty to accurately report estate values and (b) the contingent beneficiary (in this case the foundation) having an interest in ensuring that the executor does not underreport the value of the estate. Accordingly, the Eight Circuit affirmed the Tax Court’s holding that the formula disclaimer clause was not against public policy, and that the estate was entitled to a deduction for the full amount passing to the foundation.