Estate of Petter v. Commissioner, TC Memo 2009-280

On the heels of Christiansen, the Tax Court upheld a defined value clause over the IRS’ public policy objections, this time in the context of a part-gift, part-sale of LLC interests. As with Christiansen, this is an important taxpayer victory in the defined value clause arena.

Anne Petter inherited a large amount of UPS stock from her uncle. She consulted an estate planner who recommended a number of techniques to meet her goals, including (a) involving her children in the management of her newly acquired wealth and (b) providing for local charities. One of those techniques involved having Anne contribute all of her UPS stock to an LLC. Anne also created two defective grantor trusts, one for each of her children. She transferred LLC units to each child’s trust, partly as a gift and part as a sale. The gift portion was stated as amount equal to 10% of the trust’s assets, and the sale portion was stated as 90% of the trust’s assets. In addition, Anne donated LLC interests to two local charities.

A formula clause was used to divide the LLC interests between the trusts and charities. The transfer to each trust was stated as “the number of units that equals one-half of the maximum dollar amount that can pass free of federal gift tax.” As part of the transfer documents, the trustees of the trusts agreed, as a condition of the gift, that if the value of the units it received was finally determined for gift tax purposes to exceed the originally determined amount, then it would transfer the excess to the charities. The sale to each trust was stated as “the number of units that equals a value of $4,085,190 as finally determined for Federal estate tax purposes,” with any excess passing to the charities. Again, the trustees of the trusts agreed, as a condition of the sales, that if the value of the interests were adjusted upward, they would transfer additional LLC interests to the charities. Similarly, the charities agreed that, in the event of any downward adjustment, the charities would transfer a portion of the LLC interests to the trusts.

The LLC units were valued by a qualified appraiser who determined that a discount of over 50% was appropriate, and the LLC units were allocated among the trusts and charities accordingly. On audit, the IRS disallowed a significant portion of the discount, which had the result of increasing the amount passing to the charities based on the formula clauses. The IRS also disallowed any increase in the charitable deduction and asserted that the sales were for less than adequate and full consideration, resulting in gift tax.

Again, the IRS argued that the formula clause was void against public policy based on Proctor. The Tax Court did not agree, finding that this case was closer to Christiansen (in which a donor gave away a fixed set of rights with uncertain values) than Proctor (in which the donor tried to take property back). The plain language of the transfer documents showed that the taxpayer was making gifts of an ascertainable dollar value of LLC units, rather than a specified number of units. The facts also showed that the charities were advocating their own interests, not just passively helping the taxpayer reduce her tax bill. The charities conducted arm’s-length negotiations, retained their own counsel, and won changes to the transfer documents to protect their interests. In addition, the directors of the charities owed fiduciary duties to their organizations to make sure that the appraisal was acceptable before signing off on the gift. Thus, the court held that (a) the formula clause was valid, (b) the sales did not result in additional gifts and (c) an additional charitable deduction was warranted for the reallocated amount passing to charity.