Hendrix, TC Memo 2011-133
In a case involving millions of dollars of asserted gift tax deficiencies, the Tax Court has held that defined value formula clauses properly set the fair market value of S corporation stock transferred by married donors to various family trusts and a charitable foundation. Rejecting IRS's arguments, the Court found that the formula clauses were reached at arm's length and were not void as contrary to public policy.
Facts. The dispute involved gifts of stock in the John H. Hendrix Corp. (JHHC) by John H. Hendrix and his wife, Karolyn M. Hendrix (Donors). IRS and Donors agreed to the facts, the key ones of which follow.
JHHC was incorporated in’76. Upon the advice of counsel, it converted to S status in’98 after changing its stock structure in a series of steps to voting and nonvoting common.
In’99, Donors sought estate planning advice from an attorney because they wanted to give some of their JHHC stock to their three adult daughters and to a charitable entity. Because the stock was hard to value, the attorney suggested that Donors use a formula clause to define the stock transfer at the time of the gift in terms of dollars rather than in percentages, while fixing for Federal gift tax purposes the value of the transfer of the stock. He also advised them to establish a donor-advised fund at a nonprofit community organization. They followed this advice and chose the Greater Houston Community Foundation (Foundation) to administer their contemplated donor-advised fund.
The attorney advised Foundation that Donors wanted to contribute (1) $20,000 to establish a donor-advised fund and (2) JHHC nonvoting stock. The donor-advised fund was established on Nov. 9,’99.
A draft agreement between Foundation and the Donors indicated that Donors would give JHHC stock to the Foundation and would transfer (part as a gift and part as a sale) JHHC stock to the trusts benefiting the daughters. The draft indicated that a formula clause would set the portion of JHHC stock transferred to the trusts and the remaining portion given to the Foundation.
After an appraiser was retained to estimate the value of the JHHC nonvoting stock, each Donor decided to give $50,000 of JHHC nonvoting stock to the Foundation and to transfer $10,519,136 of JHHC nonvoting stock to a generation-skipping tax (GST) trust and $4,213,710.10 of JHHC nonvoting stock to an issue trust benefitting the daughters. The trusts were executed on Dec. 29,’99. The trustees were two individuals, one of whom was a daughter of Donors.
On Dec. 31,’99, each Donor, the trustees, and Foundation executed an agreement that irrevocably assigned 287,620 shares of the Donors' JHHC nonvoting stock to the GST trust and to the Foundation. Each agreement effected the transfer pursuant to a formula. Under the formula, (1) a portion of the assigned shares having a fair market value as of the effective date equal to $10,519,136 was assigned to the trustees to be held in equal shares for the benefit of the daughters, and (2) any remaining portion of the assigned shares was assigned to the Foundation for the benefit of the donor-advised fund. The assignment agreements required that the trusts pay proportionally any gift taxes imposed as a result of the transfer. The assignment agreements required that the trustees sign promissory notes obligating the trustees to pay $9,090,000 to each Donor.
On the same day, a second set of assignment agreements was executed containing the same terms, except that each Donor transferred 115,622 of JHHC nonvoting stock to his or her issue trust and to the Foundation, and the fair market value of the stock for the benefit of the daughters was set at $4,213,710. The trustee had to deliver a note to each Donor in the amount of $3,641,233.
Donors had no right or responsibility for allocating the shares among the transferees on a per-share basis. The agreements left that allocation to the transferees under a dispute resolution and buy-sell agreement. It required that any dispute related to the fair market value between or among JHHC, the shareholders, assignees, or any party be resolved by arbitration, if it could not be resolved by agreement.
The trustees delivered the notes in exchange for the shares on Dec. 31,’99.
About a month after the transfers, following two appraisals setting the per-share value at $36.66, the Foundation and the trustees entered into confirmation agreements, effective as of Dec. 31,’99, that allocated the shares among them according to the $36.66 per-share value.
Each Donor claimed a charitable contribution deduction of $50,000 and a total taxable gift of $1,414,581 on’99 gift tax returns filed in April of 2000.
IRS and Donors agreed that if a final decision in this case determined that the defined value formula clauses do not control the valuation of the transferred shares, then the fair market value of the transferred shares would be based on a per-share value of $48.60 times the number of shares agreed to by each transferee in the confirmation agreements.
Dispute over validity of formula clauses. Before the Tax Court, the parties disputed the validity of the formula clauses. Donors contended that the formula clauses were valid because the clauses were used to fix the transferred amount of JHHC's hard-to-value stock and the parties to those clauses conducted themselves at arm's length. Donors claimed that the applicable value of the stock was $36.66 per share, as reported, and that they could deduct the $100,000 claimed as charitable contributions.
IRS argued that the formula clauses were invalid because they were not reached at arm's length and they were contrary to public policy. IRS said that the value of the stock was $48.60 per share and that each Donor could deduct charitable contributions totaling $66,285 (i.e., $48.60 multiplied by the number of shares transferred to the Foundation).
Observation: Had IRS prevailed on its claim that the shares were each worth $48.60, while the donors would have been allowed a higher charitable contribution deduction, they would have had to pay substantially more gift tax on the gift portion of the transfers to the trusts for their daughters.
Donors argued that the formula clauses were valid under precedent in the Fifth Circuit to which this case was appealable. Specifically, they argued that these clause were upheld in Succession of McCord, Jr. v. Comm., (CA 5 08/22/2006) 98 AFTR 2d 2006-6147 revg 120 TC 358 (2003). IRS argued that Succession of McCord was not controlling because the Fifth Circuit did not consider specific arguments IRS was making in this case. These arguments were that the formula clauses were invalid because they were not reached at arm's length and that they were void as contrary to public policy.
Clauses were at arm's length. IRS argued that they weren't at arm's length because Donors and their daughters (or their trusts) were close and lacked adverse interests, the daughters benefitted from Donors' estate plan, and the clauses were not thoroughly negotiated. The Tax Court disagreed. It said that the mere facts that Donors and their daughters were “close” and that Donors' estate plan was beneficial to the daughters did not necessarily mean that the formula clauses failed to be reached at arm's length. The Court also noted that economic and business risk assumed by the daughters' trusts as buyers of the stock (i.e., the daughters' trusts could receive less stock for their payment if the JHHC stock was overvalued) placed them at odds with Donors and the Foundation. In addition, for a variety of reasons, the Court found no collusion between Donors and Foundation.
Clauses were not void as against public policy. IRS argued that the formula clauses were void as contrary to public policy. The Tax Court disagreed. While the Court observed that it can disallow a deduction on public policy grounds if allowing such a deduction would severely and immediately frustrate sharply defined national or State policies proscribing certain conduct, the formula clauses at issue did not immediately and severely frustrate any national or State policy. To the contrary, they supported a fundamental public policy of encouraging gifts to charity.
IRS relied on Commissioner v. Procter, (CA 4 1994) 32 AFTR 750, which found a gift tax savings clause to be void. In that case, the clause provided that if any part of the transfer was found to be a gift, the property would remain property of the taxpayer. The Tax Court found Procter to be distinguishable from the current case. Unlike Procter, in the current case, there was no condition subsequent that would defeat the transfer. Moreover, the formula clauses encouraged charitable giving.
Accordingly, the Court held that the Donors could each deduct $50,000 as a charitable contribution. IRS argued that the parties agreed to a $48.60 per-share value. However, the Tax Court read the stipulation differently. Under its reading, the $48.60 value was inapplicable because the formula clauses control the valuation.
References: For disregarded gift adjustment clauses, see Federal Tax Coordinator 2d ¶Q-1982; TaxDesk ¶711,023; TG ¶40063.