In a landmark case decided last year (Wandry, TC Memo 2012-88), the Tax Court allowed a taxpayer to use a formula clause to pass assets to heirs through a family limited partnership (FLP). The case was widely applauded by the tax community.
Alert: Don’t count your chickens just yet. Despite its decision to forgo an appeal to a higher court, the IRS has announced its nonacquiescence to this decision. (Internal Revenue Bulletin 2012-46, 11/13/12) So the IRS is still likely to contest the use of “Wandry clauses” in future business valuations.
If anything, the IRS appears to be digging in its heels for a protracted fight on the issue.
Here’s the whole story: When you transfer assets like interests in a closely held business to an FLP, the transfer is subject to gift tax. Nevertheless, you can minimize the tax damage, or possibly eliminate it altogether, through the use of the annual gift tax exclusion and the lifetime gift tax exemption.
For 2013, the annual gift tax exclusion shields transfers of up to $14,000 per recipient from gift tax (up from $13,000 per recipient in 2012). This exclusion is doubled to $28,000 per recipient for joint gifts by a married couple. Any remainder can be sheltered by the lifetime gift tax exemption, which is now permanently set at $5 million with annual inflation adjustments.
Facts of the case
In 2004, the taxpayers executed gift documents transferring membership units in a limited liability company (LLC) to their children and grandchildren. The documents specified the dollar value of each gift based on the applicable gift tax provisions at the time, but left the number of units gifted to be based on the fair market value of the LLC as determined by the IRS or a court of law. This type of formula clause in gift documents often includes a “spillover” provision with any excess value going to charity.
The IRS argued that these gifts represented a transfer of fixed percentage interest of the LLC rather than a specified dollar value. This creates a “condition subsequent to a completed gift,” so the clause should be voided as being contrary to public policy.
But the Tax Court disagreed. It distinguished a “savings clause” which a taxpayer can’t use to avoid the imposition of gift tax from a valid formula clause. Although the tax payers benefit from the spillover, as opposed to a charity, that factor wasn’t fatal.
Tip: We will keep you apprised of any further developments relating to Wandry clauses.