Congress has slowly upped the amount that can be transferred free of estate and gift taxes. This amount has changed over time. It was $1 million in 2003. It is now just over $11.5 million in 2020. This means that many people do not need to worry about estate and gift taxes.
Estate and gift taxes still impact those whose assets are in excess of $11.5 million (there is a much smaller amount for transfers to those who are not U.S. citizens, which is beyond the scope of this post). This means that the estate and gift tax is primarily limited to those own businesses and real estate.
For those whose assets exceed this amount, the estate and gift tax can be significant. It can easily eat up 30% or more of the value of the assets over $11.5 million.
Luckily, with a little advanced tax planning, those whose assets exceed this amount or whose assets are close to this amount can ensure that they do not trigger estate or gift taxes.
This tax planning often involves making lifetime gifts to family members. Lifetime gifts allow the future increase in the value of the assets to be excluded from the owners estate. This is often preferable to holding the asset and having the increased value be included in the owners estate at death.
That brings us to the Nelson v. Commissioner, T.C. Memo. 2020-81, court case. The Nelson case involves the lifetime gift of a business that was intended to transfer an amount under the exempt amount. The language used to make the gift was insufficient, which resulted in significant gift taxes.
Facts & Procedural History
This case involves the transfer of family businesses. The businesses are related to the oil and gas industry in West Texas. The primary business is a heavy equipment franchise.
The stock was owned by the taxpayer and her siblings. The agreements included stock transfer restrictions. To avoid these restrictions, the family members formed another entity and transferred their stock to that entity. This allowed the family members to transfer their interest in the new parent entity free of the transfer restrictions for the stock.
The taxpayer then transferred her interest in the parent entity to a trust. The trust was for the benefit of the taxpayer and her children.
The transfer documents specified that she transferred an “interest in a limited partner interest having a fair market value of TWO MILLION NINETY-SIX THOUSAND AND NO/100THS DOLLARS ($2,096,000.00) as of December 31, 2008, as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.” There was a second transfer with similar language.
There was no language defining the fair market value. The parties then hired appraisers to determine the value of the transfers, to ascertain what percentage interest in the entity had been transferred.
The taxpayer caused partnership returns to be filed reflecting this percentage ownership. She also filed gift tax returns reporting the transfers.
On audit by the IRS, the IRS determined that the amount of the gifts were significantly higher. This resulted in a significant amount of gift taxes being due.
About the Gift Tax
The gift tax is triggered when there is a transfer for less than fair market value. The gift tax rate for 2020 ranges from 18 to 40 percent.
There are several exceptions where gift tax is not triggered. One is the annual exclusion. This exclusion lets taxpayers give away up to a specified amount each year to any person gift tax free. The annual exclusion is $15,000 in 2020.
The other exception is the unified credit amount. This credit allows taxpayers to give a set amount away gift tax free. It is a combined lifetime amount. It does not reset each year as the annual exclusion does. It is also not a per person credit. It is applied to all taxable gifts made during lifetime. The credit is approx. $11.5M as of 2020.
Formula and Savings Clauses
This brings us to formula and savings clauses. The idea behind these clauses is that they attempt to limit the amount transferred to the amount that isn’t subject to gift taxes. They are used when someone is making a gift of property that is not easy to determine what the value is.
For example, the clause may say something like this: “I give an interest in my business to my son equal to $XXX.” The referenced to a fixed dollar amount ensures that the transfer is for an interest that doesn’t exceed a specific amount, such as the amount of the unified credit. If the IRS later adjusts the transfer, it wouldn’t trigger more gift tax. It is more common for the language to say that it is a transfer of an interest in the business equal to the remaining unified credit amount. These are examples of formula clauses. There are court cases that have upheld formula clauses.
The language may also say that if the IRS adjusts the amount of the transfer, then the parties can reallocate the transfer after that. It might also reference some other future event to reallocate the ownership at that point. These are examples of savings clauses. The courts have generally rejected savings clauses on policy grounds.
Formula Clause Based on Fair Market Value
In the present case, the taxpayer’s language was very similar to a formula clause. It specifically identified a dollar amount. But it went on to say that the fair market value was to be determined by an appraiser. This is a future event that happens after the sale. The prior savings clause court cases suggest that this is improper.
It is not clear from the court case, but the drafter may have intended to say that given the fixed dollar amount listed, the percentage ownership–not the fair market value–was to be determined based on an appraisal. The prior formula clause cases suggest this would be proper.
The court in this case held the taxpayer to the language used in the agreement. In doing so, it held that the taxpayer’s formula clause was not sufficient to set the value of the transfer. The court went on to consider the proper valuation for the business interests that were transferred.
Formula clauses may seem simple. They are not.
As this case shows, they can trigger significant amounts of tax and can result in ownership being reallocated by the IRS. This can even result in an income tax liability, as the post-transfer income tax on the income produced by the business has to be assessed back to the person making the gift. This type of dispute will also trigger significant tax preparation and legal costs.
The takeaway from this case is that taxpayers should use formula clauses that are similar to those approved in prior court cases.