IRS Won't Concede on 'Wandry Clauses'

By Ken Berry

Earlier in the year, the Tax Court allowed a taxpayer to use a formula clause to determine the value of a business interest for gift tax purposes (Wandry, TC Memo 2012-88). But the IRS refuses to knuckle under to the court. Although it has dropped its appeal, the IRS just announced its nonacquiescence to the Wandry decision (IRB 2012-46).
What it means: You can expect the IRS to continue to challenge the use of so-called "Wandry clauses" in business valuations. So tax practitioners should take this precious Tax Court victory with a giant grain of salt.
Typically, the IRS and taxpayers are at loggerheads when it comes to defining the value of gifted property. The IRS generally seeks a higher value for the gifts so it can line its coffers with additional tax revenue. Conversely, taxpayers want to lower the value of gifts to shelter more from the IRS through the annual gift tax exclusion and lifetime gift tax exclusion.

Talking Points

  • Owners of business interests may be able to use a formula clause, like the one approved in the Wandry case, to reduce the applicable gift tax liability.
  • With a formula clause, it should be clear that the donor's intent is to transfer a fixed dollar amount of property, not to transfer a fixed amount of property that would later be adjusted.
  • The IRS has refused to concede that Wandry clauses are permitted for business valuations without a charitable spillover. It is likely to challenge their validity.
  • With favorable estate and gift tax provisions scheduled to be scaled back in 2013, taxpayers should generally arrange large gifts of business interests in 2012. 
The IRs recently announced that the annual gift tax exclusion is being raised to $14,000 in 2013 from $13,000 in 2012. That's a relatively small upgrade. However, absent new legislation, the lifetime gift tax exemption will plummet from its zenith of $5.12 million in 2012 (indexed from $5 million) to only $1 million in 2013. Even if a legislative compromise is reached in Congress - a figure of $3.5 million has been floated by the Obama administration - it will soon become even more important to cut gift tax valuations down to size.  
In the Wandry case, the taxpayers executed gift documents in 2004, transferring membership units of a limited liability company (LLC) to their children and grandchildren. The documents specified the dollar value of each gift based on the applicable exclusions and exemptions 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. Such a formula clause in gift documents often includes a "spillover" provision, with any excess value going to charity.
After an audit, the IRS issued a notice of deficiency relating to the gifts. It argued that these gifts represented a transfer of fixed percentage interests of the LLC rather than a specified dollar value. This creates a "condition subsequent to a completed gift," opined the IRS, so the clause should be voided as being contrary to public policy.
Yet the Tax Court rejected this argument. In doing so, it distinguished a "savings clause," which a taxpayer can't use to avoid the imposition of gift tax, from a "formula clause," like the one used in this case, which the court says is valid. The fact that the taxpayers, not a charity, benefit from the spillover was not determinative, although the court did acknowledge it's a factor.
For the first time, the Tax Court approved a formula clause for valuing gifts of a business interest without a charitable element. But that doesn't mean you can expect smooth sailing if you use these Wandry clauses for your clients. The IRS can be expected use all the resources at its disposal to contest the tax outcome of such gifts. Practitioners are advised to proceed with caution.
In any event, if large gifts of business interests are being contemplated, it makes sense to implement them before the end of 2012. Whether or not Wandry clauses are used, a client can benefit from the favorable estate and gift tax provisions currently in effect, especially since they're likely to be scaled back in 2013.


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