The purpose of a formula clause is to assure that gifts do not exceed the donor’s gift tax exclusion amount, which could result in the payment of gift tax.
The Tax Court recently upheld a formula clause designed to control the value of a gift of a difficult-to-value asset in the case of Wandry v. Commissioner (T.C. Memo 2012-88, March 26, 2012).
In this case, Joanne and Albert Wandry formed Norseman Capital, LLC. Norseman’s assets consisted of cash, marketable securities and a family business.
In 2004, the Wandrys executed documents transferring gifts of membership units of Norseman to their children and grandchildren. The documents specified the dollar amount of each gift, $261,000 from Albert Wandry to each of the couple’s four children and $11,000 to each of the five grandchildren. Joanne Wandry made identical gifts.
The actual number of membership units transferred to each donee would be determined only after the value of each unit was determined by the IRS or a court of law. The nine gifts made by Albert totaled $1,099,000, which exactly equaled the sum of nine gift tax annual exclusions ($11,000 per donee) plus the value of his lifetime gift tax credit ($1 million). The same was true for Joanne, so neither paid any gift tax on the transfers.
The IRS argued that the Wandrys actually transferred a certain number of membership units, not a specific dollar amount. In the IRS view, the Wandrys essentially provided that any membership units exceeding the specified dollar amount would be returned to them. The IRS argued that this “adjustment clause,” as the IRS referred to it, created a condition subsequent to the completed gift, which should void the adjustment clause as being contrary to public policy.
The court, for various reasons, rejected the IRS argument. The court drew a distinction between what it called a “savings clause,” which may not be used to avoid the imposition of gift tax, and a formula clause. A formula clause was used in this case, and the court validated it. The court set forth four tests for determining the validity of a formula clause.
1. Under the terms of the transfer documents, the donees must always be entitled to receive a predefined number of units. In this case, the documents essentially expressed the number of units as a mathematical formula. For each child, the formula was:
X = $261,000 / Fair market value of the LLC
Similarly, the formula for each grandchild was:
X = $11,000 / Fair market value of the LLC
2. The value of a unit at the time the transfer documents were executed must be constant. By the time the case was heard, the IRS and the Wandrys had agreed that Norseman had a fair market value of $13,213,389 at the time of the gift. This value was constant at all times.
3. Before and after the IRS audit, the donees must be entitled to the same number of units.
Each of the Wandrys’ children was entitled to receive about a 1.975 percent interest in the LLC:
1.975% = $261,000 / $13,213,389
Each of the grandchildren was entitled to receive approximately a 0.083 percent interest:
0.083% = $11,000 / $13,213,389
4. The transfer must not be dependent on the IRS audit. Using the pre-audit valuation for the LLC, the gift tax returns indicated a transfer of 2.39 percent interests to the children and 0.101 percent interests to the grandchildren. Absent the audit, the donees may never have received the proper percentage interests they were entitled to.
The court concluded that the transfer was not dependent on the IRS audit. Rather, the audit merely ensured the donees received those units they were always entitled to receive.