Palm Beach Daily News – January 14, 2007
Advanced planning to reduce gift and estate tax frequently results in “valuation risk” – the risk that a taxpayer and the Internal Revenue Service will disagree on the value of assets transferred between family members. In order to reduce exposure to valuation risk, estate planning attorneys should consider incorporating “defined value clauses” into documents establishing the terms of intra-family transactions, particularly transactions involving difficult to value assets such as interests in family limited partnershipsor other closely held businesses.
Defined value clauses fix the value of agift or sale at a specific dollar amountand require a subsequent appraisal to determine the percentage interest inthe transferred asset necessary to correlate to the fixed dollar gift. In a long-awaited decision, theFifth Circuit Court of Appeals recently upheld a defined value clause in McCord v. Commissioner, a case involving gifts of interests in a family limited partnership (the“McCord FLP”) formed by Mr. And Mrs. McCord, their four sons and an existing general partnership owned equally by the four Mc-Cord boys. Mr. And Mrs. McCord each contributed investment and business assets worth a little more than $6 million to the Mc-Cord FLP in exchange for Class B limited partner interests and$10,000 in cash in exchange for nominal Class A limited partnerinterests.After gifting their Class A limited partnership interests to charity in a separate transaction, Mr. And Mrs. McCord irrevocably assigned specific dollar values of their Class B limited partner interest in accordance with the terms of a “sequentially structured defined value clause,” simplified as follows:
•First, to trusts for the benefit of their children and grandchildren(the “GST Trusts”), a dollar value of Class B limited partnership interest in the McCord FLP equal to the McCord’s unused generation skipping tax exemption;
•Second, to the McCord sons $6.9 million worth of Class Blimited partnership interest in the McCord FLP less any amountstransferred to the GST Trusts;
•Third, to the Shreveport Symphony, $134,000 worth Class B limited partnership interest; and
•Fourth, to the Community Foundations of Texas, the dollar value of the McCord’s entire Class B limited partnership interest in the McCord FLP remaining after satisfying the gifts to the GST Trusts, their sons and the symphony.An appraisal firm was hired to value the Class B limited partnership interests assigned by Mr. And Mrs. McCord. Thereafter,the donees engaged separate counsel to review the appraisal and entered into a “Confirmation Agreement” translating the dollar value gifts into percentage interests in the McCord FLP. At audit, the Internal Revenue Service disregarded the defined value clause and revalued the gifts based upon the percentage interest ultimately received by each donee rather than the dollar value established by the defined value clause. After an adverse decision in the Tax Court, the McCord family appealed to the Fifth Circuit, which reversed the Tax Court and held that the taxable gifts to the GST Trusts and the McCord boys should be limited to the dollar values set forth in the defined value clause.Some question remains whether the McCord decision represents and unqualified ratification of defined value clauses.
While the McCord decision is certainly the most important defined value clause decision to date, it is not controlling for cases originating in Florida, and it is based upon a fact pattern that might be difficult to duplicate. McCord involved a substantial taxable gift, which is rare today given the uncertain future of the gift and estate tax.Nevertheless, McCord represents compelling support for properly structured defined value clause transactions and likely applies well beyond its specific fact pattern. For example, the rationale of McCord should readily apply to sales of interests in closely held businesses to family members or to defective grant or trust.Alternatively, a defined value clause transaction may be structured so that excess value pours to a trust for the benefit of a spouse rather than a charity. That is, if the Internal Revenue Service successfully revalues a transferred interest so that the amount left to the overflow donee in a sequential defined value clause is increased, many clients may feel more secure if the excess value remains in trust for the benefit of their spouse rather than being paid to charity. Sophisticated estate planning requires recognition that risk and uncertainty cannot be eliminated from even the best estate plan. Thanks to defined value clauses, however, and the McCorddecision, planners have better tools to manage one of the more significant risks in advanced planning, valuation risk.
Stephen G. Vogelsang is a shareholder in Gunster, Yoakley& Steward, P.A. He practices in all areas of Federal and StateTaxation including Estate Planning and Administration, Corporateand Partnership Taxation. He has been certified by theFlorida Bar Board of Certification as a Specialist in Tax Law
