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Using a 'Formula Transfer Approach' to Help Avoid Possible Gift Tax
Posted in Tax and Finance

The higher $5.12 million federal gift tax exemption that is available in 2012 encourages you to effectuate gifts in 2012, before the federal gift and estate tax exemption falls to $1 million in 2013. In many cases, it makes sense to gift hard-to-value assets at a discount, such as interests in a family limited liability company, family limited partnership or closely held corporation.

Traditionally, gifts of interests in entities have been expressed as a specific amount of equity in the entity, and the value of the interest being gifted is based on an independent professional appraisal. For example, you may gift five units in a family limited liability company and, based on an appraisal, believe that the total value of the five units gifted is $100,000. However, with such a gift, you bear a risk that the Internal Revenue Service will challenge the value of your equity interest given away and assess a gift tax deficiency – perhaps asserting, for example, that the correct value of the five units gifted is $200,000. A recent U.S. Tax Court case, however, may make it possible for taxpayers to gift equity at a discount and avoid the risk of gift tax.

Viability of the formula transfer approach

In Wandry v. Commissioner, the taxpayers gave away interests in a family limited liability company by using a “formula transfer approach.” They gifted a certain value of limited liability company units, rather than a certain number of limited liability company units. In essence, the taxpayers’ gift assignment documents stated that the taxpayers were making gifts of that number of units in the family limited liability company that would equal the value of the taxpayers’ remaining gift tax exemption. The taxpayers went on, in the gift assignment documents, to express their intent to have an independent appraisal performed of the units in the limited liability company. The IRS argued that the taxpayers’ attempt to define a gift by reference to a formula value, rather than by reference to a specific number of units in the limited liability company, was invalid, and the IRS asserted a gift tax deficiency. The Tax Court ruled for the taxpayer.

The Wandry case appears to be the first Tax Court case to approve of such a formula transfer approach. Because the Wandry case was issued as a “Memorandum” opinion rather than as a full opinion of the Tax Court, the decision in such case is not binding upon the IRS or upon other taxpayers. The IRS recently filed a notice of appeal with the Tenth Circuit Court of Appeals, indicating that it intends to appeal the decision of the Tax Court in the Wandry case.

Using the formula transfer approach

A taxpayer who desires to effectuate a large tax-free gift of a hard-to-value asset at a discount before the end of 2012 should consider using the type of formula transfer approach that was approved by the court in Wandry. As described above, if the IRS challenges the value of an asset gifted, using the Wandry approach may help avoid a gift tax deficiency. However, because it is not yet certain how the IRS will respond to the Wandry decision, there may be a risk, for example, that utilizing a Wandry formula transfer approach will increase the risk of audit of a gift tax return.

Please contact a member of our Estate Planning Practice Group in order to discuss the pros and cons of a Wandry formula transfer approach in more detail.

DISCLOSURE REQUIRED BY CIRCULAR 230. This Disclosure may be required by Circular 230 issued by the Department of Treasury and the Internal Revenue Service. If this article, including any attachments, contains any federal tax advice, such advice is not intended or written by the practitioner to be used, and it may not be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. Furthermore, any federal tax advice herein (including any attachment hereto) may not be used or referred to in promoting, marketing or recommending a transaction or arrangement to another party. Further information concerning this disclosure, and the reasons for such disclosure, may be obtained upon request from the author of this article. Thank you.

  • Partner

    John is a partner in the firm's Estate Planning Department. He focuses his practice on estates, trusts, family business and disability planning, and the administration of estates and trusts. John also has an active health law ...

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