Nelson: Formula Clauses and Getting Exactly What You Ask

It’s common knowledge among tax practitioners that the IRS is not a fan of formula gift clauses that attempt to pin the amount of the gift to a dollar figure such that the actual gift is adjusted in the event of a successful valuation challenge by the IRS.[1] However, in a recent Tax Court case, Nelson v. Commissioner, TC Memo 2020-81, the IRS found themselves as a benefactor of two formula clauses, one from a gift and one from a sale, that were respected by the Court. However, due to the way the clauses were drafted without an adjustment based on values as finally determined for Federal gift tax purposes, the IRS came out ahead when the Court determined that the valuations used in the gift and sale were too low.

Facts

The Partnership

Mrs. Nelson owned a 93.88% limited partner interest in Longspar Partners, Ltd., a Texas limited partnership (“Longspar”). She and her husband were the sole general partners, each owning 50% of the general partnership interest. The remaining limited partner interests were owned by various members of Mrs. Nelson’s family, either in trust or a custodial account. Longspar owned approximately 27% of the outstanding common stock of Warren Equipment Co., a Delaware corporation, which itself had seven operating subsidiaries ranging from Caterpillar equipment dealerships to companies in the oil and gas industry. The Court provides a thorough discussion of Warren Equipment Co. including its Shareholder’s Agreement, as well as Longspar and it’s Partnership Agreement. The primary purpose of those discussions is in the Court’s determination of Longspar’s value. Since this article focuses on the formula gift aspect of the case, I won’t go into detail but for those interested in that discussion as well as the Court’s valuation analysis, the case can be found here.

The Transfers

As part of Mrs. Nelson’s family succession planning, Mrs. Nelson formed the Nelson 2008 Descendant’s Trust (“Trust”) on December 23, 2008. She named her husband as the Trustee. The beneficiaries were her husband and their four daughters.

On December 31, 2008, Mrs. Nelson made a gift to the Trust of a limited partner interest in Longspar valued at $2,096,000 (by appraisal). The Memorandum of Gift provided as follows:

[Mrs. Nelson] desires to make a gift and to assign to [the Trust] her right, title, and 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.

Three days later, Mrs. Nelson sold a limited partner interest in Longspar valued (by appraisal) at $20,000,000 in exchange for a promissory note from the Trust. The promissory note provided for annual interest payments of 2.06% with a balloon payment of principal at the end of year 9. The Memorandum of Sale and Assignment contained the same language as the Memorandum of Gift and read as follows:

[Mrs. Nelson]desires to sell and assign to [the Trust] her right, title, and interest in a limited partner interest having a fair market value of TWENTY MILLION AND NO/100THS DOLLARS($20,000,000.00) as of January 2, 2009, as determined by qualified appraiser within one hundred eighty (180) days of the effective date of this Assignment.

Due to the complexity of Warren Equipment Co. and all of its subsidiaries, there were multiple levels of appraisals performed by various professional including Ernst & Young and Mr. Roy Shrode. Mr. Shrode performed the final appraisal of Longspar which was used to determine the percentage limited partner interests that were transferred by the gift and the sale. All the appraisals used December 31, 2008 as the appraisal date. Based on the appraisal, the gift was determined to be a 6.14% limited partner interest and the sale was determined to be a 58.65% limited partner interest. Longspar’s Partnership Agreement was amended as of January 2, 2009 to reflect the ownership changes. The Nelsons each filed gift tax returns for 2008 reporting a transfer of a 6.14% limited partner interest in Longspar as a split gift each showing a gift of $1,048,000. The Nelsons also filed 2009 gift tax returns but did not report or disclose the sale since reporting a non-gift transaction is not required, though it may nevertheless be advisable in an attempt to start the statute of limitations.

Audit and Notice of Deficiency

Both Mr. and Mrs. Nelson’s 2008 and 2009 gift tax returns were audited. During the IRS administrative appeals process, the parties negotiated a proposed settlement agreement but it was never finalized. Based on the proposed settlement agreement, Longspar’s partnership agreement was amended to reflect the Trust’s limited partner interest in Longspar as 38.55% and made corresponding adjustments to the books for Longspar and the Trust.  Longspar also adjusted prior distributions and made a subsequent proportional cash distribution to its partners to reflect the newly adjusted interests. However, as stated above, the settlement agreement was never finalized. The reasons for not finalizing the agreement are not disclosed, but the Nelsons did initially argue that it was completed and binding before eventually abandoning that argument.

In August of 2013, notices of deficiency were issued to the Nelsons which adjusted the value of each of their gifts to $1,761,009 rather than $1,048,000 as of the valuation date. The notices also determined that Nelson had transferred by $33,607,038 as part of the sale, and therefore they each had made a split gift in 2009 of $6,803,519. Accuracy related penalties under IRC Section 6662(a) were also proposed but the IRS conceded that issue prior to trial.

Analysis

The Court began its analysis with the general principle that the burden of proof is on the taxpayer.[2] The Court next went into a brief overview of gift tax principles including IRS Section 2512(b) which states that “where property is transferred for less than adequate and full consideration, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift.”

The Formula Clauses

As stated above, the formula clauses for the gift and the sale were nearly identical other than the gift requiring an appraisal within 90 days and the sale requiring an appraisal within 180 days. Each clause tied the percentage of Longspar to be transferred to that appraisal and did not contain any adjustment clause which might serve to change the percentage of Longspar in the event of a subsequent valuation adjustment by the IRS. When issues such as this arise, the Court will look to the transfer documents themselves rather than subsequent events to decide the amount of property given away.[3] The Nelsons argued that the transfer instruments showed that what was transferred was specific dollar amounts, not fixed percentages. The Nelson put forth a series of cases that have respected formula clauses as transferring fixed dollar amounts of ownership interests to prove their case. In each case, the Court did respect the formula because the dollar value of the gift was known at the time of the gift even though the percentage amount was not and could not be known until fair market value was subsequently determined.[4]

The Court went on to discuss savings clauses which the Court generally rejects since they rely on conditions subsequent to adjust the transfer which results in the size of the transfer not being known as of the transfer date.[5] In contrasts, in cases such as Wandry, Succession of McCord, and Estate of Petter, the clauses transfer a specific dollar figure rather than percentages. Looking at the clauses found in the Nelsons’ transfer documents themselves, the Court determined the Nelsons’ clauses were more akin to Wandry, Succession of McCord, and Estate of Petter, and transferred a specific dollar value. The Court thus respected the clauses.

Since the Nelsons’ clauses tied the percentages of Longspar to a dollar value to be determined by an appraisal, the Court held that is exactly what the clauses did. The documents failed to provide for any subsequent adjustment clause or qualifications, such as “as such value is finally determined for federal estate purposes.”[6] Unlike some of the other formula cases discussed where fair market value was linked to the value as finally determined for federal gift and estate tax purposes, the Nelsons’ clauses contained no such language and were only tied to the appraisals. This would be their undoing. By asking the Court the treat their clauses as the other clauses with adjustment language, the Nelsons were “asking [the Court] to ignore…” the language in the clauses themselves and replace it with “for federal gift and estate tax purposes”, something the Court would not do. In the end, the Court respected the formula clauses as written without any subsequent adjustment clause. On that basis, the Court held the gift to be of a 6.14% limited partner interest and the sale was determined to be a 58.65% limited partner interest, each based on the appraisal of Longspar as referenced in the transfer clauses themselves.

Valuation

Having respected the formula clauses and determined the percentage limited partner interests of Longspar that were transferred, the Court next addressed the valuation of the Longspar. Due to the complexity of Longspar owning approximately 27% of Warren Equipment Co. which in turned owned 100% of seven operating companies, the valuation analysis was complicated and thorough, with each side putting forth its valuation experts. The Court walked through each expert’s appraisal of each entity. In the end, the Court determined that the gift of the 6.14% limited partner interest in Longspar was worth $2,524,983, an increase of $428,983, and the sale of the 58.65% limited partner interest in Longspar was worth $24,118,933, an increase of $4,118,933 which was determined to be a gift since the promissory note paid as consideration for the sale was only $20,000,000.

Conclusion

The IRS has long been against formula clause transfers. But in this case, the fact that the Court respected the formula clauses worked in the IRS’ favor, at least in part. The Court did respect the formula clause although not with the interpretation the taxpayers’ were pushing for. Additionally, the Court also allowed tiered discounts since Longspar held an interest Warrant Equipment Co. which in turn owned seven separate entities.

Due to the complexities of formula clause transfers and the IRS disdain for them, practitioners should use extra caution when drafting the clauses. As the Court states in its opinion, tying the gift to the fair market value as finally determined for federal gift and estate tax purposes rather than to the appraisal itself proved fatal to the Nelsons. With access to formula clauses that have been successful, and those that have not, as well as the Court’s opinion in cases like this, practitioners have a road map for how to properly craft a formula clause to give it the best chance of success.

[1] See IRS Action on Decision 2012-004 in which the IRS non-acquiesced to the infamous Tax Court case, Wandry, T.C. Memo. 2012-88; an IRS non-acquiescence is the IRS’ way of saying they disagree with a decision and will not be following it should the same issue arise in a future controversy.

[2] Tax Court Rule 142(a)(1); Welch v. Helvering, 290 US 111 (1933).

[3] Estate of Petter v. Commissioner, TC Memo 2009-280, citing Succession of McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006); see also Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944) (disregarding the subsequent reallocation of property to the donor via a saving clause as contrary to public policy).

[4] Wandry v. Commissioner, T.C. Memo. 2012-88; Hendrix v. Commissioner, T.C. Memo. 2011-133; Estate of Petter v. Commissioner, TC Memo 2009-280.

[5] Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944).

[6] Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008).