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Thursday, August 24, 2006


Federal transfer tax law has various exemptions that may apply to otherwise taxable estate or gift transfers- unified credit amounts, annual exclusion gifts, generation skipping tax exemptions, etc. Taxpayers often desire to make transfers of property that come within these exemptions. Since the value of property is always open to challenge, a taxpayer that transfers a fixed fraction or percentage of property based on the taxpayer's valuation so as to come within a specific exemption amount may be subject to a nasty surprise if the IRS or a court determines a higher value for the property. In that case, the taxpayer will have given more than the targeted exemption amount, and thus will likely suffer unfavorable tax results (usually by exceeding the available exemption amount).

One way to avoid this problem is to provide in the transfer instrument that only so much of the subject property is being transferred that equals the available exemption amount (instead of transferring a fixed percentage or value of the property). Such a clause is often referred to as a "defined value gift clause." If the value of the property is higher than anticipated, the effect will be to reduce the fraction of the property that is transferred - the total gift value remains at the stated gift amount so the applicable exemption will not be exceeded.

The IRS is generally hostile to such clauses on public policy grounds since it effectually frustrates their audit of value of gifted property - if the property value is increased on audit the IRS will not collect any additional taxes on the gift itself since the amount of property gifted is automatically reduced to remain within the total dollar amount stated for the gift.

In 2003, the Tax Court in the McCord case voided the effect of a defined value gift clause. The Tax Court hung its hat on the fact that the formula used in that case defined the gift based on its "fair market value" and not its "fair market value as finally determined for federal gift tax purposes."

You would think that this was a slender thread on which to base its decision - and you would be right! The 5th Circuit Court of Appeals has now reversed the Tax Court, and gave full effect ot the defined value gift clause provided for by the taxpayers.

Does this mean defined value gift clauses will now be accepted as valid by the IRS and courts? Not necessarily. Interestingly, the IRS did not argue the public policy enforcement issues discussed above and often raised in these circumstances (based on the old case of Procter and its progeny). Therefore, a court faced with such a public policy argument might still invalidate a defined value gift clause on those grounds. Further, since this case was in the 5th Circuit, courts in other Circuits are not bound by it.

Nonetheless, the decision is helpful both in structuring defined value gifts that will be more likely to withstand IRS scrutiny and as precedent that may eventually lead to some final acceptance by the IRS or more courts as to their effectiveness.

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