A hot topic today in estate planning is the use of formula clauses to avoid unexpected gift or estate taxes. Such clauses aim to reduce tax exposure based on uncertainty in valuation of transferred property. That is, when property is gifted or passes at death, the amount of gift or estate tax depends on the valuation. While a taxpayer may obtain an appraisal of value to determine how much is being transferred and thus subject to tax, the IRS may later object to the value and if a higher value is finally determined, unexpected or undesired taxes result.
To avoid such undesired taxes or to reduce the uncertainty involved in the transfer of difficult to value property, planners seek to use various clauses and dispositive schemes that seek to avoid tax on any increases in value that ultimately result. The IRS does not like these clauses and arrangements, and there is some uncertainty on their legal effectiveness, including questions about whether the Procter case from the 1940's has any application to voiding such arrangements.
In a recent Tax Court case, a decedent left assets at death to an heir. The heir executed a partial disclaimer that left a portion of the assets to a charitable foundation to the extent that the value of the assets exceeded a fixed value. The object of the disclaimer was to avoid additional estate taxes if assets were revalued upward, since increased assets would then pass to the charitable foundation and would qualify for an increased charitable deduction. The IRS audited the estate tax return, and found that the assets on the return were undervalued, and increased their value by approximately 50%. The estate, using the disclaimer clause, sought an increased charitable deduction to cover the valuation increase. The IRS challenged the increase in charitable deduction.
The Tax Court held for the taxpayer, allowing the increased charitable deduction. First, the Court held that the amount passing to charity was not "contingent" at death - the value at death was the value at death, even though the IRS and the taxpayer had not yet agreed on what that value was. Second, the Court rejected the "public policy" objections of the IRS. The Court did note that such clauses may discourage the IRS from challenging valuations. However, at least in regard to the situation when disclaimed property passes to charity, the Court noted that such clauses in fact encouraged charitable contributions, which are obviously favored from a public policy standpoint. The Court also noted that there were other checks on the estate to fairly value the property other than just the IRS' ability to audit - such as the fiduciary obligations of the fiduciaries of the estate and the oversight of the charity itself. The Court also distinguished Procter, noting that unlike Procter, the operation of the clause did not undue a transfer but only reallocated where transferred property passed, nor did it have the Court opine on a moot issue or upset the finality of any Court decision.
There was also another disclaimer in the case, this time to a charitable lead trust where the disclaiming beneficiary was a remainder beneficiary. That charitable deduction was disallowed because the disclaimer was ineffective based on the beneficiary's remainder interest in the recipient trust.
Conservatively, the case could be limited to disclaimer clauses and charitable recipients. Planners will need to review the case to determine their comfort in applying its principals to nondisclaimer-type formula clauses and noncharitable scenarios.
Christiansen v. Commissioner, 130 T.C. No. 1 (2008)