Will Petter v. Commissioner shut down the Internal Revenue Service’s attack on charitable lids?

 

Coming just three weeks after the U.S. Court of Appeals for the Eighth Circuit handed down a complete taxpayer victory on charitable lid planning by affirming the Tax Court in Christiansen v. Comm’r, 2009 WL 3789908 (Nov. 13, 2009), the Tax Court has once again approved another charitable lid strategy in Petter v. Comm’r, T.C. Memo 2009-280 (Dec. 7, 2009). 

(Editor’s Note: For a more general article on the ramifications of Petter and Christiansen, see the February 2010 issue of Trusts & Estates “Defined Value Clauses—Better Defined,” by Scott A. Bowman.)

 

Although the IRS almost certainly will appeal Petter to the Ninth Circuit, the floodgates may have opened with two Tax Court victories in a row, putting charitable lids at, or near the top of the list in 2010 of estate-planning strategies for wealthy individuals owning illiquid assets. 

 

That is, of course, if we have an estate tax in 2010.

  

HOW LIDS HELP

So what’s a charitable lid?  Although it can be structured in a variety of ways, basically it’s a planning technique that guarantees that if the IRS questions a valuation discount on a gift or estate tax audit and succeeds in reducing the amount of the discount, the difference will not go to the IRS in the form of estate or gift tax, but rather to one or more charities named in the estate plan. 

 

For example, assume a taxpayer gifts limited liability company (LLC) interests equal to his $1 million lifetime gift tax exemption “as finally determined for federal gift tax purposes” to his daughter with any remaining LLC units passing to a named charity.  The taxpayer obtains an appraisal valuing the LLC interests at a 50 percent discount.  The taxpayer thus has transferred the entire $1 million gift tax exemption to his daughter based on the appraised value. 

 

Then, on audit, the IRS and the taxpayer agree that the 50 percent discount was too high and the appropriate discount should be only 30 percent. 

 

With a charitable lid, the difference in the discount does not pass to the IRS in the form of gift taxes, but rather to the taxpayer’s favorite charity, with the IRS ending up with nothing.

 

For 65 years, the IRS relied on the holding in Comm’r v. Procter, 142 F.2d. 824 (4th Cir. 1944), that such valuation adjustment clauses were contrary to public policy for a variety of reasons—not the least important of which is that they discourage the IRS from collecting taxes.

 

In Procter, a taxpayer made a transfer to certain trusts with an adjustment clause providing that any portion of the transfer that resulted in gift tax would revert back to the taxpayer.  Procter held that such a clause in which property reverts back to the donor was void. 

 

That stance certainly seems to make sense from a public policy standpoint.

 

But what if the amount subject to gift or estate tax did not revert back to the transferor but instead passed to charity?  Is that against public policy? 

 

The IRS says, ‘Yes.’ The courts in Christiansen and Petter say, ‘No.’

 

What is at stake is potentially billions of dollars that would otherwise be collected in gift and estate taxes passing instead to charity. 

 

Why not take an aggressive discount when transferring an illiquid asset to family members when the only risk of the IRS reducing the discount is that the difference passes to charity but no additional gift or estate tax is due?

 

JUDGE HOLMES

 

U.S. Tax Court Judge Mark V. Holmes wrote the Petter opinion; he is the same judge who wrote the Tax Court’s opinion in Christiansen. Judge Holmes has an interesting way of writing opinions.  The Petter opinion reads like a story with more than eight of its 15 pages devoted to the facts. 

 

Anne Petter was a schoolteacher in Washington state who inherited a significant amount of United Parcel Service of America, Inc. (UPS) shares from her uncle (one of the company’s founders) in 1982.  At that time, UPS was a privately held company.  After her inheritance, Anne continued to teach and live in the same house and remained close to her three children: Donna, Terry and David, who is disabled. 

 

In 1998, with an estate estimated at $12 million, Anne retained estate-planning attorney, Richard LeMaster to put her affairs in order.  Anne wanted both to provide a comfortable life for her children and grandchildren and to give some money to charity.  She also wanted Donna and Terry to learn how to manage the family’s assets, but felt they needed help to learn how to invest and manage money wisely.

 

The centerpiece of Anne’s plan was an installment sale to an intentionally defective irrevocable trust (IDIT) made up of the Petter Family LLC (PFLLC) and two grantor trusts.  During the planning phase, UPS went public and Anne’s shares were locked up.  After the lock-up period ended in May 2001, Anne’s shares were worth $22.6 million.  Anne contributed 423,136 shares of UPS stock worth $22,633,545 to the PFLLC in return for 22,633,545 membership units, divided into three classes monogrammed with the initials of herself and two of her children:  Class A (Anne), Class D (Donna) and Class T (Terry).  The holders of each class of units had the right to elect a manager by majority vote.  Anne became the manager of the Class A units, Donna managed Class D and Terry managed Class T.  Anne, however, maintained a veto power over all corporate decision making.

 

Once Anne had all the units in place and divided into classes, it was time to transfer them to Donna and Terry.  Her lawyer set up two intentionally defective grantor trusts.  Donna was trustee of her trust as well as a beneficiary along with her descendants.  Terry was the trustee of his trust as well as a beneficiary along with his descendants.

 

FUNDING THE TRUSTS

As in all IDIT transactions, the transfer proceeded in two parts: first, a gift; then, a sale.  On March 22, 2002, Anne gave the trusts PFLLC units meant to make up 10 percent of the trusts’ assets; then on March 24, she sold the trusts’ PFLLC units worth 90 percent of the trusts’ assets in return for two promissory notes.

 

As part of these transfers, Anne also gave units to two charities—The Seattle Foundation and the Kitsap Community Foundation (both public charities)—to establish donor-advised funds.  The division of PFLLC’s units among gifts to trusts and community foundations and sales to the trusts meant that Anne had to value what she was giving and selling. 

 

Her lawyer used a formula clause dividing the units between the trusts and the two charities, to ensure that the trusts did not get so much that Anne would have to pay gift tax.  There were two sets of gift documents, one for Donna’s trust, which named it and the Kitsap Community Foundation as transferees, and a similar set for Terry’s trust, which named it and The Seattle Foundation as transferees.  The gift formula is quite complicated. 

 

Recital C of Terry’s gift document provides that Anne wishes to assign 940 Class T membership units as a gift to the transferees.  Donna’s document is similar, except that it conveys Class D membership units.  Section (1.1.1) of Terry’s gift document provides that Anne transfers to Terry’s trust the number of units described in Recital C equal to one-half of her remaining $1 million gift tax exemption and Section (1.1.2) assigns to The Seattle Foundation the difference between the total number of units described in Recital C and the number of units assigned to Terry’s trust. 

 

The gift documents also provide that the trust agrees that if the value of the units as “finally determined for federal gift tax purposes” exceeded one-half of Anne’s remaining gift tax exemption, the trustee will transfer the excess units to The Seattle Foundation as soon as practicable.  The foundation similarly agrees to return excess units to the trust if the value of the units is “finally determined for federal gift tax purposes” to be less than one-half of Anne’s remaining gift tax exemption.  Donna’s documents are similar but substitute Kitsap Foundation for The Seattle Foundation.

 

THE SALE

For the sale portion of the IDIT transaction, both trusts split their shares with The Seattle Foundation.  Recital C of the sale document provides that Anne wishes to assign 8,459 Class T [or Class D] membership units by sale to the trusts and as a gift to The Seattle Foundation. 

 

Section (1.1.1) of each sale document provides that Anne assigns and sells to each trust the number of units described in recital C equal to $4,085,190 as “finally determined for federal gift tax purposes.” 

 

Section (1.1.2) assigns to The Seattle Foundation the difference between the total number of units described in Recital C and the number of units assigned and sold to the trust in Section (1.1.1). 

 

Section (1.2) of the sale documents provides that the trusts agree that if the value of the units it receives is finally determined to exceed $4,085,190, the trustee will transfer the excess units to The Seattle Foundation as soon as practicable.  Likewise, The Seattle Foundation agrees to transfer shares to the trusts if the value is found to be lower than $4,085,190.

 

THE PROMISSORY NOTE

As is also typical in an IDIT transaction, in exchange for the units transferred in the sale documents, Donna and Terry, as trustees of their trusts, each executed $4,085,190 installment notes on March 25, 2002. 

 

The notes have a 5.37 percent interest rate and require quarterly payments of $83,476.30 for principal and accrued interest. 

 

The notes have a 20-year term, expiring on March 22, 2022. 

 

Anne and the children as trustees signed pledge agreements giving Anne a security interest in the PFLLC shares transferred under the sales agreements. 

 

The parties agree that Donna’s and Terry’s trusts have made regular quarterly payments since July 2002.

 

THE CHARITIES

The opinion emphasizes that behind these complex transactions lay Anne’s simple intent to pass on as much as she could to her children and grandchildren without having to pay gift tax, and to give the rest to charities in her community. 

 

The opinion also emphasizes the fact that the charities were active in the negotiations and signatories to the gift and sale documents. 

 

The Seattle Foundation, in fact, retained outside legal counsel to negotiate the transaction and to make sure that the charities were considered substituted members of PFLLC with full rights (including distributions) rather than assignees with no voting rights. 

 

Once the transfers were completed, the Petters directed many gifts through both foundations to a variety of local charities.

 

THE APPRAISAL AND AUDIT

To value the units transferred to the trusts and the foundations, Anne’s lawyer retained a reputable appraisal company to value the units.  The appraiser, in a 41-page appraisal, determined the value of each unit to be $536.20, reflecting a 53 percent discount.  Anne filed a timely gift tax return fully disclosing the gift and sale transactions.

 

The IRS audit began in January 2005.  The IRS had two main objections to the transaction:

 

(1) It believed that the discount on the units was too aggressive and that the value of each unit should be much higher than reported on the gift tax returns, which would balloon the value passing to the trusts and the charities. 

 

(2) The IRS stated that the formula clauses were invalid because of public policy, meaning that, although the units still might be reallocated to the charities, Anne would not get an additional charitable deduction.  This also would mean that the shares sold to the trusts were sold for “less than fair market value” and were therefore partly transferred by sale and partly by an additional $2 million taxable gift to each trust.

 

Although Anne and the IRS reached a compromise on the final value of each unit, no compromise was made on the formula clause. 

 

Anne petitioned the Tax Court asking it to decide whether to honor the formula clause for the gift and the sale, and also asking if the formula clause is honored, when Anne may take the charitable contribution deduction for the additional units passing to the foundations.

 

THE OPINION

The opinion focuses on the validity of the IRS public policy argument against formula clauses.

 

Looking at the history of the case law on formula clauses dating back to the Procter decision in 1944, the court seemed to distinguish between Procter-like adjustment clauses requiring any gift subject to gift tax to revert back to the donor and formula clauses like those in Christiansen and Petter, where any gift amount that on revaluation by the IRS would be subject to gift tax would not pass back to the donor, but instead to charity. 

 

Procter-like clauses, in which the property goes back to the donor, are void as against public policy. But formula clauses, in which the property passes instead to one or more charities, are fine—because public policy weighs in favor of giving gifts to charity.

 

The court went on to analyze formula clauses in much greater depth than can be described here, but ultimately ruled on the public policy issue that Anne’s transfers and the formulas used to effect those transfers were not void as contrary to public policy, as they failed to meet the U.S. Supreme Court test set forth in Comm’r v. Tellier, 383 U.S. 687 (1966), which held that for the public-policy exceptions to the Internal Revenue Code to be valid, the frustration of public policy that would be caused by allowing the contested deduction must be “severe and immediate.” In fact, the court cited the Tax Court opinion in Christiansen, which not only held a similar charitable formula clause not be void as against public policy, but also concluded that public policy weighed in favor of giving gifts to charities.

 

Further, the court, also following Christiansen, said it believed that fears that charities would be abused by low-ball appraisals were exaggerated.  Executors, trustees, directors of charitable foundations who owe fiduciary duties to protect charitable interests and state attorneys general all would have some incentive to police abusive appraisals.

 

On the second issue of when Anne was entitled to claim a charitable income tax deduction for her gifts of the additional units to the foundations due to the revalued membership unit price as “finally determined for gift tax purposes,” the court found that the deduction should be taken at the time the gift was made in 2002.

 

Unfortunately, Anne did not live to see her victory in Tax Court. But she, along with Helen Christiansen, leave a legacy that may change the course of sophisticated estate planning for individuals with illiquid assets.