Why Words Matter When Making Defined Value Gifts

Defined value gifts can be used to minimize gift tax on transfers of difficult-to-value assets, such as interests in a closely held business or family limited partnership (FLP). In simple terms, this technique involves transferring a specific dollar amount of an asset, rather than a set number of shares or units or a specific percentage interest.

The goal is to protect the transfer against an assessment of gift or estate taxes if the IRS subsequently determines that the asset was undervalued. But this tax-saving technique can be undermined by improperly worded transfer documents.

In Nelson v. Commissioner, the U.S. Tax Court made a distinction between the following two types of clauses:

1. A formula clause. This type transfers a fixed dollar amount. It’s subject to adjustment in the percentage interest transferred based on a final determination of the fair market value for federal gift tax purposes. A formula clause can effectuate a defined value gift.

2. A saving clause. This type transfers a percentage interest or set number of shares. But it provides for a portion of the gift to be returned to the donor if it’s ultimately determined to be taxable. A saving clause can’t be used for a defined value gift.

In Nelson, the taxpayers made the following transfers of FLP interests:

• A gift to a trust, which was purported to transfer an interest “having a fair market value of [$2,096,000] as of December 31, 2008, … as determined by a qualified appraiser within [90] days,” and
• A sale to the same trust, which was purported to transfer an interest “having a fair market value of [$20 million] as of January 2, 2009, … as determined by a qualified appraiser within [180] days.”

The taxpayers subsequently attempted to adjust the size of the transfers to reflect their stated intent to transfer defined values. But the court relied on the terms of the transfer documents. By describing the transfers in terms of interests “having a fair market value of a specified amount as determined by an appraiser within a fixed period,” the taxpayers essentially transferred fixed percentages, rather than specific dollar amounts. The outcome may have been different, the court suggested, if the transfer documents had provided for an adjustment to the number of units if the value were finally determined for federal gift tax purposes to exceed the amount described.

In recent years, the Tax Court has given its blessing to defined value gifts. However, Nelson reminds taxpayers and their advisors that the transfer documents must use precise language to protect transfers from unintended adverse tax outcomes.