In the case of Estate of Anne Y Petter et al. v. Commissioner, the Ninth Circuit Court of Appeals enabled tax payers to more easily value gifts to fit within the taxpayers yearly gift tax exemption.
In Estate of Petter, the controversy at issue is the effect of a so-called "charitable lid" or "charitable freeze" clause in an agreement to transfer membership units in a family-owned LLC. To understand the purpose of the clause, one must first examine the structure of the transaction subject to the "charitable lid" clause and then the motivation behind each step in the process.
The form of the transaction was a transfer of the membership units owned by Petter to two long term trusts and two charitable organizations, concurrently. The transaction was designed so that Anne Petter could remove the shares of her UPS stock from her estate and make a gift of some of those shares to her children without triggering the gift tax.
To reach this result, Anne first created the Petter Family LLC (PFLLC) and exchanged her UPS shares for membership units in the LLC. The purpose of this first step in the transaction is to reduce the value of the property Anne will be transferring by gift. UPS shares are publicly traded and easily valued: however the membership units of an LLC will be more difficult to value and will frequently be valued at less than the assets held by the LLC. Typically, the membership units of the LLC will be subject to some restriction on transferability, causing the units to be of less value than the shares held by the LLC. The PFLLC was designed to achieve this by dividing membership units in the LLC into three classes. One class was designated to be managed by Anne, and the other two were to be managed by Anne's two children, one class by each child. Any decision regarding the management of PFLLC required approval by a majority of the managers, and was subject to a veto power held by Anne. The Operating Agreement of the PFLLC insulated the Petter family's control from subsequent holders of membership units by requiring that only "Substituted Members" approved by the managers (the Petter family) would have the ability to exercise voter's rights. Any subsequent holder of a membership unit who was not accepted as a "Substitute Member" would receive merely an assignment of rights to profits and losses. Because the membership units are subject to these restrictions on voting rights, they will be of less value than shares of UPS stock. This transaction, the exchange of UPS shares for membership units in an LLC, was previously acknowledged by the tax court in Estate of Erickson v. Commissioner.
Having reduced the valuation of the transfer Anne intended to make, the next step was to create two long term trusts for each of her children, Donna and Terry, and fund them with the PFLLC membership units. The creation of the trusts was the mechanism by which Anne removed the membership units from her estate. However, the trusts were designed to be "defective" so that Anne would be considered the owner of the trust assets for purposes of the income tax due on the membership units. This way, Anne could pay income tax on the membership units without making a gift to the trusts holding those units. "Defective" trusts were created by allowing the trustee of either trust to purchase and pay premiums on a life insurance policy on Anne, which violates section 677(a)(3).
Having created the "defective" long term trusts, Anne proceeded to fund the trusts in a two-step process. The first step was a gift to each trust equal to one half of Anne's remaining unified credit against the gift tax. The gift of membership units was equal to ten percent of the total membership units each trusts would eventually hold. The other ninety percent of the membership units each trust received was sold by PFLLC to each trust, who in return gave a promissory note for the value of membership units received.
In conjunction with the gift of membership units to the trusts, PFLLC made a charitable donation to two 501(c)(3) funds, each charity being identified with a particular trust. The relevant language of the transfer agreement was the following:
"assigns to the trust as a gift the number of units described in Recital C above that equals one-half the minimum dollar amount that can pass free of federal gift tax by reason of Transferor's applicable exclusion amount allowed by Code Section 2010(c)."
The document first defines a total number of membership units to be transferred in Recital C, not quoted here. The design is simply that in Recital C is a total number of PFLLC membership units, and the selected passage of the document above makes a gift to each trust of the portion of those units listed in Recital C that will equal the value of the unified credit Anne has at the time of the transfer. The charities received their shares as the leftovers from Recital C which is a variable amount defined by the clause that is the subject of the case decided by the Ninth Circuit and known as either a "charitable lid" or "charitable freeze." The language of that clause is quoted below:
"The Trust agrees that, if the value of the Units it initially receives is finally determined for federal gift tax purposes to exceed the amount described in Section 1.1.1, Trustee will, on behalf of the Trust and as a condition of the gift to it, transfer the excess units The Seattle Foundation as soon as practicable."
The purpose of this clause was to protect Anne from any IRS valuation of the membership units which might cause the gift of membership units to the trusts to exceed Anne's unified credit. As discussed above, membership units in a family owned LLC are difficult to value and because of that difficulty are frequently subject to scrutiny in an IRS audit. Predicting that the IRS might value the units higher than Anne's calculations, Anne sought to prevent a subsequent application of the gift tax to the transaction. The clause required the trusts to transfer units to the charities in the event of such a valuation in an IRS audit. The sale of membership units to the trusts was subject to a similar provision, requiring the trusts to transfer units to their respective charitable organizations if the sale price was later determined to be too low. Finally, in the event that a subsequent audit revealed that the initial gift and sale transactions had over-valued the units, the charitable organizations would transfer units back to the trusts until the trusts had each received a number of units equal to one half of Anne Petter's remaining unified credit.
As predicted, during a subsequent audit the Commissioner determined that the units were indeed under-valued, that the transfer by gift to the trusts was subject to the gift tax, and furthermore that the purported sale of membership units was actually a transfer partially by sale and partially by gift. Finally, the Commissioner determined that the "charitable lid" clause was invalid, which would prevent any re-allocation of units from resulting in further charitable deductions.
The Commissioner's argument that the re-allocation clauses are invalid is informed by a long history of precedent and legal guidance, including Estate of McCord v. Commissioner; Estate of Christiansen v. Commissioner; and Rev. Rul. 86-41. The ruling of the Ninth Circuit nearly settles the matter of whether a "charitable lid" clause is valid, however there remains a potential public policy challenge to such clauses which the Ninth Circuit did not have the opportunity to consider in responding to the Commissioner's argument.
In 1944 the landmark case of Commissioner v. Procter (as interpreted by the Tax Court in Estate of Petter v. Commissioner) established that a similar re-allocation clause, known as a "savings clause," was invalid either as a present gift of a future interest in property subject to a condition precedent, or invalid as against public policy for three reasons:
"The clause has a tendency to discourage the collection of the tax since efforts would simply undo the gift"
"The effect of the clause would be to obstruct the administration of justice by requiring the courts to pass upon a moot case"
"A judicial proclamation on the value of the trust would be a declaratory judgment, because the condition is not to become operative until there has been a judgment; but after the judgment has been rendered it cannot become operative because the matter involved is concluded by the judgment"
In the Petter case, the Ninth Circuit has made very clear that the "charitable lid" is not a present gift of a future interest in property subject to a condition precedent. It is the view of the Ninth Circuit in the Petter case that the formula in this transfer agreement serves to define the interest presently transferred rather than later modify that interest. The gift and sale of membership units to the trusts and charities is for a number of units equal to the value of Anne Petter's unified credit. The re-allocation of those units upon the outcome of a subsequent IRS audit merely ensures that the parties receive only the membership units to which they were entitled under the transfer agreement.
The crux of this dispute was the eligibility of the transfer of units for the section 2522(a) charitable gift deduction after an IRS audit. The deduction is disallowed if the charitable gift will not become effective without either the performance of an act or the occurrence of an event preceding the gift, as per Treas. Reg. 25.2522(c)-3(b)(1). The IRS argued that the regulations prohibited the allowance of a charitable deduction for the transfer of units occurring as a result of an IRS audit. The Ninth Circuit has taken the view that the IRS is incorrect because the transfer of shares occurring after the audit is not in fact dependent upon the audit. The court takes the view that the transfer was effective at the date of the agreement, and the subsequent audit merely clarifies exactly how many membership units would be gifted to each trust to equal the value defined in the transfer agreement. Essentially, the court is satisfied that the agreement entitles the trusts and charities to a number of units that equals a certain monetary value rather than an express number of units of mysterious value. Because the dollar amount is the controlling definition of the property interest transferred, the subsequent audit merely ensures that no party receives more or less than their entitlement under the transfer agreement.
What remains questionable after the Ninth Circuit's ruling however is the argument that such clauses may be void as against public policy. The Ninth Circuit did not have the opportunity to pass judgment upon this argument because the IRS did not raise the argument on appeal. Like in the appeal of the McCord case noted above, the IRS has chosen to preserve that argument for another day by not raising the argument on appeal.
The Tax Court, however, did consider this argument prior to appeal in Estate of Petter v. Commissioner. In the Petter case the tax court relied upon the reasoning of Estate of Christiansen v. Commissioner in determining that "this case is not Procter." Christiansen was cited by the Tax Court where the court argued that public policy was in fact in favor of gifts to charities, that such clauses did not pose a risk of incentivizing undervaluation of membership units in similar transactions, and that the frustration of public policy that would be caused by allowing the deduction must be severe and immediate for such an argument to be persuasive to the court.
Had the Ninth Circuit considered each of the three policy prongs of the Procter case in conjunction with making the determination that the clause in the Petter was a gift of a present interest in membership units, one prong of the policy argument made in Procter may have been successful.
The first policy prong requires considering whether the "charitable lid" will have a tendency to discourage collection of the tax, and in light of the Christiansen analysis adopted by the tax court, that tendency to discourage must be severe and immediate. The Tax Court appears to have passed only upon the question of whether a "charitable lid" would incentivize fraudulent valuation practices, but does not address the impact of that clause on the collection efforts of the IRS. Even as a gift of a present interest, the clause has the tendency to frustrate IRS collection of the gift tax on transactions that are partially eligible for exemption and partially taxable. This argument remains a potentially viable challenge to future "charitable lid" clauses.
The second policy prong questions whether the clause would require the court to pass upon a case that is moot. The ruling of the Ninth Circuit appears to settle this matter by making clear that the effect of the clause is not contingent upon the ruling of the court. Instead, the clause merely operates to ensure that the interest received by each party, as valued by an IRS audit, is consistent with the interest Petter intended to transfer. While the Ninth Circuit did not pass on this argument specifically, it does not appear likely that this argument would be a successful challenge to a "charitable lid" clause going forward.
The third prong appears to be similarly defeated by the ruling of the Ninth Circuit. The concern in this prong is whether the "charitable lid" clause requires the court to provide a declaratory judgment upon a clause that does not become operative until there has been a judgment of the court. Certainly, if an IRS audit was challenged in court, the judgment of that court could be viewed as triggering the operation of the clause at issue in the Petter case. However, the Ninth Circuit appears to reject this view in holding that the clause merely operates to adjust the transfer of units to the quantity intended by the parties at the time of the original gift and sale. The clause is operative at the moment the parties enter into the transfer agreement, and the later impact of a theoretical court challenge to an IRS audit will not modify the operation of the clause in violation the third policy prong in Procter. Again, because the issue was not raised before the Ninth Circuit this is necessarily speculation, however it does appear that the third prong of the Procter public policy argument is no longer a viable challenge to a "charitable lid" clause.
The ruling of the Ninth Circuit has nearly settled the question of whether or not a "charitable lid" clause may be successfully challenged by the Commissioner in the future. While the Procter case continues to pose a potentially viable policy challenge to such clauses, that challenge appears to be significantly weaker after the ruling of the Ninth Circuit.
Posted by Jason Tyler Young, Associate Editor, Wealth Strategies Journal.
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