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Monday, November 18, 2013

Article on Formula Clauses in Estate Planning

Penpaper

Payson Lyman (Georgetown University Law Center, J.D. Candidate, 2014) recently published an article entitled, The Death of Procter and Rise of Wandry: A New Era of Formula Clauses in Estate Planning, 66 Tax Law. 803 (Spring 2013).  Provided below is the introduction to the article:

In 1976, Congress established the unified credit to streamline enforcement of the gift tax and estate tax.  Because of limits to the unified credit, taxpayers must plan carefully to ensure they are not subject to tax for exceeding the credit. This goal is relatively easy to achieve if the taxpayer is transferring assets with an easily ascertainable fair market value, such as cash or publicly traded stock. However, wealth transfers become considerably more complicated to plan for when they involve hard-to-value assets, such as units of a limited liability company (LLC).  Taxpayers have the difficult task of effectuating a transfer with a tax liability no greater than the unified credit while at the same time attempting to account for an asset's uncertain valuation.

In response to this dilemma, taxpayers and estate planners wishing to transfer units of an LLC commonly use a tool called a formula clause. A formula clause's function is to transfer an amount not in excess of gift tax exemptions, exclusions, and credits by limiting the gift amount when valuation is certain. While the Service has consistently challenged formula clauses for wealth transfers, courts today are more accepting of the planning tool than they once were. Formula clauses were first challenged in the 1944 case of Commissioner v. Procter.  There, the court held a formula clause invalid because it created a condition subsequent and was contrary to public policy.  Procter remained the standard until a recent string of cases declined to follow Procter and validated a new type of formula clause called the “charitable lid.” Charitable lids were held valid, in part, because the clause transferred any amount in excess of the gift tax exclusion and exemption to a charitable organization.  Such altruistic intentions, the courts ruled, shifted the public policy argument in favor of the taxpayer.  Most recently, in Wandry v. Commissioner, the Tax Court for the first time held valid a formula clause with no charitable component.

At issue in Wandry was the validity of a formula clause, with no charitable lid, used to transfer units of an LLC.  Petitioner's dispositive clause, the “Wandry clause,” was expressed as a formula, the effect of which was to transfer LLC units based on current fair market value.  Petitioner's document instructed the transfer of units to equal his gift tax exemptions and exclusions.  The Tax Court held the clause valid because it did not create a condition subsequent and because it was not contrary to public policy.

This Note argues that the Wandry clause is valid when analyzed under a traditional public policy framework and its broader relationship to the Code. Unique features of the Wandry clause eliminate the audit-incentive concern raised by charitable lids. Furthermore, the clause's relationship to the Code reveals that use of formula clauses to maximize use of the unified credit, if done in good faith, is perfectly legitimate. However, the Wandry clause does pose new policy concerns not present with charitable lids. This Note ends by suggesting potential safeguards that taxpayers might use to counter the new policy concerns and to create greater certainty when using such a clause.

Part II of this Note explores the history of the gift tax and unified credit, the ways in which valuation of hard-to-value assets complicates use of the unified credit, and the ways taxpayers employ formula clauses to address those complications. Part III traces the evolution of formula clause case law through Wandry. Part IV presents an argument for why the Wandry clause is valid, the new policy concerns the Wandry clause poses, and potential safeguards taxpayers can use to minimize those new policy concerns.

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