Certain Gifts with Adjustment Clauses May Not Produce Desired Tax Results

A recent ruling serves as a reminder that gifts subject to certain types of adjustments based on IRS actions may not produce the intended tax results.

Facts

In Letter Ruling (TAM) 200337012, the taxpayer and his spouse formed a limited partnership. The taxpayer executed an assignment gifting a portion of his limited partnership interest. The assignment language specified that the transferred interest would be a percentage of the assignors interest equal to a specified fair market value. According to the IRS, the clause would operate to reduce the percentage interest the taxpayer transferred if the IRS subsequently determined that the dollar value of the partnership interest was greater than the dollar value stated in the assignment. Thus, the clause was intended to protect the taxpayer from an assessment of gift tax on an IRS revaluation.

Ruling

The IRS determined in the TAM that the portion of the assignment transferring an interest with a specified dollar value was not effective for gift tax purposes; this type of adjustment clause was void as contrary to public policy. The gift had to be revalued and additional tax determinedwithout the voided clause. The IRS rejected the taxpayers argument that nothing would be returned to him through the operation of the clause, because he never intended to transfer any interest beyond a certain dollar value. In substance, a portion of the transferred interest equal to the percentage interest in the partnership that exceeded the specified value would be transferred back to the taxpayer.

The IRS relied on case law and its own revenue ruling in its conclusion, including Proctor, 142 F2d 824 (4th Cir. 1944), Ward, 87 TC 78 (1986) and Rev. Rul. 86-41. In Proctor, a frequently cited decision in this area, the Fourth Circuit analyzed a provision that would rescind a transfer to the extent it was determined to be subject to gift tax. That court determined that the adjustment provision, which imposed a condition subsequent on a completed gift, was against public policy and, thus, invalid.

The IRS rejected the taxpayers argument in TAM 200337012 that his facts were distinguishable from those in Proctor, because the transfer in the TAM was pursuant to a definitional, not a formula, clause. According to the Service, this argument merely attached a different label that did not nullify the actual effect of the clause on the transfer. In the Services opinion, such clauses discourage tax collection; any IRS action to enforce tax collection would be automatically defeated by a change to the gifted amount.

Conclusion

The invalidated clause in TAM 200337012 is distinguishable from certain other types of permissible clauses in the estate planning area. For example, clauses that condition a transfer on an amount provided in (or computed with reference to) the Code, regulations or IRS rulings are generally allowable. Testamentary marital deduction clauses, although similar to the ones rejected in Proctor and TAM 200337012, are widely used and accepted. In summary, TAM 200337012 demonstrates the IRSs aversion to certain formula clauses and emphasizes the need for adequate forethought in planning gift transactions.

From Bryan Keith, Washington, DC