Valuation Formula Clause Will Not Be Respected for Gift Tax Purposes

O n Date 1, D and S formed Partnership P. D transferred assets to P in exchange for a P limited partnership (LP) interest. S transferred assets in exchange for the general partnership interest and P's remaining LP interest. The terms of P's partnership agreement required the unanimous consent of the partners for the admission of an assignee of a partnership interest as a new partner, and permitted P to redeem certain assignee interests held by charities at fair market value.

On Date 2, D transferred his entire LP interest to S and two charities. S agreed to assume liability for the payment of any transfer taxes imposed on D as a result of the transfer. The transferred interest was to be divided among the transferees according to a formula that allocated the partnership interests among the donees based on value. The first portion of value was allocated to S, the next portion of value was allocated to one charity and all remaining value was allocated to the other charity. As a result of the allocation, S received an LP interest, the first charity received an LP interest and the second charity received an LP interest. No negotiation occurred among S and the charities as to the accuracy of the appraisal on which the allocation was based.

Approximately six months later, S redeemed the two charities' interests. Based on a second appraisal, each charity received cash. Each charity executed a release acknowledging payment in full and releasing P "of any and all obligations, including, but not limited to (1) any and all obligations pursuant to the call agreement and (2) any and all obligations pursuant to the [P agreement]."

The IRS determined a different value for the transferred interest. D argued that, even if the Service's determination was sustained, under a formula clause, any value in excess would pass to the second charity, with the result that any valuation adjustment would be offset by an increased charitable deduction.

Analysis

Under Sec. 2511(a), a gift tax imposed by Sec. 2501 applies to transfers in trust or otherwise, whether the gift is direct or indirect and whether the property is real or personal, tangible or intangible. Regs. Sec. 25.2511-1(c)(1) provides that the gift tax applies to any transaction in which an interest in property is gratuitously passed or conferred on another, regardless of the means or device employed. Under Regs. Sec. 25.2511-1(h)(1), a gift to a corporation is a gift from the donor to the stockholders to the extent the gift exceeds the donor's interest in the corporation as a shareholder. The legislative history accompanying the law that enacted the gift tax, provides that:

The terms "property," "transfer," "gift," and "indirectly" are used in the broadest and most comprehensive sense: [sic] the term "property" reaching every species of right or interest protected by law and having an exchangeable value.

The words "transfer...by gift" and "whether...direct or indirect" are designed to cover and comprehend all transactions...that, property or a property right is donatively passed to or conferred upon another, regardless of the means or the device employed in its accomplishment.

Taxpayers generally are free to structure a business transaction as they please, even if motivated by tax-avoidance considerations. However, the tax effects of a particular transaction are governed by its substance rather than its form. The simple expedient act of drawing up papers does not control for tax purposes when the objective economic realities are to the contrary. The doctrine that the transaction's substance prevails over its form is applied in Federal estate and gift tax cases.

The formation of P, the transfer to S and to the charities and the redemption of the charitable interests, was in substance a single integrated transaction, the effect of which was to transfer a P interest to S. D and S were at all times in control of the transaction and, after the transaction, S was in control of the transferred interest. There is no evidence of any arm's-length negotiations with the charities. Indeed, the sole purpose of the presence of the second charity was to imbue the appraisals (which were an integral part of the donative plan) with the patina of third-party reliance. Any additional transfer to charity under the formula clause was illusory; the charity acknowledged as much when it signed the release. The second charity received all that it was ever intended to receive. Accordingly, the transaction is appropriately treated as the transfer of an interest to S in the value determined by the IRS.

Charitable Deductions

The purpose of Congress in providing deductions for charitable gifts was to encourage gifts for charitable purposes; to make such purpose effective, there must be a reasonable probability that the charity actually will receive the use and benefit of the gift.

According to Regs. Sec. 25.2522(c)-3(b)(1), if, as of the gift's date, a transfer for charitable purposes is dependent on the performance of some act or the happening of a precedent event, making the transfer effective, no deduction is allowed unless the possibility that the charitable transfer would not become effective is so remote as to be negligible. If an estate or interest has passed to (or is vested in) a charity on the gift's date and the estate or interest would be defeated by the performance of some act or the happening of some event, the possibility of occurrence of which appeared on such date to be so remote as to be negligible, the deduction is allowed. If the donee or trustee is empowered to divert the property or fund (in whole or in part) to a use or purpose that would have rendered it, to the extent that it is subject to such power, not deductible had it been directly so given by the donor, the deduction will be limited to that portion, if any, of the property or fund exempt from an exercise of the power.

Regs. Sec. 25.2522(c)-3(b)(2), Example (1), describes a situation in which A transfers certain property in trust in which a charity is to receive the income for his life. The assets placed in trust by the donor consist of stock in a corporation, the fiscal policies of which are controlled by the donor and his family. The trustees and the remainderman are members of the donor's family and the governing instrument contains no adequate guarantee of the requisite income to the charitable organization. The example concludes that no deduction will be allowed. Similarly, if the trustees are not members of the donor's family but have no power to sell or otherwise dispose of the closely held stock (or otherwise ensure the requisite enjoyment of income to the charitable organization), the example concludes that no deduction will be allowed.

In the subject case, the conclusion is inescapable that, both as of the gift's date and today, the second charity would not receive any additional value should the Service successfully determine that the value transferred was greater than that reported. Initially, as of the gift's date, the partnership agreement precluded the receipt of any additional partnership interest in the second charity in the event the charity disagreed as to the amount that P would pay to redeem its interest. The partnership provisions that permit a redeemed charity to contest the value assigned to its interest do not control those relating to the reallocation of partnership interests, which apply only to partners. There is no evidence that the second charity was ever admitted as a partner. Thus, even as of the gift's date, it had no right to anything other than the cash it actually received.

Moreover, under D's own documents, nothing further can pass to charity. Nothing in the P partnership agreement or the releases provides a mechanism for the second charity to obtain any additional consideration for its redeemed interest if the value of the transferred interest is redetermined. The charity has released P "of any and all obligations, including, but not limited to (1) any and all obligations pursuant to the call agreement and (2) any and all obligations pursuant to the [Partnership agreement]." The charity, P or S are not parties to this proceeding and thus would not be bound by the court's findings. Indeed, D has now admitted that the charity cannot now obtain any additional payment. Accordingly, no further charitable deduction is allowed.

IRS Letter Ruling (FSA) 200122011 (2/20/01)