Defined value clauses have become a popular estate planning tool for clients making gifts of hard to value assets. The concern of donors is that if their appraisals are successfully challenged by the IRS upon a gift tax audit, significant gift and GST taxes might be due. Defined value clauses are used by donors to avoid unintended gift, estate and GST taxes by adjusting the value of the gift upon audit. The IRS routinely challenges such clauses, arguing that they are against public policy because they prevent the IRS from properly administering the gift, estate and GST tax laws.

In Estate of Christiansen, 130 T.C. 1 (2008); aff'd 586 F.3d 1061 (8th Cir. 2009), Estate of Petter, T.C. Memo. 2009-280; aff'd, 653 F. 3d 1012 (9th Cir. 2011); Estate of McCord, 461 F. 3d 614 (5th Cir. 2006); and Hendrix v Commissioner, T.C. Memo 2011-133, formula gifts were upheld, in part, because if the gift values were ultimately determined to be higher than stated in the transfer documents, any "excess" value would pass to charity (where the unlimited charitable gift tax deduction would be available to avoid any unintended gift tax). While such excess gifts could also pass - gift tax free - to the donor's spouse, a zeroed-out GRAT for a non-spouse, or an incomplete gift trust, without an independent charity involved, enforcement of the proper valuation could be lacking. Thus, reliance on these cases without the charitable component (which many donors are unwilling to include) created uncertainty.

On March 26, 2012, the Tax Court kindly offered a solution. In Wandry v Commissioner, T.C. Memo 2012-88, a formula clause without a charitable component survived the IRS's challenge. The Tax Court's decision provides a "how to" guide for practitioners. Generally, the formula used in Wandry made gifts of a specific dollar amount of LLC membership interests (as opposed to a specific number of membership units) through a formula that reduced the number of gifted units based on a final IRS or court valuation (similar to a marital deduction formula in an A-B trust).

Hopefully, the Wandry case will serve as the final nail in the coffin for defined value clause challenges by the IRS.

For more information regarding this topic, please e-mail your requests to Julius Giarmarco, or call Julius at (248) 457-7200.

In PLR 2012-16045 (released on April 20th), the IRS ruled that the present value of testamentary charitable lead annuity trust (T-CLAT) payments which increase each year by 120% of the prior year's payment (hereafter "graduated payments") would qualify for the estate tax charitable deduction.

The facts of the ruling are as follows. The decedent (let's call her "Jane") established a 10-year, "zeroed-out" T-CLAT in her revocable living trust. The sole charitable lead beneficiary was Jane's private foundation. The remainder beneficiaries were trusts for Jane's children. However, rather than defining the annuity as a percentage of the initial amount passing to the T-CLAT, a formula was used, which read as follows: "Accounting from the beginning date, the annual annuity amount shall be an amount that will produce a present value under section 7520 of the Code for the non-charitable remainder interest equal to zero or as close to zero as possible without exceeding zero." Recognizing that the formula was subject to various interpretations and that if interpreted to require a fixed annual payment, the trust would be less likely to fulfill its obligation to the foundation, the T-CLAT trustees obtained probate court approval for the graduated payment interpretation. In giving its approval, the probate court noted that the graduated payment interpretation was the "actuarial equivalent" of the fixed payment one.

For example, if $1,000,000 were left to Jane's T-CLAT this month, then based on this month's section 7520 rate (1.4%), a fixed payment interpretation would require a $107,870 annual payment. But a graduated payment interpretation would require only $42,390 in the first year, $50,868 (120% x $42,390) in the second year, $61,041 (120% x $50,868) in the third year, etc. If the trust declined to $800,000 due to a market drop shortly after death, assuming a 5% rate of return going forward, the fixed payment interpretation would support only 9 payments of $107,870 and a final payment of $54,208. Nothing would go to the children. In contrast, the graduated payment interpretation would support all 10 payments called for (the last being $218,723) and still leave something to the children ($13,657 in this example).

The probate court's approval was, however, conditioned on that of the IRS. Finding that the payments under the graduated payment interpretation were determinable as required, the IRS let stand the charitable deduction claimed for the full amount left to the T-CLAT (the $1,000,000 in the example).

This ruling, the first pronouncement from the IRS of any kind directly addressing a "real life" graduated payment CLAT situation, is welcome news for these CLATs. Why did the trustees pick 120%? The ruling doesn't say, but the likely reason is that CLATs are similar to GRATs and an annual 120% increase is the most allowed for GRATs under the GRAT regulations. As a result, planners should consider using graduated payment CLATs more often, since they can deliver more to children and charity, while still disinheriting the IRS.

For more information regarding this topic, please e-mail your requests to Salvatore J. LaMendola, or call Sal at (248) 457-7204.

With time possibly running out for clients to give away their $5.12 million gift tax exemption ($10.24 million for a married couple), many advisors are recommending (to their married clients), a spousal lifetime access trust (SLAT). For example, the spouse with the shortest life expectancy (let's assume that's the husband) creates a SLAT for the benefit of his wife. Husband funds the SLAT with his $5.12 million exemption and names his wife as the trustee. As trustee, the wife can make distributions to herself for health, education, maintenance and support. Thus, the husband maintains "indirect" access to the SLAT during his wife's lifetime. Upon the wife's subsequent death, the balance in the trust can pass - estate and GST tax free - to the children (and more remote descendants).

If one SLAT is good, are two SLATs better? At first blush it may appear that each spouse could establish a SLAT for the other's benefit. But if two SLATs are created, the IRS could recast the transaction by applying the reciprocal trust doctrine. This doctrine assumes that each spouse established a trust for his or her own benefit, thus resulting in estate tax inclusion for each spouse of the trust property. While it may be possible to draft and design around this doctrine, the conservative approach is to create only one SLAT.

A possible drawback of a SLAT is that if the wife (in our example) dies first, the husband loses access to the trust's assets. One simple solution to this problem is for the wife to create an irrevocable life insurance trust (ILIT) for the benefit of her husband. The ILIT would be funded with a life insurance policy on the wife's life to replace the wealth lost to the husband in the SLAT (in the event he survives his wife). If necessary, the SLAT can loan the ILIT the funds needed to pay the premiums under a split-dollar arrangement.

For more information regarding this topic, please e-mail your requests to Julius Giarmarco, or call Julius at (248) 457-7200.