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Posted: August 29, 2011

IRS loss is a win for you

Gift and estate tax ruling benefits families

Just as the IRS was becoming more aggressive in pursuing estate gift taxes in cases, a U.S. Tax Court judge made a key ruling in favor of the family involved in the case.

For years, the IRS has been rankled that families wishing to transfer wealth - mainly in the form of partnership interests (business assets) - used defined value formula clauses that essentially reduced the taxable value of the assets upon a transfer.

Court observers say that the long-awaited fourth case on the matter puts the IRS down for the count on fighting the use of defined value formulas. The tax court ruled that the clauses that set the fair market value of transfers of private company stock in a gift/sale transaction in the Hendrix v. Commissioner case in June were not contrary to public policy and were arm's length transactions.

We'll take a quick look at the case issues, but the bottom line result of this case is that families can continue to use the "defined value" formula to take full advantage of the tax code in their gift and estate planning.

The IRS objects

So what rankles the IRS? At a recent conference in Los Angeles, IRS Engineer Team Manager Neil Mills-Mazer introduced a model that addresses his "pet peeve" in the area of fractional interest discounts: the "minority premium," according to Business Valuation Wire. Mills-Mazer said he has seen a 99 percent owner claim a 35 percent value discount on a $2 million property.

He thought was far too much of a discount when the majority owner could buy out the minority owner for little more than the 1 percent, or $19,800. He argued that even at 50 percent ownership, the highest discount the owners should be allowed to take is 30 percent. Others at the conference argued that there is empirical evidence that minority shares trade at greater than 30 percent discounts and shouldn't be ignored. So as you can see, the IRS does not like certain fractional interest discounts, which are becoming much more aggressive and sophisticated in their valuation methodology.

So what are the basics? Families can reduce the taxable amount (gift and estate taxable) of their assets with the defined value. The reasoning generally goes that a shared interest in a non-publically held stock is worth less than if one person held all the stock. If you hold a fractional share of 25 percent of a property, and if one of the partners didn't want to sell, then you couldn't sell yours either. There might be lawsuits or other disputes between the partners, therefore lessening the value of your share.

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A formula clause allows a transfer pursuant to a formula under which a certain dollar amount (defined in terms of dollars) is assigned on the transfer to family members and in common estate planning measures; the remaining portion is generally transferred to a charity. All the time fixing for federal gift tax purposes, the value of the transfer of the stock. In the Hendrix case, the family applied the discount formulas and argued that the shares of the family business were worth $36 a share, while the IRS said they were worth $48.

The family didn't stipulate a set worth to the business, relying rather on the formulas. The family took full advantage of the tax law, portioned shares to the children and left another share to a charitable foundation. The technique is referred to as a "defined value gift" or charitable lid, because it attempts to put a lid on the part of the gift that is subject to gift tax by allocating to charity property in excess of the amount on which the donor is willing to be taxed. A taxpayer may structure a transaction in any manner that minimizes or avoids taxes by any means the tax law allows. This is exactly what the taxpayer did.

The IRS argued that the discount formulas were incorrect because they (1) reflected a transaction that was not negotiated at arm's length, and (2) were not in the public interest. Importantly, the court ruled that despite the fact that the parties were related, they negotiated in good faith at arm's length and that the transaction was not against the interests of public policy. The daughters in the case still had to assume economic and business risks associated with the business.

How to keep the deal within regulations
Any family that wants to reduce their tax burden in a gift transaction should do the following in order to stay within tax law:
• Do a good appraisal of the business by an independent outside expert.
• Don't collude between the parties or make prearranged side deals, as in, "Dad, you give me this and my sister that, and I'll pay your expenses." The negotiations have to be at arm's length. Each side in the transaction should have separate legal counsel representing their interests.
• Always make sure that economic and business risks by one party put them at odds with the other parties. However, the mere fact that parties are close and the plan is beneficial to the parties does not mean that formula clauses are not arms length.

Defined formula clauses have been repeatedly validated by the U.S. Tax Court. We expect an appeal by the IRS but the overwhelming body of rulings upholds this type of estate planning. Families can use the clauses and give the maximum tax benefit to related beneficiaries and still give to charitable causes as well.
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About the author:
Mira Finé, CPA, is the national director of tax operations for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas, and Orange County, California. She specializes in succession planning and can be reached at mfine@heincpa.com or 303.298.9600.

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