Planning, Drafting, Reporting, and Defending Them
Formula clauses can potentially be useful to your clients; after all, the whole purpose of a formula clause is to escape taxes. There are many legal issues that can arise if your client chooses to use a formula clause, and you should be mindful of the traps associated with them. Megan E. Wernke and Melissa L. Wiley, Members at Caplin & Drysdale, addressed such concerns in The Nuts and Bolts of Formula Clauses, a program presented during the MSBA’s Legal Excellence Week.
Lifetime exemptions for federal gift and estate taxes change frequently. A formula clause gives an amount to family or friends up to whatever the applicable lifetime exemption from federal gift and estate taxes is at the time of the decedent’s death. It is written in such a way that you are giving away a dollar value of an asset. Rather than saying, I hereby give 10,000 shares of my company; you say I am giving one million dollars worth of value of my company, I believe that is 10,000 shares, but the IRS will tell me if I am wrong.
Wandry v Commissioner, T.C. Memo, 2012-88
Formula clauses have been blessed by numerous courts and are a valid way to escape gift taxes. The most recent and prominent example Wernke and Wiley discussed was the tax court case of Wandry, T.C. Memo, 2012-88. The Wandry opinion ruled that a savings clause is void because it creates a donor that tries to take property back, but a formula clause is valid because it merely transfers a “fixed set of rights with uncertain value.” Wernke stated that the key lesson from Wandry is that if you want to have a successful formula clause, you need to ensure your formula clause is not taking property back but defining the initial gift as something being a fixed set of rights. Wernke added that Wandry is a phenomenal case because the case includes the exact language used that prompted litigation and was eventually approved by the court. Wiley also highly suggested that you use the exact language from Wandry to draft your formula clause. “There is no room for creative writing,” when drafting formula clauses, she said. You may watch Wernke describe formula clauses and Wandry here.
Types of Formula Clauses
Wernke identified three different types of formula clauses. Depending on what your client wants, you might want to try different versions of formula clauses, she advised. Normally, like with Wandry, you are transferring a certain, specified dollar amount that defines the transfer by a dollar amount rather than a number of units. The second type of formula clause she discussed was a defined value clause. A defined value clause uses a formula to transfer excess value to a non-taxable recipient. The example Wernke shared stated “I hereby transfer 10,000 shares, the first million dollars of it is going in the trust for my children and the excess value is going to my spouse.” A price adjust clause fixes the amount of the gift and an overage is a loan. The example Wernke gave was saying, “we are transferring 10,000 shares, the first million dollars of it is a gift, if there is any value over that, that would be a loan.” Click here for the discussion on types of formula clauses.
Should I Use a Formula Clause?
Wernke pointed out that formula clauses should be used with caution. There are a number of considerations to determine if a formula clause is right for your client before using one. One factor to consider is whether you have a solid appraisal. If you have a solid appraisal that will stand up in an audit, you may not want to use a formula clause. On the other hand, if you do not have a solid appraisal, then your client may benefit the most from a formula clause.
A second thing you should consider with a client before using a formula clause is the amount of clearance that they have left. Again, if the client is thinking I am making a one-million-dollar gift, but they still have all of their exemptions, you might not want to “pick a laundry fight” because you can do your best to value the asset at a million dollars. If the IRS revalues the assets at a higher amount, then your client will still be okay and not incur a tax.
The final factor you should consider when deciding whether to use a formula clause is your client’s risk tolerance. If your client has estimated what the IRS penalty may be, they may be willing to take the risk. If your client is one who under no circumstances wants to be subject to an audit, then a formula clause may not be for them. Wiley agreed stating, “it is important for you to go through the entire process with the client and understand their risk tolerance before proceeding with a formula clause.” Finally, Wernke added that she “would never use a formula clause without a very explicit and in-depth conversation with the client about what it is they are transferring, what exactly the risk is of being audited, and what it means about the lack of uncertainty going forward.” For the discussion on whether one should use a formula clause, click here.
Nelson v. Commissioner, T.C. Memo 2020-81
The presenters discussed the tax court case of Nelson v. Commissioner, T.C. Memo 2020-81 to illustrate the pros and cons of formula clauses. The issue in Nelson was what Ms. Nelson actually transferred using her formula clause. Ms. Nelson’s documentation reflected two separate transactions, a gift and a sale. She specifically defined the gift and sale values. However, she added language directing a qualified appraiser to determine the amount of the values she defined and not the IRS value. Of course, the IRS argued that Ms. Nelson’s transfer documents unambiguously stated they incorporated the appraised value and not the IRS value. The Tax Court agreed with the IRS stating:
[T]o decide whether the transfers were of fixed dollar amounts or fixed percentages, we start with the clauses themselves, rather than the parties’ subsequent actions. . . The clauses hang on the determination by an appraiser within a fixed period; value is not qualified further, for example, as that determined for Federal estate tax purposes. . They are bound by what they wrote at the time.
Wernke pointed out that the most important thing about the Nelson case is that it does not say that Wandry does not work or formula clauses do not work. In fact, Nelson supports formula clauses by stating the taxpayer should decide what the taxpayer wants to transfer, and the IRS will take your word for it. In contrast, Ms. Nelson stated she was transferring an appraised value, so the IRS said the transfer value will be based upon the appraised value.
Documentation – Formula Clauses
One of the most important things when using a formula clause is ensuring the taxpayer’s intent is clear and reflected in all the documents. The best way to ensure the taxpayer’s intent is clear and reflected in all documents is to cut and paste your client’s boilerplate statement of intent into all the documents including, but not limited to the gift/sale, promissory note, appraisal, corporate documentation, and Gift Tax Return. Watch the discussion on proper documentation and drafting here.
Wiley warned that if your client receives a letter from the IRS stating that their return has been picked up for examination, then beware of the IRS’ Action on Decision on the Wandry case. Actions on Decisions or AODs are extremely rare. The Wandry Action on Decision states that the IRS understands the tax court’s ruling, but the IRS thinks the tax court reached an invalid decision and as a federal agency we are not going to follow the court’s ruling. There is really nothing one can do if the IRS at the examination stage decides that it will not follow Wandry’s language on formula clauses, Wiley said. IRS agents are not allowed to act in contradiction to the Action on Decision. Practically, that means if you rely solely on Wandry you will always lose at the examination level. Just remember to establish a good record at the examination level before moving on to the appellate level.
Next, you will be given the opportunity to go to the administrative appeal level within the IRS. The administrative appeals level has been renamed to the independent office of appeals to underscore that they are supposed to be independent from the IRS. The independent office of appeals is supposed to consider whether a settlement is reasonable and a good move on the part of the government based upon what they assess to be the hazards of litigation. However, in practice, the independent office of appeals is still part of the IRS so more likely than not they are going to tow the same line as the examination.
Lastly, you can litigate the issue and go to court. Before proceeding to court make sure your client understands that litigation is very expensive and time consuming. The IRS attorneys do not usually settle these cases. If you win in court, the government may decide to appeal your win which may further lengthen the litigation. And if your client decides to pay the tax accessed and seek a refund of it, you may end up in district court or a court of federal claims. No one knows how those courts are going to interpret Wandry. You may watch the presentation regarding interaction with the IRS here.
Be careful in drafting formula clauses. If the facts and circumstances support it, use the exact language used in Wandry. Place your client’s statement of intent on all documents. Beware, the IRS’ Wandry Action on Decision does not recognize the tax court’s approval of the language in Wandry. If you get audited, the Wandry Action on Decision will dictate an unfavorable outcome at the examination level and most likely at the appellate level too. Litigation is expensive and the outcome uncertain. The presenters jointly recommended thinking hard and long before deciding to use a formula clause. If your client gets audited, it is not going to be easy. There is not a turnkey solution and it will not be quick.
Megan E. Wernke is a Member in the Private Client practice group. Her practice includes: designing and implementing estate and lifetime gifting plans; advising foreign and multinational families regarding U.S. tax-efficient wealth transfer structures; advising bona fide residents (Act 22/60 residents) of Puerto Rico; pre-immigration planning; succession planning for clients with businesses large and small; achieving creditor protection for clients and their heirs; and helping clients modernize complex or inefficient estate plans and come into compliance with U.S. tax requirements. With Ms. Wernke’s significant experience in tax controversies and litigation, she also advises clients with respect to substantial gift tax, estate tax, generation-skipping tax, and fiduciary income tax issues at all stages of controversy: voluntary disclosures, ruling requests, audits, IRS Appeals, and in court. She received a J.D., Harvard Law School and is a graduate of Princeton University.
Melissa L. Wiley is a Member in Caplin & Drysdale’s Washington, D.C. office. Ms. Wiley’s practice focuses on assisting clients to come into compliance with their U.S. tax obligations and advising U.S. taxpayers on all types of civil and criminal tax controversy matters at the federal and state level. She received her J.D. from Georgetown University Law Center and a B.S. from The College of Insurance (now part of St. John’s University).