Fifth Circuit Reverses Tax Court in McCord: Gifting Using Formula Clauses

Fifth Circuit Reverses Tax Court in McCord: Gifting Using Formula Clauses

In a unanimous decision that was nearly three years in the making, the Fifth Circuit Court of Appeals in McCord v. Commissioner, Docket No. 03-60700 (5th Cir. August 22, 2006) reversed the Tax Court’s disregard of a formula value to assign ownership interests in a family limited partnership.

The McCords formed McCord Interests, Ltd., L.L.P., a Texas family limited partnership on June 30, 1995. Mr. and Mrs. McCord, who were in their 80’s when the FLP was formed, exchanged the property contributed to the FLP in exchange for all of the Class A FLP interests and 82+% of the Class B FLP interests. The McCord children, who were in their 50’s and 60’s, were the initial general partners of the FLP. A partnership owned by the McCord children was the owner of the remainder of the Class B FLP interests.

The property initially put into the Partnership consisted of marketable securities (65%) and interests in real estate limited partnerships (30%), with the balance consisting of direct real estate holdings and some direct and indirect oil and gas holdings. In November 1995, the McCords donated their Class A interests to a charitable school foundation, and all of the partners agreed to admit the foundation as a partner.

On January 12, 1996, the McCords assigned all of their Class B interests pursuant to a formula gift assignment. The formula assignment provided that an amount of the FLP interests equal to the McCord’s unused GST exemption amount was assigned to several GST Trusts created by the McCords; any excess over this GST amount, but not more than $6,910,932.52, was assigned outright and in equal shares to the McCord children; any excess over $6,910,932.52, but not more than $7,044,932.52 was assigned to the Shreveport Symphony, Inc.; and any remaining portion of the FLP interests was assigned to the charitable school foundation. The partners did not admit the charitable assignees named in the donation as partners in the FLP.

Subsequent to the assignment of the FLP interests by formula clause, all of the donees of the Class B FLP interests also entered into an agreement confirming their ownership interests and sharing ratios in the McCord FLP amongst themselves, effectively converting the fixed dollar amounts in the assignment into percentage ownership interests that were retroactive to the effective date of the distribution.

The IRS audited the gift tax returns and assessed a higher value on two fronts. First, the Service disallowed the actuarial reduction in the amount of the gift that the McCords had taken pursuant to the potential increase in the McCords’ taxable estates under IRC § 2035(b). This issue is beyond the scope of this alert. Second, the IRS asserted that the value of the partnership interests as shown on the gift tax returns was too low.

The Tax Court deftly avoided having to determine the validity of the formula assignment based on the numerous public policy and other arguments put forth by the IRS and the McCords’ counsel, instead concluding that the formula gift made by the McCords must fail because the formula did not define “fair market value” as “fair market value as finally determined for Federal gift tax purposes.” The Tax Court majority seemed to place excessive importance upon the fact that a percentage ownership interest for each partner was fixed by an agreement between the partners and not by the assignment itself. The minority found this logic to be very strained, with Judge Chiechi stating: [t]he majority’s construction . . . is strained, unreasonable, and improper and leads to illogical results. Judge Laro, dissenting on different grounds, also found fault with the majority’s hair-splitting, noting:

[t]o my mind, the subject property’s fair market value is its fair market value, notwithstanding whether fair market value is ascertained by the parties or “finally determined for Federal gift tax purposes.” I know of nothing in the tax law (nor has the majority mentioned anything) that provides that property such as the subject property may on the same valuation date have one “fair market value” when “finally determined” and a totally different “fair market value” if ascertained beforehand. The majority’s interpretation of the assignment agreement is at odds with the interpretation given that agreement by not only the trial judge, but by both parties as well.

The Fifth Circuit was very critical of the majority opinion on the formula gift issue, stating:

[t]he Majority’s key legal error was its confecting sua sponte its own methodology for determining the taxable or deductible values of each donee’s gift valuing for tax purposes here. This core flaw in the Majority’s inventive methodology was its violation of the long-prohibited practice of relying on post-gift events. Specifically, the Majority used the after-the-fact Confirmation Agreement to mutate the Assignment Agreement’s dollar-value gifts into percentage interests in [the FLP]. It is clear beyond cavil that the Majority should have stopped with the Assignment Agreement’s plain wording. By not doing so, however, and instead continuing on to the post-gift Confirmation Agreement’s intra-donee concurrence on the equivalency of dollars to percentage of interests in [the FLP], the Majority violated the firmly-established maxim that a gift is valued as of the date that it is complete; the flip side of that maxim is that subsequent occurrences are off limits.

What does this pivotal case mean for estate planning attorneys? Our firm believes that simple, properly structured defined value gift formulas can be safely used in structuring gifts and sales to individuals and trusts. An example of this type of formula might be:

Clients assign their 89% undivided ownership interest in the Doe Family Limited Partnership (“Doe FLP”) as follows: to the Doe Irrevocable Trust dated January 3, 2001 that percentage ownership in the Doe FLP, as finally determined for federal gift tax purposes, that is equal to $1,000,000 and to ABC Charity that percentage interest of the Doe FLP in excess of such amount.

By using a simple formula such as this, any increase in the valuation of the gift by the IRS at audit will result in an increase in the percentage of the Doe FLP assigned to the ABC charity. Since the IRS will receive no additional gift tax as the result of the increase in the gift to charity, the IRS has a disincentive to aggressively pursue a redetermination of the value of the partnership as shown on the federal gift tax return.