Value Adjustment Clauses. Don't Leave Your Gift or Estate Tax Return Without One.

An important valuation dispute between taxpayers and the IRS came to a head with the Eighth Circuit’s decision in Estate of Christiansen v. Commissioner. Helen Christiansen’s will left her entire estate to her daughter Christine, but a disclaimer provision permitted a gift over to a charitable foundation and a charitable lead trust in the event Christine disclaimed any portion of the estate (in order to reduce estate tax due). Because the estate owned hard-to-value family limited partnership interests, Christine disclaimed "that portion of the estate that exceeded $6.35 million, as finally determined for federal estate tax purposes" (as opposed to disclaiming specific estate property).

The IRS examined the estate tax return and the estate agreed to a higher value for the partnership interests. But, due to the formula disclaimer, the increase in estate tax value passed entirely to the charitable entities, resulting in an increased charitable deduction, and no increase in estate tax.

The IRS challenged the increased charitable deduction. First, it successfully argued that the disclaimer was unqualified with respect to the 75% that passed to the charitable lead trust, because Christine was a remainder beneficiary of the trust. Second, the IRS unsuccessfully argued that the allowance of any increased charitable deduction was contrary to public policy because the formula disclaimer, coupled with the gift over to charity, was a disincentive to examine the return. The Tax Court allowed the increase in charitable deduction for the 25% passing to the foundation, but not for the 75% passing to the charitable lead trust.

The IRS appealed its loss on the grounds of public policy to the Eighth Circuit. As noted by the court, “the Commissioner argues that we should disallow fractional disclaimers that have a practical effect of disclaiming all amounts above a fixed-dollar amount. According to the Commissioner, such disclaimers fail to preserve a financial incentive for the Commissioner to audit an estate's return.”

The court showed little sympathy for the IRS and affirmed the Tax Court decision. The court said that “we note that the Commissioner's role is not merely to maximize tax receipts and conduct litigation based on a calculus as to which cases will result in the greatest collection. Rather, the Commissioner's role is to enforce the tax laws.” 

Had the charitable lead trust provisions been properly drafted, the net effect would have been to quash the entire IRS valuation challenge.  Taxpayers should be aware of the potential benefits of a value-adjustment provision when making any taxable transfer of hard-to-value assets.  While pitfalls abound, they can and do work if properly structured. 

Until now, the leading defined-value decision has been McCord v. Commissioner, a taxpayer-favorable decision from the Fifth Circuit. The defined value clause in McCord had also provided that any increase in the value of transferred partnership interests was to pass to charity, effectively eliminating any increase in tax and discouraging IRS audits. Notably, the IRS did not raise the public policy argument in the McCord appeal, so Christiansen may be an indication of how other circuits will respond.