Take the guesswork out of gifting hard-to-value assets with defined-value gifts
Transferring wealth to family members can reduce your taxable estate. But when gifts involve assets that are difficult to value, such as interests in a closely held business or family limited partnership (FLP), unexpected tax consequences can arise.
The challenge is that the IRS may disagree with the value assigned to a gifted asset. If it determines that the asset is worth more than you reported, the resulting adjustment could trigger additional gift tax, interest and potentially penalties. One strategy to manage this uncertainty is to make defined-value gifts.
What is a defined-value gift?
Rather than transferring a fixed percentage of a business or a specific number of partnership units, a defined-value gift transfers an interest worth a predetermined dollar amount. For example, suppose you want to give your daughter a $2 million interest in your FLP, protected from gift tax by your lifetime gift and estate tax exemption. Based on a professional appraisal, you transfer a 20% interest. Later, the IRS determines that the FLP is worth more than the appraisal. It values the 20% interest at $2.5 million. That additional $500,000 of value will use up another $500,000 of your lifetime exemption. If you don’t have enough lifetime exemption left to cover that amount, it could be partially or fully subject to federal gift tax at a rate of 40%, plus interest and even penalties.
With a properly drafted defined-value formula, the percentage interest transferred would be adjusted to reflect the final value determined for federal gift tax purposes. Your daughter would still receive an interest worth $2 million, but the ownership percentage transferred would be smaller. This approach can help prevent an unexpected valuation adjustment from increasing the gift’s taxable value.
How do formula and savings clauses differ?
Not all provisions designed to protect against valuation adjustments are legally effective. Courts have distinguished between permissible formula clauses and problematic “savings” clauses.
A formula clause establishes the dollar value of the property being transferred and determines the corresponding ownership interest using a value finally determined for federal tax purposes. If that value changes, the ownership percentage adjusts under the original formula.
A savings clause, by contrast, attempts to reverse part of a completed gift if the IRS later determines that the transfer creates an unwanted tax liability. Courts generally have rejected such provisions.
Precise wording in the transfer document matters
For a defined-value gift to be effective, language in the transfer documents must be precise. In one case, the U.S. Tax Court rejected an intended defined-value gift of FLP interests and upheld the IRS’s gift tax assessment based on percentage interests. The documents called for transferring FLP interests with a defined fair market value “as determined by a qualified appraiser” within a specified time after the transfer.
The court found that the transfer documents failed to achieve a defined-value gift because a qualified appraiser determined the fair market value. The documents didn’t provide for an adjustment in the number of FLP units if their value “is finally determined for federal gift tax purposes to exceed the amount described.”
Consult an estate planning attorney for assistance drafting proper formula clauses for defined-value gifts.
Reducing valuation-related tax risks
Defined-value gifts are useful when transferring business interests or other assets without readily available market prices. If you’re considering substantial gifts of hard-to-value assets, contact us for help determining if a defined-value gift may be right for your situation. With appropriate planning and documentation, you may be able to reduce valuation-related tax risks while advancing your long-term wealth transfer goals.
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