Tax News
Hendrix v. Commissioner – The Government Loses Another Defined Value Clause Argument
June 30, 2011
Gift and estate planning is a major component of private equity, venture capital and hedge fund taxation. The issues come up in the context of an investment manager’s individual tax planning. Investment managers typically own a profits interest in a general partnership that in turn has a 20% profits interest in one or several funds, or alternatively a management contract with the investment funds under management.  The value of the manager’s interest in the GP is minimal at the outset. The reason is that the managed investments themselves have not appreciated in value.  If the manager is successful, however, the value of its profits interest in the GP could skyrocket. The investment manager often is concerned about some form of succession planning where the future appreciation of this interest is transferred to its descendents and the value is stripped away from its estate.  To accomplish this, the manager would often transfer this interest to a trust.  It can either gift the interest, sell it under the installment method, or transfer it to a grantor retained annuity trust (“GRAT”).  One of the risks involved with this type of planning is that the Service can attack the value of the interest. This in turn could lead to unanticipated tax consequences and penalties. Defined value clauses are designed to reduce some of this risk.  The idea of the clause is to limit the value that is transferred to an amount that is tied to the final determination of such value for federal gift tax purposes. The excess is treated either as not transferred ab initio, or transferred to a non-taxable transferee such as a charity or a QTIP.

The Government has been battling these clauses on various grounds. In Hendrix et ux. v. Commissioner, T.C. Memo 2011-133 (June 15, 2011) the IRS argued that the clause should be disregarded because it was not the result of an arm's-length transaction and it was void as contrary to public policy.  The Tax Court disagreed on both counts.  It ruled that the McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), a pro-taxpayer case which the Service lost, was precedent directly on point although it was not controlling vis-à-vis the Government’s two arguments which were not addressed in McCord.  The IRS attempted to argue that Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944), and its progeny, an IRS favorite, supported the view that the clause should be disregarded on policy grounds.  The Tax Court, however, distinguished Procter on the grounds that the formula clauses in the case at bar imposed no condition subsequent that would defeat the transfer.  The Procter clause did because it provided that if a federal court of last resort held the gift subject to gift tax, the transfer should be void.  Separately, the Tax Court reasoned that the Hendrix formula clauses furthered the fundamental public policy of encouraging gifts to charity.  Ultimately the court ruled consistently with McCord that the formula clauses controlled the transfers.

The question is, is it a game over for the IRS?  It appears that at least in respect of McCord type of formula allocation clauses, as far as the Tax Court and the 5th Circuit are concerned, it is. Notably, however, Petter v. Commissioner, T.C. Memo. 2009-280 (Dec. 7, 2009), another Tax Court case where the Government lost the public policy argument, is still pending on appeal in the 9th Circuit (oral argument for this case took place June 14th). We will follow closely when the decision in this case comes out. If the Service wins this one, the taxpayers’ victories may prove transient.
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Tags: Commissioner v. Procter, defined calue clauses, defined value formula clauses, Hendrix et ux. v. Commissioner, McCord v. Commissioner, Petter v. Commissioner