McCord: 5th Circuit Respects Defined Value Clause & Allows New Type of Gift

I post, with permission from the author, Steve R. Akers, of Dallas, Texas, this summary of his 24-page analysis of the decision in McCord v. Commissioner, __ F. 3rd __ No. 03-60700 (5th Cir. August 22, 2006), reversing 120 T.C. No. 358 (2003). [NOTE: It was reported by one attorney on an ACTEC practice listserv that, on September 15, 2006, the Fifth Circuit "issued a wholly revised opinion", but that no difference could be detected in a first reading.]

The court's decision and opinion (41 pages) is found online here.

McCord v. Commissioner: Fifth Circuit Upholds Defined Value Gift and Allows Offsetting Gift Value by Contingent Assumed Liability for Estate Tax if Donor Dies Within Three Years

By Steve R. Akers, Managing Director & Associate Fiduciary Counsel, Bessimer Trust, Dallas, Texas

Copyright © 2006 by Bessemer Trust Company, N.A. All rights reserved.

Planners have watched the McCord case closely over the last several years primarily because of its use of a "defined value clause" in a gift assignment to transfer all value in excess of a specified amount to charity. The taxpayers hoped to cap their potential gift tax liability, under the rationale that any value in excess of the described amount would qualify for a gift tax charitable deduction. The assignment defines the very value that is transferred in the first place, as distinguished from a clause that assigns assets and keeps a reversion for any portion of the assets that exceed a specified value.

The Tax Court, in a divided opinion over several dissents, refused to give effect to the clause under a hard to understand “interpretation” theory. The case has been on appeal to the Fifth Circuit and the oral argument was over two years ago. The Fifth Circuit three judge panel has finally issued its unanimous opinion reversing that case and respecting the defined value clause that was used in that case. The assignment assigned limited partnership interests (really “assignee interests”) to family members and to charities. The family members and one charity were assigned interests having a specified dollar amount; the remaining charity received any excess.

1. Huge victory. This is a huge taxpayer victory. This is the first case at the court of appeals level that has recognized defined value clauses for lifetime transfers.

2. Public policy and substance over form issues not addressed. Most planners have believed that the public policy argument is the IRS’s strongest argument against these clauses (i.e., that the clause would make gift tax audits meaningless in the sense that they could not produce additional gift taxes). The court said that the Commissioner waived the argument by failing to brief it (even though the Commissioner did specifically request a remand to the Tax Court to fully consider this issue). Even so, there was no indication whatsoever that the Fifth Circuit panel viewed the transaction as abusive in any way.

3. Defined value clauses will be used more commonly in the future. Now that one federal circuit level court has blessed a defined value clause, even though it did not consider the IRS’s public policy argument, planners will be more likely to use these clauses in the future—for both gift and sales transactions. (The fact that the circuit court did not view the clause as abusive in any way at least suggests that the court would not be persuaded by the IRS’s policy argument.) This is particularly true for transactions occurring in the Fifth Circuit. However, it is only one circuit court (that did not review the policy issues) and that is the Fifth Circuit, which is generally perceived as a “taxpayer-friendly” circuit. A downside of using these clauses is that many IRS agents hate them and view them as abusive and they may red flag gift tax audits that involve these clauses for special scrutiny. So many planners will continue to be cautious of these clauses until there is wider court acceptance of them.

4. Should “values as finally determined for Federal gift tax purposes” be used in defined value clauses? The defined value clause in the McCord case did not base the assignment of dollar amounts on values as finally determined for Federal gift tax purposes. The Tax Court opinion largely relied on that feature to reject the clause under its “interpretation” theory and suggested that it might have reached a different result had the clause referred to finally determined gift tax values. The Fifth Circuit clearly rejected the Tax Court’s reasoning, and there are various reasons for making the allocations based on values under a willing buyer-willing seller test (identical to the gift tax valuation standard) but not requiring the use of finally determined gift tax values. Planners will have to decide which format to use in their defined value clauses, and there will probably be greater use of clauses that do not require the use of finally determined gift tax values, particularly in the Fifth Circuit.

5. Offset for potential §2035(b) estate tax liability. The donees assumed all gift, GST and estate tax liability attributable to the transfer, specifically including potential estate tax liability under the gift tax gross-up rule of §2035(b) if the donor were to die within three years. The Tax Court viewed that potential liability as too speculative to consider as an offset to the gift value. The Fifth Circuit reversed, viewing it as even less speculative than the “built-in gains tax” discount that has been allowed in recent years. Planners in the future may use this creative way of reducing the size of taxable gifts, but realize that the offset is very small.

A more detailed analysis of the McCord case and planning considerations in light of the case are available from Steve Akers akers@bessemer.com at Bessemer Trust, 300 Crescent Court, Suite 800 Dallas, Texas 75201 (Ofc: 214-981-9407; & Fax: 214-981-9410).

Update: 02/05/08:

For further, related developments after the McCord case, see: EE&F Law Blog posting "Tax Court Upholds FET Savings Clause" (02/05/08).