Nelson v. Commissioner is a recent gift tax case where the IRS challenged the value of the gift and sale of limited partnership interests to a trust created for the beneficial interest of the taxpayer’s family members.
In Nelson, Mrs. Nelson transferred a 27% interest in a family holding company, which owned eight subsidiaries, one of which was a real estate holding company, to a family limited partnership (“FLP”). Other assets were also transferred to the FLP by Mrs. Nelson and family members. Shortly after the formation of the FLP and transfer of assets thereto, Mrs. Nelson gifted and sold FLP interests to the trust for the benefit of her husband and daughters, of which the husband was the trustee.
Mrs. Nelson made the following two transfers of FLP interests to the Trust.
First, Mrs. Nelson made a gift on December 31, 2008. “The Memorandum of Gift and Assignment of Limited Partner Interest (memorandum of gift) provide[d]:
[Mrs. Nelson] desires to make a gift and to assign to * * * [the Trust] her right, title, and interest in a limited partner interest having a fair market value of TWO MILLION NINETY-SIX THOUSAND AND NO/100THS DOLLARS ($2,096,000.00) as of December 31, 2008 * * *, as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.”
Second, on January 2, 2009, Mrs. Nelson sold FLP interests to the Trust, whereby the trust executed a note payable to Mrs. Nelson using the mid-term AFR. “The Memorandum of Sale and Assignment of Limited Partner Interest (memorandum of sale) provide[d]:
[Mrs. Nelson] desires to sell and assign to * * * [the Trust] her right, title, and interest in a limited partner interest having a fair market value of TWENTY MILLION AND NO/100THS DOLLARS ($20,000,000.00) as of January 2, 2009 * * *, as determined by a qualified appraiser within one hundred eighty (180) days of the effective date of this Assignment * * *.”
The Tax Court noted that “[n]either the memorandum of gift nor the memorandum of sale (collectively transfer instruments) contains clauses defining fair market value or subjecting the limited partner interests to reallocation after the valuation date.”
Mr. and Mrs. Nelson split the gift and reported the same on their 2008 Forms 709, showing the gift “having a fair market value of $2,096,000 as determined by independent appraisal to be a 6.1466275% limited partner interest” in the FLP, with each of them reporting $1,048,00 as their portion of the gift. The January 2, 2009, sale transaction was not reported.
In 2013, the IRS issued notices of deficiency, determining that Mr. and Mrs. Nelson had undervalued the 2008 gift, and each of their one-half of the gift was worth $1,761,009 as opposed to $1,048,000. The IRS also determined that Mr. and Mrs. Nelson had undervalued the FLP interests sold to the Trust by $13,607,038, claiming that each of Mr. and Mrs. Nelson had as a result made a split gift in 2009 of $6,803,519. Mrs. Nelson claimed that she had transferred FLP interests of $2,096,000 and $20 million (specific dollar amounts as opposed to fixed percentages), and the IRS claimed that Mrs. Nelson had transferred FLP interests of 6.14% and 58.65% (specific percentages as opposed to specific dollar amounts).
Upon review, the court differentiated this case from previous “defined value clause” cases where the valuation clause included language stating “as such value is finally determined for federal [gift/estate] tax purposes.” Further, the court stated that “fair market value” in the valuation clauses used by Mrs. Nelson was “expressly qualified,” and that the court could not interpret the language in the transfer documentation as “transferring dollar values of the [FLP] interests on the bases of fair market value as later determined for Federal gift and estate tax purposes . . . ” even if Mrs. Nelson said that is what she intended. Therefore, the court concluded that the transfers were not defined value transfers as finally determined for federal gift tax purposes, and that Mrs. Nelson gifted FLP interests of 6.14% and sold FLP interests of 58.35% as determined by the appraiser within the applicable periods of time mentioned in the transfer documents.
While Nelson discusses other issues such as multi-tiered discounts and discounts for lack of control and marketability, the purpose of this article is to underscore the importance of careful analysis and drafting in regard to valuation clauses when transferring hard to value assets. Upon further reading of the case, Mrs. Nelson may have ultimately ended up in an okay position (i.e. the Tax Court concluded the fair market value of the transferred FLP interests was greater than the fair market value claimed by Mrs. Nelson but still much lower than that claimed by the IRS), but taking such a chance is risky and it is better to strive for as much clarity as possible on the front end when drafting transfer documentation. Doing so will put you in the best position possible if a dispute with the IRS arises.
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