Introduction and background
A taxpayer planning to make a large gift can avoid valuation and administration issues and minimize IRS scrutiny by applying lessons from a recent IRS memo and Tax Court case. Both examples feature valuation and timing issues, demonstrating that gifts of business interests require careful planning well in advance of the transfer and any liquidity event.
Timing of appraisal affects gift tax obligation
In December 2021, the IRS took a stringent stance on the effect of the valuation of assets contributed to a GRAT, resulting in a large taxable gift. Specifically, Office of Chief Counsel IRS memorandum 202152018 stated that an outdated appraisal that did not consider a pending sale was not sufficient for gift tax valuation purposes.
The taxpayer-funded a grantor retained annuity trust, or GRAT, with shares of their company in the same year the taxpayer commenced discussions with multiple buyers to sell the company. Three days after receiving multiple offers to purchase the company, the taxpayer transferred shares of the company to the GRAT.
Approximately six months after funding the GRAT, the taxpayer accepted one of the offers that was nearly three times greater than the value of the company used for gift tax purposes. Several weeks before that, the taxpayer obtained a new appraisal that considered the tender offer and made a gift to a charitable remainder trust.
The gift tax return reporting the transfer to the GRAT used an appraisal obtained seven months prior to the transfer. The appraisal did not account for the offers received from the potential buyers at the time of the transfer to the GRAT. Additionally, the appraisal was not obtained specifically for gift tax purposes; rather, the company obtained the appraisal to fulfill its reporting requirements for its nonqualified deferred compensation plans.
The IRS memorandum applied the fair market value standard, which depends on the price at which the asset would change hands between a hypothetical willing buyer and seller. The IRS stated that the hypothetical willing buyer would have been reasonably informed during the course of the negotiations of the pending purchase and sale of the shares and would have knowledge of all relevant facts in this case.1 Therefore, according to the IRS, the valuation the taxpayer used was severely undervalued for gift tax purposes.
Typically, a transfer of an asset to a GRAT results in a very low taxable gift. An asset is transferred to the trust in exchange for a retained annuity that has a present value equal or close to the value of the contributed asset, resulting in either no taxable gift or a small taxable gift. The amount of the annuity payments is based on the initial fair market value of the trust, which, in this case, was the fair market value of the shares used to fund the trust.
The taxpayer was treated as making a gift equal to the higher value of the shares, which took into consideration the pending merger and all current offers. In the memorandum, the IRS valued the retained annuity payments at zero, resulting in a very large taxable gift and gift tax balance due for the taxpayer.
Valuing the retained annuity payments at zero was a surprising stance by the IRS, rather than adjusting the amount of the taxable gift based on the higher fair market value of the contributed shares. This result is quite severe, especially because it results in a taxable gift equal to the full value of the contributed shares, even though a significant portion of the contributed value will be paid back to the taxpayer.
Some takeaways from this example include:
- Help ensure that future appreciation of contributed assets minimizes gift taxation by transferring such assets before concrete steps to market such asset are taken.
- Protect your gift transfer from an IRS valuation challenge by obtaining an appraisal that is:
- Dated as of the date of transfer
- Obtained for the purpose of that transfer
- Specifically meets the IRS gift tax valuation regulations
- Dated as of the date of transfer
- If such an appraisal follows Treasury Department guidelines, the period the IRS can challenge the value of such a gift is likely only three years.
- Make sure that GRATs are set up properly, administered properly, and that assets contributed are valued properly to avoid the IRS treating the transfer as a gift of the full value of the contributed property, effectively undermining the purpose of the GRAT.
Spousal transfers require proper timing, valuation
In Louis P. Smaldino v. Commissioner, the taxpayer incurred additional gift tax due to valuation issues and the Tax Court disregarded the gift to his spouse.
The taxpayer gifted units of his LLC to his spouse, who then transferred the shares to a dynasty trust a day later. The taxpayer did not report the initial gift to his spouse on his gift tax return. The spouse’s gift tax return did report the interest in the LLC as a gift to the dynasty trust, and there was no tax due on her gift tax return because she had enough lifetime exclusion to cover the taxable gift.
The IRS challenged the transfers on a couple of grounds and issued a $1.154 million notice of gift tax deficiency.
The IRS argued that the spouse’s contribution to the trust was, in substance, an indirect transfer to the dynasty trust from the taxpayer, who did not have enough remaining lifetime exclusion to cover the gift. In support of that assertion, the IRS argued that the transfer to the spouse was part of a prearranged plan to fund the trust and that the wife’s momentary ownership of the interest in the LLC was merely a nominal step with no significance. Furthermore, the LLC operating agreement and records never reflected that the spouse ever owned an interest in the LLC.
The Tax Court upheld the assessment, treating the transfer to the dynasty trust as coming from the taxpayer, and concluding that the interest was indirectly given to the dynasty trust through his spouse. The Court emphasized that transactions between relatives deserve heightened scrutiny.
In analyzing the case, the Tax Court then looked to experts to value the interest in the LLC transferred to the dynasty trust, as well as the facts and circumstances of the transfer. The LLC operating agreement was amended in April 2013, the same time as the transfer to the taxpayer’s spouse, to provide the taxpayer monthly guaranteed payments from the LLC. The agreement was then amended again in December 2013 to delete the provision altogether.
The taxpayer argued that the amendment eliminating the monthly guaranteed payments should have been enough to disallow their consideration in the valuation. The Tax Court reasoned in an earlier case that the IRS considers information available on or close to the valuation date, as well as facts that were reasonably known on the valuation date.2 The court also reasoned that, in general, subsequent events are not considered in fixing fair market value because they are not fairly shown to be reasonably probable.3 The court ultimately considered the guaranteed payments to the taxpayer in the LLC’s valuation, because it was not reasonably foreseeable that the operating agreement would be amended to eliminate the payments to the taxpayer.
Some important lessons to learn from the decision in Smaldino include:
- Help ensure that a transfer to a spouse will be respected by the IRS by making a transfer that allows the spouse to hold the transferred property for some period of time in order to exercise control over any decision to gift those assets.
- Avoid a prearranged plan that conditions a gift on the requirement to make a subsequent gift.
- Be vigilant about carrying out all legal and entity formalities to help ensure that all transfers are respected. If shortcuts are taken and formalities are overlooked, the intended transactions may be recast by the IRS. Properly formalizing each transaction will demonstrate that each transaction has substance and better ensure it will be respected by the IRS.
- Put into place the legal formalities required for the intended gift tax treatment before the transfer and subsequent amendments to change the result are susceptible to being disregarded by the IRS.
To mitigate the risk of an IRS challenge, it is important for you to consider the takeaways and lessons highlighted by the examples above. If you plan to make a large noncash gift, RSM is available to help with the planning. Please consult a tax advisor for guidance on how to effectively plan for and document large noncash gifts.