Transferring assets that don't have an easily determined value is one of the most challenging things for an estate planner to do. Whether the transfer technique being used is simple or sophisticated, the IRS remains free to challenge the value of the assets being transferred and create potentially devastating tax consequences. For decades, planners have searched for a way to eliminate the risk posed by valuation with little success. Through careful drafting and execution, however, valuation clauses may finally give certainty to taxpayers who want to arrange their affairs without worrying about the fickleness and nuance of valuation methodologies.

Hard-to-value assets come in many forms, including art, collectibles, stock in a closely held business, partnership interests (such as interests in hedge funds and private equity funds), real estate, intellectual property rights, mineral rights and oil and gas interests. Reasonable minds can disagree over what such assets are worth because there is no ready market for them. Even stock that is traded on pink sheets, which has some limited marketability, has an ambiguous value.

A simple example demonstrates what a crucial yet frustrating issue this can be. One of my clients wanted to give $1 million worth of stock in a family business to his children. We obtained an appraisal from a nationally renowned valuation company that did a thorough job evaluating the business itself and accounting for the fact that each child was receiving a minority interest in the company. Based on that valuation report, we filed a gift-tax return and no tax was due since the $1 million value was covered by the client's gift-tax exemption. When there was an audit, however, the IRS challenged the value of the underlying company and the minority interest discount. They concluded that the transferred stock had a $1.4 million value and that almost $200,000 of gift tax was due.

Once an audit that involves a hard-to-value asset begins, such valuation disputes are inevitable. In most cases, your only option is to negotiate the best deal you can. You don't really want to go to tax court when the only issue in question is valuation. In most cases, when appraisers disagree over a question of value the tax court simply "splits the baby" and finds the true value is somewhere in the middle of the range. Of course, the taxpayer will be forced to spend a sizable amount of money for the legal fees and expert witness needed to reach such an unsatisfying conclusion. Through a properly drafted valuation clause, a planner can achieve a better result for the client.

Valuation clauses come in two basic forms: price-adjustment clauses ("PACs") and defined-value clauses ("DVCs"). They are opposite sides of the coin with regard to what is a fixed value and what is unknown. With a PAC, we fix what is transferred and allow the price paid to float. With a DVC, we fix what is paid and allow what is transferred to float. Take, for example, my client who wanted to transfer $1 million worth of stock, but who did not know how much stock that was. This was a perfect place for a DVC. The value of the stock to be transferred was defined at $1 million; how much stock that was remained unknown. Using a DVC, the client would make a gift to the trust of a fraction, the numerator of which was $1 million and the denominator of which was the fair market value of all of the stock my client owned as finally determined for gift-tax purposes. As a result, while the client may have initially believed that he transferred 20% of the stock in the company, if it ultimately turned out that the company was worth twice what the appraiser concluded, the client would, in fact, have only transferred 10% of the stock. At that point, we would simply adjust for any distributions that may have been made by the corporation between the date of the transfer and the date the final determination of value was obtained.

In contrast, suppose the client's goal was to transfer 20% of the company to a trust for the benefit of his children. He is prepared to use up his entire $1 million gift-tax exemption, but he doesn't want to make a taxable gift, so if that stock is worth more than $1 million, he wants to be paid fair market value for the extra. This situation calls for a PAC. The client would sell his 20% interest to the trust and the terms of the sale agreement will say that if the fair market value of the stock, as finally determined for gift-tax purposes, exceeds $1 million then the trust will pay the client the difference. As a result, even if there is a final determination that the price of the stock is higher than we think it is, the client will still be making a gift of only $1 million.

Conceptually, valuation clauses are quite simple, but you must carefully consider a few issues before you start to use them in your practice. Historically, the IRS has objected to valuation clauses for public policy reasons. That argument has three legs. First, the IRS argues that such clauses remove its incentive to audit the transaction in question, since a successful outcome for the IRS on the valuation issue would still not generate any additional tax revenue. Second, the service argues that it wastes judicial resources to have a court determine the value of the transferred property if there is no possibility of generating additional tax revenue. Third, the service argues that the court will be ruling on a moot issue if the valuation clause is respected. This reasoning was adopted in 1944 by the U.S. Court of Appeals for the Fourth Circuit in a case called Procter and by at least two subsequent tax court decisions, Ward (1986) and McLendon (1993), but it has never again been adopted by a circuit court.

A great deal has changed since 1944, and these public policy arguments no longer carry the weight they once did. Today, valuation clauses are everywhere in the estate planning world. In fact, the IRS has issued regulations in a variety of contexts that either permit or require the use of such clauses. One of the most common estate planning techniques is the grantor retained annuity trust (GRAT), which contains a clause saying that if the value of the initially contributed property is determined by the IRS to be different than what the taxpayer claimed, the annuity associated with the GRAT will be increased or decreased, but no additional gift tax will be due. That is an IRS-mandated price-adjustment clause.

Since the unlimited estate tax marital deduction was introduced in 1981, the IRS has issued regulations permitting taxpayers to use formulas to divide an estate between the credit shelter amount and the marital deduction amount. If the IRS challenges the valuation on any of the assets in the estate, it will not generate any revenue; it will merely shift assets between the credit shelter trust and the marital trust. If such a case were to reach the tax court, it would make a determination of value, but there would be no change in the tax consequences. These formula divisions create a situation where an IRS victory does not generate any tax, yet they are not contrary to public policy. There is no logical distinction between this formula clause and the valuation clauses previously discussed.

The IRS has issued regulations permitting the use of formulas when a taxpayer wishes to disclaim assets or determine the annuity payable from a charitable lead annuity trust.  Formulas are also used to divide trusts that are partially exempt from the generation-skipping transfer tax (GST) into two trusts, one of which is fully GST-exempt and one of which is not. In other words, since 1944, valuation clauses of one ilk or another have percolated throughout the estate planning world in a way that was unimaginable in 1944. The idea that such clauses are contrary to public policy does not seem consistent with the regulations issued by the IRS.

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