Hendrix v. Commissioner, T.C. Memo 2011-133, 2011 WL 2457401 (U.S. Tax Court)(June 15, 2011)
A wealthy Texas couple wanted to transfer non-voting stock in their private S corporation to their three adult daughters (through trusts) and also to a charitable foundation. Because the stock was difficult to value, their attorney suggested that instead of gifting percentages, they use a formula clause to establish a dollar value at the time of the transfer, which would also fix the value of the stock transfer for federal gift tax purposes.
Three times appraised. After retaining a reputable appraiser to estimate the value of the non-voting stock (at nearly $37 per share), the couple transferred nearly 288,000 shares pursuant to a defined-value formula clause. The daughters’ trusts retained the same appraiser, and the foundation, represented by independent counsel, also required the donors to obtain an independent review of the appraisal and to assume responsibility for any additional tax liabilities. The foundation and trustees subsequently allocated the transfers amongst themselves according to the $37 per-share value.
The IRS disputed the validity of the transfers, claiming that their fair market value was closer to $49 per share and, further, that the defined-value clauses were not negotiated at arm’s length and were contrary to public policy.
The Tax Court rejected the IRS’s arguments on both points. The close relationship between the taxpayers and their daughters (and their trusts) did not necessarily mean that the formula clauses fell short of the arm’s length requirements of the code and case law, the court held. Moreover, the taxpayers had no prior history with the foundation, which assumed the potential risks of receiving the gift, including the loss of its tax-exempt status if it failed to exercise due diligence; thus its insistence on independent counsel, an independent appraisal, and the donors’ assumption of tax liabilities.
“We also note economic and business risk assumed by the daughters’ trusts as buyers of the stock,” the court said. That is, the trusts could receive less stock if it turned out to be overvalued, which placed them at odds with the taxpayers and the foundation. Finally, the defined-value clauses did not impose a subsequent condition that would defeat the charitable transfers, but actually furthered the fundamental public policy of encouraging charitable gifts, the court held, in confirming the taxpayers’ valuation of the stock transfers to the trusts and the foundation.
