The Ninth Circuit held that a taxpayer was entitled to a charitable deduction for gifts of LLC units to two charitable foundations that were transferred to the foundations when the IRS increased the value of the LLC units on audit.
After Anne Petter inherited a large amount of UPS stock, she set up a complex estate plan designed to give some of her wealth to charity and as much of her stock as she could to two of her children, Donna and Terry, without having to pay gift tax. As part of the plan, Petter transferred the stock to a family LLC in return for interests in the LLC, and she set up separate trusts for both Donna and Terry. Petter transferred membership units in a family-owned LLC partly as a gift and partly by sale to the two trusts and coupled the transfers with simultaneous gifts of LLC units to two charitable foundations. The transfer agreements included:
- A dollar formula clause, which assigned to the trusts a number of LLC units worth a specified dollar amount and assigned the remainder of the units to the foundations; and
- A reallocation clause, which obligated the trusts to transfer additional units to the foundations if the value of the units the trusts initially received was finally determined for federal gift tax purposes to exceed the specified dollar amount.
Petter filed a gift tax return to report the transfers in 2002. The return disclosed the allocation and reallocation clauses. It further disclosed that the value of the LLC for determining the amount of the transfers reported was based on the fair market value of the underlying assets of the LLC with a 46% nonmarketability discount and a 13.3% net asset value adjustment applied.
On audit in 2005, the IRS concluded that the LLC units had been greatly undervalued. Petter and the IRS eventually agreed that the value of the LLC units was slightly lower than the amount the IRS initially claimed. Under the transfer agreements, this resulted in the transfer of additional LLC units from the trusts to the charitable foundations.
Petter sought to take a deduction for the additional shares given to the charitable foundations. However, the IRS refused to allow her to take the deduction, claiming that the dollar formula clauses were void as against public policy, and the clauses caused the gifts to be subject to a condition precedent under Regs. Sec. 25.2522(c)-3. Petter challenged the IRS’s determination in Tax Court, which held that the transfers were not void as against public policy and were not gifts subject to a condition precedent (Estate of Petter, T.C. Memo. 2009-280).
The IRS appealed the decision to the Ninth Circuit, where it abandoned the public policy theory and argued only that the adjustment feature of the dollar formula clauses made the additional gifts subject to a condition precedent as described in Regs. Sec. 25.2522(c)-3(b)(1):
If, as of the date of the gift, a transfer for charitable purposes is dependent upon the performance of some act or of the happening of a precedent event in order that it might become effective, no deduction is allowable unless the possibility that the charitable transfer will not become effective is so remote as to be negligible.
The Ninth Circuit’s Decision
The Ninth Circuit held that Petter was entitled to a charitable deduction for the transfer of the additional units to the charitable foundations because the formula clauses spoke only to the value of the LLC units, not to whether the foundations were entitled to receive a specific number of units at the time of the gift. Thus, the additional transfer of LLC units to the foundations was not subject to a condition precedent within the meaning of Regs. Sec. 25.2522(c)-3(b)(1).
According to the Ninth Circuit, under the terms of the transfer agreements, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula. This formula had one unknown: the value of an LLC unit at the time the transfer agreements were executed. But though unknown, that value was a constant, which meant that both before and after the IRS audit, the foundations were entitled to receive the same number of units. Absent the audit, the foundations might never have received all the units they were entitled to, but that did not mean that part of Petter’s transfer depended upon an IRS audit. Rather, the audit merely ensured that the foundations would receive the units they were always entitled to receive.
The IRS lost on the condition-precedent issue in a similar case, Estate of Christiansen , 586 F.3d 1061 (8th Cir. 2009), which the Ninth Circuit discussed at some length in Petter . The Ninth Circuit expressed its certainty in the correctness of its decision by inviting the IRS to amend the regulations if it did not like the results of the case.
Estate of Petter, No. 10-71854 (9th Cir. 8/4/11)