The best way to handle gift and estate tax controversy work is to anticipate the dispute at the estate planning stage, according to John Porter, a senior partner at Baker Botts LLP, who shared insights from the “front lines” of tax litigation January 28 at the USC Gould School of Law Tax Institute.
Family Entities and Non-Tax Purpose
A primary focus for the IRS continues to be the use of family limited partnerships (FLPs) and other closely held entities, which the government frequently challenges by invoking IRC § 2036. This section can pull the full value of transferred assets back into a decedent’s estate if there was a retained right to enjoy the property or its income. According to Porter, the key defense against a § 2036 attack is the “bona fide sale for adequate and full consideration” exception.
To satisfy this exception, a transfer must not only be for full value but must also be motivated by a “significant and legitimate non-tax reason.” Porter stressed that this cannot be a theoretical justification; it must be an actual motivation. He noted that courts have recognized several valid non-tax purposes, such as centralizing asset management, involving the next generation in business operations, protecting assets from creditors or failed marriages, and preserving a cohesive investment philosophy.
The most effective way to prove these purposes is through contemporaneous documentation created during the planning phase. Porter advised that every letter, email, and memo should be written with the understanding that it may one day be read by an IRS agent or a Tax Court judge. This documentation provides the best evidence to counter an IRS assertion that the entity was merely a device to generate valuation discounts.
Formula Clauses
For transfers of hard-to-value assets, such as interests in a family partnership, formula clauses remain a critical tool for mitigating gift tax risk. However, their effectiveness hinges entirely on precise language. Porter highlighted the critical differences in outcomes based on the specific wording used. A clause that simply reverts property to the donor if a court determines a gift was made will fail as a “savings clause” against public policy, as established in Commissioner v. Procter (32 AFTR 750).
Successful formula clauses, in contrast, define the transfer as a specific dollar value of an asset “as finally determined for federal gift tax purposes.” This language, upheld in cases like Wandry v. Commissioner (T.C. Memo 2012-88), ensures that the gift’s value is fixed from the start, with only the percentage of the entity being transferred subject to later adjustment. If the IRS or a court later increases the value of the underlying entity, the percentage interest is simply reallocated; no additional gift occurs.
This successful approach must be contrasted with the taxpayer loss in Nelson v. Commissioner (T.C. Memo 2020-81). In that case, the clause defined the value as determined by a qualified appraiser within a fixed period. The 5th Circuit found this language insufficient because it did not tie the value to the final determination for gift tax purposes, which bound the taxpayer to the gift of a specific percentage interest that was later found to have a higher value.
The structure used in Estate of Petter v. Commissioner (108 AFTR 2d 2011-5593), where any value in excess of the defined amount is transferred to a charity, provides an additional layer of protection, as the charity’s directors have a fiduciary duty to ensure they receive the full value to which they are entitled.
QTIP Terminations and Promissory Note Risks
The IRS has also focused on specific transactions, including the termination of Qualified Terminable Interest Property (QTIP) trusts and the use of intra-family loans. In recent cases involving QTIPs, the IRS has argued that the termination of a QTIP trust followed by a distribution of all assets to the surviving spouse results in a taxable gift under IRC § 2519.
However, the Tax Court in Estate of Anenberg v. Commissioner (162 T.C. 199) held that such a transaction is not a gift from the surviving spouse, as any deemed transfer of the remainder interest is offset by the spouse’s receipt of those same assets, resulting in no gratuitous transfer. The court followed this logic in McDougall v. Commissioner (163 T.C. No. 5) but also held that the transaction did constitute a gift from the remainder beneficiaries to the surviving spouse, an issue still pending a decision on value.
Regarding promissory notes, the government has argued that a note can be valued at less than its face value for gift tax purposes, even if it carries the safe-harbor interest rate under IRC § 7872. This argument is based on factoring in commercial lending standards such as the borrower’s creditworthiness and lack of security.
In an unpublished order in Estate of Galli v. Commissioner, the Tax Court rejected this position on a motion for summary judgment, reaffirming that § 7872 provides a safe harbor for determining if a loan is a below-market gift. Nonetheless, Porter emphasized that to be respected, the underlying transaction must still be a bona fide loan with a reasonable expectation of repayment.
For more on exceptions to the estate tax lifetime transfer rules, see Checkpoint’s Federal Tax Coordinator 2d ¶ R-2105. For more on gift valuations involving family-owned businesses, see Federal Tax Coordinator 2d ¶ Q-1985. For more on qualified terminable interest property distributions, see Federal Tax Coordinator 2d ¶ Q-6315A.
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