New Life for Charitable Lids

Two recent court victories give charitable formula clauses more power in estate plans.

September 2010
by Wayne Nix, et al./Journal of Accountancy

One common estate planning technique the Internal Revenue Service (IRS) has opposed or blocked for years is “charitable lid planning.” This technique relies on “defined value” and “value adjustment” clauses or similar provisions in wills, deeds or other transfer documents to cap the transfer taxes on estates, gifts or generation-skipping trusts at some predetermined amount. The IRS has consistently argued against defined-value clauses on the basis of the Fourth Circuit’s holding in Commissioner v. Procter (142 F.2d 824 (1944)) that such clauses are void because they remove the IRS’ incentive to audit returns and thus are against public policy.

In Procter, the taxpayer’s trust indenture making a gift of a future interest in trust property to his children provided that if a “court of last resort” determined that any part of the transfer was subject to gift tax, that portion would be deemed automatically void and excluded from the conveyance. The Fourth Circuit concluded that the clause would, in effect, nullify the very court judgment it invoked as a condition, noting that a federal law at the time prohibited any declaratory judgment by a federal court as to whether a gift was subject to gift tax. In subsequent cases, courts denied “savings clauses” that provided for a portion of a gift deemed subject to gift tax to revert to the donor. The IRS has also argued on similar grounds against clauses that would have a similar effect on transfer tax liability, but by making or increasing donations to charities rather than by a reversion.

In back-to-back decisions in late 2009, however, the Tax Court and Eighth Circuit in Estate of Christiansen v. Commissioner (130 TC 1, aff’d, 8th Cir. (2009)) and the Tax Court in Estate of Petter v. Commissioner (TC Memo 2009-280) rejected the IRS’ public policy arguments and opened the door for using charitable lid strategies to limit a donor’s transfer tax liability while fulfilling charitable goals. However, CPAs and their clients should also note continuing developments in this area of estate law.

The reduction in transfer taxes also entails a couple of risks that the CPA needs to discuss with clients. First, the IRS probably will audit their transfer tax returns and make value adjustments, requiring them to transfer additional assets to charitable organizations. Second, the IRS has not indicated its acceptance of the decision in Petter, so it probably will appeal the decision to the Ninth Circuit. A victory for the IRS would mean a split among the circuits that could lead to an appeal to the Supreme Court. A taxpayer victory, however, may not keep the IRS from appealing a Tax Court decision in other circuits.

This uncertainty makes it imperative that CPAs and others who advise wealthy clients watch the tax horizon for updates on this important issue. The Eighth Circuit includes Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota. The Ninth Circuit covers Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington states.

This article has been excerpted from the Journal of Accountancy. View the full article here.