IRS Declines to Adopt the Wandry Decision

Earlier this year I blogged about good news for tax payers as a result of a court ruling known as the Wandry decision. Seems like the IRS is not about to go down without a fight.

Source Forbes
The IRS has thrown a significant road block into planning for large 2012 gifts. Our transfer tax system , gift and estate taxes, is unified. There is a credit against gift tax that if not used during a person’s lifetime is available to the estate. For the rest of 2012 the credit covers $5,120,000 in taxable transfers. Based on law in place now, that amount goes to $1,000,000 on January 1. For people who have not dipped into the $5,120,000 credit equivalent, the case for a large gift in 2012 can be compelling. There are of course problems and complications. Among them are deciding what to give and making sure that you leave yourself enough assets to live on.  The IRS announcement of non-acquiesence in the Wandry decision has made things difficult.

I wrote about the Wandry decision several months ago.  I indicated that setting up a gifting vehicle using the decision was even better than having Dr. Who, the Time Lord, helping you with your estate plan

Imagine someone with “legacy assets”.  Legacy assets are things like illiquid real estate, rare artwork or family business interests that may not provide current earnings.  Often there is a  hope that legacy assets will never be sold.  The legacy assets are owned by a family limited partnership.  In addition to the family limited partnership interest, the person, let’s call him Joe, has three million dollars in liquid investments.  Joe anticipates living on the three million dollars, perhaps depleting the principal as he gets older.  The thing for Joe to give away would be units in the family limited partnership.  How many units ?  $5,120,000 worth of course.  This is where knowing a Time Lord would be really handy.

Suppose the units are valued at $1,000.  Joe gives away 5,120 units.  The IRS challenges the valuation.  Ultimately it is agreed that the units are worth $2,000.  The gift tax, penalty and interest is going to take a pretty large chunk out of the three million dollars that Joe was counting on.  This is where time travel would be really handy.  After the case settles you ask Dr. Who to go back in time and instruct the attorney to make the gift 2,060 units rather than 5,120.  There is a possible looping problem here.  The valuation was the result of compromise and negotiation.  Maybe, if you started at $2,000 you would have ended up at $2,200 requiring another trip back in time.  The Wandry decision provided a much neater solution:

Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date.

Furthermore, the value determined is subject to challenge by the Internal Revenue Service (”IRS”). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted Units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above …….

This elegant gift tax solution seems like it could create an income tax nightmare particularly if the units were gifted to multiple persons.  You could never be sure everybody’s income tax return was right until the number of units finally transferred was determined.  There is a solution to that problem.  If the gift is made to one or more intentionally defective grantor trusts, the flow through from all gifted units ends up on Joe’s return regardless of whether the gifts are considered completed or pulled back.

What To Do Now ?

Getting Doctor Who to help would be great, but it may not be possible. There are many unperceived threats to human existence that Doctor Who is protecting us against

So he may not be able to help you with your gift tax planning.  A case can be made for actually paying gift taxes.  The top rate is scheduled to go up to 55% from 35%.  Even without a rate increase, gift taxes can be a better deal than estate taxes.  The rates are the same, but there is a big difference.  Estate taxes are computed on the gross, while gift taxes are computed on the net.  Someone who has run through the unified credit who then leaves his heirs $1,000,000 will be leaving them a net of $650,000.  With sufficient prescience, the $1,000,000 could have been used to make a gift of roughly $740,000 with the associated gift tax paid with the balance.

There are several reasons why the case for paying gift tax remains unpersuasive.  One is the general rule that you should pay no tax before its time.  Then there is the prospect of the Tea Party Triumphant amending the Constitution to ban the death tax forever.  Given all the smart people dedicating their lives to coming up with clever estate planning ideas, it is only a matter of time before one of them comes up with a way that will make it possible for you to take it with you. Then wouldn’t you be sorry that you squandered it funding an Alaska dynasty and paying gift taxes ?  The main problem, of course, is having to come up with cash.

The Wandry decision has not been overturned.  In principle, it still works, but the IRS has thrown down the gauntlet on it.  It would seem that relying on it for a mega-gift would be risky.  If there is plenty of liquidity to pay the resulting gift tax if it does not work, it might be worth trying, but not otherwise.  For those who are charitably inclined the Petter case, which was upheld by the Ninth Circuit is worth considering.  Under the Petter formula  units would be transferred to charity rather than coming back to the donor.  Barring that, 2012 mega-gifts should be made with property that is not open to significant valuation adjustment.

Author: Peter Reilly CPA