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

The Wandry case is good news for family business owners

The Wall Street Journal reports good news for small business owners who under-value their businesses during their lifetime for gift tax purposes.

Shielding the Family Business
By LAURA SAUNDERS

Small-business owners often complain of feeling caught in the cross hairs of the tax code. For a change, here's good news.

The Tax Court has just blessed a new technique that owners of closely held businesses—and wealthy families—can use to pass assets to heirs with a minimum of taxes and complications. The ruling in the case, Wandry v. Commissioner, is stirring up excitement among experts.


David Kautter, a director of American University's Kogod Tax Center, calls the ruling a "landmark decision, because it allows tax-free ownership transfers from one generation to another with certainty and in an orderly manner."

Here is why Wandry matters. Our current system imposes a gift tax of up to 35% when taxpayers give assets away, with exceptions. Individuals now get one $5.12 million lifetime exemption, and they can also give up to $13,000 of assets a year to an unlimited number of recipients. (Next year the lifetime break is scheduled to drop to $1 million and the top rate to rise to 55%.)

This means an owner who wants to give a business to children or others, such as employees, can use these exemptions to transfer ownership tax-free. He can even use the $13,000 annual exclusion to transfer value bit by bit.

That is what happened in the Wandry case. Dean and Joanne Wandry, a Colorado couple, each gave units in a family-owned limited-liability company worth $1,099,000 to their heirs in 2004. To avoid paying tax, they specified the gifts should equal the dollar amount of their exemptions—a key point. (At the time, the lifetime exemption was $1 million and the annual exclusion $11,000.)

The hitch in Wandry and other cases is that the givers have to get a professional appraisal if—as is common—the company is hard to value. Often values are low-balled a bit in order to maximize the gift. But the Internal Revenue Service can contest the appraisal after the gift—and often does. In Wandry, the value rose about 20%.

That brings up an important issue: If values rise after an IRS challenge, must the giver write a big check for tax on the amounts above the exemption?

According to the Wandry decision, no. The judge held the couple intended to make a gift equal to their exemptions, so the excess was never actually given by them. No tax was due.

Here's a simplified example: John's business is appraised at $6 million. He gave units worth $5 million to relatives last year, with more to come in $13,000 annual gifts over time.

The IRS later determines that the $5 million of units were actually worth $6.2 million. Does John owe gift tax of about $400,000 on the $1.2 million? Not if he arranges the transaction as the Wandrys did, and the $1.2 million is deemed never to have been given. It remains John's.

The IRS must feel like this decision stacks the deck in taxpayers' favor, because they don't risk writing a check if they lowball the value of a gift.

According to attorney John Porter of Baker Botts in Houston, Wandry is the latest in a line of related cases lost by the IRS. Absent the Wandry decision, often the best outcome is for a family to designate a charity to receive the excess. No tax is due, but the family gives up some control.

The Wandry case is a boon not only for business owners but also wealthy families with "family limited partnerships" or entities holding publicly traded stocks. Even though the stocks' value is easy to determine, submerging them in a non-traded company provides valuable discounts when units are transferred to heirs.

As a "memorandum" decision, Wandry may be cited as precedent in future cases. The IRS had no comment either on the decision or whether it will appeal the case to the 10th Circuit Court of Appeals.

The catch: The IRS has more than three months to appeal the case. Mr. Porter believes its reasoning is sound, but taxpayers who rely on it while gift-tax exemptions are high and rates are low run a risk.

Still, it may be important to act soon. The decision is so advantageous for taxpayers that it could inspire a response from Congress or the IRS.

Proposals on passing wealth through partnerships that would undercut Wandry have been raised repeatedly by lawmakers, notes Kogod's Mr. Kautter, and the decision could help revive them..