Solving Gifting Procrastination for 2012

The once-in-a-lifetime opportunity to gift $5 million without gift or GST tax will close on December 31, 2012.  As of January 1, 2013, the gift tax exclusion will revert to $1 million and the gift and estate tax rate will revert to 55%, unless Congress takes action.

Given the extremely partisan election year politics, it seems unlikely that a bipartisan agreement will be reached before the election or even in the lame-duck session that will follow the election. Many individuals have already taken advantage of this planning opportunity, but many others have adopted a “wait-and-see” approach.

Steve Breitstone discussed two techniques dealing with late year planning and procrastination for the “wait-and-see” approach. For these procrastinators, the opportunity to make gifts of hard-to-value assets, or those involving valuation discounts, will be made more difficult by the time required to get necessary appraisals, especially as appraisers get busier as the year end approaches. The Wandry case may be helpful in utilizing “defined-value gifts”, but it is not clear that the Internal Revenue Service will accept that result. A better alternative may be to gift liquid assets to a defective grantor trust before December 31, 2012 and then utilize the power of substitution in the future to replace the liquid assets with discounted or hard-to-value assets.

Valuation Problems  Whenever a individual considers gifts of any assets other than cash or marketable securities, the issue of valuation often drives a decision not to gift up to the maximum exemption amount. Few individuals really want to pay substantial gift tax during their lifetime. As a result, most planners suggest that the gift amount for hard-to-value or discounted assets should be 10-20% less than the maximum, even after obtaining an independent appraisal.

Planners often rely on valuation adjustment clauses to limit the individual’s exposure to unexpected gift tax resulting from audit. Since Procter and King there have been many cases in which the IRS has contested revaluation and formula clauses.  Taxpayers have had some success in recent cases in which a transfer is allocated between donees and charities by a formula clause. Recently, the Wandry case has provided new hope that a “defined value gift” in which there is no charity to which the “excess” value is transferred will be sustained.  In Wandry, the Tax Court, in a memorandum decision, reasserted that the job of the IRS is to enforce the tax laws, not just maximize tax receipts, so that the public policy exception to the Internal Revenue Code should not be invoked too freely. The court characterized the defined value clause as a technique to reallocate units among donors and donees rather than an attempt by the donor to “take back property”. Admittedly, the effect is identical to a savings clause, so it is not certain if Wandry will provide the protection that commentators suggest.

New Concept for Procrastinators.  Those who have waited and desire to make gifts up to the maximum amount of their 2012 exemption should consider gifting cash or marketable securities to an intentionally defective grantor trust (DGT) before the end of 2012. Such gifts have several advantages. First, the value of those gifts is readily ascertainable and not subject to dispute. Second, the valuation discount box on the Form 709 is not checked, and the risk of audit is negligible. Third, an appraisal is not necessary prior to filing the gift tax return. Fourth, it is not necessary to reduce the amount of the gift by 10-20% below the maximum exemption amount to allow for potential audit adjustments.

Power of Substitution of Asset.  While a gift of cash or marketable securities does not leverage the gift tax exemption as most planners and individuals would prefer to increase the value of the gift, this can be accomplished in the future by using the power of substitution common to DGT drafting. The power of substitution requires that the property to be substituted must have a value equivalent to the property withdrawn from the DGT. The DGT should provide that if the value of the substituted property is later determined by appraisal or otherwise to be less or more than the property withdrawn from the trust, the grantor and trustee will correct the deficiency.  Exercising the substitution power is not a gift that is reported on a gift tax return. Hard-to-value or discounted assets can be substituted under this power with independent appraisal support. This transaction is beyond the review of the IRS, and the valuation adjustment clause does not arise in the context of a donative transfer, so would not be subject to the body of case law in this area.

The IRS could argue that this is a step transaction. However, none of the three threshold tests for step transaction are present.  These would not be a “binding commitment” to exercise the substitution power to replace the assets originally gifted to the DGT.  While the “end result” of exercising the substitution power would be the same as if the discounted assets had originally been gifted to the trust, this should not be part of the original plan, but an option that could be exercised in the future.   Finally, the gift of cash or marketable securities to the DGT and a later independent substitution of discounted assets are not “mutually interdependent” since each step was not “fruitless” without the other step. Of course, it will be important to maintain a good record of the reasons for each of these actions in the event of audit.

For those individuals who lack liquid assets for this plan, they could consider making a gift of their own promissory note to the DGT. Revenue Ruling 84-25, 1984-1 C.B. 191 holds that the gift of one’s promissory note may be deemed a completed gift if it is legally enforceable under state law. For example, if the donee (the trustee of the DGT) or perhaps a beneficiary of the DGT detrimentally relies on the promissory note to engage in a financial transaction, the note may be enforceable.

Time is running out on the once-in-a-lifetime $5 million gift and GST tax exemption. Individuals and their advisors should consider the best way to make use of this opportunity in the time remaining.