Affluent families who wish to make large lifetime gifts should consider using defined-value clauses or other formula clauses to minimize or eliminate gift taxes. These clauses are especially effective when transferring assets that are difficult to value, such as closely held business interests or real estate.

By defining the gift according to the amount of value you wish to transfer — rather than a percentage interest or specified number of ownership units — you can protect yourself and your family in the event the IRS or state tax authorities challenge your valuation.

Revaluation risk

When you transfer difficult-to-value assets to your children or other family members, there’s a risk that the IRS, in connection with an audit of your gift tax return, will revalue those assets, triggering additional gift taxes.

Here’s an example: In 2015, Stuart transfers a 40% interest in his closely held business to his daughter, Zoe. A professional appraiser values the interest at $5 million, well within the lifetime gift tax exemption ($5.43 million in 2015). In 2017, the IRS audits Stuart’s gift tax return and determines that the actual value of the interest is $7 million and assesses gift taxes of $628,000 [($7 million - $5.43 million) × 40%] plus interest and penalties.

Hedging your bets

A properly designed formula clause can help you hedge your bets, reducing the risk that a revaluation will result in an unwelcome gift tax bill. These clauses work by adjusting:

• The amount of property transferred,
• The way assets are allocated among various transferees, or
• The amount of consideration paid by the transferee to the transferor, to protect the transferor against additional gift tax liability.

There are several types of formula clauses (see the sidebar “4 formula approaches”), but the end result is generally the same: The value of the transfer is limited to an amount that’s exempt from federal gift taxes or to some other amount that you specify.

For a formula clause to pass muster with the IRS or the courts, it’s critical to draft it carefully. Historically, the IRS and the courts have rejected value- and price-adjustment clauses as invalid “savings clauses.” In other words, the clauses operate subsequently to reverse a portion of a gift and return it to the transferor or adjust the price.

During the last several years, however, the U.S. Tax Court and several federal appeals courts have accepted value-allocation and defined-value clauses. Although the end result is substantially the same, the clauses provide for a gift of a specified dollar amount that’s fixed on the date the gift is made, even though the percentage interest or number of ownership units necessary to produce the gift may be adjusted down the road. Value-allocation clauses are more widely accepted than defined-value clauses, but defined-value clauses may be more appropriate for transferors who want to keep assets in the family, rather than donating them to charity.

Handle with care

If you wish to make substantial gifts of closely held business interests or other difficult-to-value assets, consider using a defined-value or value-allocation clause to minimize the risk that the IRS will revalue these assets and assess gift taxes. In recent years, these clauses have increasingly been accepted by the courts, but keep in mind that the IRS continues to challenge them in many cases. To increase your chances of success, seek your estate planning advisor’s help in drafting transfer documents to ensure your formula clause is treated as fixing the value of the gift on the transfer date rather than adjusting it after-the-fact.

Sidebar: 4 formula approaches

Generally, there are four types of formula clauses you can use to limit the value of gifts:

1. Value-adjustment clause. If, as a result of a revaluation, the value of transferred assets exceeds the gift tax exemption or other desired value, a portion of the assets — equal to the excess value — is returned to you.
2. Price-adjustment clause. The transferee is required to pay consideration to you (or increase the amount of consideration paid) so that the excess value is treated as a transfer for full and adequate consideration rather than a gift.
3. Value-allocation clause. The transferee receives a specified value of transferred assets (say, $5.43 million). In the event the IRS determines that the value of the assets exceeds that amount, a portion of the assets (equal in value to the excess amount) passes to a charity or other tax-exempt transferee.
4. Defined-value clause. This clause defines the value of the transferred assets at the time of the transfer. In the event of a revaluation, instead of returning assets to the transferor or adjusting the purchase price, the excess is treated as though it had never been gifted, and therefore remains with the transferor.

Bear in mind that the courts generally have rejected the first two types of formula clauses, but in recent years they’ve accepted the third and fourth types in several cases.