Article: 20
David G. Shaftel
Law Offices of David G. Shaftel, PC, Anchorage, Alaska
© 2004. All rights reserved.

DAVID G. SHAFTEL practices law in Anchorage, Alaska, and also is a member of the California Bar. He is a Fellow of the American College of Trust and Estate Counsel. Mr. Shaftel has previously written for Estate Planning . Copyright © 2004 David G. Shaftel.*

* The author wishes to thank Caroline Wanamaker for her analysis of the state property law issues created when a defined value clause is used and for her assistance in drafting Escrow Trust forms.

Whenever a client desires to “cap” gift tax exposure, planners should consider using a defined value clause implemented via an Escrow Trust. This article explores this strategy, and analyzes how to structure and draft an Escrow Trust.

Many planners have used defined value formula clauses as a backup to “cap” their clients' gift tax exposure. A defined value clause limits the quantity of assets gifted or sold until a final determination of value is made. The 2003 Tax Court decision in McCord 1 and the Service's recent rulings 2 have focused concern on whether the courts will respect these formula clauses. On the one hand, these clauses may be lumped together with “price adjustment clauses” which have already been judicially condemned. 3On the other hand, a defined value clause used to limit gift tax exposure in gift and sale transactions may be validated as are other value definition formulas which are used in similar tax contexts. 4

The theme of this article is that appropriately implemented defined value clauses are a reasonable, non-abusive method to limit gift tax liability. However, proper implementation of a defined value clause will perhaps be crucial to whether such clauses will be accepted by the courts. Careless use of this technique creates confusion with respect to basic state law property ownership concepts. Worse yet, without proper implementation, a defined value clause in operation appears dangerously similar to the price adjustment clauses that have already been condemned by most courts as against public policy.

This article suggests that an “Escrow Trust” be used to implement a defined value clause. Such Escrow Trust implementation is consistent with state law property ownership concepts and clearly differentiates such clauses from price adjustment clauses.

Background on price adjustment clauses

It is important to understand the reasoning behind the courts' condemnation of price adjustment clauses. These formula clauses were the first attempts to “cap” gift tax liability in gift or sale transactions. This type of clause provided that if it was determined that a portion of the transfer would be subject to gift tax, then the transaction would subsequently be adjusted by either transferring the excess which produced the gift tax back to the donor or seller, or by requiring the donee to pay for the excess.

In Procter , 5 the Fourth Circuit invalidated a price adjustment clause stating, “[t]his is clearly a condition subsequent and void because contrary to public policy.” 6The court was concerned that the adjustment might not be respected by the parties and stated: “[s]uch holding, however, being made in a tax suit in which the donees of the property are not parties, would not be binding upon them and they might later enforce the gift notwithstanding the decision of the Tax Court.” 7

The Fourth Circuit concluded that the adjustment clause was contrary to public policy for three reasons. First, the clause discourages the collection of tax by the tax agency because the only effect of an attempt to enforce the tax would be to defeat the gift. Second, the effect of the clause would be the obstruction of the administration of justice by requiring the courts to pass on a moot case. Third, the court stated that the final judgment of a court would be rendered meaningless because of the consequence of the clause. The court pointed out that it is not possible to obtain a declaratory judgment from a federal court concerning whether the gift in question is subject to the gift tax.

The condition subsequent defect, which requires the after-the-fact adjustment of the transaction by a transfer of assets back to the donor or seller or requires the donee to pay for the excess, has been at the core of additional court decisions invalidating price adjustment clauses. 8The IRS has focused on this condition subsequent characteristic in its rulings which challenge the validity of price adjustment clauses. 9

Defined value formula clauses

In contrast to the above-described price adjustment clauses, a properly implemented defined value cause avoids the condition subsequent adjustment of the transaction. 10Instead of fixing both value and quantity up-front, a defined value clause fixes only the pecuniary value of the gift or sale transaction. The exact quantity of assets transferred remains uncertain until values are finally determined for federal gift tax purposes.

This finality is achieved when either when the federal gift tax statute of limitations expires or when the IRS challenges the value and this challenge is resolved. The gift tax limitation period runs for three years from the filing of the gift tax return. 11Resolution of an IRS challenge may occur through negotiation, Appellate Division review, or litigation, which may take longer than the expiration of the limitations period. When the value for the asset is finally determined, the correct quantity is transferred. If the transfer is properly implemented, there is no after-the-fact change of the transaction, either theoretically (the value transferred) or practically (the implementation of the transfer). 12

The simplest and most direct defined value clause transaction is one where the excess over the defined value amount stays with the donor or seller. This can be accomplished by a transfer back directly to the donor or seller, or a transfer back to a revocable trust or a zeroed-out GRAT (grantor retained annuity trust) for the benefit of the donor or seller. 13An alternative is to have the excess amount transferred to the spouse or a charity. Such excess transfers avoid a transfer back to the donor or seller (which is similar to the operation of a price adjustment clause) without producing any gift tax liability. 14

Defined value concepts are established and accepted in the transfer tax area. Defined value formulas dividing assets between a bypass trust and the marital share or trust in a manner to avoid any out-of-pocket estate tax liability have been administratively accepted by the IRS for decades. 15Disclaimers are expressly allowed to be structured in terms of a fixed dollar or pecuniary amount or a fractional share. 16Indeed, disclaimers using defined valuation formulas can indirectly accomplish the same type of “capping” of gift tax liability as is used more directly with defined value clauses in gift or sale transactions. 17

The value of the annuity in a GRAT may be stated in terms of a fraction or percentage of the initial fair market value (FMV) of the trust's assets. The applicable Regulations allow the quantity to remain uncertain until a final determination is made concerning FMV for federal tax purposes, and then appropriate reallocations are directed which correct the annuity and substantially reduce gift tax liability. 18

Similarly, the annuity in a charitable remainder annuity trust (CRAT) may be defined in terms of a fraction or a percentage of the FMV of the property initially contributed to (CRAT) or owned by (CRUT, charitable remainder uni-trust) the trust. The IRS has expressly approved the use of such a formula which leaves the exact quantity uncertain until the FMV of the trust assets is correctly determined for federal tax purposes. Then, if necessary, allocations by the trustee are required to correct the annuity. 19These corrections may substantially reduce gift tax liability if the annuity is being paid to, for example, a child of the settlor. Finally, the generation-skipping transfer (GST) tax regulations allow GST exemption to be allocated by a formula to produce an inclusion ratio of zero. 20One effect of such formula allocation is to allow the donor to avoid unintended GST tax liability upon a taxable termination or taxable distribution if gifted assets were undervalued.

IRS and court discussion of defined value clauses. The IRS has considered defined value clauses in several rulings. In Ltr. Rul. 8611004, such a formula clause was used by the taxpayer to make small, primarily annual exclusion, gifts of partnership interests. Evidently the formula did not expressly state what would happen if the value of the gifted partnership interest percentages exceeded the numerator of the fraction. Nevertheless, the Service approved the defined value gifts, stating, “[t]o the extent that the fractional interests indicated in the agreement and returns exceeded the fractional interests properly attributable to the fair market values stated by the decedent in the assignments of gifts, the excess fractional portion was receivable by the decedent and the right to it could have been asserted by him at any time.”

Recently, though, the Service has had a change of heart. All subsequent rulings have been adverse. While recognizing the differences between defined value clauses and the price adjustment clauses, the Service has taken the position that both types of clauses violate the public policy concerns of Procter and therefore are invalid. 21The fact that the ruling situations required a transfer of assets back to the donor or seller (as did the price adjustment clause situations) has been emphasized. 22The Service has relied on several courts' concerns that the donee (or buyer) would not transfer assets back to the donor (or seller) after a final determination of FMV. 22

In its rulings, the Service admits that some assets, such as real estate and closely held stock, are difficult to value, and that marital deduction and GRAT formula clauses are acceptable methods to deal with this problem. Then, the Service attempts to distinguish the defined value formulas used in marital deduction transfers and GRATs as “Congressionally authorized.” 23The Service's recent opposition to the use of defined value clauses in gift and sale transactions may be rooted in the Service's frustration with discounts allowed in connection with family limited partnerships (FLPs), 24 and the use of defined value clauses as part of complex plans that the Service considers overly aggressive. 25

The long-awaited initial Tax Court consideration of a defined value clause in a gift or sale transaction has failed to clarify whether such a clause may be used to limit gift tax liability. However, certain aspects of this decision are directly relevant to the theme of this article and need to be underscored. 26In McCord , the defined value clause provided that a certain value of FLP interests would be given to children and GST trusts, and that the excess would go to two charities. The partnership was given a call right to purchase the charities' interests, and this right was exercised within six months at what appeared to be a “sweetheart” price agreed to by the charities. One consequence of such a quick buy-back was that when the values of the gifted interests were increased on audit, the charities did not receive those increases. Rather, the increases ended up with the partnership which had “called” and bought back the charities' interests, and which was now owned by the children and the trusts. On these facts, the Tax Court refused to give effect to the defined value clause.

The majority opinion in McCord did not mention or base its decision on Procter 's public policy reasons. Judge Foley (the trial judge), in his dissenting opinion, rejected the public policy argument because of the difference between a defined value clause and a price adjustment clause. One judge would have applied a public policy doctrine similar to that used in Procter , 27 and another thought the doctrine was broad and flexible enough to apply to overly aggressive planning. 28

The above-described call right and quick buy-back used to implement the McCord defined value clause appear to be the main reason for the Tax Court's decision. Nevertheless, the majority held out hope for a properly drafted and implemented defined value clause, stating in part:

Had petitioners provided that each donee had an enforceable right to a fraction of the gifted interest determined with reference to the fair market value of the gifted interest as finally determined for Federal gift tax purposes, we might have reached a different result. 29

The focus of the rest of this article will be on less aggressive uses of defined value clauses. The example below provides that the donee's interests are fixed only upon a final determination of value, which will occur on audit, litigation, or when the gift tax limitations period expires.

An example

Consider the following example of a situation that is appropriate for the use of a defined value clause. Grandparents and their children have previously formed an FLP that owns commercial real estate and interests in several other closely held businesses. Grandparents own 90% of the partnership interests. They desire to transfer interests in the FLP to a trust for their children and grandchildren, but they do not want to pay out-of-pocket gift tax.

They obtain an independent appraisal which indicates that a 45% FLP interest has a FMV of $1 million. Their estate planning attorney advises them that their applicable credits will offset the gift tax generated. However, the type of assets owned by the FLP and the discounts used by the appraiser create significant valuation uncertainty.

If grandparents use the percentage of the FLP determined by the appraiser to be equal to the desired gift amounts and the appraiser's value is ultimately determined to be too low, grandparents will owe federal gift tax. Their attorney advises grandparents that the gift transaction can be structured using a defined value clause. Each grandparent will gift a fraction of the grandparent's 45% interest. The numerator will be $1 million and the denominator will be the FMV of the 45% FLP interest as finally determined for federal gift tax purposes.

As a result, there will be an “interim period”, when the exact quantity of FLP interests transferred will be unknown. That is, if the appraiser's value is correct, then all of the grandparents' FLP interests will have been gifted to the trust. On the other hand, if the appraiser's value was too low, then by virtue of the use of the defined value clause, only a portion of each grandparent's 45% interest will have been gifted and each grandparent will have retained the remaining portion. This period of uncertain quantity ownership can create inconsistencies with state law property concepts that are prerequisites to desired tax results. Further, as discussed below, the manner in which the uncertain ownership is dealt with may affect a court's conclusion concerning whether the formula clause is significantly different from a price adjustment clause.

State property law ownership issues

During this interim period, a number of practical property ownership requirements exist:

•  Title to the transferred property will need to be held.

•  Specific property interests may need to be managed: expenses paid, repairs made, leases negotiated, and similar tasks.

•  Voting rights may need to be exercised.

•  Income received must be accounted for and invested.

•  Tax reporting and payment must be accomplished.

•  Records must be kept.

•  Trust beneficiaries may need advance distributions.

•  GST exempt and non-exempt assets will need to be segregated.

•  If the transaction involves a sale, then payments may have to be made.

How are these practical property ownership matters to be accomplished during the interim period when ownership of the assets is uncertain? Consider the following possible solutions.

The donor could retain title and accomplish all of these matters. However, such retention would cast considerable doubt as to whether a completed gift or sale transaction had occurred.

Alternatively, the title could be transferred and the donee could accomplish all of these matters. Then, if it is determined that an FLP interest was undervalued, at the end of the interim period the donee could return to the donor the portion of the assets “owned” by the donor. Title to some of the assets would need to be transferred back to the donor, a portion of the income earned would need to be similarly transferred, and an accounting of activities would need to be made. Moreover, the donee would be responsible for the manner in which the donor's portion of the assets was managed during the interim period. 30

This alternative solution of transferring all assets to the donee, coupled with the donee's management of assets, a portion of which are still owned by the donor, casts a shadow of unreality on the gift or sale transaction. This is not how arms-length transactions are usually structured. Further, the requirement that when value is finally determined the donee must reconvey a portion of the assets back to the donor, along with a portion of the income, and an accounting for interim management, makes the defined value clause structure uncomfortably similar to that of the price adjustment clauses and their condemned condition subsequent transfers.

A further problem created by both of the above solutions is that they ignore state property law ownership concepts. Courts have repeatedly refused to approve tax planning in situations where state property law requirements were not respected. 31Examples of such failed planning can be found in recent FLP cases, 32 and in situations where a donor or seller of a residence improperly retains use.

Use of an escrow trust

A third and best solution to the above practical ownership dilemmas described above is the use of an Escrow Trust.33At the closing of the gift transaction, the donor (a grandparent in our example) and the donee (the trustee of the trust in our example), as settlors, form an “Escrow Trust”. This trust has an independent trustee who will hold title to the gifted assets during the interim period. The trustee will manage the assets, exercise voting rights, receive and invest income, accomplish all tax reporting and payments, keep records, make advance distributions to beneficiaries of trust assets as directed by its trustee, and segregate GST exempt and non-exempt assets. 34

At the end of the interim period when the value of the gifted FLP interests is finally determined for federal gift tax purposes, the trustee of the Escrow Trust will divide the Escrow Trust's assets between the donor (grandparent) and the donee (trust) pursuant to the fraction stated in the defined value clause. At that time, title will be transferred, accumulated income will be divided and transferred, and an accounting will be provided to both the donor and the donee. During the interim period, the trustee of the Escrow Trust will have performed the trustee's duties pursuant to fiduciary standards.

This use of an Escrow Trust, with an independent trustee, is consistent with implementation of arms-length transactions between unrelated parties. It is a practical solution to the uncertainty of the quantity of assets gifted. The gift transaction will be completed when closed with respect to the pecuniary amount stated in the defined value clause. The implementation of state law ownership matters is accomplished by an independent fiduciary who is equally responsible to donor and donee. There is no transfer back by the donee to the donor, as is condemned by the price adjustment clauses and conditions subsequent. If the donee is a grantor trust, then during the interim period all of the income and deductions of the Escrow Trust will be reportable by the grantor (donor) on the grantor's individual income tax return. 35

Drafting and implementation

The following discussion provides suggestions for the structuring and drafting an Escrow Trust for a gift transaction. 36Very similar provisions would be used for a sale to grantor trust transaction or a plan that involved both gift and sale transactions. The settlors of the Escrow Trust are the donor and, in this example, a donee grantor trust. An independent trustee would be chosen. The Escrow Trust would be irrevocable during the interim period. For clarity, a purpose provision would describe the function of the Escrow Trust for implementation of the defined value clause. (Exhibit 1 contains an example of a Purpose Clause.)

The gift to the donee trust may only be partially exempt from GST tax. Therefore, the Escrow Trust should create three separate trusts: a GST exempt escrow trust, a GST non-exempt escrow trust, and a revocable trust which will hold any excess assets that may need to be returned to the donor. (Exhibit 2 contains an example of a Trust Creation Clause.)

A provision describing ownership of the transferred assets during the interim period will contain the defined value clause, and will describe how ownership of the trust assets is divided among the GST exempt escrow trust, the GST non-exempt escrow trust, and the revocable trust. (An example of an Ownership Clause appears in Exhibit 3.) The gifted amount may include a small percentage gift in addition to the defined value gift. This small percentage gift is designed to counter the public policy arguments of Procter . 37The Escrow Trust will also need a provision describing the administration of the three trusts' assets during the interim period. (An example of an Administration Clause is found in Exhibit 4.)

Finally, a provision will be needed describing the distributions that will be made among the three trusts, once there is a final determination of FMV of the gifted assets. (Exhibit 5 sets forth an example of a Distribution Clause.)

In addition to the Escrow Trust, a certificate of gift will need to be executed by each grandparent; this document will state the assets that are the subject of the gift transaction, and will use the defined value clause to describe the gift. 38A gift tax return will be filed for the grandparent and will adequately disclose the gift so as to begin the three-year limitations period. 39If the donee or buyer is to be a trust, it should have a provision authorizing its trustee to form an Escrow Trust. The advisor should draft an information letter which describes the concept of the defined value clause, its implementation using the Escrow Trust, and the uncertain state of the tax law concerning such formula clauses. This letter should be given to and discussed with the clients well before the contemplated transaction is closed.

During the interim period, the independent trustee must accomplish all of the property ownership duties allocated to the trustee in the trust instrument. Care must be taken to avoid having either the donor or donee accomplish such duties. At the close of the interim period, the independent trustee would transfer the subject assets and net income among the three trusts, and provide an appropriate final accounting.

Conclusion and upside/downside analysis

Use of a carefully implemented Escrow Trust should provide substantial support for the position that a defined value clause is a reasonable and non-abusive method to control gift tax liability. When a defined value clause is implemented in an Escrow Trust, state law property ownership concepts are respected and observed. Reality and arms-length qualities are provided to the defined value transaction.

The Escrow Trust clearly differentiates the use of a defined value clause from a price adjustment clause by eliminating the condition subsequent transfer back from the donee or buyer to the donor or seller. The Escrow Trust eliminates the Fourth Circuit's Procter concern that an untaxed gift might occur because a donee may refuse to return the excess untaxed amount determined by a court decision. Finally, in our present unified transfer tax climate, a properly implemented defined value clause should not run afoul of the Fourth Circuit's Procter public policy concerns. Amounts not transferred by gift or sale will ultimately be included in the donor's or seller's gross estate at death. Hence, the IRS continues to have a strong incentive to audit and enforce the proper valuation of the assets transferred. Correction of excessive valuation will reduce the quantity of assets transferred and will increase the ultimate federal estate tax liability. 40

Whenever a client desires to “cap” gift tax exposure, planners should consider using the defined value clause approach. If the Service successfully challenges value and the defined value clause is upheld, then its objective is accomplished. If the court refuses to give effect to the defined value clause, the client is no worse off than if the clause had not been used. The only downside to an effective defined value clause is that it does limit the quantity of assets transferred. If certainty of quantity outweighs the risk of increased gift tax liability, then a defined value clause should not be used.



Exhibit 1

Purpose Clause

Purpose of Trust. The settlors have created this trust in order to implement gifts of certain assets, and possible future gifts or sales of assets. With respect to the contemplated gift, the donor is _____ and the donee is the _________ Trust. The contemplated transaction is for a specific value of assets. This escrow trust will hold the transferred assets which are, or may be, subject to said transaction, until the fair market value of the assets is determined. Then, the trustee will distribute the quantity of assets equal to the gift amount to the donee, plus a small additional gift amount, and any excess will be distributed to a revocable trust for the donor.

During the period when the assets are held by this Escrow Trust and the trusts created under this instrument, the trustee shall hold title to such assets, collect all distributions received with respect to such assets, implement the directions of the settlors as authorized by the provisions of this instrument, accomplish any other necessary and usual custodial functions, and ultimately distribute the trust assets as provided by this instrument.

Exhibit 2

Trust Creation Clause

A. Creation of Separate Trusts. This trust creates three separate trusts:

1. ____ Exempt Escrow Trust;

2. ____ Non-Exempt Escrow Trust; and

3. ____ Escrow Revocable Trust.

The above trusts shall be administered and distributed for the beneficiaries pursuant to the directions stated below in this Article ___ and in the other relevant provisions of this trust instrument.

The ownership of assets and the administration of these trusts are governed by paragraphs B, C, and D, below (in Exhibits 3 and 4). After the fair market values of the assets have been finally determined for federal gift tax purposes, then paragraph E (in Exhibit 5) governs the distribution of assets among the above trusts.


Exhibit 3

B. Ownership of Assets.

1. Assets Held by this Escrow Trust Pursuant to Gift Transaction. [Donor] may gift a certain value of assets to the ____ Family Trust. If such a gift occurs, [Donor] and the trustee of the ____ Family Trust may decide to transfer to this trust assets which are, or may be, subject to such gift. Those assets shall be referred to herein as “Gift Transaction Assets.” The Gift Transaction Assets transferred to this trust shall be held by the trustee for the benefit of the trusts which are described below, as follows:

a. Exempt and Non-Exempt Trusts' Fractional Share. The trustee of the Exempt Escrow Trust and Non-Exempt Escrow Trust shall hold, for the benefit of the Exempt Family Trust and the Non-Exempt Family Trust, a fractional share of the Gift Transaction Assets. That fraction is as follows:

$[stated gift amount], plus 3% of the excess, if any, of the fair market value of the Gift Transaction Assets over $[stated gift amount]

The fair market value of the Gift Transaction Assets

“Fair market value” shall be determined in accordance with the valuation principles set forth in Treasury Regulation section 25.2512-1, as finally determined for Federal Gift Tax purposes. [Donor] intends that the three percent of the excess, if any, of the fair market value of the Gift Transaction Assets over stated gift amount shall be an additional gift. The above-described fractional share (herein sometimes referred to as the “Gifted Assets”), and the three percent gift (if any), shall be divided between the Exempt Trust and the Non-Exempt Trust pursuant to the directions stated in paragraph “c”, below.

b. Excess Owned by Revocable Trust. The Revocable Trust shall own the portion of the Gift Transaction Assets which represents the excess of the fair market value of the Gift Transaction Assets over the amount determined pursuant to paragraph “a”, above.

c. Exempt and Non-Exempt Trusts-Ownership of Gifted Assets. The amount determined pursuant to paragraph “a”, above, will be further divided pursuant to the following directions. The trustee shall divide the assets between the Exempt Trust and the Non-Exempt Trust as follows:

(i) To the Exempt Trust:

(1) * All of the assets if such transfer is being made from a trust, the trustees of which inform the trustees hereunder that, as of the effective date of such transfer, such transferor trust has (or will have) a zero inclusion ratio for generation-skipping transfer (GST) tax purposes, or

(2) Such fractional share of the assets as is equal in value (as of the valuation date applicable to the federal gift tax return of the transferor reporting such transfer of assets for federal gift tax purposes) to the amount (which may be initially expressed as a formula) of such transferor's GST exemption, if any, that such transferor or such transferor's personal representative, as the case may be, at the time of the transfer informs such trustee will be allocated to such transfer to the Exempt Trust, and

(ii) To the Non-Exempt Trust, the remainder, if any, of the assets comprising such share.

The Exempt and Non-Exempt trusts shall be governed by the administrative and dispositive directions stated in paragraphs C and E, below (in Exhibits 4 and 5).

* Paragraph (1) will apply when the donee or buyer is a trust to which GST exemption has been allocated. Then the donee or buyer trust will become a settlor of the Escrow Trust.


Exhibit 4

Administration Clause

C. Administration of the Exempt Trust and Non-Exempt Trust. During the period until the fair market values of the Gift Transaction Assets [ and/or the Purchase Transaction Assets ] * are finally determined, the trustee shall administer and distribute the assets of the Exempt Trust and Non-Exempt Trust pursuant to the following directions.

1. Management. The trustee shall manage and invest the trust assets, including, but not limited to:

a. Holding title to such assets;

b. Receiving, holding and investing all distributions received with respect to such assets;

c. Accomplishing all tax and other government reporting and payment obligations;

d. Keeping records of the trusts' assets and administration;

e. Distributing net income to the trustee of the ____ Family Trust if so directed by such trustee;

f. Voting the shares subject to the Voting Trust Agreement of _____;

g. Complying with provisions of any Buy-Sell Agreement of the Shareholders of ____; and

[h. Implementing payment directions received from the Independent Trustee of the ____ Family Trust with respect to assets purchased by that trust and held by this Escrow Trust. ] *

2. Directed Distributions. The trustee will distribute to, or apply for the sole benefit of, a child and/or grandchild of Donor, so much of the income and principal of this trust (subject to the limitation of paragraph “a”, below) at such time or times and in such amounts and manner, as the Independent Trustee of the ____ Family Trust directs, pursuant to such Independent Trustee's authority under the ____ Family Trust. The trustee of this Escrow Trust shall make such distributions as directed by the Independent Trustee of the ____ Family Trust and will have no liability for having carried out such distribution directions of the Independent Trustee of the ____ Family Trust.

a. Encumbrance. Any assets of this trust or a trust created under this instrument which are encumbered as security for indebtedness may not be distributed to a beneficiary of such trust unless consent and release, or consent and continued encumbrance, is first obtained from the security holder.

b. Later Adjustment. If the trustee has distributed more income to the [Donee] Trust than such trust is or was entitled to, then the trustee shall account for such excess distribution by distributing enough income or principal upon final distribution under paragraph E, below, (in Exhibit 5) to the ____ Revocable Trust established herein to adjust for any excess distribution to the [Donee] Trust.

D. Administration of the Revocable Trust. During the period until the fair market values of the Gift Transaction Assets [ and/or the Purchase Transaction Assets ] * are finally determined, the trustee shall manage and invest the assets of the Revocable Trust, pursuant to the provisions of paragraph C, 1, “a” through “d”, and “f” and “g”, above.

* The bracketed language would be added if the transactions in question included both gifts and sales–for example, a sale to a grantor trust.


Exhibit 5

Distribution Clause

E. Distributions When Fair Market Value Finally Determined.

1. Final Determination. The trustee shall decide when the fair market values of the Gift Transaction Assets [ and/or Purchase Transaction Assets ] * have been finally determined for Federal Gift Tax purposes. If an assessment has not been made, this final determination will occur when the period of time for assessing additional gift tax on a gift has expired. If an assessment has been timely made, then a final determination will occur when the assessment is resolved with the Internal Revenue Service or by a court. For this purpose, the trustee may rely on the opinion of such trustee's attorney.

2. Distribution of Assets. Upon such a final determination, the trustee shall make the distribution of assets among the trusts created under paragraph A, above, (in Exhibit 2) as is necessary to implement the ownership of assets directed by paragraph B, above, (in Exhibit 3) and any adjustment provisions as may be required under paragraph C, 2, b, above (in Exhibit 4). Then, the assets of the Exempt Trust shall be distributed to the ____ Exempt Family Trust and the assets of the Non-Exempt Trust shall be distributed to the ____ Non-Exempt Family Trust, both of such family trusts being created under the ____ Family Trust. The trustee may delay said distributions to the ____ Family Trust if the trustee determines that such delay would be advantageous for tax or other reasons. The assets of the Revocable Trust shall be distributed to [the Donor].

3. Termination of Trusts. When the assets of a trust created hereunder have been completely distributed, such trust shall terminate.

* The bracketed language would be added if the transactions in question included both gifts and sales-for example, a sale to a grantor trust.

(1) 120 TC 358 (2003).

(2) TAM 200337012; TAM 200245053; and FSA 200122011, all of which are discussed below in the section of this article entitled, “IRS and court discussion of defined value clauses.”

(3) See the discussion below in the section entitled, “Background on price adjustment clauses.”

(4) See the discussion below in the section entitled, “Defined value formula clauses.”

(5) 142 F.2d 824 (4 th Cir. 1944).

(6) Procter , 142 F.2d at 827.

(7) Id.

(8) Estate of McLendon v. Comm'r , TCM 1993-459, rev'd on another issue , 77 F.3d 477 (5 th Cir. 1995); Ward v. Comm'r , 87 T.C. 78 (1986); Harwood v. Comm'r , 82 T.C. 239 (1984), aff'd , 786 F.2d 1174 (9 th Cir. 1986). There is only one case that has sustained a price adjustment clause: King v. United States , 545 F.2d 700 (10 th Cir. 1976), which involved an arms-length sale transaction.

(9) TAM 9309001; TAM 9133001; Rev. Rul. 86-41, 1986-1 C.B. 300; TAM 8549005; TAM 8531003. The above cases (note 8) and rulings (in this note 9) are thoroughly discussed in McCaffrey, “Tax Tuning the Estate Plan by Formula,” 33 U. Miami Heckerling Inst. on Est. Plan. 4-7 through 4-10 (1999), and in Benford, “Valuation Principles and Recent Developments,” Special Session Materials, App. A, 33 U. Miami Heckerling Inst. on Est. Plan. (1999).

(10) Defined value formula clauses for gift and sale transactions were apparently first proposed by Carlyn S. McCaffrey and Mildred Kalik in Using Valuation Clauses to Avoid Gift Taxes , 125 Tr. & Est. 47 (Oct. 1986). Use of such clauses has subsequently been discussed by the following commentators. Moore and Buchanan, “Valuation Readjustment Clauses: What's Possible?”, 45 th N.Y.U. Inst. on Fed. Tax'n 31 (1987); Peterson, Savings Clauses in Wills and Trusts , 13 Tax Mngm't Est. Gifts & Tr. J. 83, 89 (1988); Cornfeld, “Formulas, Savings Clauses and Statements of Intent,” 27 U. Miami Inst. on Est. Plan. 14 (1990); Moore, “Attempting to Achieve Finality in Potentially 'Open' Transactions,” 29 U. Miami Inst. on Est. Plan. ¶ 1301.4 (1995); Trapp, “Thinking About Valuation Adjustment Clauses,” 1999 ACTEC Annual Meeting, HT II-9-JMT; McCaffrey, “Tax Tuning the Estate Plan by Formula,” supra note 9, at 4-1; Abbin, “Is Valuation the Best Planning Game Remaining?”, ALI-ABA Course of Study Plan. Techniques for Large Est. (Nov. 2001); Hood, Defined Value Gifts: Does IRS Have It All Wrong? , Est. Plan., Vol. 28, No. 12, Dec. 2001, at 582.

(11) Section 6501.

(12) See Eastland, New Tax Court Cases; Developments in Planning With Family Limited Partnerships , 29 ACTEC J. 65, 69 (2003).

(13) Sections 2055 (charitable deduction) and 2056 (marital deduction).

(14) Rev. Proc. 64-19, 1964-1 C.B. 682; Reg. 20.2056(b)-7(b)(2); Ltr. Rul. 8543035.

(15) Regs. 25.2518-3(c) and 25.2518-3(d), Example 20.

(16) See McCaffrey, “Tax Tuning the Estate Plan by Formula,” supra note 9, at 4-13; Akers, “Worth the Effort Even Beyond the Grave–An Update of Post-Mortem Planning, Formula Disclaimer as a Defined Value Clause for Lifetime Transfers,” Special Session Materials, p. III-c-13, 37 U. Miami Heckerling Inst. on Est. Plan. (2003).

(17) Regs. 25.2702-3(b)(1)(ii), 25.2702-3(b)(2), and 25.2702-3(c)(2).

(18) Reg. 1.664-2(a)(1)(iii) (CRAT); Reg. 1.664-3(a)(1)(iii) (CRUT); Rev. Proc. 90-32, 1990-1 C.B. 546.

(19) Reg. 26.2632-1(b)(2).

(20) FSA 200122011; TAM 200245053; TAM 200337012.

(21) TAM 200337012.

(22) TAM 200245053.

(23) This attempt by the Service to explain the long-established use of defined value clauses in the transfer tax area is unsatisfactory. Certainly, lifetime gifting has also been amply sanctioned by Congress in Chapter 12 of the Internal Revenue Code. (See, Hood, McCord and TAM 200245053: A Setback for Defined Value Transactions , 30 ETPL 432, 434 (Sept. 2003).

(22) See TAM 200245053.

(23) See discussion of McCord , immediately below.

(24) Thorough analysis of the McCord case may be found in Hood, McCord and TAM 200245053: A Setback for Defined Value Transactions , supra note 23, and in Prac. Drafting, p. 7324 (July 2003).

(25) Judge Laro's opinion in McCord , 120 TC at 427-428.

(26) Judge Swift's opinion in McCord , 120 TC at 404-410.

(27) Judge Laro's opinion in McCord , 120 TC at 427-428.

(28) Judge Swift's opinion in McCord , 120 TC at 404-410.

(29) McCord , 120 TC at 397. Interestingly, the majority noted that defined value clauses are expressly authorized for use in charitable remainder trusts, marital deduction formulas, and GRATs. ( Id. )

(30) Would donee/buyer's responsibility rise to the level of a fiduciary?

(31) For a discussion of this problem with respect to a transferor's improperly retaining enjoyment of assets, see Casner and Pennell, Est. Plan, Vol. II, § See also Eastland, supra note 12, at 69, 71 (footnote 11), for legislative history in support of the concept that estate and gift tax liabilities are dependent upon the ownership of property under state law.

(32) See Estate of Strangi , TCM 2003-145; Estate of Harper , TCM 2002-121; Estate of Thompson , TCM 2002-246; Estate of Reichardt , 114 TC 144 (2000); Estate of Schauerhamr , TCM 1997-242.

(33) See Estate of Maxwell , 98 TC 594 (1992), aff'd , 3 F.3d 591 (2d Cir. 1993).

(34) The use of a trust to solve such ownership requirements was first suggested by McCaffrey in “Tax Tuning the Estate Plan by Formula,” supra , note 9, at 4-15.

(35) If the transaction involved a sale, the trustee would make payments as directed by the trustee of the buyer trust.

(36) This conclusion flows from the following reasoning. At the end of the interim period, the assets which the settlors (grandparents, trustee of donee trust) contributed will be returned to the settlors of the Escrow Trust. These reversions classify the Escrow Trust as a grantor trust under Section 673. With respect to assets which are distributed to the donor, that portion of the escrow trust is a grantor trust for the donor. With respect to assets which are distributed to the trustee of the donee, that portion of the Escrow Trust is a grantor trust for the donee. If the donee trust was designed to be a grantor trust with respect to the donor, then all income and deduction items that flow from the Escrow Trust back to the donee grantor trust will then flow back to the donor.

(37) DISCLAIMER: The sample provisions included in this article are not intended to be legal or tax advice. They should be carefully analyzed by counsel with respect to each potential application. These sample provisions may not be adequate or appropriate for the particular project at hand and, therefore, may need to be rewritten or not used. In no event will the author or Estate Planning be liable for any direct, indirect, or consequential damages resulting from any use of these provisions.

(38) The theory is that an audit and, if necessary, court review of the small percentage gift will have the potential consequence of producing some gift tax liability. See , McCaffrey, “Tax Tuning the Estate by Formula,” supra note 9, at 4-14.

(39) Similarly, in a sale transaction, the Sale and Purchase Agreement would state the assets that are the subject of the sale transaction, and use the defined value clause to describe the assets sold.

(40) Section 6501(c)(9); Reg. 301.6501(c)-1(f).

(41) See discussion in Hood, Defined Value Gifts: Does IRS Have It All Wrong? , supra , note 10, at 584.