Maximize Use of the 2012 Gift Tax Exemption: A “Defined Value” Formula Clause Approach

For 2012, the cumulative lifetime gift tax exemption is $5.12 million per person ($10.24M for married couples), with a 35% tax rate on gifts over that amount.  Unless Congress takes action, the exemption is scheduled to decline to $1 million next year, with a 55% tax rate on gifts in excess of the exemption.

Most advisors regard the 2012 exemption as a great gifting opportunity that, for wealthy taxpayers, should be utilized before it disappears.

One popular strategy for utilizing the exemption is to fund an investment entity – a family limited partnership (FLP) – and then make gifts of FLP interests to children or grandchildren at discounted values.

This begs some questions:  Isn’t an interest in an FLP difficult to value? Wouldn’t gifts of FLP interests be susceptible to IRS challenge, resulting in gift tax, if the IRS were to prevail and increase the FLP valuation?

A recent Tax Court case said no.  In Wandry, the Tax Court approved the use of a so-called “defined value” formula clause that was intended to reduce the FLP percentage interest gifted to family members if IRS increased the value of the FLP upon audit, so that the value of the gift remained within (but maximized) the use of the gift tax exemption.

This case represents a milestone in the use of defined value (or “savings”) clauses; similar favorable results have been achieved in the past where the “savings” mechanism is to redirect to a charity the gift of the FLP interest that was determined to have a value in excess of the gift tax exemption.  This case approved a mere adjustment to the percentage interest that was gifted to family members, without having to redirect the excess FLP interest to a charity.

For more information about this or other Estate, Gift and Trust issues, please contact Aronson’s Michael Yuen or Richard Lee at 301.231.6200.