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Plan carefully to avoid unpleasant tax surprises

Posted On: MAY 2021

For 2021, the federal gift and estate tax exemption has reached its highest level ever. Individuals may transfer up to $11.7 million by gift or bequest without triggering federal transfer taxes, while married couples can shield up to $23.4 million from tax. This is a limited time offer, however, as the exemption amount is scheduled to drop to $5 million (adjusted for inflation) in 2026 (and Congress may decide to reduce it even sooner).

Many are considering making substantial gifts to the younger generation to take advantage of the current exemption while it lasts. Often, these gifts consist of hard-to- value assets — such as interests in a closely held business or family limited partnerships (FLPs) — which can be risky. Suppose, for example, that a business owner transfers interests to his or her children valued at $10 million. If the IRS later determines that these interests were undervalued and were actually worth $14 million, the owner would be liable for nearly $1 million in gift taxes (plus interest and possibly penalties).

Hedging your bets

A defined-value gift may help you avoid unexpected tax liabilities. Simply put, a defined- value gift is a gift of assets that are valued at a specific dollar amount rather than a certain number of stock shares or FLP units or a specified percentage of a business entity.

Structured properly, a defined-value gift ensures that the gift will not trigger an assessment of gift taxes down the road. The key is to ensure that the defined-value language in the transfer document is drafted as a “formula” clause rather than an invalid “savings” clause.

A formula clause transfers a fixed dollar amount, subject to adjustment in the number of shares or units necessary to equal that dollar amount (based on a final determination of the value of those shares or units for federal gift and estate tax purposes). A savings clause, in contrast, provides for a portion of the gift to be returned to the donor if that portion is ultimately determined to be taxable.

Language matters

For a defined-value gift to be effective, it’s critical to use precise language in the transfer documents. In a recent case, the U.S. Tax Court rejected an intended defined-value gift of FLP interests and upheld the IRS’s assessment of gift taxes based on percentage interests. The documents called for the transfer of FLP interests with a defined fair market value “as determined by a qualified appraiser” within a specified time after the transfer.

The court found that the transfer documents failed to achieve a defined-value gift, because fair market value was determined by a qualified appraiser. The documents didn’t provide for an adjustment in the number of FLP units if their value “is finally determined for federal gift tax purposes to exceed the amount described.”

Use the magic words

If you plan to make substantial gifts of interests in a closely held business, FLP or other hard-to-value asset, a defined-value gift can help you avoid unwanted gift tax consequences. If you use this strategy, however, be sure to plan your gift carefully. To be effective, the transfer documents should contain specific language that provides for the adjustment of the number of shares or units to convey the desired value.

© 2021