Monday, April 30, 2012

Defined Value Gifts

As we've discussed before, there is a "unified credit" against the gift and estate taxes which cancels out the tax on some wealth transfers--we often call the amount protected from tax the "exemption equivalent."  Right now, that exemption equivalent is $5 million (plus an annual inflation adjustment), though it is scheduled to be reduced to $1 million (plus an inflation adjustment) with the expiration of the 2001 and 2010 tax acts at the end of this year.  (The Obama administration has proposed making the future exemption equivalent $3.5 million in its last budget, but for various political reasons this is unlikely to be enacted before the election.)

If you want to make large transfers of wealth and not pay taxes (who doesn't?), you have to make sure not to give away more than the exemption equivalent.  With cash or easily-valued assets such as marketable securities, this is not difficult to accomplish.  For farmers and other family business owners, the bulk of their wealth is in non-liquid assets like land and closely-held business assets which, if you're not selling them to a buyer at arm's length, must be valued by an appraisal.  An appraisal is a professional opinion as to the "fair market value"--"the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts" as the IRS defines it. It is not unusual for two appraisers to come to different valuations for the same asset in perfect good faith. 

If the taxpayer wants to give the full amount of the exemption equivalent, and the assets available to make the gift are the sort that have to be valued by appraisal, a lot is riding on that appraisal.  Human nature being what it is, the government's expert appraiser usually values gifts or estate assets higher than the taxpayer's expert appraiser, particularly when the government's valuation results in a taxable transfer in excess of the available exemption equivalent and a tax due!  This naturally leads to a lot of IRS audits, administrative appeals, and Tax Court litigation.

One tactic used by taxpayers who wanted to max out their tax-free gifting was to make a combined gift of property to individuals and charities.  The gift instrument would designate that a fixed amount was to go to the individuals and the excess to charity.  This discouraged the government from attacking the taxpayer's valuation because any increase in the value of the gift would pass to a charity--and the IRS still wouldn't collect any tax on it.

In a recent Tax Court case reported on in the Wall Street Journal, the taxpayers made a gift of closely-held business interests under an instrument which limited the gift to $1 million, with no charitable excess gift.  The IRS revalued the assets at something more than $1 million.  The Tax Court ruled that the excess over $1 million was not a gift because the taxpayers expressed an unambiguous intent to give $1 million and no more.

This obviously makes it easier for taxpayers to make controlled tax-free gifts of hard-to-value assets, particularly high net-worth individuals who want to make large lifetime gifts before the exemption equivalent goes down at the end of this year.  As the Journal observes, "The decision is so advantageous for taxpayers that it could inspire a response from Congress or the IRS."