At the present time, there’s much discussion about possibly significant changes to both federal income and transfer taxes by Congress. One frequent twist that Congress has been known to use is to make certain law changes retroactive to a date that precedes the actual date of enactment. Despite obvious concerns about the fairness and constitutionality of retroactive changes in the law, unfortunately, the United States Supreme Court has been overly deferential and upheld retroactivity in almost every case.
In this blog, after first defining what a defined value clause is and how it is intended to work, I will explore the possible impact of retroactive law changes on a defined value transaction that is final during the taxable year and entered into prior to actual enactment of a change in the tax law but on a date covered by retroactive effect.
An example might be helpful at this point. Assume that on August 1, 2021, Saffire makes a simple defied value gift of units in a family LLC of an amount equal to her “remaining applicable exclusion amount for federal estate and gift tax purposes allowed by IRC Sec. 2010(c), as finally determined for federal estate and gift tax purposes.” Assume further that on the date of the gift, Saffire’s remaining applicable exclusion amount was her full amount under IRC Sec. 2010(c), which was $11,580,000. Suppose further that on December 1, 2021, Congress enacted a reduction of the applicable exclusion amount to $5,000,000, retroactive to July 1, 2021, i.e., a date that predates the date of Saffire’s gift, which obviously caused a possible overfunding of the remaining applicable exclusion amount by $5,580,000, and, therefore a taxable gift. Or did it?
The answer to the question is it depends upon how the defined value clause is written and construed.
What is a Defined Value Clause?
In a defined value clause, the gift assignment, disclaimer and/or the sales agreement defines a value for the transfer that is tied to both the value that the client intended to gift and/or sell for the asset as well as the value of the gift and/or sale of the asset that is finally determined for federal gift, estate, generation skipping transfer tax purposes. The defined valuation clause seeks to define the value, not as a stated pecuniary amount, but rather through a defined valuation contract.
Congress as well as the Treasury both expressly allow the use of formula language for gift tax purposes in the areas of charitable remainder trusts, qualified terminable interest property elections, disclaimers and grantor retained annuity trusts.[i] Nevertheless, the Internal Revenue Service has resisted defined value clauses for the straight gift, disclaimer and/or sale of an asset as discussed in the governing case law.
[i] See, Edward F. Koren,”Defined Valuation Clauses: Taxpayer Wins a Few,” 59 Tul. L. Sch. Ann. Inst. on Fed. Tax’n, 13-1, (2010-2011), p. 13-18 through 13-22.
What about a gift of cash or marketable securities equal to the transferor’s remaining applicable exclusion amount?
Interestingly, what makes the typical defined value transfer defined is the subjectivity of the assets being transferred. However, when considering the possible retroactivity of legislative changes, particularly any retroactive reduction of the applicable exclusion amount, should even gifts of cash or marketable securities, i.e., assets that don’t require independent valuation, be considered and drafted as defined value gifts?.
If a gift is made of cash or marketable securities in an amount equal to the donor’s remaining applicable exclusion amount, the limiting measuring point of a gift of cash or marketable securities may change after the effective date of such a gift if the Congress enacts a retroactive change, presumably a reduction, in the applicable exclusion amount under IRC Sec. 2010(c). Therefore, it may be prudent to clarify and underscore the donor’s intent that no taxable gift be made through retroactive application of a reduction of the applicable exclusion amount under IRC Sec. 2010(c).
How might one draft for the possibility of retroactive legislation? In my view, the best way is to use a two section defined value clause, with the first section setting the base defined value gift, but limiting it by the second section, which would address a retroactive reduction.
Retroactive legislation definitely could adversely affect the defined value clause and should be considered in the formulation of the clause, even if the gift is of cash or marketable securities.