Maximizing Estate Planning with Defined-Value Gifts: A Strategic Guide
Posted by Robert Ingrasci on October 17, 2024
As estate planning laws continue to evolve, 2024 presents a unique opportunity to maximize estate tax exemptions. Currently, the federal gift and estate tax exemption sits at a historically high $13.61 million per individual, but this generous limit is set to expire in 2026, reverting to an inflation-adjusted $5 million unless Congress intervenes. Given this impending reduction, high-net-worth individuals may benefit from using defined-value gifts to reduce their taxable estate while maintaining IRS compliance. However, gifting certain hard-to-value assets, such as interests in a closely held business or a family limited partnership (FLP), requires careful structuring to avoid triggering additional taxes, interest, or penalties.
Defined-value gifts—gifts measured by a specified dollar amount rather than by asset quantity—offer a way to address the IRS’s concerns about undervaluation. A well-drafted defined-value gift can help maintain the tax benefits of a large exemption without risking unexpected IRS assessments.
The Role of Formula vs. Savings Clauses
At the heart of a defined-value gift’s effectiveness is the distinction between formula clauses and savings clauses in transfer documents. A formula clause specifies a fixed dollar amount for the transfer, allowing adjustments to the number of shares or units to reach the defined value. This flexibility protects against additional tax assessments since the transfer’s value aligns with IRS-determined amounts.
In contrast, a savings clause adjusts the gift retroactively, potentially requiring a portion of the asset to be returned to the donor if its value exceeds a set limit. Because savings clauses aim to reverse a portion of the gift in cases of IRS revaluation, they have generally been deemed unenforceable for tax purposes. The IRS considers these clauses an attempt to sidestep tax liability, making formula clauses the more reliable choice for effective, legally sound defined-value gifts.
Case Study: Why Precision Matters in Defined-Value Gifts
Defined-value gifts require not only the right type of clause but also careful language in transfer documents. A U.S. Tax Court case highlighted the importance of precision when a taxpayer’s attempt at a defined-value gift of FLP interests failed to withstand IRS scrutiny. The transfer documents specified that FLP interests would be valued by a qualified appraiser, with a fair market value determined post-transfer. However, the court found that the transfer document lacked a crucial element: an adjustment clause specifying that the final number of FLP units could vary to meet the fixed dollar amount once the value was determined for tax purposes.
As a result, the court upheld the IRS’s assessment of gift tax based on the percentage interests transferred, emphasizing that the lack of an adjustment clause in the transfer documents was fatal to the defined-value gift structure. This case underscores that while defined-value gifts can be highly effective, their success depends on rigorous drafting, ensuring transfer documents reflect an IRS-compliant formula for adjusting asset quantities to match final valuations.
Practical Implications for Estate Planning
For individuals considering large gifts to leverage the current estate tax exemption, defined-value gifts can offer both flexibility and security. A properly structured defined-value gift effectively locks in the desired dollar value for the transfer, limiting the risk of unexpected tax assessments while complying with IRS requirements. However, to achieve these benefits, estate planners should work closely with experienced professionals to draft precise, compliant transfer documents.
Key considerations include:
- Clarity and specificity in the language of the formula clause, which should define the asset’s value by dollar amount with adjustments to share or unit quantities as required.
- Proactive planning to establish and verify the structure of defined-value gifts well before transfer, ensuring compliance with IRS standards.
- Engagement of professional appraisers and legal counsel to confirm that transfer documents adhere to all necessary guidelines, thereby safeguarding against potential challenges.
Final Thoughts: Leveraging Defined-Value Gifts Effectively
The imminent reduction of the federal gift and estate tax exemption makes now an ideal time to explore defined-value gifts as a means of transferring wealth. By incorporating formula clauses and avoiding unenforceable savings clauses, individuals can ensure that gifts are not only tax-effective but also legally sound.
If you are contemplating significant gifts to family members or other beneficiaries, consulting with qualified professionals can help ensure that your defined-value gifts meet IRS standards, protecting you from tax liabilities and making the most of the temporary high exemption limit. Defined-value gifts are a powerful tool in the current estate planning landscape, but only when executed with precision and professional oversight. Contact us to discuss how defined-value gifts may enhance your estate plan and preserve your wealth across generations.
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Bob is an experienced tax professional who devotes his professional time to structuring tax strategies in the areas of compliance, consulting, and planning. Bob works closely with a broad range of high-net-worth individuals and multi-generational families, specializing in the areas of gift and estate planning, charitable gift planning, trust and estate administration, individual taxation, and wealth preservation. Bob serves as a practice leader in the Family Wealth and Estate Planning group. Bob joined Lumsden McCormick in 2008 and was named partner in 2022.