The Internal Revenue Service has given its blessing to the use of some types of formula clauses used by estate planning attorneys for years, while rejecting other types of formula clauses based on tax evasion and public policy arguments.

One type of formula clause that has gained favor with the IRS is a clause that divides a married decedent’s estate or trust into two shares when he or she dies – one share containing the maximum amount of the decedent’s estate or trust that can pass free of estate tax and the other share containing the excess, which if properly planned for will qualify for the unlimited marital deduction. This type of planning allows for no estate tax to be paid at the death of the first spouse.

On the other hand, a formula clause attempting to fix the value of a gift and dissuade the IRS from challenging the gift or estate tax return has not been received well by the IRS. An example of this type of formula might involve a transfer of an interest in a family limited partnership whereby the client asserts he is transferring FLP units valued at $1 million to family members or to a trust for family members and if the IRS audits and values the FLP interests at more than $1 million, the excess value is given to a private foundation controlled by the client or some other charitable entity. The IRS has argued against this type of formula clause because any increase in valuation of the FLP interest does not result in any additional gift or estate tax to the federal government. The IRS has argued the holding in the case Commissioner v. Procter as support for its position.

The recent case, Estate of Christiansen v. Commissioner, 130 T.C. 1 (1/24/2008), is a very important case because the U.S. Tax Court unanimously held that a formula disclaimer was effective to pass to charity any increase in the federal estate tax valuation of the estate. And that the formula approach employed was not prima facie invalid, i.e., that it did not violate public policy.

In so holding the court rejected the IRS’ consistent assertion that strategic formula provisions that discourage the government from litigating valuation questions are invalid as against public policy under the Proctor doctrine. While the Christiansen case may not stop the IRS from challenging formula gifts of this nature, the case may empower knowledgeable estate planning attorneys who have been on the sidelines regarding this planning strategy.

The Christiansen case involved a testamentary bequest of the decedent’s estate (which included family limited partnership units) to the decedent’s daughter. The bequest allowed her to disclaim the bequest to the extent the IRS valued the bequest in excess of $6,350,000. The disclaimed portion passed by the terms of the decedent’s Will, 75% to a charitable lead annuity trust (CLAT) and 25% to a private foundation (which also was the lead beneficiary of the CLAT). The CLAT remainder was payable to the disclaimant if living at the end of the lead term. As explained earlier in this Alert, the idea behind the strategy is to prevent additional estate taxes from being paid should the IRS claim the bequest should be valued in excess of the designated $6,350,000 amount. For technical reasons dealing with qualified disclaimers, the court found the disclaimer to the CLAT ineffective, but as to the 25% of the estate passing to the foundation directly, the disclaimer was effective and generated an estate tax charitable deduction as if it had passed directly from the decedent.

The majority of the Court (with the two dissenting judges joining on this point, making this a unanimous holding) held with regard to the formula disclaimer language:

“We do recognize that the incentive to the IRS to audit returns affected by such disclaimer language will marginally decrease if we allow the increased deduction for property passing to the foundation. Lurking behind the Commissioner's argument is the intimation that this will increase the probability that people . . . will lowball the value of an estate to cheat charities. There’s no doubt that this is possible.

But . . . . executors and administrators of estates are fiduciaries, and owe a duty to settle and distribute an estate according to the terms of the will . . . . Directors of foundations . . . are also fiduciaries . . . [and] . . . the state attorney general has authority to enforce these fiduciary duties. . .

We therefore hold that allowing an increase in the charitable deduction to reflect the increase in the value of the estate’s property going to the Foundation violates no public policy and should be allowed.”

This type of language is comforting for estate planning attorneys looking for strategies to maximize estate tax savings for their clients and it is likely that the result of this case and the earlier case, Estate of McCord v. Commissioner, 461 F.3d 614 (5th Cir. 8/22/2006) will result in more of this formula disclaimer language being utilized by knowledgeable estate planning attorneys.