Wandry Clause: Solution to Estate Planning IRS Audit Risk

How the Wandry Clause Works

Implementation of the Wandry clause requires careful planning and consultation with a tax attorney. The gifting documents and supporting documentation, such as tax returns and company financial statements, must be prepared in a way that demonstrates the gifts are based on the fair market value of the assets transferred. If the relevant documents are not consistent with respect to gifting a specified dollar amount, then that may allow the IRS to challenge the validity of the Wandry clause and potentially collect gift tax.

In addition to the use of precise language, the Wandry’s implemented what is known as a “defined value formula clause” in their gift document. This clause determines the percentage of shares given as a gift by calculating the intended gift amount and fair market value (“FMV”) of the business. This allows the gift to equal a set amount, and the percentage of shares given is simply the result of the stated gift value divided by the concluded FMV of the business.

Here’s how it works: a donor intends to gift $250,000 in share value to a trust. If an independent valuation of the business determines the FMV of the business to be $10 million, then the percentage of shares gifted would be 2.5% (250,000/10,000,000). A year later, if the IRS challenges the valuation and the FMV of the business was determined to be $20 million at the time of the gift, then the defined value formula clause would adjust the percentage of shares gifted to 1.25% (250,000/20,000,000). In this case, the use of a defined value formula clause allows the value of the gift to never exceed $250,000.

This is different than stating a fixed percent gifted, where if the donor transferred a gift of 2.5% of the FMV of the business and the IRS determined the business was worth $20 million, the donor would have gifted $500,000.

If the donor used a fixed percentage transfer, the $250,000 difference may be subject to gift tax, depending on the donor’s remaining gift tax exclusion (for more information, see our whitepaper, “U.S. Gift Tax Lifetime Exemption Set to Expire”).

Precision in Drafting: Lessons from Recent Cases

Some recent cases brought forward by the IRS highlight the level of precision needed when drafting gift documents to ensure it qualifies as a valid application of the Wandry clause.

Nelson v. Commissioner

A tax court denied Nelson’s appeal for a redetermination of a deficiency of gift tax issued by the IRS. Like the Wandry case, Nelson intended to use a defined value formula clause to protect themselves from an upward revaluation of the business and avoid unplanned gift taxes. The language used in one of the transfers is as follows:

[Nelson] desires to make a gift and to assign to [the trust] her right, title, and interest in a limited partner interest having a fair market value of TWO MILLION NINETY-SIX THOUSAND AND NO/100THS DOLLARS ($2,096,000.00) as of the valuation date (the “Limited Partner Interest”), as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.

There are a few problems pointed out by the court that did not qualify this as a defined value formula clause as used in other cases, such as in Wandry:

• Failure to define the interests transferred as the fair market value as determined for federal gift or estate-tax purposes.
• Specific language describing what should happen to any additional shares that were transferred should the valuation be successfully challenged.
• The court could not accept the subjective intent for the use of a valid defined value formula clause rather than the objective, written description. It could be assumed that the Nelson’s had the intent to minimize their tax liability, but the court could not look into the Nelson’s minds when they were drafting the documents, and thus only the objective facts were considered.

Sorenson v. Commissioner

The founders of Firehouse Subs, two brothers (“Sorenson”), intended to transfer precisely $5 million in nonvoting stock to their respective trusts using a Wandry clause. Based on an independent valuation performed, $5 million worth of shares was 9,382.56 shares, but for simplicity, the brothers rounded up to 9,383 shares. Then, nearly three months later, the two brothers transferred just under $3 million worth of shares to their respective trusts based on the same independent valuation performed for their prior gift.

While the case was still pending, the brothers sold Firehouse Subs for $1 billion, which meant each trust received approximately $153 million. Before the case could be brought before a tax court, Sorensen and the IRS reached a settlement that resulted in an upward revision to the valuations and a gift tax liability of approximately $6,500,000 million per brother.

The IRS argued the following points:

• The use of rounding implied the shares were transferred based on a percentage, or fixed share amount, rather than precisely $5,000,000, as intended.
• The trusts never agreed to transfer shares back to the brothers in the event of an IRS challenge.
• The use of a nearly three month old valuation was too stale to use as the fair market value of the gift.

Mitigating Risks

The goal of many donors implementing the Wandry clause is to minimize potential gift taxes by restricting the amount of the gift to not exceed either the donor’s annual or lifetime gift tax exemption. Donors and tax attorneys must be aware of how tax courts are interpreting various cases including the Wandry clause. Some best practices may include:

• Up-to-date valuations of gifted assets
• Defendable valuations to limit the risk of an IRS challenge
• Explicit language detailing how the assets would be treated in the event of an IRS challenge
• Consistency in reference to the transfer amount in gifting documents, tax returns, and financial statements.
• Precision in value and shares transferred. Rounding should be avoided where possible.
• Independent valuation specifically prepared for federal gift or estate-tax purposes.

The Wandry v. Commissioner ruling provided a potential solution to the risks donors face when making gift transfers. If the Wandry clause is properly implemented, with the support of a tax attorney and an independent valuation specialist, the risk of an unplanned gift tax liability due to an IRS audit and revaluation is significantly reduced.

How ValueScope Can Help

ValueScope’s estate and gift tax services are used by hundreds of clients each year. We routinely value closely held corporations, family limited partnerships (FLPs), LLCs, stock options, and restricted stock. Fair market values are determined following the IRS’s Revenue Ruling 59-60 as well as industry standards including USPAP and SSVS. ValueScope has extensive experience in:

• Valuations of closely held interests
• Discount studies related to discounts for lack of control, lack of marketability, and built-in gains discounts
• Hard-to-value assets such as GRATs, undivided interests in real estate, stock options, and restricted stock for transfer purposes

ValueScope’s professionals have the experience and credentials to support key valuation positions for tax matters. Our team of professionals has given expert testimony in federal income tax and estate matters. Additionally, our balanced approach of working with the Internal Revenue Service, the Department of Justice, and numerous taxpayers provides an opinion that is credible and supportable to triers of fact.