Case Summaries Hendrix v. Commissioner, T.C. Memo. 2011-133

Parents transferred stock in a closely-held S corporation to trusts for their daughters and descendants and a charitable donor advised fund (the “Foundation”) using a “McCord-type” defined value formula transfer.  Parents transferred a block of stock to a trust and the Foundation, to be allocated between them under a formula.  The formula provided that shares equal to a specified dollar value were allocated to the trust and the balance of the shares passed to the Foundation.  The trust agreed to give a note for a lower specified dollar value and agreed to pay any gift tax attributable to the transfer.  Under the formula, the values were determined under a hypothetical willing buyer/willing seller test.  The transfer agreement provided that the transferees were to determine the allocation under the formula, not the parents.  The trust obtained an appraisal of the shares and the Foundation hired independent counsel and an independent appraiser to review the original appraisal. The trust and Foundation agreed on the stock values and the number of units that passed to each. (This description is simplified; in reality, each of the parents entered into two separate transfer transactions involving a “GST trust” and an “issue trust” and the same Foundation using this formula approach.)

This case is appealable to the 5th Circuit, and the court held that McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006) controlled.  The court addressed two distinctions from that case raised by the IRS—that the transfers were not at arm’s length and were contrary to public policy.  As to the arm’s length argument regarding the daughters’ interests, the court observed that just because the daughters were close to the parents and benefitted did not necessarily negate an arm’s length transfer and that having negotiations and adverse interests are not essential to the existence of an arm’s length transaction.  Furthermore, there was no evidence to persuade the court that there was no negotiation or that the trusts lacked adverse interests, because the trusts assumed economic and business risks under the transactions.  As to the arm’s length argument regarding the Foundation, the court listed several reasons for concluding that there was no collusion between the parents and the Foundation: (1) the transaction was consistent with prior charitable transfers by the parents; (2) the Foundation accepted potential risks including the loss of tax-exempt status if it failed to exercise due diligence; (3) the Foundation negotiated some elements of the transaction, by insisting that the parents pay income taxes attributable to the S corporation income if the corporation did not distribute enough cash to pay those taxes; (4) the Foundation was represented by independent counsel; (5) the Foundation conducted an independent appraisal; and (6) the Foundation had a fiduciary obligation to ensure that it received the proper number of shares.

As to the public policy argument, the court determined that the formula clauses do not immediately and severely frustrate any national or State policy. The Procter case was distinguished because there is no condition subsequent that would defeat the transfer and the transfers further the public policy of encouraging gifts to charity.  The court observed that there is no reason to distinguish the holding in Christiansen v. Commissioner, 130 T.C. 1 (2008), aff’d, 586 F.3d 1061 (8th Cir. 2009) that similar formula disclaimers did not violate public policy.

Basic Facts

[Observe:  The details of the steps taken to implement the transaction are described in considerable detail below.  These are the steps planned by a respected law firm with a great deal of experience in planning these transactions.  It may serve as a helpful blue-print for others.]

1. Parents wanted to transfer some of their interest in a closely-held corporation to their daughters and charity.  Stephen Dyer, an attorney in Houston, advised them first to redeem preferred shares in the corporation and convert the corporation to an S corporation with voting and non-voting stock. (An independent appraisal was secured to determine the value of the preferred shares in the redemption transaction.)
2. The corporation and its shareholders entered into dispute resolution and buy-sell agreement requiring that any dispute related to the fair market value of the stock would be resolved by arbitration if the parties could not come to agreement regarding the values.
3. In the summer of 1999, the parents began discussions with the Greater Houston Community Foundation at (the “Foundation”) to create a donor advised fund and to transfer $20,000 cash and closely held-stock to the fund.  The donors had never had contact with that Foundation previously (but the court never mentioned that in its analysis of the case).  Under the Foundation’s normal policy for accepting hard-to-value assets, the Foundation was represented by its outside counsel (Bill Caudill, a well respected attorney in Houston).
4. The parents’ attorney sent a draft general agreement to the Foundation’s attorney on August 10, 1999. The parties negotiated for about three months over the terms of transferring cash and stock to the Foundation. On October 6, 1999, the parents’ attorney sent a draft of an assignment agreement (with a formula transfer provision) and sent a copy of the dispute resolution and buy-sell agreement to the Foundation’s attorney.  On November 9, the parents signed an agreement establishing the fund and transferred $20,000 cash to the fund. On November 19, the Foundation’s attorney returned the draft assignment agreement with an attached rider addressing the corporation’s responsibility to distribute income timely.
5. In the fall of 1999, Howard Frazier, a well respected independent appraiser, estimated the value of the non-voting shares.  Based on that estimate, the parents decided that each of them would transfer $50,000 of stock to the Foundation, $10.52 million of stock to a GST trust, and $4.21 million of stock to an “issue trust” for the benefit of the daughters.
6. On December 30, 2999 the parents partitioned the community property non-voting shares, so that each of them owned 403,241.85 shares as their respective separate property.
7. On December 31, 1999 each of the parents, the trustees of the GST trust and the Foundation executed an assignment agreement irrevocably transferring 287,619.64 shares, to be allocated between the trust and Foundation under the following provisions:
   1. Shares worth $10,519,136.12 were allocated to the GST trust;
   2. The remaining shares were allocated to the Foundation;
   3. Values were to be determined “as the price at which shares would change hands as of the effective date between a hypothetical willing buyer and a hypothetical willing seller, neither under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
   4. The GST trust agreed to pay any gift taxes imposed as a result of the transfer.
   5. The GST trust trustees would sign promissory notes for $9,090,000 to each parent (thus resulting in a gift to the GST trust by each parent of $10,519,136.12 minus $9,090,000 minus the gift tax attributable to the transfer).
   6. The parents had no responsibility for allocating the shares under the formula; that allocation was left to the transferees. The dispute resolution and buy-sell agreement would control, thus requiring arbitration if the parties could not agree on the values.
8. Also on December 31, 1999 each of the parents signed a similar assignment document irrevocably transferring 115,621.21 nonvoting shares to an “issue trust” and the Foundation.  Under this assignment document:
   1. Shares worth $4,213,710.10 were allocated to the issue trust;
   2. The balance of the shares were allocated to the Foundation; and
   3. The issue trust agreed to pay any gift taxes imposed on the transfer and agreed to sign a promissory note for $3,641,223 to each parent.
9. Also on December 31, 1999 the parents transferred the stock and stock powers to the trusts and Foundation as tenants in common, together with an agreement stating that the trusts and Foundation “as tenants in common would collectively own all of the assigned shares.”  The trusts gave promissory notes to the parents, secured by the corresponding shares transferred to the trusts.
10. On April12, 2000 each of the parents filed gift tax returns reporting a charitable contribution of $50,000 and a gift of $1,414,581.37. The gift tax calculation was as follows:
11. Also on April 12, the trustees’ attorney (Mr. Dyer) sent to the Foundation an appraisal (by Howard Frazier) concluding that the non voting shares were worth $36.66 each.   The Foundation respected Mr. Frazier’s qualifications, but the Foundation’s policy on accepting hard-to-value assets required that it retain an independent appraisal firm to review the appraisal. An independent appraiser retained by the Foundation concluded on May 8, 2000 that the Frazier appraisal was reasonable and fair.
12. In June 2000, the Foundation and the trustees entered into confirmation agreements, effective as of December 31, 1999 (the date of the stock transfers) that allocated the shares among them based on the $36.66 appraised value.
13. In the gift tax audit, the IRS disagreed with the values and the effectiveness of the defined value transfers.  In the ensuing litigation, the IRS and donors entered a stipulation that if the allocation among the trusts and Foundation under the defined value transfer and confirmation agreement is not respected for tax purposes, the values transferred to each party would be the number of shares that each received under the confirmation agreement times a value of $48.60 per share.

Analysis

1. Burden of Proof Shifted to IRS.  The burden of proof was shifted to the IRS under §7491(a). [The court did not rely explicitly on the shift in reaching its conclusion to respect the defined value transfers, but the wording of its discussion of the “arm’s length” issue as to the daughters’ trust issue made clear that it was looking to see if there was evidence sufficient to support the IRS’s position.]
2. Succession of McCord.  A similar defined value transfer with a confirmation agreement by the parties to the transfer was respected by the 5th Circuit Court of Appeals in Succession of McCord, 461 F.3d 614 (2006), revg, 120 T.C. 358 (2003).   The government argued that the current case raises two issues not addressed in McCord: (1) the formula clauses are invalid because they were not reached at arm’s length; and (2) the formula clauses are void as contrary to public policy.  The court addressed both of these issues.
3. Arm’s Length Transaction.
   1. Generally — Substance Over Form Analysis; Evidence of Collusion Required If Non-Family Parties.  The court approached the arm’s length transaction argument in light of a substance over form analysis, and specifically observed limitations on the application of the substance over form doctrine:

      “Generally a taxpayer may structure a transaction in a manner that minimizes or avoids taxes by any means the laws allow. Gregory v. Helvering 293 U.S. 465, 469 (1935).  Courts, however, may disregard the form of a transaction in favor or its substance where there is collusion, an understanding, a side deal, or another indicium that the transaction was not at arm’s length.  The disregard of a transaction for lack of substance, however, cannot be based on mere suspicion and speculation arising from the fact that a taxpayer engaged in estate planning.  See Strangi v. Commissioner, 293 F.3d 279, 282 (5th Cir. 2002), affg in part and revg. in part T.C. Memo. 2003-145; Hall v. Commissioner, 92 T.C. 312 335 (1989).  Nor do we strictly scrutinize a transaction, or presume that a transfer is a gift, where, as here, the transaction involves a third party without familial or financial ties to the transferee’s family group.  Cf. Kimbell v. United States, 371 F.3d 257, 263 (5th Cir. 2004)(applying the strict scrutiny standard and imposing a presumption that the transferred property is a gift when a mother transferred a large portion of her estate to three entities her son owned); Harwood v. Commissioner, 82 T.C. 239, 258 (1984)(applying the strict scrutiny standard and raising the presumption that the property transferred among a family was a gift where a mother transferred her partnership interest to her sons), affd. without published opinion 786 F.2d 1174 (9th Cir. 1986).  Instead, we must find credible evidence that the parties colluded or had side deals or that the form of the transactions otherwise differed from the substance.  We find no such credible evidence here.”

   2. As to Daughters’ Trusts.  Despite the statement, quoted above, that the strict scrutiny standard does not apply to transactions with non-family parties, the court seemed to distance itself from strict application of any arm’s length transaction requirement as to the family members as well:

      “Respondent argues that the formula clauses failed to be reached at arm’s length because petitioners and their daughters (or their trusts) were close and lack adverse interests, the daughters benefited from petitioners’ estate plan, and the clauses were not thoroughly negotiated.  We disagree.  The mere fact that petitioners and their daughters were ‘close’ and that petitioners’ estate plan was beneficial to the daughters does not necessarily mean that the formula clauses failed to be reached at arm’s length.  Nor is a finding of negotiation or adverse interests an essential element of an arm’s length transaction, see Kimbell v. United States, supra at 263; Huber v. Commissioner, T.C. Memo. 2006-96; Estate of Stone v. Commissioner, T.C. Memo. 2003-309…”

      [Akers Observation:  Those general statements certainly make sense in terms of gift transactions. What is the purpose of applying an arm’s length requirement to gifts — other than just to assure that the gift transfers actually occurred without being subject to side agreements?  Gift transactions are typically conducted without any negotiation at all.  Donors unilaterally decide the terms of trusts that will receive gifts without any input from the beneficiaries.]
      
      After stating that “a finding of negotiation or adverse interests [is not] an essential element of an arm’s length transaction,” the court went on to observe in fact that

      “we find nothing in the record to persuade us either that the formula clauses were not subject to negotiation or that petitioners and the daughters’ trusts lacked adverse interests.  We also note economic and business risk assumed by the daughters’ trusts as buyers of the stock (i.e., the daughters’ trusts could receive less stock for their payment if the JHHC stock was overvalued) placed them at odds with petitioners and the Foundation.”

      [Akers Observation: The court’s wording apparently is in light of the IRS’s having the burden of proof — by observing the absence of evidence suggesting that there was no negotiation and no adverse interests instead of affirmatively stating that the court found that there were negotiations and adverse interests.  Also, the court’s reasoning about there being “economic and business risks assumed by the daughters’ trusts as buyers” relate to the sale element of the transaction.  It would be nonsensical to require the existence of “economic and business risk” of a donee in a mere gift transaction.]

   3. As to Foundation.  The court applied the arm’s length requirement as to the Foundation in terms of whether there was collusion.  The court gave various reasons for why there was no evidence of collusion between the parents and the Foundation:
      1. The transaction was consistent with prior charitable transfers by the parents;
      2. The Foundation accepted potential risks including the loss of tax-exempt status if it failed to exercise due diligence;
      3. The Foundation negotiated some elements of the transaction, by insisting that the parents pay income taxes attributable to the S corporation income if the corporation did not distribute enough cash to pay those taxes;
      4. The Foundation was represented by independent counsel;
      5. The Foundation conducted an independent appraisal; and
      6. The Foundation had a fiduciary obligation to ensure that it received the proper number of share.
4. Public Policy.
   1. General Standard:  “Immediately and Severely Frustrate Sharply Defined Policies.”  The general standard stated by the court for testing whether provisions should be disregarded on public policy grounds is based on whether the provisions “immediately and severely frustrate any national or State policy:

      “Respondent argues that the formula clauses are void as contrary to public policy.  We disagree. While the Court can disallow a deduction on public policy grounds if allowing such a deduction would severely and immediately frustrate sharply defined national or State policies proscribing certain conduct, see Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 35 (1958), the formula clauses do not immediately and severely frustrate any national or State policy.  To the contrary, the fundamental public policy here is one of encouraging gifts to charity, and the formula clauses support that policy.”

      [Another more recent Supreme Court case restating the “severe and immediate” standard for disallowing deductions on the basis of public policy considerations is Commissioner v. Tellier, 383 U.S. 687, 694 (1966).]

   2. Distinguishing Procter:  No Condition Subsequent and Clauses Encourage Gifts to Charity.  The IRS relied primarily on Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944) in which the court refused to recognize a transfer with provisions that if any part of the transfer was subject to gift tax, such property was not included in the conveyance and remained property of the donor.  Procter gave three reasons: (1) the provision discouraged the collection of gift tax because any attempt to collect the tax would defeat the gift; (2) the condition obstructed the administration of justice by requiring a court to pass on a moot case; and (3) the provision would reduce a Federal court’s final judgment to a declaratory judgment.
      
      The Hendrix court gave two reasons for distinguishing Procter: First, the formula clauses in this case “impose no condition subsequent that would defeat the transfer.”  (The entire block of shares was transferred, and nothing remained with the donors depending on whether the gift tax would apply.)  Second, “the formula clauses further the fundamental public policy of encouraging gifts to charity.”
   3. Relevancy of Christiansen.  The court cited with approval Christiansen v. Commissioner, 130 T.C. 1, 16-18 (2008), aff’d, 586 F.3d 1061 (8th Cir. 2009).  In a "regular" Tax Court opinion of the full court, Christiansen held that “an essentially similar dollar-value formula disclaimer was not contrary to public policy.”  While that case involved a formula disclaimer and this case involved a direct formula transfer, the court saw no reason to distinguish the court`s reasoning in Christiansen from this direct transfer situation: "We know of no legitimate reason to distinguish the formula clauses from that disclaimer, and we decline to do so. We hold that the formula clauses are not void as contrary to public policy."
5. Conclusion.  The court concluded that “the formula clauses control the transfers of the JHHC stock to the trusts and Foundation.” The crux of the court’s holding is the following phrase:  “Given this holding, no additional value passed to the Foundation as of December 31, 1999…”  If no additional value passed to the Foundation (i.e., the shares had been valued at $48.60 per share rather than $36.66 per share), then implicitly no additional value passed to the trusts.  The court observed that the donors collectively were entitled to deduct the $100,000 in charitable contributions claimed, but the court did not include an explicit statement about the value passing to the trusts for gift tax purposes.
   
   [SRA Observation:  This statement of the conclusion, without any discussion of why the $36.66 per share value should be binding for gift tax purposes even if it is binding under state law for determining the number of shares passing to each party under the confirmation agreement, is illustrative of a concern with using the confirmation agreement approach in structuring defined value clauses.  The 5th Circuit reasoned why the values used in the confirmation agreement should be controlling for gift tax purposes, but that issue is not without its uncertainties in other circuits that have not yet addressed the issue.  See the discussion in Item 3.a of the Observations, below.]

Observations

1. Fourth Case Recognizing Defined Value Clauses.  The IRS’s primary position is that these types of clauses should not be recognized for tax purposes on public policy grounds because they reduce the IRS’s incentive to audit returns. So far, the IRS is losing that argument in the courts.
   
   This is now the fourth case that has recognized the binding effect of defined value clauses for tax purposes, the others being McCord, Christiansen, and Petter.  (Christiansen, Petter, and Hendrix all addressed the public policy issue.  The 5th Circuit McCord Tax Court decision did not, although a majority of the Tax Court judges in the case seemed to have no problem with the public policy concerns in McCord.)
   
   With these mounting taxpayer victories, if the taxpayer wins the appeal to the 9th Circuit in Petter, one wonders if the IRS will stop fighting these clauses, as least where the non-taxable “pourover” amount passes to charity.
2. John Porter Victories. The taxpayers in all four of these cases have been represented by John Porter.  The other attorneys who assisted John in this case were Stephanie Loomis-Price and Keri Brown.
3. McCord-Confirmation Agreement Approach vs. Petter-Finally Determined Gift Tax Value Approach. Two approaches have emerged for structuring these defined value clauses to allocate the block of transferred assets among the family trusts and the charity (or other donees that would not generate gift tax consequences).  McCord and Hendrix used an approach allocating the shares based on a “confirmation agreement” among the transferees.  Christiansen and Petter used an approach of allocating the block of transferred assets based on values as finally determined for estate (Christiansen) or gift (Petter) tax purposes.
   1. Agreement Approach. One advantage of the confirmation agreement approach is that actual sales or transactions are generally the best indicators of value, and that approach involves actual negotiated agreements among independent parties as to the amounts received.  Another advantage is that the parties can reach finality rather quickly as to what the parties receive rather than having to wait for years for the finally determined gift tax value to determine how many units of the transferred asset each party receives.
      
      In McCord, the Tax Court did not recognize the agreement approach for purposes of determining the gift tax values of the shares involved. The Tax Court held that the specific formula was not “self-effectuating.” The Tax Court’s reasoning is difficult to follow, but is based on the fact that the formula is not tied to values as finally determined for gift tax purposes, but fair market values as determined by the parties.  Under the court’s reasoning, the parties to the assignment documents were supposed to determine what interests passed to the various parties “based on the assignees’ best estimation” of the value.  The Tax Court gave effect to the percentage interests agreed to by the parties but did not find those values to determine the gift tax value of the property transferred. The Tax Court specifically said that if the parties had provided “that each donee had an enforceable right to a fraction of the gifted interest determined with reference to the fair market value of the gifted interest as finally determined for Federal gift tax purposes,” the court “might have reached a different result.” The Tax Court was reversed by the 5thCircuit, because it viewed the Tax Court as impermissibly looking to events occurring after the sale date. The end result was that the 5th Circuit did recognize the effectiveness for gift tax purposes of a formula allocation clause that gave a dollar amount to donees even though it provided for funding based on the agreement of the parties. Hendrix relied on the 5th Circuit’s decision in McCord to avoid that issue, but it still might be raised in cases appealable to other circuits.  The Tax Court’s initial rejection of the agreement approach, suggesting that a different result may have been reached if the formula allocation was based on values as finally determined for gift tax purposes, causes planners to question whether that latter type of clause might be preferable.
      
      To some degree, this concern is illustrated by the Hendrix court’s concluding paragraph, as discussed above.  The Hendrix opinion does not directly address why the gift tax value passing to the family trusts should be based on $36.66 per share rather than some higher value, even though the formula allocation is respected for purposes of determining how many shares passed to each of the respective parties.  That uncertainty does not exist with the “as finally determined for tax purposes” approach.
      
      Furthermore, the taxpayer’s public policy argument seems stronger with an approach allocating values based on values as finally determined for tax purposes.  The Hendrix analysis of the public policy issue was extremely brief, omitting some of the reasons given in Christiansen and Petter.  For example, Hendrix did not respond to the arguments from Procter that the clauses should be ignored on public policy grounds because they involve a moot issue and merely result in a declaratory judgment.  Petter reasoned that those two reasons cited by Procter do not rise to the level of a “severe and immediate” threat to public policy. Petter reasoned that its case does not involve a moot issue because a judgment regarding the gift tax value would trigger a reallocation, and therefore it is not just a declaratory judgment.  That reasoning does not apply in a confirmation agreement-type approach.
   2. “As Finally Determined for Gift Tax Purposes” Approach.  While there may seem to be somewhat more certainty regarding the validity of these “as finally determined for gift tax purposes” types of clauses in light of the reasons discussed immediately above, be aware that there are potential disadvantages of this approach.  The number of units passing under the formula transfer provision may not be resolved for years, until the final conclusion of a gift tax audit (and resulting litigation, if any).  There could be underreporting and overreporting of income for income tax purposes by the respective transferees during the period of uncertainty. (This is a reason why all family trusts involved with the transaction should be grantor trusts so that all of the income is reported on the grantor’s income tax return, regardless how shares are allocated to each party if all parties to the transaction are family trusts.) Furthermore, the gift tax audit itself will determine the number of shares passing to the charity (or other entity that does not result in the creation of a taxable gift).  The family may feel more comfortable negotiating with the charity (or other “non-taxable” entity) in a real life context rather than using the values determined in a gift tax audit for that purpose.
4. Impact of Charity as “Pourover” Recipient.  Is it essential that the “pourover” party be a charitable entity rather than a family “non-taxable” entity (such as the donor’s spouse, a QTIP trust for the donor’s spouse, a GRAT, or an “incomplete gift trust” that does not result in a current completed gift for gift tax purposes)?  McCord, Christiansen, Petter and Hendrix all address formula clauses where the “excess amounts” pass  to a charity, and some (but not all) of the reasons given for rejecting the IRS’s public policy argument apply specifically where a charity is involved. Hendrix gives only two reasons for its public policy analysis, that there is no condition subsequent and that public policy encourages charitable gifts. Christiansen and Petter each have a more robust analysis of the public policy issue, and give additional reasons that the approach would not violate public policy even if a charity were not involved.
   
   From Christiansen:  (1) The IRS’s role is to enforce tax laws, not just maximize tax receipts; (2) there is no clear Congressional intent of a policy to maximize incentive to audit (and indeed there is a Congressional policy favoring gifts to charity); and (3) other mechanisms exist to ensure values are accurately reported.  The court in Christensen reasoned that “the Commissioner's role is not merely to maximize tax receipts and conduct litigation based on a calculus as to which cases will result in the greatest collection. Rather, the Commissioner's role is to enforce the tax laws.” Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009).  In light of the other more robust discussion of the public policy issue in Christiansen, it is perhaps significant that Hendrix cited Christiansen with approval even if it did not repeat all of its public policy reasoning.
   
   From Petter:  (1) There are other potential sources of enforcement (including references to fiduciary duties to assure that the parties were receiving the proper values); (2) the case does not involve a moot issue because a judgment regarding the gift tax value would trigger a reallocation, and therefore it is not just a declaratory judgment; and (3) the existence of other formula clauses sanctioned in regulations (formula descriptions of annuity amounts for charitable remainder annuity trusts, formula marital deduction clauses in wills, formula GST exemption allocations, formula disclaimers of the “smallest amount which will allow A’s estate to pass free of Federal estate tax,” and formula descriptions of annuity amounts in grantor retained annuity trusts) suggest there cannot be a general public policy against formula provisions.
   
   Even so, all four cases that have approved defined value clauses have cited various reasons that just apply to a charitable “pourover” entity to support their public policy analyses.  Of course, the donor must have charitable intent and recognize that significant assets may pass to the charities under a formula allocation clause with the excess passing to charity.  No court has yet addressed the validity of defined value clauses against the public policy issue where a charity is not the “pourover” party.
5. Structure Defined Value Clause to Require Fiduciary Review of Value Determination. The Christiansen and Petter opinions emphasize that there are other mechanisms to enforce the valuation determination, specifically emphasizing the fiduciary duties of the parties involved. To come within the scope of this rationale, a formula allocation clause should allocate the excess over the formula amount to a charitable foundation or to a trust where there are parties with fiduciary duties that have an obligation to assure that the entity is receiving its appropriate share under the formula transfer. Furthermore, someone other than the donor should serve as trustee of that entity.  [For example, if a “zeroed-out” GRAT is the excess recipient, the donor should not serve as the trustee of that GRAT.]  Furthermore, the trustee should be someone other than the beneficiary of a trust that is the recipient of the primary formula transfer, or else there would be a huge incentive to violate fiduciary duties and permit excess value to pass to the trust for the benefit of that individual. Indeed, a stronger rationale would exist if a professional fiduciary serves as the fiduciary.
6. Structure Transaction to Leave Significant Value to “Pourover” Party.  A corollary to structuring the transaction to require fiduciary review of the value determination is leaving enough value to the “pourover” recipient to justify a detailed examination and due diligence review of the transaction by that party.  A detailed review, with outside counsel and an outside independent appraisal review, will cost money.  If the “pourover” party is not receiving significant value, it might reasonably conclude that the transaction does not warrant a significant expenditure of funds to conduct a detailed and independent review of the values and overall transaction.  In Hendrix, the transaction was designed to leave $100,000 of stock value to the Foundation, based on the estimate of values provided by the donors’ independent appraiser.
7. Arm’s Length Requirement?  Hendrix is the first court to address whether defined value clauses are recognized only if they are part of an arm’s length transaction.  Some planners have expressed chagrin that the court chose to validate the argument with a detailed analysis, suggesting that there is indeed such a requirement.  Having an arm’s length requirement is nonsensical in a pure gift transaction not involving a sale.
   
   The Hendrix court approached the issue in terms of whether “there is collusion, an understanding, a side deal, or another indicium that the transaction was not at arm’s length.”  The court applied the arm’s length requirement rather narrowly, stating directly that “a finding of negotiation or adverse interests [is not] an essential element of an arm’s length transaction.” After making that statement, the court went on to point out that in fact the clauses were subject to negotiation and that there were adverse interests even as to the daughters’ trusts (apparently because of the purchase transaction).
   
   As discussed above, having a “pourover” party with some degree of independence is essential in a confirmation agreement type of clause and is also important with an “as finally determined for gift tax purposes” type of agreement to establish the bona fides of the transaction and that it is not just a tax gimmick to facilitate “cheating” on values.  The independence of the “pourover” party has been addressed by several other courts as part of the public policy issue — in terms of there being other mechanisms than just a gift tax audit to ensure appropriate enforcement of the clause.
8. Use Professional Appraiser. As in all four of the defined value cases (McCord, Christiansen, Petter, and Hendrix),use a reputable professional appraiser to prepare the appraisal for purposes of making the original allocation under the formula assignment. This helps support that the taxpayer is acting in good faith and avoid a stigma that the formula transfer is merely a strategy to facilitate (using words of the court in Petter) “shady dealing” by a “tax-dodging donor.”
9. For Many, Defined Value Clauses Not as Important With $5 Million Gift Exemption.  Many individuals may wish to make gifts in excess of the $1 million gift exemption allowed under prior law, but far less than the full $5 million allowed in 2011 and 2012.  For those individuals, perhaps the most important effect of the $5 million gift exemption is that it provides a great deal of “cushion” before a gift tax audit would require the payment of current gift taxes.  For example, an individual who wishes to make a $3 million gift will not be as concerned as in the past with having a way to structure the transaction in a manner that will transfer as much value as possible to an irrevocable trust for children without having to pay gift taxes.  Even if the individual claims substantial valuation discounts on the gift tax return, the individual may feel comfortable that current gift taxes will not be due even if there is a gift tax audit.
10. First Transfer Tax Case by Judge Paris.  This is the first transfer tax opinion by Judge Paris.  Before being appointed to the Tax Court several years ago, Elizabeth Paris served as a Senate legislative counsel, and was deeply involved in particular with transfer tax issues coming before the Senate Finance Committee.

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