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Court Rules on Gifting a Percentage of Partnership Interests Versus a Fixed Amount

August 19, 2022

Depending on the attorney and the wants of their client, gift transfer documents may indicate either a specific number of units or a percentage. They may also be “backed into” based on the dollar amount of the valuation conclusion via a formula clause.

This month’s highlighted business valuation case study reiterates the importance of drafting transfer documents so that the language within the documents matches the intentions of the attorney and their client. If the language does not match the intent, the client may be locked into specific details of a gift transfer that are different than originally planned.

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5th Circuit Court of Appeals Upholds Tax Court Finding That Taxpayer Gifted a Percentage of Partnership Interests and Not a Fixed Amount

Nelson v Commr., 2021 U.S. App. LEXIS 32741 (Nov. 3, 2021)

“Mary P. Nelson and James C. Nelson appeal from the Tax Court’s denial of their petition for a redetermination of a deficiency of gift tax issued by the commissioner of Internal Revenue for the tax years 2008 and 2009. For the following reasons, we AFFIRM.”

Facts. Mary Pat and James Nelson sought to plan their estate and formed a limited partnership, Longspar Partners Ltd., in 2008. Mary Pat and James named themselves general partners, with a 0.5% interest each. The limited partners were Mary Pat and trusts for their daughters. The majority of Longspar’s assets were shares of stock in Warren Equipment Co., a holding company for several businesses. Mary Pat also contributed her limited partner interests to a trust where Mary Pat was the settlor, James the trustee, and their daughters the beneficiaries. The interests were transferred in two transactions, a gift and then a sale. The transfer agreement stated:

[Mary Pat] 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 December 31, 2008 (the “Limited Partner Interest”), as determined by a qualified appraiser within ninety (90) days of the effective date of this Assignment.

The transfer agreement for the sale used largely the same language and was for a limited partnership interest having a FMV of $20 million. The qualified appraiser rendered a report valuing a 1% interest at $341,000. “The Nelsons’ attorney then used the fair market value as determined by the accountant to convert the dollar values in the transfer agreements to percentages of limited partner interests—6.14% for the gift and 58.65% for the sale.” The IRS audited the Nelsons’ gift tax returns and issued a deficiency notice of $611,208 for 2008 and $6,123,168 for 2009.

The Nelsons challenged in Tax Court, arguing that “they had sought to transfer specific dollar amounts through a formula clause and that the amount of interests transferred should be reallocated should the valuation change.” The Tax Court found that a 1% value was worth $411,235 and that the language in the transfer documents was not a valid formula clause that could support reallocation of the interests. “The Nelsons timely appeal the court’s finding that the transfers consisted of percentage interests, rather than fixed dollar amounts.”

Discussion. With the amount of gift tax, the nature of the transfer is determined by looking at the transfer documents. The language in the documents here expressly stated “fair market value” for purposes of determining the interests transferred. The appraiser thus determined the fair market value. “The Nelsons defined their transfer differently; they qualified it as the fair market value that was determined by the appraiser. Once the appraiser had determined the fair market value of a 1% limited partner interest in Longspar, and the stated dollar values were converted to percentages based on that appraisal, those percentages were locked, and remained so even after the valuation changed.” The Nelsons’ documents lacked specific language describing what should happen to any additional shares transferred if the valuation was sufficiently challenged.

The fact that the trust did return excess units was irrelevant and was the type of “subsequent occurrence” that “this court” has said is “off limits” when valuing the value of a gift. (Succession of McCord, 461 F.3d at 626.) For tax purposes, the value at the date of the gift was determined to be the amount of the gift. With a formula clause, the transaction was still closed even if a reallocation occurs. “The reallocation clauses thus allow for the proper number of units to be transferred based on the final, correct determination of valuation.” Both parties agreed that the transfer was complete at the date of the gift. The Nelsons attempted to draft a formula clause but failed to do so.

The interpretation of the transfer documents was not changed by looking at any objective facts outside of the language of the documents. The documents were not ambiguous, and the Nelsons’ interpretation was not reasonable as a matter of law. The Nelsons’ interpretation would amount to changing and overriding the language in the transfer documents and Texas law did not allow for that. The subjective intent of the contracts considering the estate planning intent would not be allowed. “To support the Nelsons’ reading, we would be required to disregard significant differences between these contracts and the transfer documents used in similar cases.”

The appraisal was delayed, but that had no bearing on the nature of the transfers. It does mean that the trust might have a claim against Mary, or the trust and Mary might have a claim against the appraiser. Also, “the lack of concern demonstrated for the tardy appraisal is yet another indicium of subjective intent which similarly cannot be considered under Texas’ parole evidence rule.”

Dan Rosio Partner, Valuation Services
Dan Sailer Director, Valuation Services

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