Safety nets in documents to avoid tax pitfalls
By Eugene Lyle Stoler
The Right Subject Matter
Savings clauses in documents are designed to prevent an adverse result that otherwise might arise. Although the IRS generally views tax savings clauses with disfavor, there are circumstances where a savings clause should be inserted in a document to correct any erroneous interpretations in favor of the taxpayer. The author discusses savings clauses that--
Taxpayers will have difficulty with those clauses that include a condition subsequent and attempt to revoke a transfer, alter a completed transaction, or are connected with a determination of value. Alternately, clauses that serve to assist in the interpretation of a document, or explain the parties' intention, will generally be more acceptable.
Savings clauses are included in documents to prevent an adverse result that otherwise might arise. In PLR 7916006, the IRS defined a savings clause as "a provision that takes away a power or changes a provision that is expressly given elsewhere in the instrument and is, therefore, in direct conflict with that other express power or provision." The IRS's position regarding savings clauses was stated very clearly in PLR 73092590A: "To accept savings provisions as curative for Federal tax purposes would quickly lead to the use of such provisions as a standard estate planning device. Trusts and wills would knowingly be drafted with a number of defective tax provisions. This would lead to chaos in trust administration and, also, to a serious breakdown in the administration of the code provisions under sections 2055 and 2056."
There are various types of savings clauses, some of which will operate to "save the day," and others which will not operate to correct an erroneously drafted document. The IRS generally views tax savings clauses with disfavor, placing reliance on Comm'r v. Procter, [142 F.2d 824 (CA-4, 1944)], which held a savings clause void as contrary to public policy. However, there are circumstances where a savings clause should be inserted in a document and will operate in favor of the taxpayer to correct any erroneous interpretations. In the Procter case, the savings clause at issue operated to nullify a gift in the event of a judicial determination that the transfer was subject to gift tax. The Fourth Circuit agreed that the clause was void as being against public policy because--
The IRS has a tendency to expand the decision in Procter to disqualify marital deductions and charitable trusts, and to assess additional gift tax on intrafamily transfers. For example, in PLR 9717008, the provisions of a grantor-retained annuity trust (GRAT) permitted the annuity to be satisfied with a promissory note, and the trustee was authorized to retroactively amend the trust for the sole purpose of complying with applicable IRC provisions and Treasury regulations. Citing Procter, the IRS ruled that the provision for retroactive amendment of the trust would nullify any gift tax consequences resulting from the examination of the gift tax return reporting the transfer and that such a provision was "against public policy and is disregarded for tax purposes."
Similarly, in PLR 9104003, the decedent provided that a bequest to the surviving spouse was intended to qualify for the Federal estate tax marital deduction (to the extent elected by the executor) and "the terms of this will shall be construed in accordance with such intent." Citing Procter once more, the IRS ruled that this spouse's entire interest in the marital trust was subject to a power in the executors to appoint the corpus to someone other than the surviving spouse, and that this savings clause was ineffective in altering that result. See also PLR 9325002 where the IRS, citing Procter, ruled a savings clause ineffective in preserving the marital deduction. Notwithstanding these attacks, there are some tax savings clauses that will be effective.
Nullifying a Transfer
In Estate of Dickinson, Jr. [63 T.C. 771 (1975)], the decedent had an agreement with his closely held corporation provided the corporation would purchase the stock at book value from his estate. This was amended by a supplemental agreement to provide that if the IRS would not accept book value for estate tax purposes, the buy-sell agreement would be voided and the estate would not be required to sell to the corporation at book value. Following a successful increase in the valuation of the stock substantially above book value, the IRS, relying on Procter, contended that the supplemental agreement was void as contrary to public policy and the buy-sell agreement fixed the price the estate could realize at book value. In holding the supplemental agreement valid, the court stated it was a reasonable and appropriate means of anticipating possible adverse action by the IRS and avoiding its consequences, thus saving the estate from adverse consequences since the estate tax payable could have exceeded the amount received from the sale of the stock, leading to a potentially serious liquidity problem.
Revoking a Transfer
In several cases, the courts have upheld savings clauses that serve to revoke the transfer, particularly in the context of charitable remainder trusts. In O'Brien v. Comm'r [46 T.C. 583 (1966)], the taxpayers established a charitable remainder trust and the agreement provided that if the IRS disallowed any contributions to the trust as charitable deductions, they would be returned to the donors. The taxpayers contributed property to the trust, and the claimed charitable deduction was disallowed. The IRS contended that the requirement that the property be returned to the taxpayers in the event of a disallowed deduction resulted in broad powers in the grantors which invalidated the charitable trust, because it provided for a distribution of property to someone other than a charity. The court disagreed with the IRS, holding that the savings clause by itself did not defeat the charitable deduction, nor did the broad powers in the grantors. Furthermore, the mere fact that a savings clause revokes a transfer because it involves a condition subsequent will not render it invalid.
In Rev. Rul. 76-199, 1976-1 C.B. 288, the IRS permitted a marital deduction even though the settlement agreement with the surviving spouse conditioned payment upon a favorable determination that the transfer would qualify for the marital deduction. Notwithstanding the foregoing, in TAM 8901004, the IRS stated that, in the case of a "hanging" Crummey power (used to avoid adverse gift tax consequences associated with the lapse of demand rights), where the trust provides that the withdrawal power will hang until its termination will not result in a taxable gift, the provision would be considered a condition subsequent and be ignored for gift tax purposes.
Defining the Amount of a Transfer
"Definition-type" clauses are rarely challenged by the IRS and are frequently used in connection with the marital share. See, for example, PLR 8611004, where the decedent's gift of his partnership interest was predicated on a specified fair market value. This necessitated the determination of fair market value before determining the percentage transferred by gift and the portion of the remainder of the decedent's interest includable in his estate.
Altering the Terms of a Transfer
The IRS has opposed adjustment clauses, contending that when a transfer may be recharacterized depending on the value of the property as determined by the IRS, the savings clause is ineffective to avoid the imposition of a gift tax. For example, in Rev. Rul. 86-41, 1986-1 C.B. 3000, it was held that a price adjustment clause would be disregarded for Federal gift tax purposes where a donor transferred property under terms which required that the transaction be recharacterized if the IRS found a gift had been made. The IRS stated that, if such a clause were operative, it would serve to discourage tax collection efforts by either defeating the gift tax or otherwise rendering examination of the gift tax return ineffective.
In TAM 8531003, the parties entered into an estate freeze, realigning ownership interests in a partnership and corporation. The agreement provided that if an audit by the IRS determined valuations different than agreed to by the parties, the interests transferred would be adjusted accordingly. The IRS ruled that the savings clause was ineffective to eliminate the gift.
In King v. U.S. [545 F.2d 700 (CA-10, 1976)], the taxpayer sold closely held corporate stock to trusts he had created for his children. The agreement contained an adjustment clause that provided that if the IRS adjusted the fair market value of the stock, the purchase price would be similarly adjusted. Following an increase in the stock's value, the IRS, relying on Procter, contended that the adjustment clause was void as being against public policy since it served to alter the terms of a completed transfer and consequently avoided a gift tax. However, the court found that the parties intended to pay full and adequate consideration, the transaction was at arm's length and free of intent to donate, and the adjustment clause was an acceptable method of determining the fair market value of an asset difficult to value.
However, in other cases involving price adjustment clauses intended to operate as savings clauses, taxpayers have not fared as well. In Ward v. Comm'r [87 T.C. 78 (1986)], such a clause was held inoperative where, at the time of making a gift of stock, the donors agreed with the donees that a retroactive adjustment in the number of shares gifted would be made if the fair market value as determined for Federal gift tax purposes was less than or more than an agreed-upon sum. Similarly, in Harwood v. Comm'r [82 T.C. 239 (1984)], a price adjustment clause that provided for a subsequent change in the consideration, based upon the final values stated in a settlement agreement with the IRS or by an appraiser, was found to be invalid. The court felt the parties had not bargained at arm's length since the buyer was not concerned about the price it paid but rather only that no gift tax be incurred by the seller.
Modifying Fiduciary Powers
The most popular form of savings clause is the provision that if any power granted to a fiduciary would serve to disqualify the trust for a marital or charitable deduction, that power is void or ineffective. Frequently this type of savings clause has been found to be effective and valid. In Rev. Rul. 75-440, 1975-2, C.B. 372, a provision in a decedent's will stated that any power, duty, or discretionary authority granted to the fiduciary would be void to the extent that either the exercise or right to exercise thereof would cause the estate to lose any part of the marital deduction. The IRS construed the clause as an aid in determining the testator's intent rather than a savings clause and allowed the estate to claim a marital deduction. Absent a holding that the savings clause was valid, the estate would have been denied a marital deduction because the trustee's powers included a power which, if not invalidated, would have served to disqualify the marital trust.
Similarly, in PLR 7916006, where the fiduciary powers in the decedent's will were not exercisable if their exercise would defeat the marital deduction, the IRS permitted the savings clause to be effective to illustrate the testator's intent and preserved the marital deduction. Absent the validity of the savings clause, the estate would have been denied a marital deduction because the fiduciary was permitted to invest in insurance, an unproductive property.
Notwithstanding these taxpayer victories in the area of marital deduction savings clauses, there are some cases where they are deemed ineffective. In PLR 8437093, a pre-1982 will made a fractional share formula gift to a marital deduction power of appointment trust authorizing the trustee, during the surviving spouse's lifetime, to make principal distributions to a son and his issue. The will contained a savings clause that provided that if any provision of the will prevented the allowance of the marital deduction with respect to the marital deduction trust, the provision was not to apply. Citing Rev. Rul. 65-144, 1965-1 C.B. 442, and distinguishing Rev. Rul. 75-440, supra, the IRS found that the savings clause was not merely an aid in interpretation but was an attempt to revoke a disqualifying power and therefore deemed the savings clause to be ineffective.
The courts have likewise recognized the validity of savings clauses that render a provision in a document void and of no effect where it might cause adverse tax consequences. For example, in Oakes v. Comm'r [44 T.C. 524 (1965)], a "Clifford trust" document contained a provision giving the grantors the power to appoint a successor trustee that could have resulted in the trust income being taxable to the grantors. However, the savings clause, which declared any provision determined to violate the provisions of the IRC so as to cause the income to be taxable to the grantors to be inoperative, was held effective. The court concluded that a savings clause that serves to render a trust provision inoperative if it violates a provision of the tax law should be given effect.
Savings Clauses at the State Level
Interestingly, several states have adopted statutory provisions dealing with savings clauses. For example, Wash. Rev. Code Sec. 11.108.020 provides: "If a governing instrument contains a marital deduction gift, the provisions of the governing instrument, including any power, duty, or discretionary authority given to the fiduciary, shall be constructed to comply with the marital deduction provisions of the IRC and the regulations thereunder in order to conform to that intent." Similarly, California Probate Code Section 1032 is designed to ensure the allowance of a marital deduction by negating offensive or ambiguous provisions in the will or trust once an intent to obtain the deduction is found.
Although the IRS has adopted an adverse posture towards savings clauses and will review them carefully, taxpayers will have the most difficulty with those clauses that include a condition subsequent and attempt to revoke a transfer, alter a completed transaction, or are connected with a determination of value. Alternatively, clauses that serve to assist in interpretation of a document, or explain the parties' intention, will generally be more acceptable. However, even though savings clauses may not always be deemed valid, they are recommended because they cannot hurt and in fact may save the day if and when unexpected qualification issues arise. *
Eugene Lyle Stoler, LLM, CPA, is a partner with Konigsberg, Wolf & Co., P.C., New York, N.Y.
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