New Life for Charitable Lids

Two recent court victories give formula clauses more power in estate plans.

One common estate planning technique the IRS has opposed or blocked for years is “charitable lid planning.” This technique relies on “defined value” and “value adjustment” clauses or similar provisions in wills, deeds or other transfer documents to cap the transfer taxes on estates, gifts or generation-skipping trusts at some predetermined amount. The IRS has consistently argued against defined-value clauses on the basis of the Fourth Circuit’s holding in Commissioner v. Procter (142 F.2d 824 (1944)) that such clauses are void because they remove the IRS’ incentive to audit returns and thus are against public policy.


In Procter, the taxpayer’s trust indenture making a gift of a future interest in trust property to his children provided that if a “court of last resort” determined that any part of the transfer was subject to gift tax, that portion would be deemed automatically void and excluded from the conveyance. The Fourth Circuit concluded that the clause would, in effect, nullify the very court judgment it invoked as a condition, noting that a federal law at the time prohibited any declaratory judgment by a federal court as to whether a gift was subject to gift tax. In subsequent cases, courts denied “savings clauses” that provided for a portion of a gift deemed subject to gift tax to revert to the donor. The IRS has also argued on similar grounds against clauses that would have a similar effect on transfer tax liability, but by making or increasing donations to charities rather than by a reversion.


In back-to-back decisions in late 2009, however, the Tax Court and Eighth Circuit in Estate of Christiansen v. Commissioner (130 TC 1, aff’d, 8th Cir. (2009)) and the Tax Court in Estate of Petter v. Commissioner (TC Memo 2009-280) rejected the IRS’ public policy arguments and opened the door for using charitable lid strategies to limit a donor’s transfer tax liability while fulfilling charitable goals. However, CPAs and their clients should also note continuing developments in this area of estate law.


The reduction in transfer taxes also entails a couple of risks that the CPA needs to discuss with clients. First, the IRS probably will audit their transfer tax returns and make value adjustments, requiring them to transfer additional assets to charitable organizations. Second, the IRS has not indicated its acceptance of the decision in Petter, so it probably will appeal the decision to the Ninth Circuit. A victory for the IRS would mean a split among the circuits that could lead to an appeal to the Supreme Court. A taxpayer victory, however, may not keep the IRS from appealing a Tax Court decision in other circuits.


This uncertainty makes it imperative that CPAs and others who advise wealthy clients watch the tax horizon for updates on this important issue. The Eighth Circuit includes Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota. The Ninth Circuit covers Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington state.


This article explains how defined-value clauses activate charitable lid strategies and considers the impact of Petter and Christiansen on using charitable lid strategies to limit transfer taxes. The article should provide CPAs a basis for informing their high-net-worth clients about the technique and its applicability to their situations.



Charitable lid strategies rely on a combination of defined-value clauses (also called formula clauses) and value adjustment clauses to limit transfer taxes. A defined-value clause is used to calculate the value of property transferred by gift (will) to noncharitable and charitable beneficiaries. The transferor often limits the value transferred to the noncharitable done (heir) to his or her remaining gift (estate) tax exclusion, but the limit can be any predetermined amount. The value of the property in excess of the amount transferred to the noncharitable beneficiary is transferred to the charitable beneficiary. The goal of this technique is to limit transfer tax liability to zero or a predetermined amount. For example, a defined-value clause might state a gift amount as equal to the donor’s “net remaining generation-skipping tax exemption.”


Most value-adjustment clauses define “value” for purposes of computing the amounts passing to the beneficiaries as the value at the date of the transfer, as finally determined for transfer (gift, estate or generation-skipping) tax purposes. If the IRS or a court later determines that the value of the property transferred is greater than initially reported on the gift (estate) tax return, only the “excess” amount (the amount transferred to the charitable beneficiary) increases. The amount transferred to the noncharitable beneficiary is set by the formula and will not increase. The value-adjustment clause ensures that the donor’s transfer tax liability is not increased by value adjustments proposed by the IRS during its audit of the transfer tax return.


A charitable lid strategy uses these clauses to limit the transfer tax liability by specifying the portion of a split-interest gift going to a noncharitable donee (often through a family partnership or LLC created to facilitate the transfers). If the value of the property at the transfer date exceeds the formula-derived amount, the excess passes to the charities designated by the donor.


Often, family partnership or LLC interests transferred under a charitable lid strategy are discounted in value for lack of marketability and/or control. The IRS, however, may contest the discount and increase the value of the interests. With formula clauses, when this happens, the resulting increase can be channeled to one or more designated charities. This allows the donor to claim a higher charitable deduction without paying additional transfer taxes. The formula clauses effectively place a “lid” on the transfer tax liability. The example in Exhibit 1 illustrates how the strategy typically works.



Exhibit 1: Charitable Lid Planning Strategy Example

Joshua Benz wishes to transfer units of a family LLC to a family trust in an amount equal to the gift tax exclusion, $1 million. Benz also wishes to transfer LLC units to the Greystone Public Health Foundation, a section 501(c)(3) tax-exempt public charity, in an amount equal to the value of the transferred property in excess of the exclusion amount. The transfer document accomplishes these goals with the following provisions: “Joshua Benz hereby transfers property described in the attached schedule (which describes units of the Benz Family LLC) with a fair market value not to exceed $1,000,000 to the Benz Family Trust; any excess shall be transferred to the Greystone Public Health Foundation. Fair market value shall be defined as the value of the property as finally determined for federal gift tax purposes.”


Benz retains a qualified appraiser to value the property he transfers to the Benz family trust. The appraiser values the units at $1,100,000 on the date of transfer. The IRS subsequently audits the transfer return, and Benz agrees with the IRS that the value of the units as of the date of the gift was $1,500,000. Estate planning by Benz results in the following:

  1. Benz transfers Benz Family LLC units equivalent to the excess value at the transfer date, $100,000, to the Greystone Public Health Foundation ($1.1 million appraisal value - $1 million to Benz Family Trust = $100,000 excess).
  2. Benz transfers Benz Family LLC units equivalent to the maximum value specified in the transfer document, $1,000,000, to the Benz Family Trust.
  3. Benz transfers Benz Family LLC units equal to the increased agreed-upon value to Greystone Public Health Foundation ($1.5 million - $1.1 million = $400,000).
  4. Benz pays no transfer tax on the transfers because the $1 million lifetime exclusion offsets the amount transferred to the Benz Family Trust, and Benz’s charitable deduction shields the gift from taxation.



Another commonly used estate planning technique, useful for reducing both gift and estate taxes, is a qualified disclaimer. IRC § 2518 provides that if certain conditions are met, a beneficiary can disclaim all or a portion of an interest that can be treated for gift tax purposes as passing directly from the transferor of the property to the person entitled to receive the property as a result of the disclaimer.


In Christiansen, Helen Christiansen’s will left her entire estate to her daughter, Christine Hamilton, but included a provision that any portion disclaimed by Hamilton would pass to a designated charitable foundation. Christiansen’s estate consisted primarily of an interest in a family LLC that a reputable independent appraiser valued at $6.5 million shortly after her death. Hamilton disclaimed the value of the estate in excess of $6.35 million, resulting in $150,000 passing to the foundation (for a discussion of related aspects of the case, see “Tax Matters: Charitable Deduction Due to a Partial Disclaimer,” JofA, March 2010, page 61).


The IRS audited the estate tax return and challenged the value of the estate. The parties settled on a value of $9.5 million. Because of the formula disclaimer, the entire additional amount passed to the foundation. The estate claimed a corresponding increase in its charitable deduction and thus took the position that it incurred no additional estate taxes.


The IRS disallowed the increased charitable deduction for the increase in value that passed directly to the foundation on the grounds that the adjustment clause included in the disclaimer was contrary to public policy. The IRS contended that the adjustment clause took away its opportunity to collect additional estate taxes regardless of the value determined during audit and thus its incentive to audit tax returns.



The Tax Court disagreed with the IRS’ public policy contention and let the estate increase its charitable deduction for the increase in value passed directly to the foundation. The court rejected the IRS’ contention that Christiansen was analogous to Procter. In contrast, the adjustment phrase in Christiansen did not undo a transfer, the court said; it merely reallocated the value of the property between Hamilton and the charitable foundation. Besides, Judge Mark V. Holmes wrote in the court’s opinion, “We are hard pressed to find any fundamental public policy against making gifts to charity—if anything the opposite is true.”


On appeal, the IRS again tried to get the value-adjustment clause voided, claiming it was contrary to public policy. The Eighth Circuit, however, rejected the IRS’ arguments and affirmed the Tax Court’s decision. The appeals court listed three reasons that the value-adjustment clause was not void as a matter of public policy: (1) The IRS’ role is to enforce tax laws, not just maximize tax receipts, (2) there is no clear congressional intent of a policy to maximize tax collections by providing an incentive to audit (but there is a congressional policy favoring gifts to charity), and (3) other mechanisms exist to ensure values are accurately reported.



The petitioner in Petter, Anne Petter, inherited a substantial amount of stock in United Parcel Service of America Inc. (UPS) before the company went public. After holding the UPS stock for 16 years, Petter retained an estate planner to help put her estate in order. She wanted the plan to accomplish two objectives: (1) provide a comfortable life for her children and their children and (2) contribute the remainder to two charitable foundations. To accomplish these objectives without exceeding Petter’s remaining lifetime gift exclusion, her estate planner developed a plan that included a complex formula for allocating the property’s total value among the donees.


To implement this plan, Petter first transferred her stock investments (primarily the UPS stock) to a family-owned LLC. Second, she transferred the LLC units in a part sale/part gift arrangement to family trusts created for the benefit of her children and grandchildren. Last, Petter donated LLC units to the two charitable foundations. The estate planner obtained a formal appraisal of the property and used the allocation formula to allocate LLC units among the donees.


The transfer documents stipulated that the property value exceeding that transferred to the family trusts should be transferred by gift to the charitable foundation. The value and quantity of each donee’s gift was determined by the formula provided in the transfer document. The transfer documents defined the value of the LLC units as the value finally determined for federal gift tax purposes. Petter timely filed her gift tax return and included the appropriate documentation. The IRS subsequently audited the gift return and concluded that the value established by the appraiser was too low. Petter agreed to the IRS’ proposed adjustment to the value of the property but opposed the IRS’ disallowance of a corresponding increase in the charitable deduction. The IRS once again relied on Procter to argue that the defined-value clause was void as a matter of public policy.



The Tax Court rejected the IRS’ public policy arguments and held for Petter, based upon the reasoning of the court in Christiansen. It again struck down the IRS’ contention that using formula clauses to achieve a donor’s transfer objectives leaves the public unprotected from inaccurate estate values. The opinion, again by Holmes, further stated that the fiduciary responsibilities of transferors and the policing responsibilities of state agencies and the IRS already provide sufficient safeguards to protect charities from inaccurately low values and to enforce tax laws.



These decisions are important victories for taxpayers and estate planners since they encourage the use of formula clauses to effect charitable lid strategies. CPAs should inform wealthy clients who want to leave their estates to a combination of individuals and charitable organizations about the significant reduction in transfer taxes that formula clauses and value-adjustment clauses can produce.


Some “best practices” that may be helpful in reducing the risks related to the use of charitable lid techniques are provided in Exhibit 2.



Exhibit 2: Best Practices From the Opinion in Petter

  • Ensure that charities are not just passively enabling the donor to reduce transfer taxes. The following practices were noted in Petter:
  • Engage in arm’s-length transactions with the charities.
  • Involve the charities in the planning process so that they are in a position to protect their interests.
  • Allow the charities to receive ownership rights rather than mere assignees’ rights, so that both the LLC managers and the family trust have fiduciary duties to the charities.
  • Give the charities an ascertainable dollar amount rather than a specified number of units or a percentage of ownership in the LLC.
  • Use a professional appraisal for allocating the initial transfer under the formula clause.
  • Fully disclose the gift/sale transactions on the gift tax return. For example, Petter’s disclosures included the following items:
    • Formula clauses included in the transfer documents
    • Spreadsheet showing the family LLC unit allocation
    • Organizing documents of the LLC
    • Trust agreements
    • Letters of intent provided to foundations
    • Annual financial statements
    • The appraisal report
  • Consistently describe the donations used to establish charitable gifts (in this case, to donor-advised funds) as formula transfers.
  • Provide for or discuss mechanisms available to enforce the valuation determination in the transfer documents (that is, advise parties of fiduciary duties).




The Tax Court’s acceptance of formula and value-adjustment clauses used in Petter and Christiansen could eventually prompt the IRS to agree with Judge Holmes’ conclusion in Petter that “formula clauses are fine.” Until the IRS reaches this point, however, CPAs can add value for their clients by explaining the risks, costs and benefits of using formula clauses to put a lid on transfer taxes.





  The IRS has opposed “charitable lid” strategies to limit estate and gift taxes, but recent taxpayer victories in the Tax Court and Eighth Circuit Court of Appeals have opened a door for CPAs to at least explore them with clients in their estate plans.


  Defined-value clauses (also known as formula clauses) put a lid on taxes by expressing a gift by reference to a tax exclusion amount. Value-adjustment clauses designate a fair market value of a gift as it is “finally determined” for transfer taxes, ensuring that it will remain constant even if the valuation of underlying units changes as a result of an examination or other development.


  A partial disclaimer by a noncharitable beneficiary of an interest in excess of a stated amount, with that excess going to a charitable beneficiary, accomplished a similar result in Estate of Christiansen v. Commissioner (130 TC 1, aff’d, 8th Cir. (2009)).


  In Estate of Petter v. Commissioner (TC Memo 2009-280), the donor allocated gifts among charitable and noncharitable donees with defined-value clauses that were upheld by the Tax Court. The court’s opinion provides some indications of best practices to follow in such plans that could lessen the likelihood that they will be successfully challenged by the IRS.


Wayne E. Nix ( is an assistant professor of accounting at Jackson State University in Jackson, Miss.; Lee G. Knight ( is a professor of accountancy at Wake Forest University in Winston-Salem, N.C.; and Ray A. Knight ( is managing director of Capstone Planning Alliance LLC in Winston-Salem, N.C.


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