EState Y. Petter v. Comm'r of Internal Revenue

• Decision Date: 04 August 2011
• Docket Number: No. 10–71854.,10–71854.
• Citation: 653 F.3d 1012,108 A.F.T.R.2d 2011,2011 USTC P 60623,2011 Daily Journal D.A.R. 11779,11 Cal. Daily Op. Serv. 9838
• Parties: ESTATE OF Anne Y. PETTER, deceased; Terrence D. Petter, personal representative, Petitioners–Appellees,v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

653 F.3d 1012

108 A.F.T.R.2d 2011-5593

2011-2 USTC P 60,623

11 Cal. Daily Op. Serv. 9838

2011 Daily Journal D.A.R. 11,779

ESTATE OF Anne Y. PETTER, deceased; Terrence D. Petter, personal representative, Petitioners–Appellees,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellant.

No. 10–71854.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted June 14, 2011.Filed Aug. 4, 2011.

Jonathan S. Cohen and Andrew M. Weiner (argued), Department of Justice, Washington, D.C., for the respondent-appellant.John W. Porter (argued), Kerri D. Brown, and Jeffrey D. Watters, Jr., Baker Botts L.L.P., Houston, TX, for the petitioners-appellees.Appeal from a Decision of the United States Tax Court. Tax Ct. No. 25950–06.Before: DIARMUID F. O'SCANNLAIN, FERDINAND F. FERNANDEZ, and JAY S. BYBEE, Circuit Judges.

OPINION

BYBEE, Circuit Judge:

Anne Y. Petter (“Taxpayer” or “Anne”) transferred membership units in a family-owned LLC partly as a gift and partly by sale to two trusts and coupled the transfers with simultaneous gifts of LLC units to two charitable foundations. The transfer documents include both a dollar formula clause—which assigns to the trusts a number of LLC units worth a specified dollar amount and assigns the remainder of the units to the foundations—and a reallocation clause—which obligates the trusts to transfer additional units to the foundations if the value of the units the trusts initially receive is finally determined for federal gift tax purposes to exceed the specified dollar amount. Based on an initial appraisal of the LLC units, each foundation received a particular number of units. But after an Internal Revenue Service (“IRS”) audit determined that the units had been undervalued, the foundations discovered they would receive additional units. Everyone agrees that the Taxpayer is entitled to a charitable deduction equal to the value of the units the foundations initially received. But is the Taxpayer also entitled to a charitable deduction equal to the value of the additional units the foundations will receive? The Tax Court answered that she was. We agree.

I

After inheriting a large amount of United Parcel Service (“UPS”) stock, Anne devised a complex estate plan designed to give some of her wealth to charity and as much of her stock as she could to two of her children, Donna and Terry, without having to pay gift tax. To accomplish these goals, the Taxpayer first created the Petter Family LLC (“PFLLC”), a Washington limited liability company, and transferred approximately $22.6 million worth of UPS stock to it in exchange for membership units in the PFLLC. Then, the Taxpayer created the Donna K. Moreland 2001 Long Term Trust, which named Donna as trustee, and the Terrence D. Petter 2001 Long Term Trust, which named Terry as trustee, and transferred PFLLC units to these two trusts.¹ This appeal centers around these latter transfers, which are discussed in more detail below.

Because Anne did not want to pay gift tax in connection with the transfer of LLC units to the trusts, the transfers were coupled with simultaneous donations of units to two tax-exempt public charities ² and occurred in two phases: first a gift, then a sale. On March 22, 2002, the Taxpayer gave the trusts PFLLC units equal in value to the unused portion of her unified tax exemption.³ On the advice of her estate planner, Richard LeMaster, these units served as a baseline that limited the amount of units later sold to the trusts; specifically, the units transferred as a gift were meant to make up 10% of the trusts' assets.⁴ On March 25, 2002, Anne sold the trusts additional PFLLC units that, when added to the units already transferred as a gift, were worth 90% of the trusts' assets.⁵ As consideration for the LLC units, each trust executed a 20–year promissory note, undertaking to pay $4,085,910 at 5.37% interest in quarterly installments of $83,476.30. The trusts have made regular quarterly payments since July 2002.

As regards the March 22 gifts, there were two sets of gift documents: one for Donna's trust, which named it and the Kitsap Community Foundation as transferees, and one for Terry's trust, which named it and the Seattle Foundation as transferees. The relevant sections of Terry's gift document—Recital C, the dollar formula clause (section 1.1), and the reallocation clauses (sections 1.2 and 1.3)—provide:

C. Transferor wishes to assign 940 Class T Membership Units in the Company (the “Units”) including all of the Transferor's right, title and interest in the economic, management and voting rights in the Units as a gift to the Transferees.

....

1.1 Subject to the terms and conditions of this Agreement, Transferor:

1.1.1. assigns to the Trust as a gift the number of Units described in Recital C above that equals one-half the [maximum] dollar amount that can pass free of federal gift tax by reason of Transferor's applicable exclusion amount allowed by Code Section 2010(c). Transferor currently understands her unused applicable exclusion amount to be $907,820, so that the amount of this gift should be $453,910; and

1.1.2 assigns to The Seattle Foundation as a gift ... the difference between the total number of Units described in Recital C above and the number of Units assigned to the Trust in Section 1.1.1.

1.2 The Trust agrees that, if the value of the Units it initially receives is finally determined for federal gift tax purposes to exceed the amount described in Section 1.1.1, Trustee will, on behalf of the Trust and as a condition of the gift to it, transfer the excess Units to The Seattle Foundation as soon as practicable.

1.3 The Seattle Foundation agrees that, if the value of the Units the Trust initially receives is finally determined for federal gift tax purposes to be less than the amount described in Section 1.1.1, The Seattle Foundation will, as a condition of the gift to it, transfer the excess Units to the Trust as soon as practicable.

Donna's gift document substitutes Class D units for Class T units and the Kitsap Community Foundation for the Seattle Foundation, but is otherwise identical.

As regards the March 25 sales, there were also two sets of sale documents: one for Donna's trust, which named it and the Seattle Foundation as transferees, and one for Terry's trust, which named it and the Seattle Foundation as transferees. The relevant sections of Terry's sale document—Recital C, the dollar formula clause (section 1.1), and the reallocation clauses (sections 1.2 and 1.3)—provide:

C. Transferor wishes to assign 8,459 Class T Membership Units in the Company (the “Units”) including all of Transferor's right, title and interest in the economic, management and voting rights in the Units by sale to the Trust and as a gift to The Seattle Foundation.

....

1.1 Subject to the terms and conditions of this Agreement, Transferor:

1.1.1 assigns and sells to the Trust the number of Units described in Recital C above that equals a value of $4,085,190 as finally determined for federal gift tax purposes; and

1.1.2 assigns to The Seattle Foundation as a gift ... the difference between the total number of Units described in Recital C above and the number of Units assigned and sold to the Trust in Section 1.1.1.

1.2 The Trust agrees that, if the value of the Units it initially receives is finally determined to exceed $4,085,190, Trustee will, on behalf of the Trust and as a condition of the sale to it, transfer the excess Units to The Seattle Foundation as soon as practicable.

1.3 The Seattle Foundation agrees that, if the value of the Units the Trust initially receives is finally determined to be less than $4,085,190, The Seattle Foundation will, as a condition of the gift to it, transfer the excess units to the Trust as soon as practicable.

Donna's sale document substitutes Class D units for Class T units, but is otherwise identical.

Shortly after these documents were executed, LeMaster requested that Moss Adams Advisory Services, a Seattle valuation firm, determine the fair market value of the membership units as of the transfer dates. Moss Adams concluded that the fair market value was $536.20 per unit. Based on this appraisal, the Kitsap Community Foundation received 93.47 units, the Seattle Foundation received 1773.91 units, and Terry's and Donna's trusts each received 8465.31 units.

The Taxpayer filed a Form 709 gift tax return for 2002, which reported no gift tax liability as a result of the transfers. The return listed gifts of $453,910 each to Donna's trust and Terry's trust; gifts worth $50,128, $450,618, and $450,618 to the Seattle Foundation; and a gift worth $50,128 to the Kitsap Community Foundation. Along with her return, Anne included a disclosure statement and supporting documents detailing the nature of the gifts as transfers of LLC units subject to defined-value allocations and reallocations “if the value of the ... Units transferred was later finally determined for federal gift tax purposes to differ from the estimated value as determined by the Moss Adams appraisal.” The Taxpayer further disclosed that “the value of the limited liability company [as reflected in the Moss Adams appraisal] is based on the fair market value of the underlying assets with a 46% nonmarketability discount and a 13.3% net asset value adjustment applied.”

The IRS audited the return in 2005 and concluded that the LLC units had been undervalued. Specifically, the IRS determined that the correct value was $794.39 per unit. From the IRS's perspective, this higher valuation had two significant gift tax consequences. First, it meant that the Taxpayer had underreported the value of the units transferred as gifts to the trusts and, accordingly, that the Taxpayer's gifts exceeded the unused portion of her lifetime unified tax exemption. Second, it meant that the shares sold to the trusts were sold for “less than full and adequate consideration,” and thus were transferred partly by sale and partly by an...