5th Circuit of Appeals Upholds Ruling in Nelson v. IRS

5th Circuit of Appeals Upholds Ruling in Nelson v. IRS

Appellate Court upholds that a farmer can’t take back the cows.

December 21, 2021

Following the U.S. Tax Court's decision in the case of James C. Nelson & Mary P. Nelson v. Commissioner of the Internal Revenue (T.C. Memo 2020-81), we covered a plethora of valuation issues, including the appropriate valuation methodology for Warren Equipment as well as the appropriate consideration of dual level discounts for valuing a minority interest in Longspar Partners, Ltd., which held the interest in Warren Equipment. However, the brunt of the opinion tackled the hyper-relevant topic of how to properly structure and document a formula gift. Specifically, Judge Pugh found that the fixed-dollar amounts of certain gifts ($2.1 million made by the petitioners in December 2008) and a sale of Longspar interests ($20.0 million in January 2009), were in fact gifts and a sale of specific percentage interests. Accordingly, the size of the gifts/sale, in terms of percentage interests in the partnership could not be adjusted in audit to ensure the values of such transfers did not exceed $2.1 million and $20.0 million, respectively, as intended by petitioners. The 5th Circuit held that Judge Pugh got it right in the original Nelson case and here is why:

Breaking Down the Appellate Court's Decision

Most of the appeal court's analysis focused on the specific verbiage of the gift and sale document:

The Nelsons will be transferring right, title, and interest in a limited partner interest having a fair market value of TWO MILLION NINETY-SIX THOUSAND and NO/100THS DOLLARS as of December 31, 2008, as determined by a qualified appraiser within 90 days of the effective date of this agreement.

The appeals court found that the additional bolded language added expressly qualifies the definition of fair market value for the purpose of determining the interests transferred. This verbiage separates their agreement from the formula clauses considered in other cases that defined the interests transferred as the fair market value as determined for federal-gift or estate tax purposes (as in Petter1, Christiansen2, and Wandry3). Having the appraiser determine the fair market value at a set dollar value, converted to a set percentage, locks in that percentage without the possibility of change, even if the value changed.

Further, the gift/sale document lacked crucial language that described what would happen to any additional shares that were transferred upon successful challenge of the valuation. Some documents contain language that excess shares will go to charity and Wandry provided that the number of gifted units shall be adjusted so that the value of the number of units gifted to each person equals the amount set forth. The Nelsons' agreements contain no such language. Nothing in the agreements compels the trust to return excess units, or do anything with the excess units, should the valuation change.

Relying upon the colorful example provided by the government, if a farmer agrees to sell a number of cows worth $1,000 as determined by an appraiser, and the appraiser determines that five cows equal that stated value, then the sale is for five cows. If a later appraisal determines that each cow was worth more, and that too many cows were included in the deal, nothing in the agreement would allow the farmer to take any cows back.

As stated in our previous write up of the original case, the devil is in the details when it comes to the proper drafting of the gift/sale document.

  1. Estate of Petter v. Commissioner of Internal Revenue, T.C. Memo. 2009-280.
  2. Estate of Christiansen v. Commissioner of Internal Revenue, T.C.
  3. Dean Wandry v. Commissioner of Internal Revenue, T.C. Memo. 2012-88.