A Valuator’s View: Abandoning the Wandry Clause Argument

On August 22, 2022, the IRS reached a settlement with taxpayers in Sorensen v. Commissioner,^[1] which had been in dispute since 2015. The disputed items included:

1. Use of Wandry defined value transfers^[2]
2. Use of an appraisal with a valuation date 90 days prior to the transfer date
3. Tax affecting
4. The use of rounding
5. Tax penalties and waiver for reasonable cause

Why Give Up on Wandry?

Much of the buzz about Sorenson has to do with the taxpayers abandoning the Wandry clause argument, which is a formula clause that defines the initial gift as something that is a fixed set of rights. This has led to questions as to whether anything was wrong with how the taxpayers’ attorneys drafted the defined value transfer clauses. It is likely that nothing was wrong with the drafting of the gift documents including Wandry clauses contained therein. Rather it appears giving up on Wandry made economic sense for these taxpayers.

For those unfamiliar with Sorenson, it’s the story of entrepreneurial brothers and Firehouse Subs. Chris and Robin Sorensen grew up in a firefighter family. They loved joining in communal meals at the firehouse, and Robin decided at an early age that one day he would open a restaurant. Eventually, the brothers scrounged together $28,000 in loans from family members and in 1994 began the first of a sandwich empire. At their first sandwich shop, they had only one employee and family volunteers to work at the sub shop. Their single sandwich shop eventually turned into thousands of Firehouse Subs franchises across the country.

By 2014, the Firehouse Restaurant Group, Inc. (FRG), a Florida corporation that elected to be a subchapter S corporation for federal income tax purposes, owned 27 restaurants, had 823 franchisees, and had over $550 million of sales restaurant wide. In late 2014 the brothers decided to make gifts to take advantage of the then $5.34 million gift exclusion amount for fear that the gift exclusion might be reduced in the future. On December 31, 2014, each brother created a trust and made a gift to the trust of the precise number of nonvoting shares of FRG stock having a value of $5,000,000 as finally determined for federal gift tax purposes.

An appraisal valued the nonvoting shares at $532.79 per share as of December 31, 2014, and $5.0 million worth of shares was 9,384.56 shares. The attorney recommended transferring that amount exactly, but the parties rounded the number of initially transferred shares to 9,385, which represented about 30 percent of each brother’s nonvoting shares. This rounding of the shares became one of the major arguments by the IRS.

As found in the PTM, the IRS argued that the brothers failed to follow their own transfer clauses which stated that a precise number of shares would be transferred with a value equal to $5,000,000. But, due to the rounding, each brother transferred 9,385 nonvoting shares-not the 9,384.56 shares as mentioned above. The rounding created a valuation differential of just $234.15. During his presentation, Steve Akers expressed his surprise that the IRS made such an issue of such a small amount. According to Stephanie Loomis-Price and Bo Trudeau in the ABA Webinar, however, the nature of the IRS argument was a serious issue during the settlement negotiations.

The brothers later decided they wanted to transfer a total of approximately 50 percent of the FRG appraised value based on their received appraisal and on March 31, 2015, each brother sold 5,365 nonvoting shares in exchange for a $2,858,418 secured promissory note from their respective trusts (using the $532.79 per share value in the appraisal as of December 31, 2014).

The 2015 gift tax returns did not report the sale of shares as a non-gift transaction. The sales were not Wandry defined value transfers.

Of course, the IRS selected the 2014 gift tax returns for IRS audit. In the 2014 gift tax audit, the IRS’s expert appraised the shares at $2,076.86 per share—almost 400% higher! The amount of 2014 gift tax in dispute for each brother was about $8.95 million. The IRS expert also valued one nonvoting share of FRG at $2,228.62 (rounded) as of March 31, 2015. This created a $4.62 million dispute for 2015, totaling about $13.57 million in dispute with the IRS for both years. In addition, penalties in dispute for each brother were about $3.58 million for 2014 and $1.85 million for 2015, totaling $5.43 million in penalties.

Behind the Scenes: What Happened?

Much of what happened in the settlement negotiations between the IRS and the taxpayers is not a matter of public record and therefore, no elaboration of the details are available, nor can they be disclosed by those who were there. The IRS’s PTM, however, outlines much of the IRS’ arguments and case. The PTM also included a detailed description of the valuation differences between the IRS’s valuation expert (RE) and the taxpayers’ valuation expert (TE). Would this have been a battle of the experts at trial, we’ll never know but would have been quite interesting testimony to justify such vastly different valuations.

From the PTM we learn that the TE and the RE used the Income Approach and the Market Approach to determine value. RE’s Opening Report differs from TE’s Return Appraisal’s income approach as follows: 1) RE did not reduce FRG’s projected net cash flows by a theoretical corporate income tax because FRG, as an S corp, pays no income tax at the corporate level (i.e., RE did not tax affect); and 2) RE’s cost of capital was 13.14% as opposed to TE’s 26.00%.

RE’s Opening Report differs from TE’s Return Appraisal’s market approach as follows: 1) RE stated that no true comparable exists, and thus used 23 companies as opposed to TE’s 7 companies; 2) RE did not apply a size adjustment factor to his comparable companies as opposed to the 60% size adjustment factor TE applied to its comparable companies; and 3) RE used Revenues, Earnings Before Income Taxes, Depreciation, and Amortization (EBITDA), and Earnings Before Interest and Taxes (EBIT) as valuation multiples, as opposed to TE’s Return Appraisal’s use of only Revenues and EBITDA.

Interestingly, no discussion about valuation discounts was found in the PTM. It may be that the valuation experts, given their valuation methodology choices, did not apply minority interest discounts and that their discounts for lack of marketability were not too far apart.

At the time that each brother transferred 9,385 nonvoting shares to his trust on December 31, 2014, 9,385 shares equaled 10.4278% of the outstanding shares of FRG. The IRS was able to show that a shareholder holding a 10.4278% interest in FRG would have received $9,951,034.90 in aggregate distributions over the previous six years. That amount is almost twice TE’s Return Appraisal’s valuation for those same 9,385 nonvoting shares, which TE valued at $5,000,234.15 (The IRS cited this unrounded figure to illustrate that what was transferred was not “precisely” the $5,000,000 in value as the transfer documents called for.)

The IRS Holds Firm

Even though the settlement talks extended beyond the 2019 Estate of Jones v. Commissioner case (in which tax affecting was accepted by the Tax Court), the IRS did not change its stance on tax affecting during the settlement negotiations.

The IRS also made much of the fact that the taxpayers’ March 31, 2015 sale transaction used the same valuation as had been used for the December 31, 2014 gift. Besides being a “stale” number, the RE was apparently fairly convincing that the FRG stock price appreciated during that quarter.

Although this has never been confirmed, it seems clear that the taxpayers and their advisors realized that their valuation may not hold and that, based on the Wandry formula transfer, a significant amount (well over 50%) of the shares designed to go into the trusts were to be “readjusted” between the donee and donor.

The IRS strongly objected to this language stating that there was conclusive evidence that the 9,385 shares had been irrevocably transferred. The donee cannot give back the shares without creating their own gift. Here, the IRS cited the analogy of a farmer who has transferred cows to his son at a given value. The son breeds the cows and opens a barbeque stand. If a later gift tax examination finds that each cow was actually worth more, and that two extra cows had been included in the transfer, nothing in the agreement would allow the farmer to take the two cows back. They were sold as barbeque. Ms. Loomis-Price and Mr. Trudeau describe in the ABA Webinar why this analogy goes “a few steps too far” and may fall flat.

Getting Into the Weeds of the IRS Argument

For those interested in “getting into the weeds” of the IRS arguments against Wandry, the PTM is a must read. In addition, the Akers Presentation is an excellent commentary for gaining a better understanding of the points and counterpoints of the taxpayers’ and the IRS’ arguments and merits.

During the on-going settlement negotiations, on November 15, 2021, Restaurant Brands International, which also owns Burger King and Popeye’s announced that it had reached an agreement to acquire FRG (Firehouse Subs) for $1 billion in cash.

Reading between the lines it seems fairly obvious why Wandry no longer worked for the brothers and why abandoning the argument made economic sense for them. That is, if the taxpayers prevailed on Wandry, a significant amount of the transferred shares would be going back to the donors. The tax consequences of the $1 billion sale of the FRG shares would hit the brothers much harder than these shares remaining in the trust. Ms. Loomis-Price and Mr. Trudeau confirm this much in the ABA Webinar. Since the case was not tried and settlement negotiations are confidential there is no further information available.

Based on this, it would appear estate planners should not infer that Sorensen did anything to strengthen the IRS’ hand with regards to its non-acceptance of Wandry. Mr. Trudeau, in the ABA Webinar, expressed his optimism that, had this case gone to trial on the Wandry issue, the taxpayers would have prevailed.

In fact, he and Ms. Loomis-Price expressed that their clients were extremely reluctant to give up on the Wandry argument because doing so meant that a much larger number of shares remained in the trusts. Based on the 2021 sale for $1 billion (which no one foresaw in 2014), the trusts now held over $100 million in value. The taxpayers’ original intent was to put less than $10 million of value in each trust. Mr. Trudeau and Ms. Loomis-Price indicated what finally convinced their clients to accept the abandonment of Wandry was the fact that the trusts could make large discretionary charitable contributions.

In the settlement, the 10 percent negligence penalty under IRC Section 6662(a) was applied to the 2015 transaction but not the 2014 transaction. According to both the Akers Presentation and the ABA Webinar, this was likely the case for a couple of reasons. First, the fact that the 2015 transfer was not reported on a gift tax return was the source of considerable confusion (and, no doubt, frustration) for the IRS. Second, the sale price was based on an appraisal as of three months earlier and significant financial changes occurred during those three months. The stipulated per share value increased by 5 percent from December 31, 2014, to March 31, 2015, representing a 20 percent annualized increase.

Takeaways for Valuators

While most of the discussion about Sorensen has been and may always be about Wandry, there are some important valuation takeaways.

First, and most importantly, Sorensen vividly illustrates the need to use contemporaneous appraisals for estate and gift tax purposes. The IRS has often accepted the use of December 31 appraisals for a second transaction occurring on January 1 but stretching the applicability of this leeway to 90 days is not acceptable.

An updated appraisal should always be performed. The amount of work required to update a valuation opinion is commensurate with the time elapsed and what has transpired during the time gap. In many instances, a 90-day differential may result in very little difference in value. At times, however, a difference of just a few days can make a huge difference.

The second takeaway is that rounding in Wandry-style transactions is obviously a bad idea.

The conclusion of the taxpayers’ appraiser in 2014 looks overly aggressive and insupportable. Even if the taxpayers could have won the Wandry battle, the fact that the appraisal battle was lost was enough to nullify the intended effects of the taxpayers’ sophisticated estate planning. Nevertheless, given the huge amount of value transferred to the trusts and the comparatively small amount of taxes and penalties paid, Sorensen was a major victory for the taxpayers.

© 2024

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^[1]Sorensen v. Commissioner,Tax Ct. Dkt. Nos. 24797-18, 24798-18, 20284-19, 20285-19 (decision entered Aug. 22, 2022). The Sorenson case was settled by the parties prior to trial so many of these issues have not been determined by a court of competent jurisdiction. The issues raised by Sorensen are of great interest to those involved in estate planning whether it be from a tax, legal or valuation perspective. The author is a valuation professional and as such any tax and legal comments contained herein are solely for contextual and informational purposes. The information used for the author’s insights come from the following main sources: (i) 57th Annual Heckerling Institute On Estate Planning (University Of Miami School Of Law); Session titled “Recent Developments 2022”, Steve R. Akers discussed Sorensen in which he provided a detailed and insightful analysis of the facts and issues presented by the case (the “Akers Presentation”); (ii) Stephanie Lommis-Price and Robert “Bo” Trudeau. “Significance of Settling Sorensen: Wandry Warnings and Winnings.” American Bar Association. Available at: Significance of Settling Sorensen: Wandry Warnings and Winnings (the “ABA Webinar”). Bo Trudeau was the Sorensen family estate planning attorney for the matters discussed herein and Stephanie Loomis-Price was the lead attorney in the tax litigation with the IRS; (iii) Although both the IRS and the taxpayers filed pretrial memorandums, the pretrial memorandum referred to herein is the IRS’ June 24, 2022 pretrial memorandum (PTM).

^[2] Wandry v.Comm’r, T.C. Memo. 2012-88.