October 2008 Intrafamily Transfers of Interests in the Family Business: Gift, Compensation or Both?

By James A. Nitsche

James A. Nitsche examines whether intrafamily transfers of family business interests are gifts subject to gift tax only, compensatory transfers subject to income tax only or both.

Introduction This article considers whether transfers of business interests to the objects of the transferor’s bounty are (i) An important goal of the owners of any family busi- gifts subject to gift tax only, (ii) compensatory transfers ness is to transfer ownership of the business to the subject to income tax only, or (iii) gifts subject to gift tax younger generation in the most tax-effi cient manner. and compensatory transfers subject to income tax. A typicalpical methodmethm of accomplishing this goal is to haveave thethe seniorsenior generation make pperiodic transfers Background offif iinterestsnterrests in the businessiness tot the membersmembers of the youngerounger generation.generaatio Inn tthe usualua case, such tratransfers The present federal income tax was adopted follow- arere mamadede foforor nnoo coconsideration,ideration, with gift tax rreturns ing the passage of the 16th Amendment in 1913,1 beingng fi ledlldbed bothbbthh tooa acknowledgeo led liabilityliabil tf for and limit while the gift tax was enacted in 1924,2 repealed exposure to the gift tax, with no apparent thought of in 19263 and reenacted in 1932.4 While a principal the potential income tax coconsequences.equencces. SShouldhould thee reasoneason for the giftgift taxtax wasas toto serveserve asas a “backstop”backstop tax consequences of suchuch transfersnsfer dedependpend upuponpon foror ththee incomeincome tax (and(a the estatees ate tax),tax),5 oneonet taxax is whether the recipient plays no role in the business or not dependent on the other and the repeal of one is an active participant? What if the recipient is active would have no effect on the applicability of the other. in the business, and is fully and fairly compensated For purposes of the gift tax, whether a gift has been for services rendered in the business? Should that pre- made is determined by reference to whether property vent the fair market value of the property from being has been transferred for less than adequate and full included in the recipient’s income, as compensation consideration in money or money’s worth.6 It was ob- or otherwise? Conversely, does that necessarily estab- served many years ago that Congress intended to use lish that the transfer is subject to the gift tax? What the term “gift” in its broadest and most comprehen- if the recipient is active in the business, but receives sive sense for gift tax purposes, with donative intent minimal or no cash compensation? being largely irrelevant.7 Meanwhile, for income tax purposes, a transfer of property for less than suffi cient consideration is excludable from the gross income James A. Nitsche, J.D., LL.M., is a member of the Louisville, Kentucky offi ce of Wyatt, Tarrant & Combs, LLP’s Tax, Busi- of the recipient as a gift only if the transfer is made 8 ness and Personal Planning Service Team. He concentrates his out of “detached and disinterested generosity.” Thus, practice in federal, state and local tax matters, including the donative intent is essential for a seemingly gratuitous taxation of business entities and transactions. transfer to be excludable for income tax purposes. In a

©2008 J.A. Nitsche TAXES—THE TAX MAGAZINE® 19 Intrafamily Transfers of Interests in the Family Business

nutshell, this may be the sum and substance of it: The do not invoke the gift tax, regardless of any shortfall term “gift” is broadly construed for gift tax purposes in the consideration received in the transaction. Does and narrowly construed for income tax purposes. the parents’ transfer of the car to the child in the busi- In the typical case involving an intrafamily transfer ness context get the same treatment? of property outside the business context, only the gift tax will apply under traditional tax principles. Illustrative Cases Consider the situation in which the parents present the child with a $30,000 automobile in recognition A host of cases involving intrafamily transfers of inter- of the child’s graduation from college. From the ests in business entities have found that the transfers parents’ perspective, the transfer constitutes a gift were subject to gift tax only. For the most part, the under Code Sec. 2512(b), since the transfer is for cases discussed in the following paragraphs looked at less than adequate and full consideration in money the tax consequences of the transfers solely from the or money’s worth. On the other hand, the value of perspective of the transferors, and so did not address the car should be excludable from the child’s gross the recipients’ income tax consequences. income under Code Sec. 102(a), on the theory that One such case is W.H. Gross.10 There, the taxpayer the car was received by the child as a result of the (H) and his wife (W) formed a partnership with their parents’ detached and disinterested generosity. daughter (D) and son-in-law (S) in 1942. The partner- The result may be quite different where property ship was funded solely with assets provided by H and is transferred to a family member in a business set- W, while profi ts were to be shared 60 percent (H), ting. For example, suppose the car in the preceding 20 percent (W), 10 percent (D) and 10 percent (S). example is transferred to the child for a job well done The assets included a trade name and the formula in working for the family business. Can it be said for a then-popular soap. The partnership agreement that the car was given to the child out of detached required each partner to devote his or her time to and disinterested generosity so as to permit the child the partnership’s business. On liquidation, the net to exclude the value of the car from gross income assets of the partnership were to be distributed, fi rst, underer CodeC e SeSec. 102(a)? Viewed from the parents’ to H and W in the amount of their unreturned capital side,dee, iiss ggifgiftift ttaxax avoaavoided on the ground that the transfer contributions, and second, to the partners in propor- wassmas mamadeade ffor adadea adequatete consconsiderationderatio in momoney or tion to their profi t-sharing ratios. monmoney’sney’s wworth?oorth?? A year after the partnership was formed, the IRS ThThehe regulationsregulationo s containc ntain an importantimpor ant exceptionexc determined that H and W had made taxable gifts to D to thetheh generalgenerale l giftftt tax t rulesles in i the case ca offt transfers and S. Before the Tax Court, the parties stipulated that, made in everyday business transactions. According if gifts were made, the value of each was $56,500. to the regulations, sales, exchangesexc ngges oror otherother transferstrans ers H anandd W argueda d thatthat no giftgif hadhad beenbeen made,made, citingc tin of property made in the ordordinaryry cocourserse of bubusiness,sinees , thehe fafactac thathatt the parpartnershipn hip agreagreementeement hhadad rreservedeserve that is, transfers that are bona fi de, at arm’s length to them all of the capital they had contributed to the and without any donative intent, are deemed to have partnership. The court determined, however, that, be- been made for an adequate and full consideration cause the assets contributed to the partnership were in money or money’s worth.9 For example, suppose likely to create substantial earnings, it necessarily a fl edgling but promising business needs capital to followed that a gift had been made to D and S to the achieve its potential. Unable to obtain conventional extent the earnings allocated to them exceeded the fi nancing, the business secures the necessary funds value of the services they provided to the partnership. via a loan or capital contribution from a venture D and S presumably included in their gross incomes capital fi rm. As a condition to making the advance, the value of what they received in exchange for their the venture capitalist is granted warrants to acquire services. In any event, to the extent D and S received an additional stake in the business, at a price that is something in excess of reasonable compensation for without question below fair market value (i.e., the their services, the excess was deemed a taxable gift. warrants are “in the money”). No one would suggest No mention was made of whether D and S realized that the business made a gift by issuing the warrants gross income on the receipt of such excess. for less than their objective worth, as the issuance of An argument can be made that, under the facts the warrants was bona fi de, at arm’s length and free of presented by Gross, irrespective of the transferors’ gift donative intent. Thus, genuine business transactions tax consequences stemming from the transfer of the 20 October 2008 excess, the receipt of the excess should be includible formed a partnership in 1955, with each holding a in the gross income of the recipient pursuant to Code 1/3 interest. The partnership was formed to acquire Sec. 61(a)’s mandate that gross income includes all and hold timberland, timber rights and other prop- income from whatever source derived. Whether that erties. When the father died in 1958, his widow excess is taxable as compensation under the circum- succeeded to his interest. On January 1, 1973, the stances or represents some other type of income, ownership of the partnership’s outstanding interests it is beyond debate that such excess constitutes an was revised. In the revision, the mother transferred “accession to wealth” under Eisner v. Macomber. 11 her interest in the partnership to her sons in exchange The only apparent defense to income inclusion is that for promissory notes. At the same time, the boys’ sis- the excess was excludable ter, who had never been as a gift under Code Sec. An important goal of the owners active in the business of 102(a) as having been the partnership, received transferred out of detached of any family business is to transfer a 1/9 interest for no con- and disinterested generos- ownership of the business to the sideration. As a result, the ity. In that regard, Code younger generation in the most tax- brothers each held a 4/9 Sec. 102(c)(1), which was interest and the sister a enacted in 1986,12 ex- effi cient manner. 1/9 interest. pressly provides that, with When the transaction limited exceptions for employee achievement awards came before the Tax Court, the taxpayers claimed and de minimis fringe benefi ts, Code Sec. 102(a) shall that the 1973 transfers were made in the ordinary not apply to exclude from gross income any amount course of business and so were exempt from gift tax, transferred by or for an employer to, or for the benefi t even if the value of the transferred interests exceeded of, an employee. the face amounts of the notes given in exchange for The Gross case was decided many years prior to the them. In addressing the taxpayers’ position, the court 1969 enactment of Code Sec. 83.13 If the facts presented acknowledged that the gift tax regulations exempt by Grossrossss wereweere ppresented today, the IRS might assert that sales, exchanges and other transfers in the ordinary thee excessexcess was receivedr byy D and S “in connection course of business on the basis that such transac- withh the e performance perrformmaman off services”servic s” by themth m and wasw not tions are deemed made for an adequate and full byy vvirtueirtue ooff CodCodede Sec. 1102(c)(1)) otherwiseise exclexcludable consideration in money or money’s worth. The court ass a gift.giftt. Thus,Thus, underunu de thathat theory,theory, D andan S wouldwoul have noted, however, that transactions within a family compensationmpennsatiionii incomei com equalqalt to suchsche excess. group are subject to special scrutiny, the presump- In J.B. Hitchon Est.,14 a father (F) owned 1,509 tion being that a transfer between family members shares of the stock of a cocorporation.oration FsF’s tthreehree sosons,ons, iss a gift.i . NNotingoting the prpresenceence of tatax planninglanningg bbyy ththe each of whom was employedplo by thehe ccorporation,o porat o , family’sami y sac accountantcountan and theeab absencesenceof of anyya arm’s-rm’ owned one share apiece. F caused the corporation length negotiation, the court held that the mother to redeem 1,508 of his shares for no consideration. had made a gift to the sons to the extent the value The Tax Court concluded that F had made a gift to of the transferred interests exceeded the value of the each son equal to 25 percent of the fair market value notes she received in the transaction. The court also of the corporation on the date of transfer. determined that the transfer of the 1/9 interest to the Hitchon did not address the sons’ income tax daughter was a taxable gift for gift tax purposes. Even consequences. Since gross income includes any ac- though the case involved tax years to which Code cession to wealth, it follows that the sons realized Sec. 83 applied, the case did not address the income taxable income when F relinquished an interest in the tax consequences of the transfers to the children. family corporation in their favor, unless the transfers M.D. Anderson Est.,16 another pre-Code Sec. 83 were excludable under Code Sec. 102(a). Also, if the case, saw the application of the gift tax ordinary ordinary course of business exception to the gift tax course of business exception. There, the senior ex- applies in the family contest, why would that excep- ecutives of a closely held corporation sold shares tion not apply in this circumstance? of stock to certain junior executives, none of whom The gift tax consequences of another intrafamily were related to the transferors, for less than fair mar- transfer of partnership interests were at issue in V.Z. ket value. The transfers were made for the purpose of Harwood.15 In that case, a father and his two sons perpetuating the success of the business and transi-

TAXES—THE TAX MAGAZINE® 21 Intrafamily Transfers of Interests in the Family Business

tioning management to the key younger executives. gifts to Driggers, and the fact that the taxpayer did The transferred shares represented approximately 30 not agree to make the transfers in question as part percent of the corporation’s outstanding stock. of the parties’ business relationship, the court con- Before the Tax Court, the IRS conceded that the cluded that the transfers in question were gifts and sales to the junior executives were bona fi de and at not transfers made in the ordinary course of business. arm’s length, but contended they were not made in No mention was made of the transfers’ income tax the corporation’s ordinary course of business, that consequences to Driggers. the value of the stock transferred exceeded the value of the consideration received, and that the excess Rev. Rul. 80-196 represented a taxable gift. The taxpayers argued that, while donative intent is not a necessary element of a In Williams, the taxpayer cited Rev. Rul. 80-19618 gift for gift tax purposes, the absence of donative intent in support of its argument that the transfers to Drig- is strong evidence that a transfer is exempt from gift gers were not gifts but were transfers in the ordinary tax as being made in the ordinary course of business course of business. In that revenue ruling, a corpo- under the applicable regulations. The Tax Court agreed ration had two equal shareholders. To encourage with the taxpayers, fi nding that the stock transfers were certain of the corporation’s younger key employees genuine business transactions. The opinion gave no to remain in the corporation’s employ, each of the indication of the federal income tax consequences shareholders transferred shares of stock to the key of the below-market sales. Query whether the result employees for no consideration. The ruling stipulated would have been the same had the transferors and the that none of the parties were related to one another transferees been members of the same family. or otherwise had a special relationship other than a In E.B. Williams Est.,17 the issue was whether cer- business one. The ruling held that the transfers were tain transfers of interests in timberland were gifts, as not gifts but were made in the ordinary course of contended by the IRS, or compensation for services, business, with the result that no gift tax was due on as contended by the taxpayer. The taxpayer and the the transfers. The transferees were considered to have recipientpiennt off the timberland (Driggers) were unrelated realized gross income to the extent of the value of the exceptxceept forfor thetthhfe factfaf that Driggersg was married to the stock received in accordance with Code Sec. 83.19 taxpayer’saxppayeer’ s niece.nieccece. Nevertheless,verthel ss, theythe had a long- The Williams court rejected the taxpayer’s argument, standing,tannding, closec e personalp on relationship,ati p, particularlypartic due to the strong personal relationship between the afterfter thethe deathdeath ofof thet taxpayer’staxpayer’s husbandhusband in 1962. taxpayer and Driggers. Theyy alsoalslso hadhahadd a signifign cantnt bbusinessess rerelationship,ti hi and the decedentd hired Driggers to manage and exploit Rev.Revv Rul. 81-1866 the decedent’s timberlandnd alongong withwith somesome of thee decedent’s other businessss assets. a s. Rev. Rul.Rul. 81-1861-18620 shoulds ld bbe contrasted con rasted withw th Rev.Re In 1980, the taxpayer transferred an undivided half Rul. 80-196. In the 1981 ruling, A owned all 99 interest in approximately 2,000 acres of timberland shares of a corporation, X. X’s offi cers included B, C to Driggers for no consideration. The deed of transfer and D. D was A’s brother-in-law, while B and C had stated that the transfer was made in consideration of no familial or other special relationship to A. As part love and affection. In 1983, the taxpayer transferred to of a plan to retire from the business, A gave equal Driggers for $10 an undivided half interest in property shares of A’s X stock to B, C and D. It was stipulated worth $50,000. In 1987, the taxpayer gave Driggers without explanation that A’s transfers of the shares to $10,000 as an “advancement on inheritance.” When B, C and D were subject to gift tax and did not result she died, the taxpayer left most of her estate to Drig- in any amount being included in the income of B, C gers. No gift tax returns were fi led with respect to the or D, “since the transfers were motivated solely by 1980 and 1983 transfers. A’s donative intent and were not in consideration of Before the Tax Court, the IRS claimed that the 1980 either past or future services.” and 1983 transfers were taxable gifts. The taxpayer’s On what grounds can Rev. Rul. 80-196 and Rev. Rul. estate claimed that the transfers were exempt from 81-186—issued within two years of one another—be gift tax as having been made in the ordinary course distinguished? The rulings present essentially the same of business. Largely in reliance upon the parties’ close facts and rationale: retiring owners desiring to pass personal relationship, the taxpayer’s history of making ownership of the business to a younger generation of 22 October 2008 persons active in the business. Clearly the transfers ployees. It was represented that bonuses, if any, to in each ruling were motivated by business concerns. be paid to A’s sons would not be the highest in dollar Yet, Rev. Rul. 80-196 found no gifts by the transferors amounts or disproportionate to bonuses to be paid and compensation income to the transferees, while to other employees performing comparable work for Rev. Rul. 81-186 found just the opposite. C. To encourage participating current employees to remain with C following the sale, such employees Rev. Rul. 77-293 would receive their bonuses on reaching age 62. While not receivable until age 62, the bonuses would Rev. Rul. 77-29321 illustrates the typical situation be funded by annuities purchased at the time C was involving an intrafamily transfer of the ownership sold. Retired bonus plan participants were to get their of a family business. There, A owned all 100 shares bonuses at the time C was sold. of the outstanding stock of X, a corporation. A was A requested rulings that (i) the bonuses would president of X, and A’s son, B, had been employed be taxable to the employees in the year received by X for many years as an offi cer. As part of A’s plan and (ii) the bonuses would not be subject to gift to retire from the business, A gave B 60 shares of X tax. As to the fi rst requested ruling, it was held that stock “as a gift, and not as consideration for past, the bonuses would be taxable upon the earlier present, or future services.” Immediately thereafter, of (i) the time they were received (in the case of X redeemed A’s remaining 40 shares of X stock. The the retired plan participants) or (ii) the time the primary issue presented by the ruling was whether annuity contracts were purchased (in the case of the redemption of A’s 40 shares of X stock quali- plan participants for whom annuity contracts were fi ed for sale or exchange treatment as a complete purchased). Citing the ordinary course of business termination of interest under Code Sec. 302(b)(3). exception and Rev. Rul. 80-196, the ruling also held In concluding that the redemption so qualifi ed, the that the bonus payments would not trigger gift tax. ruling observed: The rulings were predicated on the theory that the bonuses, though not a legal obligation of C, were Here,ere,, thee ggift of stock by A was to B who is in recognition of past services to C. As in the case activeacctive andannddk knowledgeablekno in the affairs of the of Rev. Rul. 80-196, this private letter ruling can be businessbusinness of XXa anda who intendsintends to control and reconciled with Rev. Rul. 81-186 only on the bases managemanaagge thet corporationco at inn thet future.ure. The gift that (i) A, C’s sole shareholder, lacked donative in- waswas intendedintended ssolelyole y for the purpospurpose of enabenabling tent in establishing the bonus plan and (ii) donative AAt to retireretiirei whilewhileil leavinga ing thehe business b it to B. intent can exist only where the benefi ciaries of the (emphasish added). transferor owner’s largesse are few. The ruling made no refereferencece to CoCodede SSec.ec. 883.. TAMTAMM2 200014004000140 422 While it also did not discuss the gift tax consequences of A’s transfer to B, it must be inferred that A and B In 1988, the decedent (D) and his spouse (S) es- viewed the transfer as being subject to gift tax. tablished a revocable trust. D and S’s two children, X and Y, were named trustees. Upon D’s death in LTR 199928013 1988, D’s community share of the revocable trust was divided into two trusts, a credit shelter trust In this private letter ruling, A sought rulings concern- (Trust A) and a trust intended to qualify as qualifi ed ing the federal income and gift tax consequences terminable interest property (Trust B) under Code of proposed payments to various employees of C, a Sec. 2056(b)(7). During her life, S was the principal corporation. A owned 100 percent of C’s outstanding benefi ciary of Trust B. Upon S’s death, the corpus of stock. C had more than 100 employees, including A’s Trust B was to be distributed to Trust C, for the benefi t sons. C had never adopted a qualifi ed retirement plan of X and Y. During the period from 1991 through or stock-based compensation plan for its employees. 1997, X and Y were each paid trustee’s fees of [$w] When C’s sale became imminent, A decided it would per year, which were treated by D’s estate as salaries be appropriate to reward the loyalty of C’s long-time deductible under Code Sec. 162. The amounts of employees. To that end, A caused C to adopt a plan such salaries were agreed upon by S, X and Y after to pay bonuses to 62 of C’s current and former em- consulting a “trust attorney.”

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Upon examination of Trust B’s returns for 1994, Rev. Rul. 80-196, if not with Rev. Rul. 81-186. By 1995 and 1996, the examining agent determined the same token, the TAM shows that intrafamily that the trustees’ fees paid to X and Y were excessive transfers will be scrutinized closely for their tax and not fully deductible as ordinary and necessary consequences, and any transfer for insuffi cient trade or business expenses under Code Sec. 162. The consideration is likely to not meet the gift tax ordi- taxpayer argued that the fees were paid to X and Y to nary course of business exception and trigger gift manage not only Trust B, but other trusts that D and tax liability. S had established, and that the fees were reasonable under the circumstances. Duberstein23 When the question was presented to the National Offi ce, it was concluded that, to the extent the fees In a leading case involving payments made “in a were excessive, the excess represented gifts from S context with business overtones,” the Supreme Court to X and Y. In reaching this conclusion, the National defi ned an excludable gift for purposes of Code Sec. Offi ce observed: 102(a) as a payment made out of “detached and dis- interested generosity” rather than in return for past, The trustees’ fees were paid by agreement of present or future services or in anticipation of the [S] to her two children, the natural objects of receipt of a benefi t. According to the Court, under her bounty. There is no evidence of any arm’s this standard, transfers made in connection with length bargaining regarding the setting of the employment constitute gifts excludable from income fees, and little evidence of a good faith effort to only in rare circumstances. M. Duberstein, of course, determine the appropriate fee amount, at least preceded the 1986 enactment of Code Sec. 102(c)(1), on an ongoing basis. The income tax examiner which makes it even more diffi cult to exclude from has determined that there is a substantial dispar- gross income the value of any property received in ity between the fees paid and that which would the employment context. constitute a reasonable fee. Thus, there is no in- dicationcatiion thatt the setting of the trustees’ fees and Proposed Reg. §1.102-1(f)(2) ththehe ssubsequentuubbseequene payment should be viewed as a tratransactionansaactioon in nthn theth ordinarydinary courseourse ofof businessbusine ... Code Sec. 102(c)(1) provides that Code Sec. 102(a) [S[S’s]S’s] agreementaaggreeement to, andnd acquiescenceie e in, the pay- shall not apply to any amount transferred by or for mmentent ofof excessiveexcessis ve feeses effectivelyeffectively divertedd verted to her an employer to, or for the benefi t of, an employee. childrenhildrhhildren trusttttt incomenco she was otherwiseother it entitled This provision makes clear that, with the exception to receive.i We believe the facts (including the of employeep achievement awards under Code Sec. substantial disparity betweenetw en a reasonablereasonable fefeee 74(c)4(c andnd ddee mminimisinimis fringeringe bbenefien fi tss uundernder CCodeod and the fees actually paid)paid supportupport the the conclu-conclu- Sec.ec. 1132(e),32( ), aannem employeem yee cacannotnnot excexcludeludef fromrom sion that the excessive fees were intended by all gross income any amount transferred to, or for the the parties involved to facilitate [S’s] estate plan benefi t of, the employee by, or on behalf of the by transferring assets that would otherwise be employer on the ground that it is a gift. Thus, under subject to estate tax in [S’s] gross estate to [S’s] the express language of Code Sec. 102(c)(1), with children without the payment of transfer tax. the exceptions noted, no amount transferred by, or on behalf of, an individual’s employer is exclud- TAM 200014004 suggests that the IRS’s position able from gross income under Code Sec. 102(a). regarding intrafamily transfers is that a compensa- The statute does not carve out any exception for tory payment that is reasonable will (i) not expose intrafamily transfers. the transferor to gift tax liability and (ii) constitute In 1989, Proposed Reg. §1.102-1(f)(2) was adopted compensation income to the recipient. In other to address the application of Code Sec. 102(c)(1) to words, when a parent transfers property to a child intrafamily transfers.24 Now almost 20 years old, the for services rendered to the family business, no gift proposed regulation softens the mandate of Code tax liability results, as long as the fair market value Sec. 102(c)(1) in the case of transfers between family of the property does not exceed the reasonable members. According to the regulation, “extraordi- value of the services. Thus, even though it involved nary” transfers to the natural objects of the employer’s related parties, TAM 200014004 is consistent with bounty will not be considered transfers to, or for the 24 October 2008 benefi t of, an employee if the employee can show that the legislative history and statutory language that the transfer was not made in recognition of the compelled the conclusion that the phrase “in con- employee’s employment. Thus, says the regulation, nection with the performance of services” is to be Code Sec. 102(c)(1) does not apply to amounts given its broadest application. transferred between related parties if the purpose Based on Alves, a transfer of employer stock to of the transfer can be substantially attributed to the an employee, whether by the employer or by a familial relationship of the parties and not to the shareholder of the employer,26 should, except in circumstances of their employment. rare circumstances,27 be treated as having been According to the preamble to the proposed regula- made “in connection with the performance of tion, the Duberstein case will apply in determining services.” Under Alves, the relationship between whether property transferred from an employer to the transferor and the transferee should have no an employee constitutes a gift for income tax pur- bearing on the federal income tax treatment of poses only if the transferee employee would be the any such transfer. natural object of the employer’s bounty. In other words, except for transfers subject to Code Sec. Chapter 14 74(c) or Code Sec. 132(e), a transfer to an “unre- lated” employee is never excludable as a gift under The Revenue Reconciliation Act of 1990 amended Code Sec. 102(a), while an intrafamily transfer in subtitle B of the Internal Revenue Code of 1986 to such circumstances can be excludable for income add Chapter 14, which comprises Code Secs. 2701 tax purposes if the transfer is made out of detached through 2704.28 The rules contained in these sec- and disinterested generosity. tions are intended to augment Code Sec. 2512(b)’s Whether the relaxed standard of the proposed general rule that a gift results whenever property is regulation will ever have the force and effect of law transferred for less than adequate and fair consider- is uncertain. Most importantly, unless and until the ation in money or money’s worth. Code Sec. 2701 regulation is fi nalized, intrafamily transfers of prop- provides special valuation rules for determining the erty witwithinthin the business context are no less subject amount of the gift when an individual transfers an to iincomencome taxtaxationatia under Code Sec. 102(c)(1) than interest in a corporation or partnership to a member compensatoryommpennsatory tratransfersrs betwbetweenen unreunrelatedlated paparties. of the individual’s family for inadequate consider- ation. In general, Code Sec. 2701 does not apply AlvesAlvlves unless, following such a transfer, the transferor holds an “applicable retained interest.” Where Code Sec. In L.J. AlAlves,25 the taxpayer became employed by 2701 applies, the amount of the gift is established General Digital Corporationati aass iitsts vicvicee prepresidentesident usingusing thehe so-calledso-called subtractionsu ract on memethodthod outloutlinedned bby for fi nance and administrationistr on not notlo longng afterafter itss thehe regulations. regulat ons.299 formation. At the time he became employed, the For example, where the transferor holds both taxpayer signed an employment and stock pur- common and preferred stock of Corporation X and chase agreement pursuant to which he purchased transfers the common stock to the transferor’s child certain shares of the corporation’s stock for what for inadequate consideration, the transfer will result was agreed to be the stock’s fair market value. A in a taxable gift under Code Sec. 2512(b), and the portion of the shares were subject to forfeiture amount of the gift will be determined in accor- restrictions. The taxpayer did not make a Code dance with Code Sec. 2701.30 Most signifi cantly Sec. 83(b) election at the time he acquired the for purposes of this article, whether the child is shares, nor did he include any amount in income employed by Corporation X is irrelevant. While this at the time the restrictions lapsed, even though the does not resolve the question of the stock transfer’s wage statements he received from the corporate income tax consequences to the child, it makes employer refl ected the additional compensation. clear Congress’ intent that the gift tax is to apply in Before the Tax Court and the Ninth Circuit, the the context of certain transfers of business interests taxpayer claimed that Code Sec. 83 applies only between family members and that the ordinary in the case of bargain purchases and since his course of business exception of the gift tax regula- purchases were at fair market value, Code Sec. 83 tions is not available in such circumstances.31 Does was inapplicable. The courts disagreed, fi nding this mean that Congress intends that the ordinary

TAXES—THE TAX MAGAZINE® 25 Intrafamily Transfers of Interests in the Family Business

course of business exception can never apply to When T learned of this result, T fi led a claim for refund transfers of business interests in the family context, of the gift tax that previously had been paid, not on the or only where Code Sec. 2701 applies? After all, basis that a gift had not been made, but on the ground even if Code Sec. 2701 is inapplicable due to the that if the income tax applied to R’s receipt of the securi- lack of an applicable retained interest, a transfer ties, T’s transfer could not also be subject to gift tax. In of an interest in the family business for less than response, the IRS noted that the gift tax was intended adequate consideration is literally within the ambit to supplement both the income tax and the estate tax of the gift tax, unless the ordinary course of business by reducing the incentive to make transfers to avoid exception applies. higher income tax brackets and the transfer tax imposed at death. The ruling also asserted that a single transfer Reconciliation of property can be subject to both the gift tax and the income tax. In support of this position, the ruling cited Duberstein’s detached and disinterested generosity stan- M. Beck Est.,33 which involved a transfer in trust that dard, the mandate of Code Sec. 102(c) and the broad was, under the statutes in effect at the time, complete for reach given the statutory phrase “in connection with the gift tax purposes but not for income tax purposes. The performance of services” by Alves compel the conclu- taxpayer in Beck Est. contended that a single transfer in sion that a parent’s transfer of an interest in the family trust could not be subject to both a gift tax and income business to a child who is active in the business results tax, as such result was “unbearably inconsistent.” In in taxable income to the child. This result seems irrefut- rejecting the taxpayer’s position, the court discussed able under modern federal income tax law, unless the the distinction in the defi nition of the term “gift” for gift transfer is “extraordinary,” and then only to that extent. and income tax purposes. The court further noted that On the other hand, by virtue of Chapter 14, the gift tax the distinction has always been known to Congress, necessarily applies to any intrafamily transfer of a family and that any perceived failure on the part of Congress business interest in which the transferor retains an appli- to eliminate the distinction was intended. cable retained interest, regardless of the circumstances. It does not appear that the IRS has ruled publicly Accordingly,ordinglyy, ththe clear implication is that both the gift or privately since 1979 that a single transfer of prop- taxx aandnd tthehihe incomeincomo tax can applyp to a singleg intrafamily erty can trigger both gift tax to the transferor and transferranansfer of a ann int interestter in the famfamilyily busibusiness.ess. This result income tax to the recipient. Nevertheless, the present iss coconsistentonsistent witwithh tthe notionot thatt tthe federaleral incoincome tax statutory framework not only does not preclude the andnd the ffederalederal gifggiftt tatax systems are indeindependent.pendent. argument but virtually welcomes it, whether in the Itt isi nonotott uunprecedentednpre eded d for tthe IRS to taketk the th posi- family context or otherwise. tion that bboth the gift tax and the income tax can apply to a single transfer of property.pert In a 1979979 privatepr vate letterletter AvoidingAvo dingng ““D“Doubleo blee TTaxTaxation”xaatioon” ruling,32 the transferor (T) transferredtra erred securitiessecuri ies to thethe recipient (R). The transfer was accompanied by a letter While an intrafamily transfer of a business interest is in which T expressed gratitude for R’s loyal friendship. likely to attract the gift tax, to the extent such a transfer T reported the transfer as a gift on a timely fi led gift tax is “extraordinary” under Code Sec. 102(c)(1), it should return. Although T and R were not related, T had known escape the income tax. A transfer can be viewed as R, an attorney, for many years. When R had encountered extraordinary for purposes of Code Sec. 102(c)(1) on fi nancial diffi culties due to an inability to earn enough either of two grounds. First, if the transferee is otherwise income to support and educate R’s children, T encour- fully and fairly compensated, the parties can take the aged R to accept employment with a company (C) with position that the transfer of the interest is not, objectively which T played a signifi cant role. When R indicated that viewed, compensation for past, present or future servic- the proposed salary offered by C would not be adequate es. This view accords with the estate planners’ traditional to meet R’s needs, T transferred securities to R, and fi led treatment of intrafamily transfers of business interests a gift tax return reporting the transfer. Shortly after R as invoking the gift tax but not the income tax.34 This received the securities, R became employed by C. treatment is subject to manipulation, however, and When R’s income tax return was audited, the IRS de- will often lead to uncertainty as to what is “ordinary” termined that the fair market value of the securities was and what is “extraordinary.” Perhaps the better view of includable in R’s gross income under Code Sec. 61(a), what constitutes an extraordinary transfer can be best and could not be excluded under Code Sec. 102(a). illustrated by example. Suppose the parents have three 26 October 2008 children, two of whom are, and have for many years Proposed Reg. §1.102-1(f)(2). Hence, only the gift tax been, active in the family business, and the third of should apply in this circumstance. whom has never shown an interest in the business. If the parents transfer a portion of their ownership interest Conclusion to the two children who are involved in the business, and fail to transfer property of equal value to the dis- Except in “extraordinary” circumstances, the transfer of interested child, it will be diffi cult to demonstrate that an interest in the family business to a family member the transfers of the business interests were “extraordi- who is involved in the business for less than adequate nary.” Hence, under Code Secs. 83 and 102(c)(1), such consideration should be treated as if the interest were transfers will be subject to income tax. In addition, the transferred to an unrelated party. In any such case, gift tax will apply by virtue of Code Sec. 2701 if the taxable compensation invariably results. On the other parents hold an applicable retained interest after the hand, if and to the extent the transfer is objectively ex- transfer or if the parents do not hold such an interest traordinary, the transfer should be income-tax free to the after the transfer but the ordinary course of business recipient. Viewed from the standpoint of the transferor, exception does not apply to the transfer. On the other if the transferor holds an applicable retained interest hand, if property of equal value is transferred simultane- after the transfer, Code Sec. 2701 will always impose ously to the disinterested child, the IRS would be reluctant a gift tax obligation on the transferor. Even if there is to challenge the transfers on income tax grounds, as no applicable retained interest, the gift tax will apply, such transfers would appear to meet the “detached and unless the transfer is considered to have been made in disinterested generosity” rationale of Duberstein and the ordinary course of business.

ENDNOTES 1 §II.B., c. 16, 38 Stat. 167 (1914). 15 V.Z. Harwood, 82 TC 239, Dec. 40,985. existence of other persons entitled to buy 2 Revenue Act of 1924, ch. 234, 43 Stat. 253 16 M.D. Anderson Est., 8 TC 706, Dec. 15,694 stock on the same terms and conditions (2 sects. 271–27; 48 sect. 845) (1924). (1947). as an employee may indicate that in such 3 Revenue Act of 1926, ch. 234, 44 Stat. 9 (48 17 E.B. Williams Est., 75 TCM 1758, Dec. circumstances a transfer to an employee is sect. 84845)45) (1(1926).92 52,568(M), TC Memo. 1998-59. not in connection with the performance of 4 RevenueReevenuue Act tof19t of 191932,93 ch. 209, 47 Stat. 169 18 Rev. Rul. 80-196, 1980-2 CB 32. services. See Reg. §1.83-3(f). This rationale (1932).(1932). 19 Under RReg. §1.83-6(d), a transfer of a had no bearing in Alves, since the individu- 5 SeeSSeee A.C.ACA.CCHi. HigginsHiggggiins, CA-1,CACA-C 42-22 USTCUS ¶10,189,0 189 corporation’sat stock by a shareholder to als who acquired stock on the same terms 129129 F2dF2d 237,2377, at 240.2 an employeeempl of the corporation is recast and conditions as the taxpayer were em- 6 CodeCoode SSec.ec. 22512(b).512(b).b All sectionctio referencesenc as a compensatorym transfer of stock by the ployees of General Digital Corporation. aree to tthehe IntInternalternal RRevenueeve Code of 1986,986, corporationat to the employee. The validity 28 Act Sec. 11602(a) of The Revenue Reconcili- as amenamended.nded.. of this regulation was challenged and ation Act of 1990 (P.L. 101-508). 7 W.H. Wemyss, SCt, 45-1 USTC ¶10,179, 324 upheldp in H.C. Tilford Jr., CA-6, 83-1 USTC 29 See Reg. §25.2701-3. US 303, at 306. ¶9310,9 10, 705 F2F2dd 8828, rev’g, 755 TC 134134, 30 TheTh amountmount of thehe giftg ft will beb establishedestablis ed by 8 M. Duberstein, SCt, 60-2 USTC ¶95¶9515, 363 DDec.e 337,344,344 ((1980).980 subtractings acting the valuvalue oof all ppreferredeferred sstockock of US 278 (1960). 20 Rev. Rul.R 8181-186,18619 1981-22CB CB 8585. CorporationC t XhX heldld by theht transferor’sf ’ ffamily 9 Reg. §25.2512-8. 21 Rev. Rul. 77-293, 1977–2 CB 91. from the value of all family-held interests in 10 W.H. Gross, 7 TC 837, Dec. 15,386 (1946). 22 TAM 200014004 (Dec. 10, 1999). Corporation X determined immediately prior 11 Eisner v. Macomber, SCt, 1 USTC ¶32, 252 23 Supra note 8. to the transfer. See id. US 189 (1920). 24 See 54 FR 5, 627 (Jan. 9, 1989). 31 See Reg. §25.2512-8 (last sentence). 12 Act Sec. 122(b) of Tax Reform Act of 1986 25 L.J. Alves, CA-9, 84-2 USTC ¶9546, 734 F2d 32 LTR 7921017 (Feb. 16, 1979). (P.L. 99-514). 478, aff’g, 79 TC 864, Dec. 39,501 (1982). 33 M. Beck Est., CA-2, 42-2 USTC ¶10,195, 129 13 Act Sec. 321(a) of P.L. 91-172. 26 See Reg. §1.83-6(d)(1). F2d 243. 14 J.B. Hitchon Est., 45 TC 96, Dec. 27,597 (1965). 27 The regulations acknowledge that the 34 See Rev. Rul. 77-293, supra note 21.

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