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Intrafamily Transfers of Interests in the Family Business: Gift, Compensation Or Both?

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Intrafamily Transfers of Interests in the Family Business: Gift, Compensation Or Both? 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 methmmethod of accomplishing this goal is to haveave tthehe sseniorenior generation make pperiodic transfers Background offif iinterestsnterrests in the businessiness tto the membersmembers of the youngerounger ggeneration.eneraatio 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fi lldbleded bothbbthh tooa acknowledgeo led liabilityliabil tf for and limit while the gift tax was enacted in 1924,2 repealed exposure to the gift tax, with no apparent thought of in 19263 and reenacted in 1932.4 While a principal the potential income tax coconsequences.equencces.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 ggiftift ttaxax wasas ttoo seserverve aass a “backstop”backstop tax consequences of suchuch transfersnsfer dedependpend upuponpon foror ththee incincomeome tax (a(and the esestateate ttax),ax),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 adade aadequatete 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 rregulationsegulationo s containc ntain an importantimpor ant exceptionexc determined that H and W had made taxable gifts to D to ttheheh ggeneralenerale l giftftt ttax rulesles iin the cacase 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, excexchangesngges oorr ototherher trtransfersans ers H anandd W argueda d ththatat no gifgift hadhad bbeeneen mmade,ade, ccitingtin 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.
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