Many of us have encountered variations of the following scenario:  a parent owns and operates a business; his kids are employed in the business; as the kids mature and become more comfortable and established in the business, some of them may want to assume greater managerial responsibility and to have a greater voice in the strategic planning; inevitably, the kids also are anxious to realize a greater share of the economic benefits resulting from their efforts.

It is not always the case that the parent and the kids will see eye-to-eye.  The parent, for example, may want to emphasize a traditional line of business, while his children seek to expand the business, either by product lines, services, or geographically.  Alternatively, the children may want to take the business in an entirely different direction.

Sometimes, however, the parent will feel that the kids are quite capable of growing the business, and that the appreciation in the value of the business resulting from their efforts should inure to their benefit, instead of becoming a part of the parent’s gross estate.   These situations may present difficult estate and succession planning considerations for the family and the business. They also present income tax issues.  In some cases, a tax-free “spin-off” from the parent’s company may be possible and advisable.    However, where this structure is not available, the parties must proceed with caution.

One means by which some folks have sought to accomplish a transition to their kids is by “allowing” the kids to go off on their own and to start their own business.  The existing customers from the parent’s business may “transition” over to the new company, while the parent phases out the old company.  Any “new” business is directed to the new company.

While this process may seem innocuous enough, it raises a number of tax-related issues; for example, has the parent liquidated a portion of the old business and made a gift thereof to the kids?  This “liquidation-reincorporation” risk is not all that far-fetched. Indeed, it was the subject of a recent Tax Court decision, Bross Trucking v. Comr., T.C. Memo 2014-107.

 Bross:  The Kids Get Into the Business; The IRS Takes a Closer Look

In Bross, the parent had been involved in the trucking business for thirty years.  He founded the business, managed it, and was its sole shareholder. Its principal customers were owned by individuals with whom the parent had close personal relationships, and the parent’s corporation did not have formal written agreements with these customers.  In the late 1990’s, the business came under scrutiny by state transportation regulators for various safety concerns.  The business suffered and the parent decided to wind it down.

In 2003, the kids started their own trucking company.  They had not previously been involved in the trucking business, but they sought to service the principal customers of the old business.  They also decided to provide additional services not previously provided by the parent’s business.  The kids owned over 98% of the new company, and an unrelated third party owned the balance.  The parent was not involved in the new company. While the latter did not assume any contracts, insurance or licenses from the parent’s business, it did eventually hire one-half of its workforce from the parent’s company. It also leased many vehicles that had previously been leased by the parent’s company and that displayed that company’s logo, but they placed signs over the logo.  The parent’s company remained in existence and continued to collect its receivables and contend with its liabilities.

The IRS asserted that the parent’s company had distributed its “operations” to the parent, which the parent then gifted to his kids (the alleged value of which would have required the payment of gift taxes), who then organized the new company.  In addition, the IRS asserted that the alleged distribution of the operations (specifically, “goodwill,” which the IRS claimed subsumed several other “attributes” of the business, such as workforce and customer base) to the parent as the sole shareholder of the company should be treated as a sale of such assets, in accordance with IRC Sec. 311(b), the gain from which should be taxed to the parent’s company.  The parent would be taxed upon the gain realized on his receipt of such assets.

The Court considered the issue of whether the parent’s company had, in effect, made a taxable distribution of goodwill.  What it found was that the company did not own any goodwill.  First, it found that any goodwill that the company may have owned was lost when state regulators investigated its safety record and found it wanting. Second, the remaining “attributes” of goodwill were personal to the parent.  Any established revenue stream or developed customer base was a direct result of the parent’s personal efforts.  He developed crucial relationships with the customers and they chose to patronize the company solely because of those personal relationships.  It was his personal ability and reputation that the customers sought.  These relationships were owned by the parent personally, and never were transferred to his company through an employment agreement or non-compete agreement.  He was free to leave the company at any time and to take his personal assets with him.

Moreover, the kids did not contribute any goodwill to their new company because they were never employed by the parent’s company.  The fact that one-half of their workforce had worked for the parent’s company did not convince the Court that there was a transfer of an established workforce-in-place.  This was demonstrated, the court said, by the fact that the new company offered services not previously offered by the parent’s company.  The fact that the old company’s customers had a choice of trucking options, and chose to switch to the new company, further supported the conclusion that no customer base had been transferred.

Thus, the Court concluded, there was no distribution by the parent’s company to the parent, and no gift by the parent to the kids.

From the taxpayer’s perspective, the facts in Bross were fortuitous.  There were a number of items that greatly weakened the IRS’s argument that corporate goodwill had been transferred. In most other settings, the parent’s company will not have been the object of a public regulatory investigation, and the kids would have been involved in the parent’s business, and would have developed their own relationships, before “breaking away” to start their own, similar business.

The takeaway here is that the IRS could have triumphed on better facts.  Thus, the liquidation-gift-reincorporation risk must be considered in any situation where the kids are planning to separate from the parent’s company, to go off on their own.  In any such situation, it is imperative that the parent, the kids, the company and their advisors consider the various alternatives by which the new business may be established, identify the tax risks associated with each, then plan accordingly.  It is not acceptable to simply move ahead and hope for the best.