Last month we considered a situation in which the recapitalization of the equity in a family-controlled business resulted in a taxable gift. Today we will consider how a family-owned corporation’s redemption of shares from a parent-shareholder may be treated as a taxable gift from the parent, and may result in some unexpected consequences for the beneficiaries of such gift.
Parent “Makes” A Gift
In 1995, Parent sold his stock in Company back to Company. Because he sold the stock back for a price below its fair market value, this sale increased the value of the stock of the remaining stockholders. At the time of the sale, there were five other Company shareholders including Parent’s Ex-Wife, other individuals, and trusts that held Company stock. Parent passed away later that year.
The IRS audited Parent’s 1995 gift taxes and determined that Parent had made an indirect gift to the Company shareholders when he sold his stock back for below market value and issued a notice of deficiency. Parent’s Estate challenged the deficiency. After several years of negotiation over Parent’s tax liability for this indirect gift, the IRS and Parent’s Estate entered into a stipulation that determined the value and recipients of the indirect gifts. However, Parent’s Estate still did not pay the gift tax.
IRS Seeks to Collect
In 2008, the IRS assessed gift tax liability for Parent’s unpaid gift tax against the donees. Under the Code, a donor’s unpaid gift tax for a period becomes a lien upon all gifts made during that period. If the tax is not paid when due, the donee of any gift shall be personally liable for such tax to the extent of the value of such gift.
In 2010, the IRS brought suit against the donees, seeking to recover the unpaid gift taxes and to collect interest from the beneficiaries. In a series of orders issued in 2012, the district court held for the IRS.
The Court Supports the IRS
The Code imposes a tax on a “transfer of property by gift.” The gift tax applies “whether the gift is direct or indirect,” and includes transfers of property (like stock) when the transfer was “not made for an adequate and full consideration.” When the gift tax is not paid when it is due, the Code imposes interest on the amount of underpayment.
Pointing to IRS Regulations, the Court stated that “[i]t is well-settled that a transfer of property to a corporation for less than adequate consideration is to be treated as a gift to the shareholders to the extent of their proportionate interests in the corporation.” (“A transfer of property by B to a corporation generally represents gifts by B to the other individual shareholders of the corporation to the extent of their proportionate interests in the corporation” where the transfer was not made for adequate and full consideration in money or money’s worth.)
The Court acknowledged that “[t]he donor, as the party who makes the gift, bears the primary responsibility for paying the gift tax.” However, if the donor fails to pay the gift tax when it becomes due, the Code provides that the donee becomes “personally liable for such tax to the extent of the value of such gift.” The term “tax” includes interest and penalties and, so, the donee can be held liable for the interest and penalties for which the donor is liable.
The donees argued that the district court erred when it found both that this creates an independent liability on the part of the donee to pay the unpaid gift tax, and further disputed that the donee can be charged interest until the gift tax is paid.
The Court disagreed with their arguments and held that interest accrued on a donee’s liability for the unpaid gift taxes and, moreover, that the interest is not limited to the extent of the value of the gift.
An Interesting Aside
One of the “beneficiary-shareholders” – the Ex-Wife – claimed that the “ordinary course of business exception” applied because the IRS did not prove that there was donative intent. She argued that whereas in other cases involving indirect gifts, the ordinary course of business exception did not apply because, given the close family relationship between the donor and the shareholders, courts were able to infer donative intent, Parent and Ex-Wife here had been divorced for many years and each had remarried. Thus, according to Ex-Wife, the IRS failed to prove that there was a close family relationship and that this was a gift.
The Court disagreed. Though under the ordinary course of business exception, “a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free from any donative intent), will be considered as made for an adequate and full consideration in money or money’s worth,” here the Court found it clear that Parent intended to make a gift.
Context Can Be Everything
A stock redemption provides a means by which a parent may “shift” value to children-shareholders (without actually transferring anything to them), by reducing the parent’s percentage interest in the redeeming business entity and increasing that of the children-shareholders.
If the redemption is effected for FMV (unlike in the situation considered above), there is no gift to the other shareholders—even though their relative interests increase. The removal of some of the parent’s equity in the business freezes the value thereof by replacing it with cash that may be spent. The reduction in his or her percentage interest of the total equity may also put the parent in a less-than-controlling position, allowing for a minority discount at the time of his or her death.
Of course, a redemption may also eliminate the ability of the parent’s estate to pay the estate tax attributable to the business in installments, by reducing the percentage of the value of the gross estate that is represented by the business.
Where the redemption is not for FMV, the resulting reduction in estate tax value for the parent’s remaining shares may justify some current gift tax liability. However, the parent needs to be mindful of the fact that a redemption is generally an income-taxable event to the parent, though the specific consequences will depend upon several factors. In any case, the income tax expense must be weighed against the potential transfer tax savings.
Even where the stock redemption is not made strictly made for FMV, gift treatment may still be avoidable. For example, given the difficulty of valuing closely held stock, a purchase price adjustment clause in the redemption agreement may defeat gift characterization of the transfer in the face of an IRS challenge to the redemption price.
Similarly, the redemption of a parent’s stock as part of the settlement of a bona fide family/shareholder dispute may also be deemed to have been made for adequate and full consideration in the context of the overall settlement.
What the parent-shareholder, the redeeming corporation, and the other shareholders need to keep in mind is that there are many factors to consider before undertaking a redemption of the parent’s stock. With proper planning, any unpleasant surprises should be avoidable.