A law suit was recently filed against the U.S. in which the Taxpayers seek a refund of gifts taxes and interest that they claim were erroneously assessed against them by the IRS for their 2007, 2008 and 2009 tax years (the “Tax Years”).

Although it may be some time before the Taxpayers’ claims are resolved, the factual setting upon which the disputed taxes are based is a commonly recurring one.

It is also one that highlights the importance of recognizing the various contexts in which the equity interests in a closely-held business are valued, how they may impact one another, and the importance of being able to distinguish among them.

Family Transfers

Taxpayers are shareholders of Company, an S corporation, the shares of which (the “Shares”) are owned by members of the Taxpayer Family and certain key employees and directors of Company.

Transfers of Company Shares by members of the Taxpayer Family are restricted pursuant to the terms of the Company’s bylaws. Under the bylaws (the “Bylaws”), the “Taxpayer Family” was defined as the issue and descendants of X & Y or trusts whose beneficiaries are members of the Taxpayer Family.

The Bylaws were intended to ensure continuity of ownership in that they provide that members of the Taxpayer Family can only transfer their Shares to other members of the Taxpayer Family. However, no price is established in the Bylaws for Shares that are transferred between members of the family.

A qualified, independent valuation firm (“Appraiser”) annually values the Company to determine the value of minority blocks of Company Shares.

Purchases and sales of Company Shares between Taxpayer Family members are transacted at the Appraiser’s valuation of those Shares.

Key Employee Transfers

According to the complaint filed by the Taxpayers (the “Complaint”), the Share ownership structure of Company has long had as one of its underlying principles the desire to create continuity of ownership for the Company and to give key employees and directors a stake in Company’s success. (This is a common theme in the closely-held business, especially where family members are no longer actively engaged in the business and, so, need to retain qualified employees.)

Historically, Company has offered certain of its key employees and its directors the opportunity, from time to time, to purchase Company Shares. The purchase price for Shares sold to such key employees and directors was set by the Company at the benchmark purchase price of 120% of the book value of such Shares. (Presumably, the service providers did not report any compensation income in connection with the purchase of the shares.)

Transfers of Shares by key employees and directors who are not Taxpayer Family members are restricted and subject to a right of first refusal in favor of the Company pursuant to the terms of the Company’s Bylaws and by restrictions contained in separate stockholder agreements entered into by such key employees and directors. Pursuant to the terms of the Bylaws and the separate stockholders agreements, key employees and directors desiring to sell their Shares back to Company may only do so at a price equal to 120% of the then-current book value of the Shares.

Taxpayers represented that the “120% of book value” purchase price for Company Shares was established by the Company for the purpose of ensuring that key non-Taxpayer Family employees and directors who wished to buy and sell their Shares would have an easily calculated purchase and sale price for those Shares. According to the Complaint, it is only a benchmark for purchases and sales by key employees and directors and bears no relationship to what a willing buyer and willing seller would establish for the price of Company shares.

The Gifts

During the Tax Years, Taxpayers gifted minority Shares to their children and grandchildren. The Taxpayers filed gift tax returns to report the gifts and stated a per share fair market value as determined by the Appraiser. The Appraiser’s valuation was based on a variety of factors including, but not limited to, Company’s historical earnings and financial data, current economic and market conditions, pricing for shares in comparable publicly-traded companies, dividend history, and the book value of all Company assets.

The Appraiser’s valuations included a significant discount for lack of marketability because the Company was a privately-held business lacking an active market for its shares.

Another reason for the lack of marketability discount, the Complaint stated, was the restriction on transfers of Company Shares between the Taxpayer Family members: the Bylaws prohibit Taxpayer Family members from transferring Shares except to other members of the Taxpayer Family. According to the Complaint, the restrictions on the Taxpayer Family transfers were a “bona fide business arrangement” and not a device to transfer shares to a family member for less than adequate consideration.

The Dispute

On the gift tax returns for the Tax Years, Taxpayers reported and paid almost $2.4 million of gift taxes with respect to the gifted Shares.

The IRS challenged the amounts reported on the returns, and eventually sent Taxpayers “30-day letters” proposing an alternative valuation of the Company Shares based upon 120% of the book value of the Shares (the same methodology established by the Bylaws to benchmark the purchase and sale price of Shares sold to and repurchased from key Company employees and directors).

Taxpayers subsequently received Notices of Deficiency (dated August, 2014) from the IRS alleging they owed additional gift tax as a result of the IRS’ fair market value determinations of the minority shares of Company for the Tax Years.

In November, 2014, Taxpayers paid to the IRS the additional amount of gift tax (plus interest) set forth in the Notices of Deficiency. (It is unclear why Taxpayers did not choose to contest the asserted deficiencies in the Tax Court; as a jurisdictional matter, a taxpayer may access the Tax Court without first paying the taxes asserted by the IRS.)

In February, 2015, the Taxpayers filed amended gift tax returns with the IRS for the Tax Years, claiming a refund of the federal gift taxes and interest paid in response to the Notices of Deficiency.

After more than six months had elapsed from the filing of such refund claims (a jurisdictional requirement), the Taxpayers filed a suit for refund in the U.S. District Court.

Which Valuation Standards?

We have heard it a million times: for purposes of the gift tax, the fair market value of an interest in a closely-held business is the amount that a willing buyer would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of the relevant facts.

Among these relevant facts, one would consider any transfer restrictions relating to the interest, provided that any such restriction is a bona fide business arrangement, is not a device to transfer such property to members of the donor’s family for less than full and adequate consideration, and its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction.

We are also familiar with the following refrain: where property (including an equity interest in the service recipient) is transferred to an employee or independent contractor in connection with the performance of services by such individual, the fair market value of such property (less any amount paid therefor by the employee or independent contractor) shall be included in the gross income of such employee or independent contractor for the taxable year in which the property becomes substantially vested.

For purposes of this compensation rule, the fair market value of the equity interest for gift tax purposes is generally irrelevant. Rather, for compensation purposes, the fair market value of the transferred equity interest is determined without regard to any transfer restriction other than one which by its terms will never lapse.

Such a “non-lapse restriction” is a permanent limitation on the transferability of property that will require the transferee of the property (e.g., the employee) to sell, or offer to sell, the property at a price determined under a formula, and that will continue to apply and be enforced against the transferee or any subsequent holder (e.g., the employee’s estate).

As a result, in the case of property subject to a non-lapse restriction, the price determined under the formula for compensation purposes will be considered to be the fair market value of the property, unless the IRS establishes otherwise.

Thus, for example, if stock in a corporation is subject to a non-lapse restriction that requires an employee to sell such stock only at a formula price based on book value, the price so determined will ordinarily be regarded as determinative of the fair market value of such property for compensation purposes.

The Outcome?

Interestingly, it appears that the fair market value for the Company Shares as determined by the Taxpayers for gift tax purposes was less than the fair market value of such Shares as determined for compensation purposes – the “120% of book value” purchase price for the Company Shares is likely a non-lapse restriction.

Although, as was noted above, the valuation standards are different for each purpose, a taxpayer who is contemplating a gift of equity in his or her close business should be mindful of any equity-based compensation arrangements and the valuations thereunder, especially where the employee-participants are not related to the taxpayer.

The taxpayer must be prepared to defend the difference in values, especially insofar as such difference may call into question the bona fide business nature of the family-related restrictions, or may support the IRS’s characterization of such restrictions as a device for transferring property to members of the taxpayer’s family for less than full and adequate consideration.

Stay tuned.