Don’t miss Part I, here!
Taxable Gift Transfers
In general, where property is transferred for less than an adequate and full consideration in money or money’s worth, the amount by which the value of the property exceeded the value of the consideration is deemed a gift. A necessary corollary of this provision is that a transfer of property in exchange for an adequate and full consideration does not constitute a gift for gift tax purposes.
The Treasury Regulations confirm that:
“[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth, or to ordinary business transactions.” The application of the gift tax depends “on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor.” Thus, donative intent on the part of the transferor is generally not an essential element in such application.
The regulations define a “transfer of property made in the ordinary course of business” as (i) a transaction which is bona fide, (ii) at arm’s length, and (iii) free from any donative intent. A transaction meeting this standard “will be considered as made for an adequate and full consideration in money or money’s worth.” That is so even if one party to the transaction later concludes that the consideration he received was inadequate. In other words, even in the case of a bad bargain, no one would think for a moment that any gift is involved.
Of course, a transfer of property within a family group will almost always receive close scrutiny. However, a transfer of property between family members may nonetheless be treated as one “in the ordinary course of business” if it meets the criteria set forth above.
On numerous occasions, the courts have held that an arm’s-length transfer of property, in settlement of a genuine dispute between family members, was made for “a full and adequate consideration” because it was a transaction in the “ordinary course of business.” For example, a taxpayer’s settlement of litigation with a family member may be regarded as economically advantageous where the taxpayer was not certain of the outcome of the litigation and, by accepting the settlement, the taxpayer also avoided additional legal expense. In that case, the taxpayer may be said to have acted as one would act in the settlement of differences with a stranger, and a payment of settlement of the litigation may be described as “an adequate and full consideration in money or money’s worth.”
A transfer of property will be regarded as occurring “in the ordinary course of business” and thus will be considered to have been made “for an adequate and full consideration in money or money’s worth” if it satisfies the three elements in the regulations described above. To meet this standard, the transfer must have been (1) bona fide, (2) transacted at arm’s length, and (3) free of donative intent.
In applying this regulation to settlements of family disputes, the courts have identified certain subsidiary factors that may also be relevant. They have considered, for example:
- whether a genuine controversy existed between the parties;
- whether the parties were represented by and acted upon the advice of counsel;
- whether the parties engaged in adversarial negotiations;
- whether the value of the property involved was substantial;
- whether the settlement was motivated by the parties’ desire to avoid the uncertainty and expense of litigation; and
- whether the settlement was finalized under judicial supervision and incorporated in a judicial decree.
1. Bona Fide
The requirement that the transfer be “bona fide” considers whether the parties were settling a genuine dispute as opposed to engaging in a collusive attempt to make the transaction appear to be something it was not. Here, there was no indication that the dispute between Father and Number Two was a sham designed to disguise a gratuitous transfer to Number Two’s children. (A word of warning to advisors who would fabricate a dispute: don’t.)
Number Two was not working in concert with Father or Number One in any sense of the word. To the contrary, he was genuinely estranged from them, and this estrangement worsened as time went on. On both the business and family fronts, they each had (or believed they had) legitimate grievances against one other.
According to the Court, Number Two’s agreement to release his claim to 33 1/3 shares of Holding Co stock represented a bona fide settlement of this dispute. Although he had a reasonable claim to all 100 shares registered in his name, Father had possession of these shares and refused to disgorge them, forcing Number Two to commence litigation. The Court went on to note that the “oral trust” theory on which Father relied was evidently a theory in which he passionately believed. Additionally, it had some link to historical fact: at Holding Co’s inception, Number Two was listed as a registered owner of 33.33% of Holding Co’s shares even though he had contributed a disproportionately smaller portion of its assets.
2. Arm’s Length
The requirement that the transfer be “arm’s length,” the Court said, is satisfied if the taxpayer acts “as one would act in the settlement of differences with a stranger.” Number Two was genuinely estranged from Father and Number One. The evidence established that they settled their differences as such.
Number Two hired a lawyer and commenced lawsuits against Father, Number One and Holding Co. The lawyers for all parties negotiated for many months as true adversaries in search of a compromise. They eventually reached a settlement that Number Two accepted on his lawyer’s advice; both evidently regarded this compromise “as ‘advantageous economically.’” “The presence of counsel at the conference table for the purpose of advising and representing the respective parties as to their rights and obligations, together with other relevant facts and circumstances, dispelled any theory that a payment made in connection with such settlement was intended for or could have been a gift,” the Court stated.
All the elements of arm’s-length bargaining existed here. There was a real controversy among the parties; each was represented by and acted upon the advice of counsel; they engaged in adversarial negotiations for a protracted period; the compromise they reached was motivated by their desire to avoid the uncertainty and embarrassment of public litigation; and their settlement was incorporated in a judicial decree that terminated the lawsuits. Because Number Two acted “as one would act in the settlement of differences with a stranger,” his transfer of shares in trust for his children was an arm’s-length transaction.
3. Absence of Donative Intent
Although donative intent is not prerequisite to a “gift,” the absence of donative intent is essential for a transfer to be treated as made “in the ordinary course of business.” Generally, donative intent will be found lacking when a transfer is “not actuated by love and affection or other motives which normally prompt the making of a gift.”
Number Two transferred 33 1/3 Holding Co shares in trust for his children. A transfer of stock to one’s children, however, is not necessarily imbued with donative intent.
Number Two’s objective throughout the dispute was to obtain for himself ownership of (or full payment for) the 100 Holding Co shares originally registered in his name. He filed lawsuits because he refused to embrace the “oral trust” theory and wished to obtain possession, in his own name, of all 100 shares.
Both economic and family reasons may have motivated Number Two to insist on securing outright ownership of (or payment for) all 100 shares. Having abruptly quit the family business, he was likely concerned about his own financial security, and he may have been reluctant to transfer wealth to his children, one of whom he had recently placed in a mental hospital.
The evidence clearly established that Number Two transferred stock to his children, not because he wished to do it, but because Father demanded that he do it. The transfer of stock in trust for his children was prompted by Father’s desire to keep the family business within the family. Number Two was forced to accept this transfer in order to placate Father, settle the family dispute, and obtain a $5 million payment for the remaining 66 2/3 shares.
Thus, the Court concluded that Number Two acquiesced in the notion of an “oral trust” because he had no other alternative. There was no evidence that he was motivated by love and affection or other feelings that normally prompt the making of a gift. Because his transfer of stock to his children represented the settlement of a bona fide dispute, was made at arm’s length, and was “free from any donative intent,” it met the three criteria for a transaction “in the ordinary course of business.”
The Tax Court Disagrees with the IRS
The Court next turned to the IRS’s argument that, because Number Two’s children were not parties to the litigation or settlement of the dispute, they did not provide (and could not have provided) any consideration to Number Two for the transfer of the shares. Because no consideration flowed from the transferees, the IRS contended that Number Two ‘s transfer was necessarily a gift.
According to the Court, the IRS’s argument derived no support from the text of the governing regulations, which provide that “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth.” They further provide that a “transfer of property made in the ordinary course of business * * * will be considered as made for an adequate and full consideration in money or money’s worth.”
The IRS’s argument, the Court noted, focused on whether the transferees provided consideration. However, the regulation asks whether the transferor received consideration, that is, whether he made the transfer “for a full and adequate consideration” in money or money’s worth. The regulation makes no reference to the source of that consideration.
The Court determined that Number Two received “a full and adequate consideration” for his transfer—namely, the recognition by Father and Number One that he was the outright owner of 66 2/3 Holding Co shares and Holding Co’s agreement to pay him $5 million in exchange for those shares.
Thus, the Court concluded that Number Two’s transfer of 33 1/3 shares of Holding Co stock to the trusts for his children constituted a bona fide, arm’s-length transaction that was free from donative intent and was thus “made in the ordinary course of business.” Because “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth, or to ordinary business transactions,” the Court found no deficiency in Federal gift tax.
What Does This Mean for Planning Purposes?
The application of the “ordinary course of business” exception in the context of a family dispute, as described above, is almost, by definition, something for which a taxpayer cannot plan. After all, a dispute among family members, especially in a business setting, can arise under any number of circumstances, few of which are reasonably foreseeable.
That being said, there are some important lessons to be derived from the Court’s discussion of the regulation’s three factors that may be applicable in many other family business settings.
As always, the members of a family that owns a business must never forget that any transactions involving the business, or transfers of interests in the business, within a family group will receive close scrutiny by the IRS that may result in the characterization of such transactions or transfers, at least in part, as taxable gifts. These transactions may include the sale or leasing of property, the sale of stock, the issuance of stock to an employee, the payment of compensation, including incentive and deferred compensation.
Although a gift may not even be intended, it will behoove the family to recognize the factors on which the IRS will focus and to prepare accordingly. Thus, the parties to a transaction should be represented by separate counsel, and they should act in an arm’s length manner, as one would act when dealing with a stranger. In this way, they will avoid the surprise that the IRS tried to spring on the taxpayer in the decision discussed herein.