Mostly Divisions

Over the last several months, many of the projects on which I have been working have involved the division of a corporation or of a partnership. Yes, there have been purchases and sales of businesses along the way. And, yes, there have been restructurings of organizations for various purposes, including to facilitate a sale of a business or the admission of a new investor. However, the divisive transaction seems to be ascendant in that sector of the tax firmament over which I keep watch.[i]

Some of these business divisions were strategic in nature,[ii] but some originated[iii] in disputes between individual owners who are family members, and were once friends and collaborators. Over time, and with changing circumstances, the relationship between the owners begins to fray, and eventually devolves into a cold war, and sometimes outright hostility. As a result, the business suffers.

As many earlier posts have explained,[iv] the feuding owners may be separated on a tax-efficient basis through some variation of the spin-off transaction, in the case of a business organized as a corporation, provided the many requirements therefor are satisfied.[v] There are far fewer criteria to be met in order for the division of a partnership to be effected without materially adverse tax consequences.[vi]

One factor that is often considered in the context of such a spinoff, but which rarely presents much of an issue given the reason for the transaction, is the receipt of adequate value by each owner. Because neither shareholder is in any way inclined, under the circumstances, to leave behind value to which they believe they are entitled, the likelihood of either owner experiencing a windfall or being shortchanged is fairly remote.

That being said, the spin-off does not always result in a dollar-for-dollar exchange;[vii] as a practical business matter, this is not unusual, and is sometimes unavoidable. That is not to say, however, that any “bargain” element rises to the level of a gift, even where the parties are members of a single family.

Ordinary Business Transactions

The IRS has long recognized this economic and business reality. At the same time, however, it has stated that donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer.[viii] Rather, the application of the tax is based 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, transfers reached by the gift tax[ix] are not confined to those which, being without a valuable consideration, accord with the common law concept of gifts; instead, the tax also embraces sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the transferor-donor exceeds the value in money or money’s worth of the consideration given therefor.

Does this mean that any bargain element may trigger gift tax? No. The IRS has explained that, in addition to not being applicable to a transfer for full and adequate consideration, the gift tax also does not apply to “ordinary business transactions.”[x] Thus, a sale, exchange, or other transfer of property made “in the ordinary course of business” – i.e., 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.[xi]

This last point acknowledges the fact that there are circumstances in which the application of the gift tax would not be appropriate notwithstanding that the parties – even related parties – have not exchanged equal values, whether in terms of property or services, provided the exchange represents an arm’s length, genuine business transaction.

In the case of a divisive transaction, provided that the values received or relinquished are not so disproportionate, relative to the value of each party’s interest in the divided business prior to the division, as to call into question the business purpose for the transaction, it would be inappropriate to find there was a gift from one party to the other. Instead, the party being “shortchanged” may have determined that the resolution of the conflict with the other party, via the division of the corporation, and the resulting benefit of being able to own and operate their own business without interference from the other, constitute adequate consideration.

Stated differently, provided the division is principally motivated by at least one strong business purpose, the likelihood of finding a gift transfer is more remote.

This approach recalls the “device” test, which seeks to prevent the use of a spin-off for the purpose of withdrawing earnings and profits from a corporation.[xii] Any evidence of such a device may be outweighed by the existence of a corporate business purpose. The stronger the evidence of device, the stronger the corporate business purpose required to prevent the determination that the transaction was used principally as a device.

What About Combinations?

Intuitively, there is no reason why the same line of reasoning should not apply to the combination of two business entities. Provided the parties are motivated primarily by a bona fide, non-tax business reason, the fact that one party to the transaction ends up with a slightly disproportionately larger share of the combined entity’s fair market value should not be taken as evidence of a gift from the other party.

However, where the individuals involved are members of the same family, and the values “exchanged” are, let’s say, out of whack – whether intentionally or not – the IRS may rightfully wonder why.

Which brings us to a recent case[xiii] that was before the U.S. Tax Court on remand from the Court of Appeals for the First Circuit.[xiv] Although the First Circuit sent the case back to the Tax Court for reconsideration on the issue of valuation, the underlying facts are worthy of examination.

A “Donative” Merger?

Parents owned Corp A, out of which they operated Business X. Their children (“Kids”) were employed by the corporation.  In order to diversify its operations and provide another source of revenue, Corp A began development of a new technology (“IP”).

The development process proved to be expensive, so Parents decided that Corp A should just focus on Business X. Kids, however, believed they could develop IP and find a market for it.  Parents assented to their continued efforts.

Kids formed a new corporation, Corp B, to which they made a nominal capital contribution in exchange for all of its shares.  At no time, however, did Corp A grant to Corp B the right to produce or sell Corp A’s IP.

As Kids continued to develop IP, Corp A continued to compensate them as employees of Corp A. What’s more, Corp A personnel, using Corp A’s equipment, assisted Kids with implementing their development ideas.  In time, Corp A was manufacturing products based on IP, which Corp B sold and distributed.

Unfortunately, however, Corp A and Corp B never took a consistent approach to the overall allocation of income and expenses between them. Instead, it appeared that profits were disproportionately allocated to Corp B, which the Court (see below) attributed either to the “deliberate benevolence” of Parents, or else to “a non-arm’s length carelessness born of the family relationships.”

The lax approach to the relationship between the two corporations was also reflected in the fact no documentation existed that memorialized any transfer of IP from Corp A to Corp B.  Indeed, the relevant documents affirmatively showed that Corp A owned IP.

Several years into their “relationship,” Corp A and Corp B decided that, on the advice of their accountant (“Accountant”), they would need to merge, with Corp B as the surviving entity, if they wanted to expand their market. Accountant projected that “the majority of the shares (possibly as high as 85%)” in the surviving entity would go to Parents as a result of the merger, in their capacity as the shareholders of Corp A. Accountant valued the merged company as being worth between $70 million and $75 million.

However, the corporations’ attorney (“Attorney”) advised Parents to assume (incorrectly) that Corp B, not Corp A, owned IP. Accountant did not agree with that view, and shared this concern with Attorney; the latter responded: “History does not formulate itself, the historian has to give it form without being discouraged by having to squeeze a few embarrassing facts into the suitcase by force.”[xv] Accountant acquiesced.

The two corporations merged in a tax-deferred merger,[xvi] with Kids receiving 81-percent of the surviving corporation, based upon the incorrect assumption that Corp B – which Kids owned – held IP.

Slightly before the merger, Attorney prepared[xvii] a “confirmatory” bill of sale that reflected an earlier purported transfer of IP from Corp A to Corp B despite the lack of any evidence as to Corp B’s ownership of IP.

Gift by Corporate Merger

The IRS conducted a gift tax examination relating to Parents, and eventually issued a notice of deficiency which determined that Parents made significant gifts to Kids by merging Parents’ company (Corp A) with and into Kids’ company (Corp B), and allowing Kids an 81-percent interest in the merged entity.

Parents petitioned the Tax Court for a redetermination of the resulting gift tax liability. The Tax Court agreed with the IRS.

The Court noted that donative intent on the part of the donor is not an essential element for gift tax purposes.  The application of the gift tax, it said, is based on the objective facts and circumstances of the transfer rather than the subjective motives of the donor.  The Court quoted from IRS regulations: “Where property is transferred for less than an adequate and full consideration …, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift.”  Such taxable transfers, the Court said, include exchanges between family members.  Indeed, when a transaction is made between family members, it is “subject to special scrutiny, and the presumption is that a transfer between family members is a gift.”

Parents argued that the transaction should be considered one that was made for “an adequate and full consideration” because it was made in the “ordinary course of business” and was “bona fide, at arm’s length, and free from donative intent.”

The Court disagreed.  It pointed out that if an unrelated buyer had approached either Corp A or Corp B, it would have demanded to see documentation regarding the ownership of IP, and it would have acted accordingly.[xviii]

The instant case, the Court stated, did not involve a hypothetical unrelated party; instead, it involved parents “who were benevolent to their sons,” and it involved “sons who could … proceed without the caution that normally attends arm’s length commercial dealing between unrelated parties.”  The Court observed that, throughout the process of developing IP, Parents gave no thought to which corporation would own it, and they gave no thought to which corporation would pay for its development.

In the end, the Court concluded, based on the IRS’s valuation of the corporations, that there was a gift, the amount of which would be based upon a 60-40 split of value between Corp A and Corp B, respectively.[xix]

The Valuations

During trial, Parents entered into evidence two reports on the issue of valuation: the Accountant’s valuation, on which the post-merger share distribution had been based, and another valuation prepared for trial. These reports valued the combined company at between $70 million and $75 million, and both assumed (incorrectly) that Corp B had owned IP, and that Corp A had been a contractor for Corp B in the development of IP.

The IRS’s appraisal report assumed (correctly) that Corp A had owned IP. It also made adjustments to Parents’ allocation of profit and loss between the two related corporations. Using a discounted cash flow analysis, the report concluded that the total value of the merged entity was $64.5 million (less than the value determined by Parents’ appraisers), that Corp A’s value was $41.9 million (i.e., 65% of the total), and that Corp B’s value was $22.6 million (i.e., 35% of the total). On the basis of this analysis, the IRS argued that the merger of the two corporations, and the disproportionate distribution of shares among their shareholders, resulted in a gift to Kids totaling $29.7 million.

Parents challenged the IRS’s appraisal methodology, alleging that its valuation was flawed for a number of reasons, including its reallocation of profit between the two corporations.

The Court found that: Corp A, rather than Corp B, owned IP; the merger transaction was “notably lacking in arm’s length character”; the merger of the two corporations with the issuance of 81-percent of the stock of the new combined entity to Kids reflected a presumption that Corp B had owned IP; the 81-percent:19-percent allocation of the stock was therefore not in accord with the actual relative values of the two corporations; and the transaction, therefore, resulted in disguised gifts to Kids.

The Court held in favor of the IRS, and never considered the merits of Parents’ arguments concerning the IRS valuation.

Appeal and Remand

Parents appealed to the Court of Appeals, alleging that the Tax Court erred in various respects, including the following: (1) concluding Corp A owned IP; and (2) failing to consider flaws in the IRS valuation.

The Court of Appeals sustained the Tax Court’s findings and conclusions, with one exception: it determined that the IRS valuation had “methodological flaws that made it . . . excessive.”

On remand, Parents argued that the IRS valuation erred by not taking into consideration Attorney’s “confirmatory” bill of sale that attested to a transfer between Corp A and Corp B, which Parents contended was a “cloud on the title”, and that the IRS valuation therefore erred by not discounting the value of Corp A, because a “buyer considering the acquisition of [Corp A] without [Corp B] would have to take into account the risk that [Corp B] might claim rights to the [IP].”

This argument, the Court pointed out, was based on premises that were explicitly contrary to its earlier factual finding that “the . . . ‘confirmatory’ bill of sale confirmed a fiction”, and “[i]f an unrelated party had purchased [Corp B] before the merger and had then sued [Corp A] to confirm its supposed acquisition of [IP], without doubt that suit would fail.”[xx]

Parents also renewed their criticism of the profit reallocation calculation that the IRS performed before valuing the two corporations, arguing that it was unnecessary.

The Court rejected Parents’ position that the profit reallocation was unnecessary because the argument was contrary to the Court’s findings that (i) “[Corp A] received less income than it should have as the manufacturer . . . , while [Corp B] received more than it should have as the mere seller,” and (ii) the allocation of stock in the merger was not done at arm’s length.

The IRS’s profit reallocation adjustment, the Court explained, reflected the correct view that Corp A and Corp B were not dealing with each other at arm’s length, that Corp A was effectively subsidizing Corp B’s operations, and that Corp A, rather than Corp B, owned IP. The Court concluded that this reallocation was necessary to yield an accurate valuation of the two corporations.[xxi]

After correcting for an error in the IRS’s valuation, the Court determined that the proportion of the combined value attributable to Corp A was 51-percent. Because Parents received only 19-percent of that value in stock from the merger, the Court determined that Parents “forfeited in favor of their sons 32% (i.e., 51% minus 19%) of that combined value to which they were entitled.” Therefore, the Court concluded, Parents made disguised gifts totaling 32-percent of the $70 million combined company, or $22.4 million.

Be Alert, Be Prepared

Corporate divisions and combinations involving family-owned businesses are just two of the scenarios in which owners and their advisers must be attuned to possible gift tax consequences. There are others.

For example, the transfer of property by a corporation to a non-shareholder may be a gift to the non-shareholder from the shareholders of the corporation if the non- shareholder has provided neither property nor services, either to the corporation or to its shareholders.[xxii] If the recipient is a shareholder, the transfer may be a gift to them from the other shareholders, but only to the extent it exceeds the recipient-shareholder’s own interest in such amount as a shareholder. Similarly, a transfer of property by an individual to a corporation, other than in exchange for stock, may represent a gift by the individual to the other individual shareholders of the corporation to the extent of their proportionate interests in the corporation.[xxiii]

Likewise, when property is transferred to a corporation by two or more persons in exchange for stock, and the stock received is disproportionate to the transferors’ prior interest in such property, “the entire transaction will be given tax effect in accordance with its true nature,” and the transaction may be treated as if the stock had first been received in proportion, and then some of such stock had been used to make gifts.[xxiv]

For example, Parent and Kid organize a corporation with 100 shares of common stock to which Parent transfers property worth $8,000 in exchange for 20 shares of stock, and Kid transfers property worth $2,000 in exchange for 80 shares of stock. No gain or loss will be recognized on these exchanges.[xxv] However, if it is determined that Parent made a gift to Kid, such gift (of $6,000) will be subject to gift tax.[xxvi]

Whatever the scenario, it is imperative that family members and their commonly-controlled business entities be especially careful when transacting with one another.  They must recognize these transactions will be subject to close scrutiny by the IRS; accordingly, they have to “build their case” contemporaneously with the transactions.  They must treat with each other at arm’s length as much as possible, they must document their business dealings, and they must be able to support the reasonableness of any transactions between them.

If a gift is intended, an appraiser should be consulted, and the “transfer” should be timed and structured so as shift as much of the potential for appreciation in the gifted interest as possible, while minimizing the tax cost and exposure.

[i] “And God said, Let there be a firmament in the midst of the waters, and let it divide the waters from the waters. And God made the firmament, and divided the waters which were under the firmament from the waters which were above the firmament: and it was so.” Genesis 1 (KJV): 6-7. See what I mean? The “firmament” was all about dividing things.

[ii] Seeking to position each business so as to enable it to compete more effectively, or to enable it to issue equity to a key employee.

[iii] Had their genesis, you might say. Hmm.

[iv] For example,


[vi] Reg. Sec. 1.708-1(d).

[vii] Rev. Proc. 2017-52 requires the following representation: “The fair market value of Controlled stock, Controlled securities, or Other Property to be received by each shareholder of Distributing that surrenders Distributing stock will be approximately equal to the fair market value of Distributing stock surrendered by the shareholder in the transaction.” Emph. added.

[viii] Reg. Sec. 25.2511-1(g)(1).

[ix] Chapter 12 of the Code; IRC Sec. 2501 et seq.

[x] Reg. Sec. 25.2511-1(g)(1).

[xi] Reg. Sec. 25.2512-8.

[xii] IRC Sec. 355(a)(1)(B); Reg. Sec. 1.355-2(d).

[xiii] Cavallaro v. Comm’r, T.C. Memo. 2019-144.

[xiv] Cavallaro v. Comm’r, 842 F.3d 16 (1st Cir. 2016).

[xv] Well-written, but WTF.

[xvi] Presumably under IRC Sec. 368(a)(1)(A).

[xvii] “Concoct” was the word used by the Tax Court.

[xviii] Absolutely.

[xix] As opposed to the 20-80 split claimed by Parents and Kids in the merger. Actually, a friendlier position for the taxpayers, from a gift tax perspective, than the one they had originally decided upon.

[xx] The Court of Appeals affirmed this finding, stating that Parents “advanced no argument that would warrant overturning the Tax Court’s finding that [Corp A] owned all of the [IP] at the time of the merger.”

[xxi] Parents argued that the IRS’s reallocation violated the principles of IRC Sec. 482. Section 482 is an income tax provision. It gives the IRS discretion to allocate income and deductions among taxpayers that are owned or controlled by the same interests, for purposes of preventing the evasion of taxes or to clearly reflect income. Broadly speaking, “[t]he purpose of section 482 is to prevent the artificial shifting of the net incomes of controlled taxpayers by placing controlled taxpayers on a parity with uncontrolled, unrelated taxpayers”. Section 482 is expressly applicable when the issue in dispute is the income tax of the subject companies, not the gift tax of their shareholders. This generality does not mean that principles and authorities under section 482 may never be considered in analogous contexts; but neither is section 482 the governing authority every time a gift tax valuation requires allocating profits between two companies.

[xxii] In the latter situation, the corporation’s payment may be treated as a constructive dividend to the relevant shareholder.

[xxiii] Reg. Sec. 25.2511-1(h)(1). For example, where the contributor has no business connection to the corporation in connection with which it may be making the transfer.

[xxiv] Reg. Sec. 1.351-1(b)(1).

[xxv] Under Section 351 of the Code.

[xxvi] Depending upon the relationship between the contributing parties, the disproportionate transfer may represent compensation for services rendered, or repayment of a loan, among other things.