The Benefit of Knowing
Monday morning quarterbacking – the connotations are anything but positive.
Life is full of instances in which someone, in possession of all the factors that informed – or that should have informed, had they known about them – another’s earlier decision, and with full knowledge of the outcome of such decision,[i] has been critical of the decision-maker, or has proffered what their own choice would have been had they been in the decision-maker’s place.
Notwithstanding the negative reactions that such behavior may elicit, it is a fact that decisions will always be judged by reference to their results[ii] – how can they not? It’s the most obvious manifestation of a decision.
Regardless of its consequences, however, a more thoughtful observer may determine that a decision was sensible under the circumstances, where it was made after careful consideration, and on the basis of the relevant facts, both known and reasonably knowable at the time.
In many cases, it may be small comfort to the decision-maker that some folks have concluded the decision made sense. In other situations, however, the ability to demonstrate that one acted reasonably and thoughtfully may be enough to shield the decision-maker from certain “penalties.”
That being said, it is unlikely that the decision-maker will be able to convince anyone that they acted sensibly, and that the consequences of their decision should be accepted, if they were no more than a passive recipient of data; rather, they must take a proactive role in gathering information, assessing its accuracy, and deducing its implications.
Post-Date Events and Taxes
Naturally, these precepts have found their way into the tax law, where they have assumed many forms.
For example, penalties imposed with respect to various tax-related transgressions occurring in earlier years may be abated if, years later, the taxpayer can show that they had “reasonable cause” for the action taken at the time it was taken.
Generally, the most important factor in determining whether a taxpayer acted with reasonable cause is the extent of the taxpayer’s effort to assess their proper tax liability in the earlier year. Where the taxpayer consulted a professional, all facts and circumstances must be taken into account in determining whether the taxpayer reasonably relied in good faith on the professional’s advice as to the tax treatment of the taxpayer.[iii]
In the case of the sale of a closely held business, the owner of the business and the potential buyer will sometimes disagree as to the fair market value of the business because they have differing expectations[iv] for the future performance of the business, at least over the short term.
That being said, they will often agree on a “base” value – in general, the amount the buyer is willing to pay at closing – and they will then wait for the actual financial results of the business, typically over a one-to-three-year period[v] immediately following the closing, to retroactively determine the “final” sale price. In that case, the seller will treat the subsequent earn-out payment as a deferred payment of purchase price; similarly, the buyer will increase their basis for the business.[vi]
Assignment of Income
More relevant to the ruling that is the subject of today’s post, a donation of shares of stock in a closely held business to a charity will often be followed by a sale of such stock, which raises the question of whether the donating taxpayer has assigned income in these circumstances.[vii]
One relevant question is whether the prospective sale of the donated stock was a mere expectation on the date of the gift, or was it or a virtual certainty? Another relevant question is whether the charity was obligated, or could be compelled by one of the parties to the transaction, to surrender the donated shares to the acquirer?
The existence of an “understanding” among the parties, or the fact that the contribution and sale transactions occurred simultaneously, or according to prearranged steps, may be relevant in answering these questions.
For example, a court will likely find there was been an assignment of income where stock was donated after a tender offer has effectively been completed and it is unlikely that the offer would be rejected.
Another area of the tax law in which subsequent events have played a key role in determining the tax consequences of an earlier event is the charitable contribution of property; specifically, the valuation of such property.
For example, where a donee charity sells property within three years of its receipt as a charitable contribution, the charity must report the subsequent sale on IRS Form 8282; this acts as a check on the amount claimed by the donor as a charitable deduction in respect of such property for the year in which the contribution was made.[viii]
Transfer Tax Valuation Date
Consider also the valuation of a donor’s lifetime gift of property for purposes of determining the federal gift tax liability with respect to such transfer, or the valuation of property that is included in a decedent’s gross estate for purposes of determining the decedent’s federal estate tax liability.
In each case, the value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.[ix]
In each case, the valuation is keyed to a specified date: the date on which the gift transfer is completed or the date of death, as the case may be.[x] For example, the gift tax regulations provide that “if a gift is made in property, its value at the date of the gift shall be considered the amount of the gift.” These regulations go on to state that “[a]ll relevant facts and elements of value as of the time of the gift shall be considered.”[xi]
The foregoing references to the date of death and to the date of the gift seem to imply that events occurring after the relevant valuation date should not be considered in determining fair market value as of such date; indeed, that is the general rule.
However, the IRS has long acknowledged that “[v]aluation of securities is, in essence, a prophesy as to the future and must be based on facts available at the required date of appraisal.”[xii]
Post-Transfer Date Events
Can one reconcile the statement that post-date-of-transfer events should not be considered in determining the fair market value of property on the transfer date with the statement that the valuation process seeks to “predict” the future performance of the property?
Absolutely, if one accepts the proposition that post-transfer events should be taken into account for valuation purposes if they were reasonably foreseeable as of the valuation date.[xiii]
However, what does it mean that an event was “reasonably foreseeable?”
According to the IRS, “[a] prospective seller would inform a prospective buyer of all favorable facts in an effort to obtain the best possible price, and a prospective buyer would elicit all the negative information in order to obtain the lowest possible price. In the arm’s length negotiation between the two parties, all relevant factors available to either buyer or seller, known to both, provide a basis on which the buyer and seller make a decision to buy or sell and come to an agreement on the price.”[xiv] This would include current information concerning transactions that may occur after the valuation date.
In other words, the “reasonable knowledge of relevant facts” to which the valuation regulations refer should include those “future facts” that were knowable on the valuation date.
A recent IRS pronouncement[xv] considered whether the hypothetical willing buyer and seller of shares in a corporation[xvi] should consider a pending merger when valuing shares of the corporation’s stock for gift tax purposes.
Facts of the Ruling
Donor was a co-founder and chairman of the board of Corporation A. On Date 1, Donor transferred shares to Trust, a newly-formed grantor retained annuity trust.[xvii] Under its terms, the remainder of Trust would pass to Donor’s children upon the expiration of the annuity interest.
Later, on Date 2, Corporation A announced a merger with Corporation B. The merger was the culmination of exclusive negotiations between the two corporations occurring before the Date 1 transfer to Trust.
After the merger was announced, the value of the Corporation A stock increased substantially, though it was less than the agreed-upon merger price.[xviii]
The merger was consummated at some point after Date 1, the date of Donor’s transfer to Trust.
The IRS audited Donor’s gift tax return,[xix] and reviewed the underlying transaction documents from the year preceding the merger, including the correspondence between Corporation A and Corporation B, and the Corporation A board’s meeting minutes.
According to the IRS, the record as compiled supported the position that, as of Date 1, the hypothetical willing buyer of the shares transferred to Trust could have reasonably foreseen the merger of the two corporations and anticipated that the price of Corporation A stock would trade at a premium over what its value would otherwise have been at the valuation date.
Analysis of Valuation Rules
The IRS first reviewed the valuation rules for gift transfers (described above), including the “hypothetical willing buyer and willing seller” standard, where neither party is under any compulsion to buy or sell, and both parties have reasonable knowledge of relevant facts. The CCA stated, where it is established that the value per share of stock – as determined under the normally applicable rules[xx] – does not represent the fair market value of the stock,[xxi] some reasonable modification of the value determined on that basis, or other relevant facts and elements of value, should be considered in determining fair market value.[xxii]
“The value of property for federal transfer tax purposes,” the CCA continued, “is a factual inquiry wherein the trier of fact must weigh all relevant evidence and draw appropriate inferences to arrive at the property’s fair market value.”
The willing buyer and willing seller are hypothetical persons, the CCA stated, rather than specific individuals or entities, and their characteristics are not necessarily the same as those of the donor and the donee. What’s more, “the hypothetical willing buyer and willing seller are presumed to be dedicated to achieving the maximum economic advantage.”
According to the CCA, the principle that the hypothetical willing buyer and seller are presumed to have “reasonable knowledge of relevant facts” affecting the value of the property at issue applies even if the relevant facts at issue were unknown to the actual owner of the property.
Moreover, both parties are presumed to have made a reasonable investigation of the relevant facts. Thus, in addition to facts that are publicly available, reasonable knowledge includes those facts that a reasonable buyer or seller would uncover during the course of negotiations over the purchase price of the property. In addition, a hypothetical willing buyer is presumed to be “reasonably informed” and “prudent,” and to have asked the hypothetical willing seller for information that is not publicly available.
Reasonably Foreseeable Events
Generally, a valuation of property for federal transfer tax purposes is made as of the valuation date without regard to events happening after that date.
Subsequent events may be considered, however, if they are relevant to the question of value. Specifically, a post-valuation date event may be considered if the event was reasonably foreseeable as of the valuation date.
The CCA next reviewed a Court of Appeals decision that addressed the application of the assignment of income doctrine to a charitable contribution of stock in a corporation.[xxiii] The taxpayers owned 18 percent of Target and served as officers and directors of the corporation. Target’s board authorized an investment bank to find a purchaser for Target. Shortly thereafter, Target entered into a merger agreement with Acquirer. Target’s board unanimously approved the merger agreement, and a tender offer was started. The taxpayers then executed a donation-in-kind record with respect to their intention to donate stock to certain charities. One month later, the charities tendered their stock. A couple of days later, the final shares were tendered, and then the merger was completed. The Court concluded that the transfers to charity occurred after the shares in Target “had ripened from an interest in a viable corporation into a fixed right to receive cash” because the merger was “practically certain” to go through. In particular, the Court noted that “as of [the valuation] date, the surrounding circumstances were sufficient to indicate that the tender offer and the merger were practically certain to proceed by the time of their actual deadlines – several days in the future.” Consequently, the assignment of income doctrine applied, and the taxpayers realized gain when the shares were disposed of by the charity.
The IRS observed that the situation under consideration in the CCA shared many factual similarities with the case of donor-taxpayer, above, including a merger agreement that was “practically certain” to go through. While the Court’s opinion dealt exclusively with the assignment of income doctrine, it also relied upon the proposition that the presently-known facts and circumstances surrounding a transaction were relevant to the determination that a merger was likely to go through. The current situation, the IRS stated, presented an analogous issue; that is, whether the fair market value of the stock should take into consideration the likelihood of the merger as of the Date 1 transfer of Corporation A shares to Trust. The Court’s opinion, the CCA asserted, supported the conclusion that the value of stock in Corporation A must take into consideration the pending merger with Corporation B.
Accordingly, the value determined under the applicable regulations did not represent the fair market value of the shares transferred to Trust as of the valuation date; other relevant facts and elements of value had to be considered in determining such fair market value. Under the fair market value standard as articulated in the regulations, the hypothetical willing buyer and willing seller, as of Date 1, would be reasonably informed during the course of negotiations over the purchase and sale of the shares and would have knowledge of all relevant facts, including the pending merger. Indeed, the CCA stated, “to ignore the facts and circumstances of the pending merger would undermine the basic tenets of fair market value and yield a baseless valuation.”
Thus, the IRS concluded that, under the fair market value standard, the hypothetical willing buyer and seller would consider a pending merger of a corporation when valuing the corporation’s stock for gift tax purposes.
Use Your Crystal Ball
So, what does this mean for the owner of a closely held business who may be planning for the sale of their business, but who may also be interested in doing some estate planning?
In order to maximize the effectiveness of an estate plan that involves the transfer by the owner of their interest in the business, it is important to recognize certain guiding principles: (i) the gift transfer of the interest to a family member, or to a trust for the benefit of a family member, will remove the current value of the interest from the transferor’s gross estate for purposes of the federal estate tax; (ii) the transfer will also remove the income generated by that interest from the gross estate; (iii) if a grantor trust is used as the vehicle for the gift transfer, the transferor’s future gross estate will be reduced by the amount of the tax on such income; and, perhaps most importantly, (iv) the appreciation in the value of the transferred interest will be removed from the transferor’s gross estate.[xxiv]
What Really Happens
Of course, in order to obtain these transfer tax benefits, the business owner has to be willing to give up at least some of their equity in the business sooner rather than later.
Predictably, however, most business owners are reluctant to give up any ownership until they are ready to consider a sale of the business. This is borne out by the number of times I have had owners, who have just executed a letter of intent (“LOI”) for the sale of their business, ask me about transferring some of their interest in the business to a trust for the benefit of their children.[xxv]
Therein lies the issue. Assume that, within a month of executing the LOI, the owner makes a gift of some of their equity – representing a minority interest – to a trust, and say that the sale of the business is consummated a couple of months after that, on substantially the same business terms as set forth in the LOI.
The owner obtains an appraisal report for the minority interest that claims discounts for lack of control and lack of marketability. The report does not mention the LOI or the sale. The owner then files a gift tax return reporting the transfer and the gift tax consequences thereof using the value set forth in the appraisal.
The owner, the trust and the business each file an income tax return reporting the sale of the business; the gain realized is based upon the agreed-upon purchase price.[xxvi]
How is the IRS going to approach the now-former owner’s gift tax return?[xxvii] For one thing, as in the case of the CCA described above, was the sale of the business reasonably foreseeable at the time of the gift? The IRS will consider that the LOI was already executed by the time the gift was made, and it will observe that the business was, in fact, sold shortly thereafter.
With the benefit of hindsight, the IRS can choose from two lines of attack: the reported valuation was too low – no discounts should have been claimed because the sale (and the resulting conversion of the equity interest to cash) was reasonably foreseeable at the time of the gift;[xxviii] or the reported valuation was too low for purposes of the gift tax, and the grantor should be taxed on the gain from the sale.[xxix]
Bottom line: a gifting program with respect to the equity in one’s business is not something to be initiated on the eve of a sale of the business if one hopes to minimize the gift tax impact thereof, and one must take a realistic approach to the valuation of the gifted interest, which should include a consideration of significant upcoming “corporate” events.
[i] And often without due regard to the circumstances or context within which such decision was made.
[ii] I am told that psychologists refer to this as “outcome bias.” No surprise there.
[iii] See, e.g., Reg. Sec. 1.6664-4.
[iv] Based in no small part on their differing perspectives with respect to the business.
[v] Anything longer may be more indicative of the buyer’s efforts on behalf of the business rather than of the going concern that the seller built and then sold to the buyer.
[vi] This is commonly referred to as an “earn-out” and is premised on the attainment by the business of certain agreed-upon financial targets. Installment reporting, under IRC Sec. 453, will be applied to report the gain attributable to the receipt of a post-closing earn-out payment. In addition, the imputed interest rules will apply to convert some of the “deferred” purchase price from capital gain into ordinary interest income. IRC Sec. 1274.
[viii] Donee Information Return (Sale, Exchange or Other Disposition of Donated Property).
[ix] Reg. Sec. 20.2031-1(b); Reg. Sec. 25.2512-1; Rev. Rul. 59-60, 1959-1 C.B. 237.
[x] We’ll ignore the alternate valuation date under IRC Sec. 2032.
[xi] Reg. Sec. 25.2512-1.
[xii] Rev. Rul. 59-60, Sec. 3. That’s because the date-of-death value of a property – such as an equity interest in a business – necessarily reflects the future stability of the property and its prospects for growth. A negative view of its future as of the date of transfer will result in a lower value as of that date, whereas a more positive outlook would result in a greater value.
[xiii] Furthermore, a post-valuation date event, even if unforeseeable as of the valuation date, may be probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date.
For example, a sale of stock between other parties shortly after the valuation date. The same concept underlies the purpose of IRS Form 8282 dealing with the subsequent sale of property contributed to a charity.
[xiv] Rev. Rul. 78-367, 1978-2 C.B. 249.
[xv] Chief Counsel Advice Memorandum (“CCA”) 201939002. CCAs are issued by the Office of Chief Counsel to assist IRS personnel in performing their functions by providing legal opinions on certain matters.
[xvi] The corporation in the CCA was publicly traded, but the concepts discussed are just as applicable to the case of a closely held corporation.
[xvii] GRAT. IRC Sec. 2702; Reg. Sec. 25.2702-3.
[xviii] The merger price reflected a premium?
[xix] IRS Form 709.
[xx] For example, based on a multiple of earnings.
[xxi] For example, where, as in this case, there was a merger in the corporation’s future.
[xxii] Reg. Sec. 25.2512-2(e).
[xxiii] Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999), aff’g 108 T.C. 244 (1997).
[xxiv] This strategy is most effective if the donor funds a generation-skipping trust to which they allocate their GST exemption amount. In this way, the value of the gifted interests will not be taxable to the family until they are distributed to the beneficiaries, who then make a taxable transfer thereof.
[xxv] Sadly, a not-so-distant second is the following question: “Can I change my residence to Florida and avoid paying New York tax on the gain?” Shoot me now.
[xxvi] Depending upon the form of the sale, this may include the buyer’s assumption of, or their taking subject to, certain liabilities.
[xxvii] Yes, I am assuming that the return will be examined. One should always assume that a return will be examined, and advise accordingly.
[xxviii] This would result in the owner’s exhausting more of their estate tax exemption amount than they had anticipated; it may even cause the owner to incur a gift tax liability.
[xxix] If the gift was made via a grantor trust, the owner would be taxable on the gain in any event. IRC Sec. 671.