Rafferty v. Commissioner

Sibling Rivalry

Many of us encounter family-owned corporations in which the founder’s children are engaged in the business to varying degrees. They may even own shares in the corporation, typically having received them as gifts from their parents.[i] These situations may develop in such a way that they present difficult succession planning considerations for the business.

It may be that two or more siblings actively participate in the business. The more capable among them may aspire to lead the corporation after their parents have retired or passed away. At some point, their competing goals, personalities, or divergent management styles may generate enough friction between the siblings, and within the corporation, so as to jeopardize the continued well-being of the business.[ii]

Alternatively, the siblings may be interested in different parts of the corporation’s business. Each sibling may be responsible for a different line of business; for example, a different product, service, or geographic region. Their differing interests may lead to disagreements as to the allocation of resources and the prioritization of goals.

The dispute between the siblings will sometimes fester – and their relationship will deteriorate – to the point where litigation, along with its attendant costs and disruption of the business, are inevitable.[iii]

Dividing the Business?

In that case, it may still be possible to de-escalate the situation, and avoid further bloodshed[iv] – not to mention expense and loss of revenue – if it can be demonstrated to the feuding siblings that the business may be divided between them on a tax-efficient (i.e., economical) basis, especially where they have already incurred significant legal costs in trying to divorce themselves from one another.

Of course, it would be preferable (and less expensive) if the siblings could separate from one another without first resorting to litigation, although it is often the case that such litigation becomes the impetus for a more constructive approach toward the settlement of the parties’ disputes.

Indeed, if the parents could reasonably foresee the risk of serious disagreement among their successors in the business, they may decide to explore with their tax and corporate advisers whether the business can be divided among the kids while the parents are still alive and before the business suffers the adverse consequences that typically accompany such infighting.[v]

There are two basic forms of corporate division by which two or more shareholders may go their separate ways. In the “split-off” form of division, the parent corporation distributes all of its shares in a subsidiary corporation[vi] to one of more of its shareholders in a complete redemption of their shares in the parent corporation, leaving the parent corporation in the hands of its remaining shareholders. In the “split-up” form of division, the parent corporation distributes all its shares in at least two subsidiary corporations to at least two different sets of shareholders in a complete liquidation of the parent corporation.

There is also a third form of division – a “spin-off” – by which a parent corporation may distribute the stock of its subsidiary corporation to at least some of its shareholders by way of a “dividend,” thereby changing the form of the relationship to that of brother-sister corporations with some degree of common ownership.[vii]

“Tax-Free” Divisions

Whatever form of division is selected, there are numerous requirements that must be satisfied in order for the division to receive favorable tax treatment. In general,

    1. the distributing parent corporation must distribute to some or all of its shareholders all of the stock of a subsidiary corporation[viii] controlled by the parent,
    2. the distributing corporation and the subsidiary corporation must each be engaged in the “active conduct of a trade or business” immediately after the distribution,[ix]
    3. neither active trade or business was acquired in a taxable transaction during the five-year period preceding the distribution,
    4. there is a real and substantial business purpose for the distribution that cannot be accomplished by another nontaxable alternative which is neither impractical, nor unduly expensive,
    5. the transaction must not be used principally as a “device” for the distribution of the earnings and profits of either the distributing corporation or the subsidiary corporation,
    6. the distributee shareholders did not acquire their shares in the distributing parent corporation by “purchase” during the five-year period ending on the date of the distribution; and
    7. the distribution is not made pursuant to a plan by which at least 50% of parent or of the former subsidiary is acquired by third parties.[x]

In general, if these requirements are satisfied, (1) the shareholders will not recognize gain or loss upon the receipt of the subsidiary stock, (2) the distributing corporation will not recognize gain or loss upon the distribution of the subsidiary stock to the shareholders, (3) the aggregate basis of the subsidiary stock received by each shareholder immediately after the distribution will equal the shareholder’s aggregate basis in the distributing corporation stock surrendered in the distribution, and (4) the holding period of the subsidiary stock received by each shareholder will include the holding period of the stock in the distributing corporation with respect to which the distribution of the subsidiary stock is made.[xi]

If these criteria are not met, then the distributing corporation will be treated as having sold the distributed property for an amount equal to the property’s fair market value, it will have to recognize the gain realized on deemed sale of the property, and it will be taxed thereon. The shareholders will be taxed on their receipt of the property distributed by the corporation, either as a dividend of an amount equal to the fair market value of such property, or as a payment of the same amount in exchange for their shares of stock in the distributing corporation.

In order to avoid the adverse tax consequences described immediately above, it is imperative that each of the requirements for a “tax-free” division of the distributing corporation be satisfied.

Business Purpose

In the context of a family-owned corporation, the requirement that the distribution be carried out for a real and substantial corporate business purpose may present a unique challenge, at least where the ostensible business purpose for the division of the corporation is to enable competing siblings – who would otherwise succeed to the ownership and management of the corporation – to go their separate ways.

Specifically, it may be difficult in that case, depending upon the facts and circumstances, to distinguish between a corporate business purpose, on the one hand, and a personal non-business purpose of the shareholders, on the other.

That being said, it should be noted that one of the most commonly relied upon corporate business purposes for the distribution of a subsidiary as part of a corporate division is that it will enhance the success of each corporation’s business by enabling a significant shareholder or shareholder group to concentrate on a particular line of business, and to thereby resolve management or other problems that arise, or are exacerbated, by the operation of different businesses within a single corporation.[xii]

However, the IRS has long recognized the potential, in the context of a family-owned corporation, for such a distribution to also facilitate the personal planning (such as estate planning or gifts) of a shareholder.

In order to better understand how to prepare for an IRS challenge on such grounds,[xiii] the parties and their advisers will need to familiarize themselves, in the first instance, with the published guidance provided by the IRS itself, including the two rulings described below.[xiv]

Scenario One

The IRS once considered the case of a corporation (“Corp”) that operated an automobile dealership.[xv] Its franchise for the sale of automobiles was in Dad’s name; the franchise could not be held by the corporation, was renewable periodically, and was not transferable by inheritance or otherwise.

Dad managed Corp and owned a majority of its stock. He was elderly, and the Corp stock constituted the bulk of his estate. The balance of Corp’s stock was held equally by Dad’s five daughters, only three of whom were active in the business.

Corp’s wholly-owned subsidiary (“Sub”) was engaged in the business of renting automobiles.

The automobile manufacturer did not permit the granting or continuing of a franchise where there were inactive shareholders in the corporation unless an active majority shareholder held the franchise. Alternatively, the manufacturer permitted the granting or continuing of a franchise where there was no majority shareholder, provided the shareholders were few in number and all were active in the business.

The IRS noted that, upon Dad’s death or retirement, the present stock ownership of Corp, with proportionate bequests or gifts to Dad’s daughters, would preclude satisfaction of the active-shareholder criteria described above for the purpose of renewing the franchise.

In order to ensure that its remaining shareholders would be able to renew the franchise upon Dad’s death or retirement under the alternate conditions of the franchise policy – without chancing a potential interruption in the continuity of, or even the loss of, the franchise which might occur if nothing was done until after Dad’s departure – Corp distributed 75% of Sub’s stock to the two inactive-daughter shareholders in exchange for all of their stock in Corp. The remaining 25% of Sub’s stock was distributed to Dad in exchange for Corp shares of equal value.

Dad intended that, upon his death, the inactive-daughter shareholders would receive their inheritance in Sub stock (and assets other than Corp stock), while the active-daughter shareholders would receive his shares of Corp stock.

The IRS determined that distribution of the Sub stock to Dad furthered the objective of enabling Corp’s active-daughter shareholders to retain the franchise by increasing their percentage of ownership in Corp, and by providing Dad with Sub stock which he could bequeath or gift to the inactive-daughter shareholders, leaving his remaining Corp stock available for transfer to the active-daughter shareholders.

The IRS also found that Dad’s age presented an immediate problem, [xvi] and that the distribution of Sub’s stock was germane to the continuation of Corp’s business in the reasonably foreseeable future. Execution of the plan, therefore, was directly related to the retention of a franchise vital to Corp’s business and would forestall an impending disruption to such business by reason of the current active family group being unable to renew the corporation’s franchise upon Dad’s death or retirement.

Scenario Two

In another ruling[xvii] the IRS considered a corporation (“Corp”) the stock of which was owned equally by Parents, Son, and Daughter. Although Parents participated in some major management decisions, most of the management, and all of the operational activities, were performed by Son and Daughter.

Son and Daughter disagreed over the future direction of Corp’s business. Son wished to expand one line of business, but Daughter was opposed because this would require substantial borrowing by Corp. Daughter preferred to sell that line of business and concentrate on Corp’s other business. Despite the disagreement, the two siblings cooperated on the operation of the business in its historical manner without disruption. Nevertheless, it prevented each sibling from developing, as he or she saw fit, the business in which he or she was most interested.

Parents remained neutral on the disagreement between their children. However, because of the disagreement, Parents preferred to bequeath separate interests in the business to their children.

To enable Son and Daughter each to devote their undivided attention, and apply a consistent business strategy, to the line of business in which he or she was most interested, and to further Parents’ estate planning goals, Corp contributed one of its lines of business to a newly-formed and wholly-owned subsidiary corporation (“Sub”), and distributed 50% of Sub’s stock to Son in exchange for all of his stock in Corp. Corp then distributed the remaining Sub stock to Parents in exchange for half of their Corp stock.

Going forward, Daughter would manage and operate Corp and have no stock interest in Sub, and Son would manage and operate Sub and have no stock interest in Corp. Parents would also amend their wills to provide that Son and Daughter would inherit stock only in Sub and Corp, respectively. After the distribution, Parents would still own 50% of the outstanding stock of Corp and of Sub, and would continue to participate in certain management decisions related to the business of each corporation.

The IRS determined that the distribution would eliminate the disagreement between Son and Daughter over the future direction of Corp’s business, and would allow each sibling to devote their undivided attention to the line of business in which they were most interested, with the expectation that each business would benefit. Therefore, although the distribution was intended, in part, to further the personal estate planning of Parents and to promote family harmony, it was motivated in substantial part by a real and substantial non-tax purpose that was germane to the business of Corp. Thus, the business purpose requirement was satisfied.

Guideposts?

It is clear that the division of a family-owned corporation may be effectuated for the purpose of resolving or eliminating management disputes among siblings. It may also be undertaken for the purpose of staving off reasonably foreseeable or imminent harm to a business that is attributable to the composition of its shareholders.

Moreover, the division may be accomplished on a tax-efficient basis, provided the criteria set forth above are satisfied, including the requirement that the distribution by the family-owned corporation of the stock in its subsidiary be motivated in whole or in substantial part by a business purpose, as distinguished from a nonbusiness purpose. Specifically, can the parties to the transaction demonstrate that there is an immediate business reason for the distribution?

In each of the two scenarios described above, there were “clear and present” reasons for the divisive distribution; the failure to act would have resulted in significant harm to the business of either or both of the corporations. The difficulties anticipated were not remote, and the resulting harm to the business was not conjectural.

However, one can imagine a situation in which the immediacy of the stated business purpose may not be obvious to an outsider, or where the severity of the consequences to be avoided is not easily determinable. In the context of a family-owned corporation, the presence of these factors – a remote risk or an ill-defined harm – may call into question whether the distribution is motivated in substantial part by a bona fide business purpose; the failure to establish such a purpose may cause the corporation’s distribution of its subsidiary to be taxable.

For that reason, if a “divisive” transaction is to withstand IRS scrutiny, the closely held corporations and the shareholders that are parties to the transaction must be prepared to substantiate the corporate business purposes which they claim motivated the transaction in whole or substantial part. They must be ready to present documentation that provides complete factual support for the stated business purpose, that describes in detail the problems associated with the current corporate structure, and that demonstrates why the distribution will lessen or eliminate those problems. As always, this body of “evidence” should be compiled contemporaneously with the events that culminate in the division of the corporation – not after the IRS has selected the parties for audit.


[i] Or as partial gifts (as in the case of a bargain sale); rarely in exchange for capital contributions, or as compensation.

[ii] Regardless of the size of the social unit, be it a family, a business, or even a nation, the results can be severe. History gives us many examples. The Old Testament alone is full of references to the consequences of sibling rivalry: Cain and Abel, Isaac and Ismael, Esau and Jacob, then down to the sons of Solomon (ironic that the kingdom of the man who rendered the Judgment of Solomon – “suggesting” that a baby be split in half in order to ascertain its true mother – should be split in two after his death).

[iii] Forget about holidays and family gatherings – Thanksgiving is never the same.

[iv] Tax lawyers enjoy the figurative use of language because we are so rarely afforded the opportunity. Our exchanges (pun intended) with others are so often limited to words such as “gain, loss, deferral, recognition . . .” and, of course, “tax.”

[v] Too often, the parents don’t want to deal with the obviously gestating issues within their family. They tell themselves that the kids will learn to work together, or they will deny the problem altogether, leaving it for the kids to resolve it after the parents are gone. We know how that usually works out. Not the sort of legacy for which most folks yearn.

[vi] The subsidiary may be formed just prior to the distribution; for example, the parent corporation may contribute one line of business to a newly-formed subsidiary as a prelude to the distribution of the stock of the subsidiary, as described above; or it may be an existing entity that is engaged in a trade or business that is related to, or completely different from, the business conducted by the distributing corporation (or by its remaining subsidiary).

[vii] This is likely the form of division that parents would undertake in preparation for transferring different parts of their business to different children.

[viii] Often referred to as the “controlled corporation.”

[ix] I.e., a “trade or business” that has been “actively conducted” throughout the 5-year period ending on the date of the distribution. This requirement has spawned some litigation between taxpayers and the IRS.

[x] Underlying the divisive reorganization provisions of the Code is the principle that it would be inappropriate to tax a transaction as a result of which the participating taxpayers – the corporations and their shareholders – have not sufficiently changed the nature of their investment in the corporation’s assets or business, provided the transaction is motivated by a substantial non-tax business purpose.

[xi] IRC Sec. 355, IRC Sec. 368(a)(1)(D).

[xii] For example, in Example (2) of Reg. Sec. 1.355-2(b)(5), Corporation X is engaged in two businesses: the manufacture and sale of furniture and the sale of jewelry. The businesses are of equal value. The outstanding stock of X is owned equally by unrelated individuals A and B. A is more interested in the furniture business, while B is more interested in the jewelry business. A and B decide to split up the businesses and go their separate ways. A and B expect that the operations of each business will be enhanced by the separation because each shareholder will be able to devote his undivided attention to the business in which he is more interested and more proficient. Accordingly, X transfers the jewelry business to new corporation Y and distributes the stock of Y to B in exchange for all of B’s stock in X. The example concludes that the distribution is carried out for a corporate business purpose, notwithstanding that it is also carried out in part for shareholder purposes.

[xiii] An exercise that should be completed before the transaction is even undertaken.

[xiv] Although the IRS’s public pronouncements are generally limited to the application of the law to a specific set of facts, they nevertheless provide a useful glimpse into the IRS’s thinking on the issues examined therein.

[xv] Rev. Rul. 75-337.

[xvi] In contrast, the IRS described a decision where the court held, under a plan to avoid any remote possibility of interference in a business by future sons-in-law, that the spin-off had no immediate business reason, involved a personal motive, and had as its primary purpose a desire to make bequests in accordance with an estate plan. The difficulties anticipated were so remote that they might never come to pass. The daughters might never marry – thus eliminating completely any cause to worry about business interference by future sons-in-law. There was, at best, “only an envisaged possibility of future debilitating nepotism,” and the effect on the business was conjectural. Rafferty v. Commissioner, 452 F.2d 767 (1st Cir. 1971).

[xvii] Rev. Rul. 2003-52.