Crossing the Streams[i]

It is not uncommon, in the context of a business entity in which a family owns a controlling or substantial interest, for an adviser to encounter intersecting gift and income tax issues.

This week’s post will consider one such instance in which the IRS was asked to determine the tax consequences of certain transfers of stock by an individual shareholder of the issuing corporation and by the trusts created for the benefit of the shareholder’s family.[ii]

Before describing these transactions, it may be helpful to briefly review some of the applicable tax principles.

Gift Tax Basics

The gift tax applies to a transfer by way of gift whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.

Any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to tax.[iii]

For example, a transfer of property by a corporation to an individual is a gift to the individual from the shareholders of the corporation,[iv] assuming that the transfer was not made for an adequate and full consideration in money or money’s worth. If the individual is also a shareholder, the transfer is a gift to him from the other shareholders but only to the extent it exceeds the individual’s own interest in such amount as a shareholder.[v]

Similarly, a transfer of property by the individual to the corporation, that is not made for an adequate and full consideration in money or money’s worth, generally represents gifts by the individual to the other individual shareholders of the corporation to the extent of their proportionate interests in the corporation.

Donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer. 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.[vi]

The gift tax is applicable only to a transfer of a beneficial interest in property. It is not applicable to a transfer of bare legal title to a trustee.[vii]

In addition, the tax is not applicable to a transfer for full and adequate consideration in money or money’s worth, or to “ordinary” business transactions.[viii]

An otherwise gratuitous transfer of a beneficial interest in property is not treated as a taxable gift unless and until the donor has so parted with dominion and control as to leave in the donor no power to change the disposition of such property interest – the gift must be completed.[ix]

That said, the gift tax is not imposed upon the receipt of the property by the donee, nor is it necessarily determined by the measure of enrichment resulting to the donee from the transfer, nor is it conditioned upon the ability to identify the donee at the time of the transfer.[x]

Instead, the tax is a primary and personal liability of the donor that is imposed upon the donor’s making the transfer, is measured by the fair market value of the property passing from the donor, and attaches regardless of the fact that the identity of the donee may not then be known or ascertainable.

Now let’s turn to the scenario presented to the IRS.

The Transfers

Corp was engaged in Business and employed Taxpayer as an executive.

Corp had three classes of common stock outstanding: Stock A, Stock B, and Stock C. The shares of Stock A and Stock B were identical except each share of Stock B carried greater voting rights than each share of Stock A. Stock C had no voting rights, except as otherwise required by law.

At varying times, Taxpayer established separate trusts for the benefit of various members of Taxpayer’s family (the “Trusts”); none of these beneficiaries were employees of Corp or Taxpayer.

Corp formed LLC for what was represented to be a valid corporate purpose (the “Corp Purpose”); because Corp was its only member, Corp controlled the policies of LLC related to the Corp Purpose. LLC was disregarded as an entity separate from Corp for federal income tax purposes.[xi]

Stock B was held, in part, by Taxpayer and eight of the Trusts. A ninth trust owned shares of Stock A.

At some point, Corp made an initial contribution of newly issued shares of Stock C to LLC. These shares of Stock C were not considered outstanding for federal income tax purposes.[xii]

Under its terms, upon a transfer of any Stock C share to a holder other than LLC or another subsidiary of Corp, the transferred Stock C share would automatically convert on a share-for-share basis into a share of Stock A.

Taxpayer, the Trusts, and Corp intended to enter into a binding agreement (the “Agreement”) whereby Taxpayer and the Trusts would each surrender a portion of their shares of Stock A or Stock B, as the case may be, to Corp to be retired, following which Corp would transfer a like number of newly issued shares of Stock C to LLC (the “Proposed Transaction”).

Specifically, and for what were represented to be valid business purposes:

(i) The Trusts and Taxpayer (each a “Contributing Shareholder”), in accordance with the Agreement, would contribute a portion of their Stock A or Stock B, as the case may be, to the capital of Corp for the benefit of LLC (the “Contribution”).[xiii]

(ii) When Corp received shares from Contributing Shareholders pursuant to the Agreement, Corp would retire such shares and transfer a like number of newly issued shares of Stock C to LLC.

(iii) LLC would use cash derived from Stock C for the Corp Purpose.

Corp and the Contributing Shareholders made the following representations regarding the Proposed Transaction:

(a) The Contributing Shareholders would not receive any consideration from Corp with respect to the surrender of their stock to the capital of Corp in the Proposed Transaction.

(b) The stock surrendered to the capital of Corp in the Proposed Transaction would be canceled and such stock or similar shares of stock of Corp would not be returned to the Contributing Shareholders following the Proposed Transaction.

(c) Corp did not intend to fund LLC with property other than Stock C or cash.

(d) There was no plan to transfer the shares of Stock C to any employee or independent contractor in connection with the performance of services.[xiv]

(e) The Contributing Shareholders were not related to any of the Non-Contributing Shareholders such that stock ownership of a Contributing Shareholder would be attributed to a Non-Contributing Shareholder.[xv]

(f) The Proposed Transaction was motivated solely by the Contributing Shareholders’ and Corp’s business considerations and was not motivated by any intent to confer a federal income tax benefit on any shareholder.

Transaction Rulings

Based on the foregoing, the IRS ruled that:

(1) The surrenders of Stock A or Stock B by the Contributing Shareholders to Corp in the Proposed Transaction were a non-taxable contribution to the capital of Corp and accordingly, the Contributing Shareholders would not recognize gain or loss on such contribution.[xvi]

(2) Each Contributing Shareholder’s basis in the shares surrendered in the Proposed Transaction would be allocated to the Contributing Shareholder’s basis in their remaining shares.[xvii]

(3) Corp’s receipt of shares of Stock A or Stock B from the Contributing Shareholders would not be taxable to Corp.[xviii]

Gift Tax Rulings

The Code imposes a gift tax for each calendar year on the transfer of property by gift during such year by any individual.[xix]

Where property is transferred for less than an adequate and full consideration in money or money’s worth, then the amount by which the value of the property exceeded the value of the consideration is deemed a gift, and is included in computing the amount of gifts made during the calendar year.[xx]

As indicated above, donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer. 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.[xxi]

Any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to tax.

A transfer of property by an individual to a corporation without the transfer of consideration by the corporation to the individual – such as shares of stock of the corporation, other property (including money), or a note – generally represents a gift by such individual to the other individual shareholders of the corporation to the extent of their proportionate interests in the corporation.[xxii]

Ordinary Course of Business

The gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth.

Significantly, the tax is also inapplicable to ordinary business transactions.[xxiii] 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 – is considered as made for an adequate and full consideration in money or money’s worth.[xxiv]

For example, the IRS has previously ruled that the transfer of stock by two shareholders to three employees as a bonus in consideration of past services to the corporation was not subject to gift tax where the shareholders were not related to the employees and no other special personal relationship existed between them.[xxv] The transfers to the employees were made in the ordinary course of business[xxvi] because the transfers were motivated by a valid business reason – retaining valuable personnel in the employment of the corporation. Therefore, the transfers were not subject to gift tax.[xxvii]

The Non-Contributing Shareholders

Corp was owned by Taxpayer, the Trusts, and the Non-Contributing Shareholders. Taxpayer and the Trusts agreed to surrender shares to Corp in order to fund LLC. By entering into Agreement, Taxpayer and the Trusts were increasing the value of the shares held by the Non-Contributing Shareholders.

For gift tax purposes, this transfer was characterized as an indirect transfer of property from Taxpayer and the Trusts to the Non-Contributing Shareholders.[xxviii]

A transfer of property made in the ordinary course of business – a transaction which is bona fide, at arm’s length, and free from any donative intent – is considered as made for adequate and full consideration in money or money’s worth. Such a transfer is not subject to the gift tax.

The transfer made through the Agreement satisfied all three of the requirements to be considered as made in the ordinary course of business:

1. First, the Agreement was for the bona fide business purpose of furthering the Corp Purpose.
2. Second, the transfer from Taxpayer and the Trusts to the Non-Contributing Shareholders was at arm’s length because the transaction was a business transaction, the parties acted in their own self-interest and were not subject to pressure from the other parties, and the Non-Contributing Shareholders were not related to Taxpayer or the Trusts.
3. Finally, the transfer was made without donative intent because the transfer was made for the sole purpose of furthering the Corp Purpose.

Accordingly, the indirect transfer from Taxpayer and the Trusts to the Non-Contributing Shareholders was deemed to be made for adequate and full consideration in money or money’s worth. Therefore, the indirect transfers made to the Non-Contributing Shareholders pursuant to the Agreement did not constitute gifts from Taxpayer or the Trusts.

Taxpayer and the Trusts

By entering into the Agreement, each party thereto was increasing the value of the shares held by the other; i.e., Taxpayer was increasing the value of the shares held by the Trusts, the Trusts were increasing the value of shares held by Taxpayer, and each individual trust was increasing the value of each other individual trust.

The transfers between Taxpayer and the Trusts were not at arm’s length, and, therefore, they were not made in the ordinary course of business. However, under the Agreement, Taxpayer and the Trusts were each surrendering an equal proportion of their shares of Corp and, consequently, the value of the indirect transfers made by each of the parties to the Agreement was equal to the value of the indirect transfers received by each party.

Accordingly, the indirect transfers made from Taxpayer to the Trusts and from the Trusts to Taxpayer (and each other trust) were made for full and adequate consideration in money or money’s worth.

Therefore, the Contributing Shareholders were not subject to gift tax.

What Does It Mean?

According to the IRS, donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer. 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 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.” 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, as explained above – will be considered as made for an adequate and full consideration.

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.

Of course, a transfer of value 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.

The key is that the transfer or other transaction is principally motivated by at least one strong business purpose, and that such purpose be well documented contemporaneously with the transfer. The stronger the business purpose, the greater the likelihood of the IRS’s finding the transaction was made for an adequate and full consideration, thereby avoiding a taxable gift.

The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] “Crossing streams is like Russian roulette, protonic reversal may never happen. But it might.” Ghostbusters.

[ii] PLR 202406006 February 13, 2023

[iii] Reg. Sec. 25.2511-1(c).

[iv] Corporations and other regarded business entities are not subject to the gift tax.

[v] Reg. Sec. 25.2511-1(h)(1).

[vi] That said, we will see shortly that there are circumstances under which the donor’s motive may be relevant.

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

[viii] See below.

[ix]Reg. Sec. 25.2511-2(b).

[x] Reg. Sec. 25.2511-2(a), (c), and (d).

[xi] Reg. Sec. 301.7701-3.

[xii] Again, LLC was a disregarded entity of which Corp was the sole member. Thus, Corp was treated as owning its own Stock C.

[xiii] The shareholders of Corp, other than the Contributing Shareholders, were referred to as the “Non-Contributing Shareholders.”

[xiv] Within the meaning of IRC Sec. 83 or otherwise.

[xv] Pursuant to IRC Serc. 318(a)(1) or Sec. 267(c)(2).

[xvi] See Commissioner v. Fink, 483 U.S. 89 (1987).

[xvii] Id.

[xviii] IRC Sec. 118(a).

The IRS also ruled that the Non-Contributing Shareholders would not recognize any income as a result of the Proposed Transaction, and the Contributing Shareholders’ surrender of shares to Corp would not be treated as a distribution of property to the Non-Contributing Shareholders. Reg. Sec. 1.305-3(b)(3) and Sec. 1.305-3(e), Example (13).

[xix] IRC Sec. 2501(a)(1).

[xx] IRC Sec. 2511(a); Reg. Sec. 25.2511-1(c)(1).

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

[xxii] Reg. Sec. 25.2511-1(h).

[xxiii] As described in Reg. Sec. 25.2512-8.

[xxiv] That is so even if one party to the transaction later concludes that the consideration received in the exchange was inadequate.

[xxv] Rev. Rul. 80-196.

[xxvi] Reg. Sec. 25.2512-8.

[xxvii] Gross income generally does not include the value of property acquired by gift. However, this rule generally does not exclude from an employee’s gross income any amount transferred by or for an employer to, or for the benefit of, such employee. IRC Sec. 102(a) and Sec. 102(c)(1).

[xxviii] Reg. Sec. 25.2511-1(c)(1) and Sec. 25.2511-1(h).