In a recent division opinion, the Tax Court considered whether a settlement agreement that required shares be transferred to trusts for the benefit of the transferor’s children were not taxable gifts because they were ordinary business transactions. The case is a good read because it unpacks the Tax Court’s framework for considering the “ordinary business transaction” rule in the gift tax context. Also, the Tax Court rejected the IRS’s proposed “source of the consideration” standard in this context.
The decedent died in late 2011. Decedent, his father, and his brother were engaged in a family drive-in movie theater business. As the family business grew, they formed a consolidated entity, known as NAI. Although each of them contributed different amounts, they received equal share ownership in the consolidated entity (100 shares each). As dad got older, he developed a plan to retire gradually from the business. He decided to transfer half of his common stock to his grandchildren (which were placed in trust) and to exchange the remaining for preferred stock. Due to various issues, decedent decided to leave the family business.
Upon leaving, the decedent demanded possession of his 100 shares; however, he did not receive them. So, he hired a lawyer. The decedent “threatened to sell the shares to an outsider if NAI did not redeem them at an appropriate price.” Father and brother wanted to keep the business within the family. In response, Father argued, among other things, that a portion of the decedent’s stock was actually held in an oral trust for the benefit of decedent’s children—this argument was based on that decedent had contributed more capital than he had received stock.
The parties negotiated for several months without success. Eventually, lawsuits ensued in state court, which were “quite adversarial” and their “public nature was extremely distressing” to the family. The parties later reached a settlement. Of the 100 shares, the parties agreed that the decedent owned free and clear only 66 2/3 of the shares; the remaining 33 1/3, they agreed, had been held by the decedent for the benefit of his children in trust. The parties then agreed that NAI would purchase the 66 2/3 shares; decedent also executed irrevocable declarations of trusts for the benefit of his children. In the settlement agreement, the parties executed various releases against each other and resolved other disputes. The settlement agreement was incorporated into a final judicial decree in 1972.
Later litigation brought the series of events to the attention of the IRS. No gift tax return had been filed for 1972 because decedent and his accountant believed that he did not make a taxable gift to the trusts. Rather, they viewed the transfer as renouncing his ownership interest in those shares to obtain payment for the remaining 66 2/3 shares. In 2013, the IRS assessed a gift tax deficiency allocable to the 1972 transfer.
The issue before the Tax Court, then, was whether a taxable gift occurred by virtue of the settlement.
Section 2512(b) provides that, “[w]here 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 shall be deemed a gift . . . .” Thus, as the court noted, “[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 Federal gift tax purposes.” See Comm’r v. Wemyss, 324 U.S. 303 (1945). Indeed, the relevant Treasury Regulations provide 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 . . . .” Treas. Reg. § 25.2511-1(g)(1). The regulations continue to define a transfer made in the ordinary course as “a transaction which is bona fide, at arm's length, and free from any donative intent . . . .” Treas. Reg. § 25.2512-8. Even though intra-family transactions receive close scrutiny, transfers of property between family members can still be treated as in the ordinary course of business if they meet the elements in the regulation.
Citing to Beveridge v. Commissioner, 10T.C. 915 (1948), and other cases, the court noted that “this Court has held that a transfer of property between family members, in settlement of bona fide unliquidated claims, was made for “a full and adequate consideration” because it was a transaction in the “ordinary course of business.” The court then turned to the three elements: the transfer must have been (1) bona fide, (2) transacted at arm’s length, and (3) free of donative intent. In the context of family disputes, the court identified other “subsidiary” factors that may be relevant, including whether the controversy was genuine; whether the parties were represented by counsel; whether the parties engaged in adversarial negotiations; whether the settlement was motivated by desire to avoid litigation hazards (e.g., uncertainty and costs); and whether the settlement was incorporated into a judicial decree.
First, the court first examined the bona fide element. The test here is to consider “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.” The court found that the decedent’s transfers of stock in trust for his children represented bona fide settlement of a genuine dispute.
Second, the court examined the arm’s length requirement. The test is satisfied “so long as the taxpayer acts ‘as one would act in the settlement of differences with a stranger.’” (quoting Beveridge, 10 T.C. at 918). The court noted that the parties hired lawyers and negotiated as genuine adversaries. Moreover, the court also examined the subsidiary factors, such as settling to avoid litigation hazards and that the compromise was incorporated into a judicial decree. Thus, the court held that the transfer of shares in trust was an arm’s length transaction.
Third, the court examined whether any donative intent was present. Donative intent is not a prerequisite for a taxable gift, but “the absence of donative intent is essential for a transfer to be treated as made ‘in the ordinary course of business.’” As the court noted, “[g]enerally, 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.’” (quoting Beveridge, 10 T.C. at 918). Here, the court found that decedent transferred stock not because he wished to do so, but rather because to settle the dispute and to obtain payment for the remaining shares. In other words, there was “no evidence that [decedent], in making this transfer, was motivated by love and affection or other feelings that normally prompt the making of a gift.”
Because the transfer of stock was due to a settlement of a bona fide dispute, was made at arm’s length, and was free from any donative intent, the court held that it met the requirements of a transaction “in the ordinary course of business” under Treas. Reg. § 25.2512-8.
Nevertheless, the IRS further argued that because the children were not parties to the settlement, they could not provide any consideration in exchange for the shares; thus, because no consideration flowed from the transferees, the transfer was necessarily a gift (i.e., the source of the consideration argument). The Tax Court found that this argument “derives no support from the text of the governing regulations.” Indeed, the court emphasized that Treas. Reg. § 25.2512-8 provides “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth,” and 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.” As noted above, because the transfer met all three elements of the ordinary business transfer, “[t]he consequence of that determination is that ‘[t]he gift tax is not applicable to . . . [the] transfer.’” (quoting Treas. Reg. § 25.2511-1(g)(1)). In other words, the court did not agree that the regulations require that the transferee provide the consideration, but rather the regulations require the transferor to receive consideration.
The case is Estate of Redstone v. Comm’r, 145 T.C. No. 11 (Oct. 26, 2015). You can read the opinion here.
Peter J. Reilly, another Forbes contributor, also discusses the case here.