• Tax Court evaluates family business transactions for gift tax and capital gains taxes—In Cynthia L. Huffman and Estate of Chet S. Huffman, T.C. Memo. 2024-012 (Jan. 31, 2024), Patricia and Lloyd Huffman were married and employed by Dukes, a company that engineered and manufactured parts for the aerospace industry. Eventually, Lloyd became president and led the company for 17 years while acquiring a significant holding in the company. The company also employed two of his sons. Then, after Lloyd had a serious accident, their third son, Chet, became CEO.
While president, Lloyd had entered into a stock purchase agreement with an unrelated shareholder, under which he had an option to purchase company shares for a price “not exceeding” $2 per share. In 1993, Lloyd assigned his rights in that agreement to Chet, and Chet exercised the rights, paying $150,000 for over 300,000 shares.
Then Chet entered into two other right to purchase (RTP) agreements with other Dukes shareholders: (1) DRM, an S corporation wholly owned by Patricia; and (2) a family trust. In these agreements, Chet obtained the right to purchase approximately 422,000 shares for $5 million on the death of Lloyd and Patricia. Chet was also granted rights of first refusal, which didn’t apply to offers to purchase from his brothers. The RTP agreements contained other transfer restrictions that could be overridden by the consent of certain parties. The agreements stated that the terms weren’t compensatory or made in connection with the performance of services.
Over time, Chet expanded the company’s product line and developed new strategies for reaching new markets. It acquired other businesses, and various other entities were formed to support the company and lease it equipment. In the early 2000s, the company started to attract interest from investors
for acquisition.
In 2007, Chet exercised his right under both RTP agreements, purchasing all the shares from both DRM and the family trust for $5 million (equating to about $11.83 per share). After the purchase, Chet owned 43.7% of all the shares of Dukes. Two years later, in 2009, Dukes entered into an asset purchase agreement whereby Dukes was purchased for over $96 million.
In 2010, Chet filed gift tax returns for 2007 as part of a large accounting project to bring their tax filings up to date. The memorandum doesn’t discuss what was shown on the gift tax return, but the Internal Revenue Service issued notices of deficiency, claiming that the RTP agreements weren’t determinative of value and that the fair market value (FMV) of the purchased shares was in fact about $31 million. Because the purchase price didn’t reflect the FMV, the difference was a gift.
Under IRC Section 2703(a)(1), an “option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property” isn’t taken into account when valuing the property. However, there are several exceptions to the general valuation rule, which apply if the agreement is: (1) a bona fide business arrangement; (2) not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and (3) comparable to similar arrangements that are negotiated at arm’s length. The taxpayer argued that the RTP agreements were bona fide and comparable to other arm’s-length arrangements. And, if not, Chet made additional payments in the form of foregone/reduced compensation.
The court agreed with the IRS and held that while the RTP agreements had bona fide business purposes and weren’t testamentary devices because they were negotiated by the family members with competing goals, they weren’t comparable to similar arrangements entered into by individuals in an arm’s-length transaction.
The taxpayer offered another shareholder agreement, among unrelated Dukes shareholders, to show that Chet’s agreement was similar to those entered into in arm’s-length transactions. But the court noted the RTP agreements: (1) exempted offers from Chet’s brothers from being subject to the right of first refusal; (2) allowed Chet the right to purchase the shares at any time at his discretion; and (3) stated their purpose was to keep Dukes owned within the Huffman family. Due to these differences, the court held Chet’s agreement wasn’t similar to the arm’s-length agreement among the unrelated shareholders. Finally, the court found that the taxpayer wasn’t able to meet the burden of proof to establish that their valuation of Dukes was correct. Therefore, the difference in value between payment ($5 million) and the stock’s FMV was a gift.
Note that Treasury Regulations Section 25.2703-1(b)(4)(i) states:
A right or restriction is considered a fair bargain among unrelated parties in the same business if it conforms with the general practice of unrelated parties under negotiated agreements in the same business.
Based on this section, it’s odd that the application of the third prong was based solely on a comparison to a specific agreement related to Dukes stock rather than determining whether the arrangement as a whole “conforms with the general practice of unrelated parties under negotiated agreements in the same business.” The “same business” in the regulations seems to refer to the industry rather than the specific company at issue. If the latter were the test and there were no other agreements, that prong could never be satisfied.
• IRS works to prepare for online gift tax return filing—At the American Bar Association Section of Taxation meeting on Jan. 19, 2024, Lisa Piehl of the IRS Small Business/Self-Employed Division confirmed that the IRS is working to devise new formatting options for gift tax returns (Form 709) that would make online filing an option. This could involve some changes to the form itself. This is becoming more important as the number of gift tax returns being filed is significantly increasing as taxpayers are making more gifts to take advantage of the historically high gift and estate tax exemptions.