• The Tax Court assesses family business transactions for gift tax and capital gains tax-In Cynthia L. Huffman and Estate of Chet S. Huffman, Memo TC. 2024-012 (January 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 ran the company for 17 years while acquiring a substantial stake 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 shares of the company for a price of “no more than” $2 per share. In 1993, Lloyd assigned Chet his rights in that deal, and Chet exercised the rights, paying $150,000 for over 300,000 shares.
Chet then entered into two additional 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 deals, Chet gained the right to purchase approximately 422,000 shares for $5 million upon the deaths of Lloyd and Patricia. Chet was also granted rights of first refusal, which did not apply to takeover offers from his brothers. The RTP agreements contained other transfer restrictions that could be waived with the consent of certain parties. The agreement stated that the terms were not compensatory or made in connection with the performance of services.
Over time, Chet expanded the company's product line and developed new strategies to reach new markets. It bought other businesses and other entities were created to support the company and lease its equipment. In the early 2000s, the company began to attract interest from investors
for appropriation.
In 2007, Chet exercised his right under both RTP agreements, purchasing all of 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 Dukes stock. Two years later, in 2009, Dukes entered into an asset purchase agreement where Dukes was acquired for over $96 million.
In 2010, Chet filed gift tax returns for 2007 as part of a major accounting project to update their tax filings. The memo does not discuss what was shown on the gift tax return, but the Internal Revenue Service issued notices of deficiency, alleging that the RTP agreements were not determinative of value and that the fair market value (FMV) of the shares of the purchase was actually about $31 million. Because the purchase price did not reflect the FMV, the difference was a gift.
Under IRC Section 2703(a)(1), an “option, agreement, or other right to purchase or use the property at a price less than the fair market value of the property” is not taken into account when valuing property . However, there are some exceptions to the general valuation rule that apply if the arrangement is: (1) a bona fide business arrangement; (2) not a device for transferring such property to members of the decedent's family for less than the full and adequate amount in money or money value; and (3) comparable to similar agreements that are negotiated on an equal footing. The taxpayer argued that the RTP agreements were bona fide and comparable to other unfavorable agreements. And, if not, Chet made additional payments in the form of lost/reduced compensation.
The court agreed with the IRS and held that while the RTP agreements had bona fide business purposes and were not testamentary devices because they were negotiated by family members with competing purposes, they were not comparable to similar agreements entered into by individuals in a transaction unfavorable.
The taxpayer offered another shareholder agreement, among unrelated Dukes shareholders, to show that Chet's agreement was similar to those entered into in the free transactions. But the court noted RTP's agreements: (1) exempted the offers from the Chet brothers from the right of first refusal; (2) allowed Chet the right to purchase the shares at any time at his discretion; and (3) stated that their intent was to keep Dukes owned by the Huffman family. Because of these differences, the court ruled that Chet's agreement was not similar to the first agreement between unrelated shareholders. Ultimately, the court found that the taxpayer was unable to meet its burden of proof to establish that their valuation of Duke was correct. Therefore, the difference in value between the payment ($5 million) and the FMV of the stock was a gift.
Note that Section 25.2703-1(b)(4)(i) of the Treasury Regulations states:
A right or restriction is considered a fair bargain between unrelated parties in the same business if it is consistent with the general practice of unrelated parties under negotiated agreements in the same business.
Based on this section, it is puzzling that the application of the third prong was based only on a comparison with a specific arrangement related to Dukes stock rather than determining whether the arrangement as a whole “conforms to the general practice of unrelated parties under agreements negotiated in the same business.” “Same business” in the regulation appears to refer to the industry rather than the specific company in question. If the latter were proof and there were no other arrangements, this point could never be met.
• IRS works to prepare for online gift tax return filing—At the American Bar Association Tax Section meeting on January 19, 2024, Lisa Piehl of the IRS Small Business/Self-Employed Division confirmed that the IRS is working to draft new formatting options for gift tax returns (Form 709 ) that would make the online presentation of an option. This may involve some changes to the form itself. This is becoming more important as the number of gift tax returns being filed is increasing significantly as taxpayers are making more gifts to take advantage of historically high gift and estate tax exemptions.