A Little-Known Gift Tax Exclusion: Transfers in the Ordinary Course of Business
Analyzing PLR 202406012, and an introduction to Treas. Reg. 25.2512-8
Table of Contents
Intro
The gift tax usually does not require donative intent. It can apply anytime there is a sale or exchange whereby the donor gives away more than they get back. This comparison looks at the fair market value of what is given up versus what is received. IRC Section 2512(b) clarifies that a transfer where the donor receives less than “adequate and full consideration in money and money’s worth” results in a gift to the extent of the value difference between the consideration received and the property transferred.
However, in estate and gift tax law, certain transfers are deemed to have been made for adequate and full consideration. Certain types of consideration, while not actually being “money or money’s worth” in the technical sense, are still respected for gift and estate tax purposes. While this issue has perhaps been most litigated in the realm of family limited partnerships and estate tax inclusion, a recent private letter ruling illustrates application in the corporate context. And, where something other than money substitutes for consideration, donative intent may become a factor.
Structure of Transaction
In PLR 202406012, the IRS determined there was no deemed gift, either to non-participating shareholders or participating shareholders, in a corporate share reorganization.
While the ruling was sparse on facts about the “Company Purpose” that later formed the basis for the ruling, the proposed transfers involved corporate stock. Class A and Class B was voting stock, and Class C was nonvoting. The individual donor involved owned some shares of Class A and B stock, and had also funded some trusts for family and non-family in a handful of irrevocable trusts and GRATs.
Class C stock was all owned by a disregarded single-member LLC owned by the Company issuing the stock (creating a cross-ownership situation). The Class C stock was convertible into Class A shares if not held by the LLC or another subsidiary of Company.
For the aforementioned “Company Purpose,” the Executive and Trusts planned to surrender their Class A and Class B shares to the Company in proportionate tranches. In return, the Company would issue a like number Class C shares to the LLC.
Gift Tax Treatment
The IRS considered first whether the surrender of shares would result in an indirect gift to the other shareholders who were not participating.
Normally, this indirect transfer would be subject to gift tax unless the value of the transfer is reduced by consideration received from the non-participating shareholders. However, the IRS noted under Treas. Reg. 25.2512-8 that transfers in the ordinary course of business are considered as made for adequate consideration in money or money’s worth. Given the facts of the “Company Purpose” articulated in the ruling request (but not repeated in the PLR), the IRS was satisfied that the transfer met the three requirements for this ordinary business purpose exception. These requirements are:
1. The transaction and related transfer is bona fide;
2. The transaction and related transfer is at arms-length; and
3. The transaction and related transfer is free from any donative intent.
Further, the IRS determined that the transaction would not result in any impermissible indirect transfers from the GRATs to the executive. This is because the Executive and all trusts had to surrender proportionate amounts of shares to their percent holdings, which eliminated any indirect transfers that could otherwise have been made among participating shareholders for each round of surrendered shares. Thus, there were no additional distributions that would cause the GRATs to fail under IRC Section 2702.
Income Tax Treatment
The IRS also determined that the surrender of shares would be treated as a capital contribution to the Company, in accordance with IRC Section 118 and the U.S. Supreme Court decision from Fink v. U.S., 483 U.S. 89 (1987).
Accordingly, no loss could be deducted on the surrender of shares by the Executive and each Trust. Instead, the basis of the surrendered shares would be added to the basis of any retained shares. However, there would be no share transfer or disproportionate dividend to the non-participating shareholders under IRC Section 305. This outcome was supported by the representation that the participating shareholders and non-participating shareholders were not related for purposes of IRC Sections 318 and 267(c).
Practical Implications
Please note – I have taken the liberty of not providing citations to the cases listed below due to their popularity, broad availability, and frequency of citation.
The subject of consideration that is not cash or property often pops up for estate tax purposes – usually as a test ancillary to whether a lifetime transfer with a retained interest is made for a significant, non-tax business purpose as successfully asserted in several intrafamily transfer cases such as Levine, Morrissette, Thompson, Kimbell, and Bongard. While these cases are heard in the context of IRC Sections 2036 and 2038, the assertion of these Code Sections usually reveals the IRS abandoning a position of gift tax deficiency during a taxpayer’s life.
Nonetheless, adequate and full consideration is an issue to be considered during life as well. It is rare to see this issue raised in the corporate context, however, as corporations are often considered to have more well-rounded, fixed property rights among both family members and third parties. Byram is a case often cited for its utility in the corporate context of recognizing the fiduciary duties owed by corporate directors to shareholders, but the U.S. Supreme Court’s holding from that case is often interpreted too broadly. Fiduciary duties, however, usually come into play for arguing that a shareholder’s retained right over transferred property cannot rise to the level of having gift or estate tax significance (i.e., the fiduciary duty keeps the transfer subject to a retained right from being “testamentary” in nature).
In this context, however, we are reminded that transfers within a corporation can have ancillary gift tax effects – especially redemptions and surrenders of shares. While attribution rules such as IRC Section 318 often discourage redemptions, it is nonetheless important to not lose sight of the possibility of “indirect” transfers to other shareholders under the gift tax rules. As seen in this private letter ruling, there may be a business purpose exception to avoid this outcome. But, while the determination of business purpose seemed to have been easily met here, remember that PLRs often omit the material and identifying facts giving rise to the conclusions and reasoning of the IRS. There could be more depth here that we are not seeing. In addition to the fact that PLRs are not binding authority on taxpayers not requesting the ruling, this is another reason why PLRs are not often a good source of tax law.