Parents are often in a position to help their children take advantage of business opportunities. A parent’s connections, business knowledge, expertise, and other intangibles acquired over may years of work can be used to benefit a child starting a career or business. Likewise, a parent may advance funds to a child to start or acquire a business on terms more favorable than any commercial lender would consider. While these events occur all of the time, few consider whether the potential tax consequences, including estate, gift, and income tax. As part of any intrafamily transaction, it is important to carefully think through the tax considerations. Often, the issue surrounds valuation of intangible assets of the parent, child, and their related entities. The recent Cavallaro1 case is a reminder of these issues.
In Cavallaro, the parents owned Knight Tool Co., Inc. (“KT”). Their three sons owned Camelot Systems, Inc. (“CS”). The two corporations merged with CS being the surviving corporation following the merger. The issue in the case involved valuation of the two corporations, and primarily of the intangibles owned by the corporations. The IRS argued KT shareholders, the parents, took a disproportionately low number of shares of CS following the merger as a result of failing to account for the value of intangibles of KT, thereby making a taxable gift of $29.7 million to the shareholders of CS, their children.
KT was a machine shop and contract manufacturer in which Mr. Cavallaro and his three sons worked. Mr. Cavallaro and one of his sons developed a liquid-adhesive dispensing machine prototype (the “Prototype”) which ultimately was manufactured and sold by CS. Both corporations shared the same building, shared payroll and accounting systems, and collaborated in development of the Prototype.2 KT funded both corporation’s operations with CS not even having its own bank accounts.3 There was no documentation about the working relationship between KT and CS such as contracts for services, intellectual property licenses, etc., including a transfer of rights to the Prototype from KT to CS (it was not disputed that KT originally owned these rights).4
Mr. and Ms. Cavallaro’s accountants and attorneys disagreed about ownership of the intangible assets associated with the Prototype.5 In the end, the attorneys prevailed in that disagreement such that the parents received a combined 19% of the shares of CS and the sons received a combined 81% of the shares of CS. The issue before the Court related to a question of ownership of the technology rights associated with the Prototype, an intangible asset with substantial value. The Tax Court agreed with the IRS that the intangible value of the Prototype belonged to KT and a valuation dispute ensued, going to the First Circuit Court of Appeals and back to the Tax Court on remand. Ultimately, the Tax Court valued the deemed gift at $22.8 million.
In Cavallaro, the facts indicated a plan designed specifically to pass value to children without incurring transfer tax costs. Based on the facts presented, the taxpayers were found to have made a significant gift to their children. Although Cavallaro is a recent example that tax consequences can flow from passing business value from one generation to another, it is hardly the only case where this has been an issue. Sometimes taxpayers have won; sometimes they have lost. Some other relatively recent cases are described below.
In Bross Trucking6, a road construction company (“Bross Trucking”) had lost most of its goodwill due to negative publicity and regulatory problems. The owner, Mr. Bross, worked for the corporation and had good relationships with a number of key contacts in the industry. Mr. Bross did not have any employment or non-competition agreement with the corporation. Mr. Bross’ sons started a similar business (“LWK Trucking”), offering increased service lines. No assets were directly transferred from Bross Trucking to LWK Trucking. Mr. Bross provided services to LWK Trucking, allowing the new business to benefit from the Mr. Bross’ business relationships. Over time, Bross Trucking lost value while LWK Trucking grew.
The IRS argued that Bross Trucking distributed its corporate goodwill to Mr. Bross in a taxable distribution. Then, Mr. Bross gifted that goodwill to his sons. The result could have been both income tax and gift tax exposure of over $2.7 million. After trial, the Tax Court held in the taxpayer’s favor. The ultimate outcome turned on the specific facts of the case.
Factually, what allowed the taxpayer to prevail were a number of factors:
- Bross’ personal relationships are the reason Bross Trucking was able to obtain business (as opposed to business goodwill)
- Bross had not transferred his personal goodwill to Bross Trucking through any employment or non-competition agreement
- Any corporate goodwill which historically may have been owned by Bross Trucking was seriously diminished due to regulatory problems (the new company even going so far as to hide the logo of Bross Trucking from trucks it purchased from the old company)
- Bross Trucking retained all licenses and insurance to continue in business, and many historic employees stayed with Bross Trucking;
- Bross was not involved in operating or managing LWK Trucking, but rather remained associated with Bross Trucking
- Bross’ sons also had personal relationships in the industry
After analyzing these and other factors and citing to previous legal authority7, the Tax Court determined that any goodwill belonged to Mr. Bross individually. It was not corporate goodwill. As a result, there could have been no taxable distribution of corporate goodwill. Further, given these facts, Mr. Bross could not be seen as having gifted his personal goodwill to LWK Trucking. The taxpayer prevailed avoiding any income or gift tax assessment. Here, it is almost certainly true that Mr. Bross’ sons benefited from their father’s industry knowledge and connections. They used that benefit to start a profitable company. However, the evidence did not support an actual transfer of value from Mr. Bross to his sons. As a result, a father was able to pass along business success to his children without negative tax consequences.
While the taxpayer prevailed in Bross Trucking, the decision was based on the facts which supported that conclusion. In a situation where the facts are not so one-sided, the outcome could have been different.
Estate of Adell
Adell involved the valuation of STN.Com (“STN”). A resolution of this valuation question was dependent on the effect of business dealings between STN (wholly owned by a trust included in Mr. Adell’s taxable estate) and Mr. Adell’s son, Kevin. STN provided broadcasting services. Kevin was president of STN. He had significant and valuable relationships in the industry which were the source of STN’s success. However, he was not under any employment agreement or other non-competition agreement with STN. At any time, Kevin was free to leave STN and compete.
Prior to Adell’s death, STN had a sole customer with which Kevin had a close relationship. STN’s success depended on Kevin’s continued good relationship with this customer. It was apparent to the court that the customer and its key personnel worked with STN solely due to their trust in Kevin. As a result, the goodwill attached to Kevin contributed significantly to the value of STN. Therefore, in valuing STN at Adell’s death, the issue arose as to whether the value of Kevin’s business relationships belonged to STN or Kevin.
Since Kevin had not transferred any of the value of his personal goodwill to STN through a covenant not to compete or other type of agreement, all of the value of his personal goodwill belonged solely to Kevin. The value of STN should reflect this fact, resulting in a much lower business valuation than argued by the IRS. This is analogous to a key person discount which has been applied in other cases.8
Adell illustrates a situation where a father’s business was able to generate substantial income for the family, both the father and the son. However, the son’s personal efforts and relationships in growing that business were discounted from the value of the father’s taxable estate. With the right facts, taxpayers may look for opportunities to benefit from family members’ business connections to grow the family’s wealth while minimizing the tax consequences. Adell shows a unique situation where that may be done.
In Cox Enterprises9, a corporation contributed a television station business to a partnership, taking back interests in the partnership. The value of partnership interests received by the corporation was lower than the value of its contribution to the partnership ($60.5 million lower). The corporation contributed assets of $300 million taking back an interest as managing general partner with a right to profits between 55% and 75% (depending on the source of funds). The other partners contributed assets of $62 million. Although Cox contributed almost 83% of the assets, Cox had a right to a much smaller amount of profits distributions.
The IRS argued that the disproportionate share of partnership interests retained by Cox resulted in a deemed distribution of assets from Cox to its shareholders (trusts) in order for the shareholders to transfer partnership interests to certain trust beneficiaries (the partners receiving excess interests in the partnership). This would cause in taxable gain of over $56 million.
In analyzing the arguments, the Tax Court noted several factors that favored the taxpayer. Some of those factors included:
- Cox had attempted to sell the relevant assets but could not find a buyer. Use of the partnership allowed working capital to be retained for other uses.
- Cox’ board took steps to be sure other partners were required to contribute capital equal to the value of their interests.
- Cox retained outside accounting expertise to consider valuation of the interests at formation and the partners made contributions based on those opinions. When that valuation was determined to be inaccurate, additional capital contributions were made by the other partners to correct the error.
- There were certain non-family member partners to whom the parties owed fiduciary duties limiting their ability to use the partnership to shift value among the family.
- The trust shareholders would have violated the terms of the relevant trust instruments (making the trustees potentially liable for breach of duty) by providing value to the relevant partners. Those partners held remainder interests in the trust which would have to be accelerated in violation of the trust terms in order to have the IRS’ argument prevail.10
Cox Enterprises was a taxpayer victory as a result of well documented grounds for issuing partnership interests. The parties engaged competent professionals, followed their advice, documented the reasons for their actions, and even took corrective action when mistakes were uncovered. The facts of the case show substantial business purpose rather than a desire to effectuate tax free transfers of assets.
The Dynamo Holdings11 case is an example of the need to strictly document and comply with intended business arrangements. The important parties were Beekman Vista (“Beekman”), a U.S. corporation, and Dymano Holdings (“Dynamo”), a U.S. limited partnership. Beekman was owned by a Canadian company. Dynamo was owned by parties related to the beneficial owners of Beekman who were located in the U.S.
Beekman sold multiple properties to Dynamo in at least five bargain sales exceeding $200 million. At issue was withholding tax relating to US and Canadian trust transactions. The IRS argued that the transactions constituted deemed taxable distributions up the entity chain to the Canadian owners who then made gifts to the U.S. based owners. The Tax Court found that undervaluing assets sold to Dynamo was intended to benefit Dynamo and, as a result, certain dynasty trusts owning Dynamo. The result is that the taxpayer lost on the deemed distribution issue. For tax purposes, this gave rise to certain withholding obligations which had not been satisfied, resulting in substantial penalties.
Another issue in the case dealt with the treatment of certain related party loans. Citing to a general principal of law, transactions between family members are presumed to be gifts12. Beekman advanced funds to Dynamo to finance operating expenses. Those advances were booked as “due to/from” on the companies’ books. The original balances accrued interest. However, the parties did not formalize this arrangement through arms-length type agreements. When making the advances, there was no security, no fixed maturity date, no written promissory note (although later the parties executed a promissory note with more typical third-party terms), etc. The Tax Court noted that it is useful to compare related party transactions to arms-length transactions, courts must “be mindful of the business realities of related parties.” With that backdrop, and applying a number of factors to consider the true nature of the advances13, the Tax Court held the advances to constitute bona fide debt. The advances were consistently documented in the parties’ general ledgers as debt, they accrued interest, they were ultimately documented in written promissory notes on customary business terms, they were reported for income tax purposes as debt, and they were at least partially repaid annually. In addition, any time an advance was made by Beekman to Dynamo, management was aware of that Dynamo had the financial ability to repay the advance.
The result for the taxpayer in Dynamo Holdings was a mixed bag. The taxpayer won on a significant issue but lost on another issue. Where the taxpayer won, it was clear from the facts that the taxpayer’s position in Tax Court could be substantiated.
As can be seen from these cases14, related parties can provide benefit to one another without negative tax consequences. However, failure to properly document valid business purposes as well as the intended arrangement can have serious consequences. Likewise, factually supporting the intended tax treatment in a way which is clear to a court is important.
To achieve the intended tax consequences, the transaction should be properly structured not to constitute a hidden or deemed transfer of assets which could result in income, gift, or estate tax. Rather, the transactions should be based on real business goals, properly documented, and followed. Even when documentation is not perfect, having facts which substantiate the intended treatment can make-or-break the case. Further, when there are benefits provided among related parties, care must be taken in how rights and obligations are structured. In Bross Trucking and Estate of Adell, the non-existence of contractual agreements transferring rights to personal goodwill to the business entity allowed the taxpayers to prevail.
Any time related parties are engaging in business transactions, they should consult competent tax professionals. Careful consideration of factors as were discussed in these cases aligned with the parties’ business transaction can both serve to support intended tax consequences as well as guard against IRS arguments to the contrary.
- Cavallaro v. Commissioner, TC Memo 2019-144.
- Cavallaro v. Commissioner, TC Memo 2014-189.
- It is worth noting that before the merger a previous determination by an accounting firm engaged by KT determined that KT was the owner of rights to the Prototype, resulting in research and development income tax deductions for KT. Id.
- Bross Trucking, Inc. v. Commissioner, TC Memo 2014-17.
- See, esp., Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998).
- Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005); Estate of Huntsman v. Commissioner, 66 TC 861 (1976); Estate of Ruben Rodriguez v. Commissioner, TC Memo 1989-13; Furman v. Commissioner, TC Memo 1998-157.
- Cox Enterprises Inc. & Subsidiaries v. Commissioner, 2009-134.
- Since Cox Enterprises, the Tax Court has issued its opinion in Estate of Powell v. Commissioner, 148 TC 18 (2017) in which the fiduciary duty limitation (i.e. fiduciary restraints on exercising a power are not “rights” of the individual holding the power) from U.S. v. Byrum 408 U.S. 125 (1972), was distinguished where fiduciary duties are illusory. After Powell, it will be seen how this factor continues to affect the outcome of cases.
- Dynamo Holdings Ltd. Partnership v. Commissioner, TC Memo 2018-61.
- Citing to Perry v. Commissioner, 92 TC 470, 481 (1898); Barr v. Commissioner, TC Memo 1999-40; and Vinikoor v. Commissioner, TC Memo 1998-52.
- On this issue, see, Edmondson, Gray, Moore: What is Bona Fide Debt?, https://esapllc.confit.dev/moore-debt2019/.
- See also Lender Management, LLC v. Commissioner, TC Memo 2017-246 which illustrates using related parties in asset management while also obtaining deductions for fees paid to the family member discussed in Edmondson, Gray, The Importance of Being a “Trade or Business”, https://esapllc.com/the-importance-of-being-a-trade-or-business/.