By, Caitlin Glynn
Overview: Transfer made as part of settlement of family litigation is not a taxable gift
Summary: The Tax Court case, Estate of Redstone v. Commissioner, 145 T.C. No. 11, focuses on a family dispute that led to a transfer of 33 ⅓ shares of a family business to a trust for the shareholder’s two children. The issue the Tax Court reviews is whether the shareholder’s transfer of stock in trust for his two children was a gift subject to the gift tax or whether it constituted a bona fide, arm’s-length transaction that was free from donative intent and that was “made in the ordinary course of business.”
Summary of Facts: Edward Redstone (“Edward”), along with his brother, Sumner, and father, Mickey, incorporated a closely-held family company National Amusements, Inc. (“NAI”). Upon NAI’s incorporation, Mickey contributed a disproportionate amount of capital. Nevertheless, Edward, Sumner and Mickey each were listed as the registered owners of an equal ⅓ of NAI’s shares, equal to 100 shares each.
Edward was eventually forced out of the business after numerous family disputes within the Redstone family, originally stemming from the institutionalization of Edward’s son, Michael, by Edward, for psychiatric problems. Edward felt marginalized, not only with his family, but also within the family business. Eventually, Edward quit the business. Upon leaving, Edward demanded possession of the 100 shares of common stock registered in his name.
Mickey refused to give Edward the stock certificates. Mickey argued that a portion of the shareholder’s stock, though registered in Edward’s name had actually been held since NAI’s inception in an “oral trust” for the benefit of Edward’s children, because of Mickey’s disproportionate contribution of capital. Mickey contended that he had gratuitously accorded Edward more stock than he was entitled to, and the “extra” shares should be regarded as being held in trust for Edward’s children.
The parties negotiated for six months in search of a resolution. Edward sued NAI to recover the 100 shares of stock that were registered in his name. A settlement was ultimately reached. The parties agreed in a Settlement Agreement that Edward was the owner of 66 ⅔ shares of the stock, and the remaining 33 ⅓ shares of stock would be transferred into irrevocable trusts for the benefit of Edward’s two children. The Settlement Agreement further provided that Edward would transfer the 66 ⅔ shares to NAI for $5 million.
The IRS determined that Edward’s transfer of stock to the irrevocable trusts for the benefit of his children was a taxable gift. The IRS further determined that in addition to gift tax owed, there were further penalties for fraud, negligence and failing to file a gift tax return.
Applicable Legal Principles and Analysis: Where property is transferred for less than adequate and full consideration in money or money’s worth, the amount by which the value of the property exceeds the value of the consideration is deemed a gift. A transfer of property within a family group normally receives close scrutiny as to whether it is a gift. However, on numerous occasions, the Tax Court has held that a transfer of property between family members in settlement of bona fide unliquidated claims was made for “full and adequate consideration” because it was a transaction in the “ordinary course of business.” A transfer of property will be regarded as made for “a full and adequate consideration” in the “ordinary course of business” only if it satisfies the three elements specified in Treas. Reg. Sect. 25.2512-8. The three elements are that the transfer is bona fide, transacted at arm’s length and free of donative intent.
The Tax Court held that the transfer was not a gift as it satisfied all three elements. The settlement was “bona fide” because 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.” See 145 T.C. No. 11, at 21. The transfer was at “arm’s length” as Edward acted “as one would act in the settlement of differences with a stranger.” See id. at 22. The Tax Court found that Edward was genuinely estranged from his father. There were legitimate business grievances against one another that led to the parties being represented by counsel and engaged in adversarial negotiations for many months prior to settlement that was incorporated into a judicial decree. The transfer was free of donative intent as Edward transferred stock to his children not because he wished to, but because his father demanded it. See id. at 25. At the time of the settlement, Edward had no desire to transfer stock to his children but was forced to accept this transfer in order to placate his father, settle the family dispute, and obtain a $5 million payment for his 66 2/3 shares.
Take Away Considerations: In the settlement of litigation in a family related context, concerns are often raised by planners as to whether any parties are making taxable gifts as a result of the settlement. Although transfers in compromise and settlement of genuine trust and estate disputes will typically be treated as transfers for full and adequate consideration in the ordinary course of business, this Tax Court case summarizes certain factors to consider in this context, which include: whether a genuine controversy existed between the parties; whether the parties were represented by and acted upon the advice of counsel; whether the parties engaged in adversarial negotiations; whether the value of the property involved was substantial; whether the settlement was motivated by the parties’ desire to avoid the uncertainty and expense of litigation; and whether the settlement was finalized under judicial supervision and incorporated in a judicial decree. See 145 T.C. No. 11, at 20. These factors offer helpful guidelines for practitioners to consider when advising clients whether a transfer of property in the context of a family settlement should be reported as a taxable gift.