“It does not do to leave a live dragon out of your calculations, if you live near one.”
J.R.R. Tolkien

For some estate and gift tax advisors counseling clients on succession planning, that dragon is the IRS. Many clients look to minimize the tax costs of business succession when selling to a third party, employees, other shareholders, or transitioning within the family. It may seem the IRS thwarts attempts to do so that are outside the lines of accepted planning and tax rules. This article examines five lessons to be learned from three recent cases and one Chief Counsel Advisory (CCA) in which the IRS challenged pre-sale planning techniques.

I. Assignment of Income

Assignment of income is the shifting of taxation from one party to another, a concept that has long been recognized in the Internal Revenue Code (IRC). Specifically, IRC Section 61 tells us that income from whatever source is to be taxed to the person or entity that earned it (Helvering v. Horst, 311 U.S. 112 (1940)). To shift income to another taxpayer, the shift must occur before the income is earned.

For those seeking to sell their business, the shift of ownership of some or all of one’s entity interests often is discussed. One strategy is to minimize the seller’s overall tax cost by contributing interests to others.

One often used technique is to transfer some of the owner’s ownership interests to a tax-exempt organization. The recipient tax-exempt entity (TEE) could be a public charity, private foundation or donor advised fund (DAF). There are two reasons that this technique can reduce the tax cost: (1) tax-exempt entities do not need to pay capital gains tax on the gains allocable to the shares it owns, and (2) a charitable contribution deduction can be generated by a contribution to the exempt entity. For now, let us focus on the first.

For example, imagine a taxpayer is about to sell her company through a stock sale for $10 million. Her basis is $2 million. Were she to sell all of her stock directly or indirectly (e.g., shares in a grantor trust), she would experience an $8 million gain. If she successfully contributed 25% to a TEE, and assuming no discounting, 25% of the gain would shift, reducing her taxable gain to $6 million – and in fact, no tax owed on the shares held by the tax-exempt entity.

A variation is to spread the taxable gain among more than one taxpayer. Similar to a charitable contribution, this approach entails transferring to others, such as children or grandchildren, or into non-grantor trusts for them. This can shift some of the gain to those with lower effective tax rates, or even if neutral on tax rates, spread the gain among others.

To be effective in implementing either variation or technique of this strategy, the transfers must be made before the income is earned, that is, before the company is sold. But according to a recent case, when the company is sold for assignment of income purposes is a gray area that can be a conundrum for taxpayers and their advisors. While it is clear that a company is sold no later than the date upon which the buyers furnish payment, for assignment of income tax purposes, the sale can be deemed to occur on an earlier date.  That date is the one on which the sale is virtually certain or practically certain to occur.

Imagine that a business owner receives an unsolicited offer from an unknow party to purchase the company for $x. If the owner says yes, has the deal become certain? Typically, it has not because after the parties come to an understanding, there can be non-binding letters of intent, purchase agreement documentation, due diligence, inspections, and more. So long as the buyer can walk away without a breach (e.g., no funds forfeited), we would conclude the sale likely has not become a “done deal.” The Tax Court focuses on the realities of the transaction, not on formalities or hypotheticals, such as the hypothetical possibility of abandonment.

On the other hand, the mere anticipation or expectation of income at the time of the gift does not establish that a donor’s right to income is fixed. Instead, the Tax Court looks to several other factors that bear upon whether the sale of shares was virtually certain to occur at the time of a purported gift as part of the same transaction. Relevant factors may include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transaction. See Jones v. United States, 531 F.2d 1343, 1345 (6th Cir. 1976); Allen v. Commissioner, 66 T.C. 340, 346 (1976).

In a 2023 case, some of the relevant facts can be summarized in this timeline:

• Day 1: Company board of directors approves sale of company and approves shareholder contributing some shares to a DAF
• Days 2+: Sale of company successfully negotiated, but not closed
• Day 32: DAF receives stock certificate; seller pays over $10 million in bonuses and dividends to sweep all cash out of the company
• Day 33: Sales agreement modified to reflect shares at DAF
• Day 34: Sale of company completed

One of the issues in the case resulted from the donor/shareholder not reporting capital gains on the shares contributed to the DAF. In Tax Court, the IRS successfully argued that all gains were to be taxed to the donor due to acts that suggested the sale was a virtual certainty. One of the key points the Court made was that it was considered highly improbable that the sellers would have emptied the company of its working capital if the transaction had even a small risk of not consummating (Estate of Hoensheid v. Comm., T.C. Memo. 2023-34).

The lesson to be learned from Hoensheid on assignment of income is that transfers, whether to a tax-exempt entity or other taxpayer, will be effective when executed while there is still a meaningful possibility that the contemplated sale will not take place. While we know that some clients wish only to transfer once they are certain the deal will close, the advice to them is that likely by such time, it is too late.

II. Charitable Deduction Substantiation Requirements

Continuing on with Hoensheid, we add these facts:

• Day 150: DAF sends letter acknowledging receipt of the shares on Day 1
• Day 200: Investment banking firm provided, for free, an unsigned letter valuing the shares donated to the charity – but reflected the wrong date.

On his tax return, Mr. Hoensheid took a $3.2 million charitable contribution deduction. The IRS successfully denied the deduction. This was not based on virtual certainty of the deal, but on his failure to comply with the Section 178(f)(8) substantiation requirements (see callout box). Given the size of the purported deduction, requirements set for in number 5 applied. The IRS argued that the contemporaneous written acknowledgment from the DAF was ineffective. Although the Court stated that it applies the rules strictly and that the doctrine of substantial compliance is inapplicable, it held that the IRS was wrong, and the acknowledgment was in compliance.

The IRS also argued that the valuation by the representative of the investment banking firm did not constitute a qualified appraisal, as required. On this issue, the Tax Court flipped and described the qualifications as directory not mandatory, but ironically found for the IRS nonetheless. Among the issues were that the individual who did the valuation was not a credentialed appraiser, regularly providing reports for fees, and that the appraisal itself contained errors that even if it had been prepared by an individual with the appropriate bona fides, the product itself was insufficient. Thus, no charitable contribution deduction was allowed.

One could question the jurisprudence of punishing a donor so significantly for what could be characterized as a minor technicality. After all, the shares were valued based on the purchase price, so what better indication of the “willing buyer/willing seller” test? However, these tax rules, now codified in the statute, were established after Congress was made aware of significant abuse stemming from the overvaluation of property contributed to charities. See Abusive Tax Shelters: Hearing Before the S. Subcomm. On Oversight of the Internal Revenue Serv. of the S. Comm. on Fin., 98th Cong. 71 (1983) (statement of Robert G. Woodward, Acting Tax Legis. Couns., Dep’t of Treasury)

The result is the rules as we now have them, and the Court was correct in its application. The lesson here is that taxpayers, their advisors, and tax preparers should be careful to abide by the rules.

TRIPLE WHAMMY:  In this case, we have seen a double whammy – the income on the donated shares was taxed to Mr. Hoensheid, and his income tax deduction on the donation was denied, but there is another shoe to drop. Under state law, the transfer to his DAF was effective, so not only did he have to pay tax on the proceeds relative to those shares with no deduction, he also didn’t get the proceeds. They rightfully belong to his DAF.

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IRC Section 170(f)(8) – Substantiation Requirements

1. Less than $250. Must keep adequate records to substantiate the contribution. If the contribution is in cash, you must have a bank record or a receipt from the charity identifying the name of the charity, the date of the contribution, and the amount of the contribution.
2. Between $250 – $500. Must keep adequate records and obtain a receipt, called a Contemporaneous Written Acknowledgment (CWA)*, from the charity.
3. Greater than $500, but less than $5,000. All substantiation previously stated plus additional information as the Treasury may require. This essentially means meeting the requirements of the specific IRS form for income tax reporting and its instructions. For example, Form 8283 provides taxpayers with instructions on the information that must be provided for property donations, including basis in the property, and dates when the property was acquired and donated, and the method used to determine the fair market value. There are also specific substantiation requirements for vehicle, boat and airplane donations that are above $500, including a CWA and a 1098-C, if sold by the charity.
4. Greater than $5,000. All substantiation previously stated as well as a qualified appraisal that supports the value claimed for the donated property. Generally, the taxpayer must provide a summary of the appraisal.
5. Greater than $500,000 ($20,000 for artwork). Must attach a qualified appraisal and obtain the signature of an authorized official of the charity on Form 8283.

Note: An appraisal must be attached for a gift of a qualified conservation easement regardless of value.

* Indicates the amount of the cash and a description of any property other than cash contributed. The acknowledgment must say whether the organization provided any goods or services in exchange for the gift and, if so, must provide a description and a good faith estimate of the value of those goods or services. It must be received by the earlier of the filing of the tax return or the due date for the return, including extensions.

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III. Setting Share Value in a Buy-Sell Agreement that Binds the IRS

Two brothers, Thomas and Michael Connelley, owned a company and established a buy-sell agreement. Two of its key provisions, both common, play a key role in this case. First, the agreement provided that at the death of one of the shareholders, the surviving brother had the option to purchase the shares. To the extent not invoked, the company was obligated to redeem all of the (remaining) shares of the deceased shareholder.

For pricing, the agreement provided two methodologies for establishing the shares’ value. First, it would be at the value that the shareholders annually agree and set forth on the agreement’s schedule. Second, the shareholders were authorized to hire two or more appraisers, and average their valuations.

As is often the case in such matters, neither method was utilized. Thomas, who owned 77.18% of the shares, passed with no set valuation. Michael did not purchase the shares, so the company did. Thomas’ son, Michael’s nephew, was executor of the estate, and he and Michael agreed to a redemption value of $3 million, without any support such as of an appraisal. The company had purchased life insurance with a death benefit of $3.5 million: $500,000 was added to operating capital, and the remaining $3 million used to purchase the shares from Thomas’ estate.

It is possible to fix value for estate tax purposes under Section 2703. To do so, the following requirements must be met:

1. Three statutory requirements (i) must be a bona fide business arrangement, (ii) the agreement must not be a device to transfer property to the family for less than full adequate consideration, and (iii) the agreement must be comparable to similar agreements negotiated at arm’s length between unrelated parties.
2. There must be a fixed and determinable offering price, the agreement must be binding both during life and after death.
3. There must be a bona fide business reason.
4. There must not be a testamentary disposition for less than full and adequate consideration.

The first issue for the court was whether the agreement by the estate and surviving brother satisfied these requirements and thus bind the IRS. The court found in favor of the IRS that the buy-sell agreement was ineffective to fix the price as, among other things, the price was not fixed and determinable. Fixed would have been set; determinable would have been based on a formula (Connelly v. United States, No. 21-3683 (8th Cir. 2023)).

IV. Valuing a Company that Owns Life Insurance to Redeem Shares

We are not done learning from the above discussed Connelly case but getting to perhaps the more important issue to the IRS, the valuation of a company that owns life insurance to fund a mandatory stock redemption.

The IRS appraiser valued Thomas Connelley’s shares at slightly less than $3 million excluding $500,000 of the insurance death benefit because these funds were used for capital to operate the company. At trial, the parties to a $3.1 million valuation of the shares in the estate and proceeded on the merits of the insurance. Both also agreed that the $500,000 added to capital increased the value of the company, but disagreed on whether the balance of the death benefit did. The positions were set: the taxpayer argued no, so the company was worth $3.86 million; the IRS said yes, so the company was worth $6.86 million.

The taxpayer had several precedents from other Federal circuit courts as support.

In 2005, the 11th Circuit Court (Alabama, Florida, and Georgia) held insurance owned by company is an asset that is offset dollar-for-dollar by the contractual liability to redeem the shares, zeroing it out (Estate of Blount, 428 F.3d 1338 (11th Cir. 2005)).

In 1999, the 9th Circuit Court (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington) determined that the purchase of a deceased’s stock in an incorporated law firm was an offset by the obligation (the rest was deemed compensation based on the terms of the agreement). Estate of Cartwright, 183 F 2d 1035.

But in 2023, the 8th Circuit Court (Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota) in Connelly rejected that argument and included the death benefit in valuing the company with no offsetting liability. This was a victory for the IRS.

This leaves a split in the Federal circuits, which is one of the pathways to the U.S. Supreme Court. Of course, we do not see a significant number of Supreme Court cases in the estate, tax and trust planning field, so this is a topic perhaps worthy of monitoring as well as the more relevant lesson that of the IRS position and willingness to litigate their stance.

V. Appraisal Frugality Doesn’t Pay

In planning, one can be “penny wise but pound foolish,” and this rings especially true when it comes to valuations. It is understandable that business owners can be hesitant to embrace the need for an additional appraisal and its concomitant effort and expense. In fact, those companies with a non-qualified deferred compensation plan, known as a 409A plan, already are required to obtain an annual appraisal. It can be difficult to appreciate the nuance between appraisals and valuations for different purposes, let alone different tax purposes. Thus, it can be tempting for a business owner to seek to use one valuation for both purposes, but as this CCA demonstrates yet again, this is a mistake that can be tax costly.

Just as in the charitable deduction cases, the need for a proper gift tax valuation is unavoidable and applies when implementing estate tax planning techniques. In this matter, the Chief Counsel focused on the failure to obtain a proper appraisal.

Some relevant facts:

• December 31, Yr 1: Company obtains annual 409A valuation.
• January – July, Yr 2: Actively looking to sell, Company hires investment bankers and receives tender offers from five potential buyers.
• July, Year 2: Three days after receiving the offers, shareholder funds a GRAT using Year 1 409A value.
• Dec. 31, Year 2: 409A value doubled.
• Pre closing: Taxpayer funded a charitable remainder trust and used valuation based on the tender offer price.
• Year 4: Merger closed at four times Year 1 409A valuation.

The IRS audited the GRAT and argued that the shareholder did not use a proper gift tax valuation when funding shares into a GRAT. Seeking internal guidance, the matter was referred to the Chief Counsel’s office. Guidance from the office, referred to as a Chief Counsel Advisory (CCA), is not dispositive of the matter nor is it binding precedent. However, it provides the auditor and the taxpayer of the position the IRS likely would take should the matter be litigated.

The Chief Counsel was impressed, to the detriment of the taxpayer, by the position that no separate valuation was needed because, according to the taxpayer, business operations had not meaningfully changed in the seven months between the 409A valuation and the funding of the GRAT. The CCA notes, however, that much had changed. The company had hired two investment bankers to market the firm and three days before funding the GRAT, the company had received offers from five different potential buyers, each in the multi-billion dollar range.

Generally, when advisors contemplate valuation issues for GRATs, they have a sense of confidence in the regulations that suggest if a value is inaccurate, the annuity simply is adjust to reflect the proper valuation.  The trust is to pay to the recipient, in the case of an undervaluation, or be repaid by the recipient, in the case of an overvaluation, an amount equal to the difference between the amount the trust should have paid if the correct value were used and the amount the trust actually distributed (Treas. Reg. 1.664-2(a)(iii)).  In fact, GRAT regulations require language in the GRAT trust agreement to this effect (Treas. Reg. 25-2702(c)(2)).

A valuation of property for Federal transfer tax purposes generally is made as of the valuation date without regard to events happening after that date (Ithaca Trust Co. v. United States, 279 U.S. 151 (1929)). While the company eventually was sold to one of the offering firms, closing did not occur until after the GRAT term had expired. Still, the IRS seemed displeased that the ultimate price was billions of dollars and more than four times the original value. It concluded that the 409A valuation was outdated and misleading. Because the annuity was “34 cents on the dollar” and held back “tens of millions,” the CCA  said the annuity did not qualify under Section 2702. The resulting operational failure caused the entire funding value of the shares transferred into the GRAT to be fully gift tax taxable. This is known as the Atkinson rationale[1] (CCA 202152018 (Dec. 30, 2021)).

Conclusion

Pre-sale planning can be powerful in furthering clients toward achieve their financial, tax and estate planning goals. However, as we have seen, despite the rules in this area  not materially changing in years, mistakes still occur. From them, we can learn about assigning income, substantiating charitable deductions, binding the IRS with a buy-sell agreement, valuing the company that owns life insurance to fund a redemption, and not being frugal when it comes to obtaining appraisals.

Armed with this knowledge, we can see the legal context for the early and careful counsel. Perhaps an insight from Edward Gibbon may apply, “Vicissitudes of fortune, which spares neither man nor the proudest of his works, which buries empires and cities in a common grave.”[2] In the meantime, if the IRS dragon is lurking outside the door, do not pretend it isn’t there.

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This article is provided solely for informational purposes and is not intended to provide financial, investment, tax, legal, or other advice. It contains information and opinions which may change after the date of publication. The author takes sole responsibility for the views expressed herein, and these views do not necessarily reflect the views of the author’s employer or any other organization, group, or individual. Information obtained from third-party sources is assumed to be reliable and has not been verified. No outcome, including performance or tax consequences, is guaranteed, due to various risks and uncertainties. Readers should consult with their own financial, tax, legal, or other advisors to seek advice on their individual circumstances.

[1] In Atkinson v. Commissioner, 115 T.C. 26, 32 (2000), aff’d, 309 F.3d 1290 (11th Cir. 2002), the Court treated as non-qualifying a charitable remainder annuity trust when no payments were actually made to the donor during the two-year period between the creation of the trust and the donor’s death.
[2] Edward Gibbon, “The History of the Decline and Fall of the Roman Empire,” W. Strahan and T. Cadell, in the Strand, 1776.