The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Jeffrey D. Chadwick, Esq.
Winstead PC, Houston, TX
In Estate of Redstone v. Commissioner,1 the Tax Court rejected the IRS's argument that a taxpayer's transfer of stock in a closely held company to his children pursuant to a contested family settlement agreement was, in fact, a taxable gift. The court explained that because the transfer was made in the ordinary course of business for full and adequate consideration, it was not a gift within the meaning of the gift tax regulations. In securing the victory, the taxpayer avoided approximately $1.3 million in taxes and penalties assessed by the IRS.
The facts of the Redstone case date back to 1936, when Michael "Mickey" Redstone entered the drive-in movie theater business. From 1936 to 1954, Mickey opened many drive-in movie theaters throughout the Northeast. Each theater was typically managed by three companies—one to own the real estate, one to operate the theater, and one to handle the concessions. Mickey soon involved his two sons, Sumner and Edward, in the family business, with each owning portions of the various business entities.
To meet the growing demands of the family's drive-in empire, the Redstones formed National Amusements, Inc. ("NAI"), headquartered in Massachusetts, as a closely held holding company in 1959.2 Mickey, Sumner, and Edward were named the original directors. To form NAI, Mickey, Sumner, and Edward each contributed their stock in existing drive-in theater companies. NAI issued 300 shares of common stock to its shareholders and, even though Mickey's initial capital contribution was greater than that of his sons, 100 shares were issued to each of Mickey, Sumner, and Edward. The stock certificates indicated that each family member was the registered owner of 100 unrestricted shares of common stock, and the physical stock certificates were kept at NAI's corporate office.
In the late 1960s, Mickey began to transition out of active management of the family business. As the eldest son, Sumner was given the more public and glamorous job of networking with the movie studios and acquiring new drive-in theaters. Edward's tasks were more mundane, with his duties limited to operational and back-office functions. While Mickey was transitioning out of the business, Edward's son began developing serious psychiatric problems. Edward ultimately decided to admit his son to a psychiatric home, a decision which Mickey and Sumner strongly opposed. Edward began to feel marginalized, both within the family and within the business, and began to discuss, in broad terms, the possibility of him leaving the family business. Without consulting Edward, Sumner hired a third party to take over Edward's responsibilities, and Edward promptly quit the family business in 1971.
Upon leaving, Edward demanded possession of the 100 shares of NAI common stock registered in his name. The shares were not delivered to Edward, and he threatened to sell them to a third party unless NAI agreed to redeem the shares at an appropriate price. Edward eventually enlisted the help of an attorney to secure his shares. In response to Edward's demands, Mickey and his legal team devised an argument that a portion of Edward's stock had been administered, since the incorporation of NAI, in an "oral trust" for the benefit of Edward's two children, Ruth Ann Redstone and Michael David Redstone. Mickey based this argument on the fact that Edward's initial capital contribution to NAI was disproportionate to the equal one-third share of the company he received.
The family dispute lingered without resolution, prompting Edward to file a lawsuit against Mickey, Sumner, and NAI to compel delivery of his 100 shares. After much publicity, the family reached a settlement in which they agreed that Edward was the sole owner 66 2/3 shares of NAI common stock and that the remaining 33 1/3 shares were held (and had always been held) in a trust for the benefit of his children. NAI agreed to purchase Edward's 66 2/3 shares for $5 million and Edward agreed to execute irrevocable trust agreements for the benefit of his two children, which named Sumner as trustee. Edward also executed assignments transferring 16 2/3 shares to each trust. Finally, each of the parties executed mutual releases regarding claims the other may have with respect to the ownership of the contested shares.
Edward did not file a federal gift tax return for 1972 because he did not believe that he made a taxable gift when he assigned the rights to a portion of his NAI shares to his children's trusts. Edward died in 2011 and in 2013, the IRS issued his estate a notice of deficiency assessing $737,625 in unpaid federal gift tax for 1972 and approximately $552,000 in penalties.
Tax Court Analysis
Reg. §25.2511-1(g)(1) provides that "[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money's worth, or to ordinary business transactions, described in §25.2512-8." Reg. §25.2512-8, in turn, defines a "transfer made in the ordinary course of business" as a "transaction which is [i] bona fide, [ii] at arm's length, and [iii] free from any donative intent." Thus, even though a transfer of property between family members should be closely scrutinized, if the transfer of shares to the trusts for Edward's children satisfied the above requirements, it would not be considered a taxable gift.
The Tax Court began its analysis by referring to numerous cases involving intra-family transfers in settlement of a bona fide dispute in which the court found such transfers to be made for full and adequate consideration in the ordinary course of business.3
The court then applied the facts of the Redstones' disputed transfer to the three requirements of Reg. §25.2512-8. First, the court found that the Redstones' family dispute was bona fide. In short, there was no evidence that the dispute was a sham perpetrated by the Redstone family to conceal a gift to Edward's children from the IRS. Second, the court found that the family settlement was made at arms' length. The court stated that a genuine controversy existed among Edward, Mickey, and Sumner, and that the family members behaved just as they would with third parties by hiring attorneys, participating in lengthy negotiations, and making concessions in order to settle a contested matter. Lastly, the court found that Edward exhibited no donative intent with respect to the transfer. In fact, Edward showed the opposite of donative intent by initially demanding his 100 shares of NAI stock and filing a lawsuit in an attempt to compel their delivery.
While it was quite clear that the requirements of Reg. §25.2512-8 were met, the IRS relied on a more novel argument. The IRS contended that because Edward's children were not parties to the family litigation in 1972, it was impossible for them to provide any consideration to Edward for his transfer of the shares to the trusts for their benefit. Without consideration from the transferees, the IRS argued that Edward's transfer must be treated as a taxable gift.
In rejecting this argument, the Tax Court explained that the gift tax regulations focus on whether the transferor received full and adequate consideration, and not whether the transferees provided such consideration.4 Not only did the IRS fail to provide any statutory or judicial support for its argument, a U.S. district court, in a remarkably similar case, relied exclusively on the test set forth in Reg. §25.2512-8 to find that a transfer of assets to trusts for a taxpayer's children was not a gift because the transfer was made pursuant to a disputed family settlement. Because Edward received full and adequate consideration for the transfer of his NAI shares (i.e., the redemption of 66 2/3 shares and mutual releases from Mickey and Sumner), Edward did not make a taxable gift, regardless of whether his children did (or could) provide such consideration.
In addition to its colorful facts, Redstone is a good reminder for all practitioners to consider the potential transfer tax implications of both friendly and disputed family settlement agreements. While transfers made in the course of contested litigation should generally not be viewed as taxable gifts under Reg. §25.2512-8, that does not mean they are free from IRS scrutiny. If such a litigious transfer is challenged, Redstone may be a good place for the taxpayer to start when building its response to the IRS.
This commentary also appears in the January 2016 issue of the Estates, Gifts and Trusts Journal. For more information, in the Tax Management Portfolios, see Lischer, 845 T.M., Gifts, and in Tax Practice Series, see ¶6320, Gift Taxation.
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