Option Agreement to Purchase Shares in Family Business Was a Taxable Gift

(Parker Tax Publishing February 2024)

The Tax Court that a taxable gift occurred when a taxpayer exercised his rights assigned to him by his parents to buy stock in a company for $5 million that the IRS determined were worth $31 million. The court found that the valuation of the shares provided in the right to purchase agreements between the taxpayer and his parents was disregarded under Code Sec. 2703(a) and that the exception in Code Sec. 2703(b) did not apply because the taxpayers failed to establish that the terms of the buy-sell agreements were comparable to similar arrangements entered into by persons in an arm's length transaction. Huffman, et al. v. Comm'r, T.C. Memo. 2024-12.

Background

Infinity Aerospace, Inc. (Dukes) was formerly known as Dukes, Inc. Dukes manufactured and supplied various engineering components to the aerospace industry. Lloyd Huffman and his spouse, Patricia Huffman, both worked for Dukes; he initially as a design engineer and she as a bookkeeper.

In 1970 Lloyd was made president of Dukes and acquired 113,365 shares in the company. In January 1979 Lloyd and Patricia formed the Huffman Family Trust (Trust). They appointed themselves trustees of the Trust. Lloyd had his 113,365 shares in Dukes reissued to the Trust. The Trust acquired an additional 5,000 shares in 1990. Lloyd held the position of Dukes president until 1987. When he stepped down, Lloyd and Patricia's son, Chet Huffman, was made chief executive officer (CEO) and issued 5,000 shares of Dukes (representing 0.7 percent of the total outstanding shares).

In 1990 Lloyd and majority shareholder Robert Barneson entered into an agreement (Lloyd-Barneson agreement) whereby Lloyd was granted the right to purchase Barneson's shares. At that time, Barneson owned 322,241 shares (representing 43 percent of the total outstanding shares). The Lloyd-Barneson agreement entitled Lloyd to purchase Barneson's shares upon Barneson's death or by a right of first refusal for a price not to exceed $2 per share. There was no specific termination or exercise date for purchasing the shares in the agreement. In 1993 Lloyd assigned his rights under the Lloyd-Barneson agreement to Chet, and Chet exercised his assignee rights under the agreement As a result, Chet became the majority shareholder of Dukes with 43.7 percent of the total outstanding shares.

In November 1993 Chet entered into two additional right to purchase agreements (RTP agreements) - one with Dukes Research and Manufacturing, Inc. (DRM), and another with the Trust. DRM was an S corporation owned entirely by Patricia; it owned 304,124 Dukes shares (representing 40.5 percent of the total number outstanding). The Trust owned 118,635 Dukes shares (representing 15.8 percent of the total number outstanding).

For a sum of $2 and "other good and valuable consideration," the RTP agreements provided Chet with the right to purchase DRM's and the Trust's Dukes shares for a price not to exceed $3.6 million and $1.4 million, respectively, upon the death of Lloyd and Patricia. The parties executed an addendum to the RTP agreements that provided Chet with the option to purchase the shares at any time, in addition to the stated events in the agreements themselves. The RTP agreements provided that they were "not compensatory in nature, rather the purpose [was] to retain the ownership of" Dukes within the family. A tax opinion letter Chet obtained from the law firm Proskauer Rose LLP (Proskauer) stated that the purpose behind the RTP agreements "was not compensatory. It was not in connection with the performance of services."

Dukes's business grew significantly under Chet's leadership. The company expanded its product offerings and altered its strategy for acquiring new business. Chet also networked extensively and strived to acquire and maintain a strong workforce. Dukes grew from around five engineering employees in the 1980s to 18 employees by 2007. By the end of fiscal year 2006, Dukes had annual revenue of over $28 million.

In 2007, Chet exercised his rights under the RTP agreements, purchasing all of the Trust's and DRM's Dukes shares for $1.4 million and $3.6 million, respectively. This equates to $11.83 per share. In a notice of deficiency, the IRS determined a gift tax deficiency and penalties for Patricia's 2007 tax return based on its position that Chet received a taxable gift when he exercised his rights under the RTP agreements.

Taxable Gifts

Under Code Sec. 2512(b), 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.

Code Sec. 2703(a)(1) provides that, for gift tax purposes, the value of any property must be determined without regard to "any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right)." An exception to the rule in Code Sec. 2703(a) applies under Code Sec. 2703(b) for any option, agreement, right, or restriction that meets all of the following requirements: (1) it is a bona fide business arrangement; (2) it is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and (3) its terms are comparable to similar arrangements entered into by persons in an arm's-length transaction.

If Code Sec. 2703(b) requirements are satisfied, then the agreement may be respected for valuation purposes. To meet the first requirement of Code Sec. 2703(b), an agreement must further some business purpose. Maintaining managerial control or family ownership satisfies Code Sec. 2703(b)(1). For the second requirement of Code Sec. 2703(b), the Tax Court considers the totality of the facts and circumstances. Whether an agreement constitutes a testamentary device depends in part on the fairness of the consideration received by the transferor when it executed the transaction. The regulations under Code Sec. 2703 provide guidance on the final requirement of Code Sec. 2703(b). Under Reg. Sec. 25-2703-1(b)(4)(i), a right or restriction is treated as comparable to similar arrangements entered into by persons in an arm's length transaction if the right or restriction could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arm's length.

The IRS argued that the RTP agreements were not controlling as to the fair market value of the shares (i.e., the shares were not in fact worth $5 million in 2007), because the second and third requirements of Code Sec. 2703(b) were not met. According to the IRS, the shares were worth approximately $31.3 million, and so the differential value between the purchase price and the true fair market value should be deemed a gift.

Patricia and Lloyd's estate (the taxpayers) maintained that the RTP Agreements were valid business arrangements. They argued that Chet paid full consideration for the shares not in dollars but in reduced compensation from the time he became CEO of Dukes. From 1993 to 2006, Chet's salary ranged from $65,000 to $85,000. In 2007 it increased to $147,000 but was far less than the only other paid officer's salary of $243,300. This, the taxpayers argued, led to Chet's forgoing approximately $3.5 million in compensation over the years. According to the taxpayers, the RTP agreements contemplated reduced compensation as a form of payment because each stated that the agreements were entered into for "Two Dollars ($2.00) and for other good and valuable consideration." Patricia and Lloyd's estate further contended that the third requirement of Code Sec. 2703(b) was satisfied by the Lloyd-Barneson agreement, which they claimed was comparable to the RTP agreements and was entered into in an arm's length transaction.

Analysis

The Tax Court held that Chet received a taxable gift when he exercised his rights under the RTP Agreements. The determined that the amount representing the value of the shares minus the $5 million Chet paid for them ($3.6 million for shares from DRM and $1.4 million for shares from the Trust) was subject to gift tax.

The Tax Court agreed with the IRS that the rights associated with the RTP agreements were worth substantially more than $2. However, the court did not think that the RTP agreements were a testamentary device by which Lloyd and Patricia attempted to pass assets on to Chet. The court explained that if it viewed the exchange of $2 for the rights under the RTP agreements without considering the circumstances, it would agree that this was an inequitable exchange. While noting that the agreements themselves purported not to be compensatory, the court found that Chet did accept a reduced salary during his years as Dukes's CEO. Given his significant contributions to the company, the court thought that his reduced salary should be deemed consideration for the RTP agreements.

The court noted the significant amount of earnings growth that would have had to occur for the options to become "in the money." According to the IRS, the Dukes shares were worth around $0.51 per share in 1993. In 2007, Chet was able to purchase the shares for $11.83 per share. The court determined that the Dukes shares that Chet purchased in 2007 had increased in value by 2,414 percent. This level of growth was, in the court's view, unusual and unexpected. The court also noted that the RTP agreements - though negotiated among family members - did have the characteristics of an arm's length transaction. The court reasoned that both parties were motivated to reach a fair price. Lloyd and Patricia were willing to part with their shares for $5 million - an amount which they considered sufficient for their retirement. Chet, on the other hand, was incentivized to drive this number down so that he could reach the "in the money" value sooner. This incentivized Chet both to stay with the company and to increase its per-share value. Taking these facts together, the court concluded that the RTP agreements were not a testamentary device by which Lloyd and Patricia transferred Dukes shares to Chet for less than full consideration.

However, the court found that the third requirement Code Sec. 2703(b) was not satisfied by the Lloyd-Barneson agreement. The court agreed with the IRS that there were differences between the Lloyd-Barneson agreement and the RTP agreements which rendered the Lloyd-Barneson agreement not a good comparable. The noted differences were that (1) Lloyd Huffman was allowed to freely transfer his rights whereas Chet had to obtain consent from the owners; (2) the right of first refusal in the RTP agreements exempted offers from Chet's brothers; (3) the RTP agreements had an addendum that granted Chet the right to purchase the shares at any time at his discretion; and (4) the stated purpose of the RTP agreements was to retain ownership of Dukes within the Huffman family. Because the third requirement of Code Sec. 2703(b) was not satisfied, the court concluded that the RTP agreements had to be disregarded for purposes of valuing the Dukes shares that Chet purchased in 2007.

The court also found that Patricia and Lloyd's estate had reasonable cause for their failure to report any gift tax liability. The court found that Lloyd and Patricia relied in good faith on Tammy Ross-Stearn, a CPA with many years of experience, to advise on their tax liability. The court determined that Ross-Stearn was provided all the necessary information which would have alerted her to a potential gift tax liability owing from Lloyd and Patricia. In addition, the court noted that Patricia had no income or gift tax training whatsoever and totally relied on Ross-Stearn to advise on tax matters.

For a discussion of valuing property subject to restrictive agreements for estate, gift, and generation-skipping tax purposes, see Parker Tax ¶223,530.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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