Hidden Gift in Merger Transaction

Summary: Disguised gifts found in a merger transaction, along with an interesting story on how the gifts came about.

Most tax practitioners are trained to look behind the transfers occurring in family corporate transactions to determine if a disguised gift is being made. A recent Tax Court case provides a real world example of such gifts

In the case, the parents' manufacturing company was merged with another company owned by their sons. The Tax Court found that the parents' company was substantially undervalued in the merger. Therefore, the parents received less stock in the resulting entity (and the sons received more) than was appropriate based on the relative values of the two companies. This resulted in a taxable gift of $29.6 million from the parents to the sons.

We could stop here and view this as an instructive case on how, if the IRS can successfully challenge values in mergers involving family entities, gifts can arise. However, this case has another interesting aspect.

This is that it is possible that this taxable gift would not have arisen but for the involvement of estate planning attorneys. At a point in time prior to the merger, estate planning attorneys determined that it would be more beneficial for the family if certain intellectual property relating to a manufacturing process for computer circuit boards belonged to the sons' company and not the parents' company. This is because the value of the process would thus not need to be transferred from the parents to the sons during their lifetime or at death in a taxable gift or taxable transfer at death. Factually, however, there was no transfer documentation showing a transfer of ownership of the process from the parents' company where it had been originally developed. Nonetheless, through interviews with the principals and other review of available evidence, the estate planning law firm believed there was enough support to treat the process as having previously been transferred to the sons' company at the time of the formation of that company. They were able eventually to convince the CPAs of the same, even though prior tax returns did not support such a change in ownership of the process. To have some documentation for the ownership in the event of a later IRS examination, the law firm prepared a bill of sale to memorialize a prior transfer of the process to the sons' company.

In valuing the companies in the merger, the position was taken that the ownership of the process was in the sons' company. The Tax Court determined that such a transfer of ownership to the sons' company never took place and thus that the parents' company was worth a lot more in the merger (per the substantial value of the process) than the parents received stock for. This was the source of the large gift found by the Tax Court. One has to wonder whether this gift would have arisen if the estate planning attorneys had not gotten involved.

This case was just resolved. However, the merger and resulting gift occurred in 1995. Thus, in addition to the large gift tax liability, there will be a substantial interest amount due on that gift tax liability. Luckily for the taxpayers, the Tax Court found that based on their reliance on counsel they had reasonable cause for their underpayments of gift tax and are not liable for accuracy -related penalties.

William Cavallaro et ux. v. Commissioner, T.C. Memo. 2014-189