Selling a successful family business can create a number of complex planning challenges, not the least of which is handling what may be a substantial financial gain appropriately in terms of estate planning and tax considerations. Thorough research and expert advice can be well worth the investment. The case below offers a cautionary tale.
In early 2023, the U.S. Tax Court ruled on a case involving a charitable gift of shares of a privately held business in anticipation of its sale. Estate of Hoenshied v. Commissioner (T.C. Memo 2023-24) provides two important lessons to family business owners who are contemplating a sale of their business.
The first lesson involves the “anticipatory assignment of income” doctrine, which essentially means the taxpayer who earns the income must pay the tax on that income. In the context of charitable giving, timing of donation is a critical factor in determining whether the donor who gifts pre-sale shares will nonetheless still be responsible for capital gains taxes attributable to the subsequent sale of those shares.
The second lesson highlights the importance of obtaining a qualified appraisal for gifts of non publicly traded securities exceeding IRS limits.
The facts of the case in brief
- A family business founded in 1927 had been distributed, in equal shares, to three brothers. When one brother announced his intention to retire, they decided to pursue a sale of the company to a third party.
- The brothers hired an investment banking firm to facilitate the sale.
- One of the brothers, Scott, expressed a desire to donate some shares before the sale to a Donor Advised Fund (DAF) at Fidelity to “avoid some capital gains.”
- Working with his estate planning attorney and two wealth advisers, Scott expressed a desire to wait as long as possible before transferring the shares to a DAF in case the sale did not go through, since the DAF gift would be irreversible.
- Scott wrote in an email to his attorney, “I do not want to transfer the stock until we are 99% sure we are closing.”
- On the question of valuing the gift, Scott and his advisers were of the mind that the investment banking firm would be able to provide an appraisal and that the firm would not charge an additional fee for the service.
- The Internal Revenue Service requires the value of charitable contributions of items such as real property or non publicly traded securities to be supported in writing by a qualified appraiser.
- Scott did solicit a quote to obtain a qualified appraisal but declined the service to save costs, opting to rely on the business valuation provided by the investment banker.
- The stock donation was received by Fidelity two days before the closing on the sale of the business.
Lesson One: Anticipatory Assignment of Income Doctrine
The Tax Court ruled that when the DAF subsequently sold the shares, Scott owed capital gains taxes with respect to those shares because a transaction involving those shares had become “practically certain to occur” by the time of the gift, “despite the remote and hypothetical possibility of abandonment.”
To avoid the application of the assignment of income doctrine, the Court ruled that “a donor must bear at least some risk at the time of the contribution that the sale will not close.”
Lesson Two: Qualified Appraisals of Charitable Gifts
To be able to take an income tax deduction for a charitable contribution, several requirements must be met. Notably in this case, for gifts over $500,000 (other than gifts of cash or publicly traded securities), the taxpayer must attach to their return a “qualified appraisal” prepared by a “qualified appraiser.” These terms are defined in IRS regulations.
While the investment bank that prepared the valuation did not charge a fee, it was also not a qualified appraiser. The court therefore disallowed the income tax charitable deduction.
This case is another in a line of cases where the private business owner did not obtain their desired tax outcome due to a failure to respect the required formalities. In this case, by waiting until the sale of his company was practically certain to occur before gifting the shares to a DAF, the business owner did not avoid capital gains taxes on the gifted shares as he had hoped to do. Further, by failing to obtain a qualified appraisal for the gifted shares, he was not able to take a charitable income tax deduction for the gifted shares.
This case illustrates the importance of retaining a team of advisors to advise and execute on gifting and wealth transfer strategies.
Pathstone is an independently owned and operated wealth management firm serving multigenerational families with complex needs, single-family offices, and foundations and endowments. Our comprehensive range of services and deep expertise goes far beyond investment management. Every client has different values, goals, and objectives. No two paths are the same. Our expansive capabilities and personal, in-depth approach enable us to customize our solutions and leverage best practices to accommodate each of our client’s unique needs. It’s what makes us Pathstone – The Family Office.
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