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Passing the Torch

Many of us have encountered variations of the following scenario:  a parent owns and operates a business; one or more of their children are employed in the business; as the children mature and become more experienced and established in the business, some of them may want to assume greater managerial responsibility and to have a greater voice in strategic planning; inevitably, the children become eager to realize a greater share of the economic success enjoyed by the business which they may insist is attributable to their efforts; they want to become owners.[i]

A recent decision of the U.S. Tax Court[ii] illustrated one of the gift tax issues that may be encountered in the process of transitioning ownership of a family business to a younger generation. It also highlighted an unintended consequence of incentivizing the children by tying their “reward” to their effort. Finally, it considered whether the contributions of the anointed child[iii] can be separately identified and measured upon the successful sale of the business, which is a question that confronts many closely held businesses.

A Successor is Chosen

For many years, Dad was the president and a shareholder of Corp, which was treated as a C corporation for tax purposes.

Dad and Mom formed Family Trust (Trust) to which Dad transferred his shares of Corp stock. The Trust subsequently acquired additional shares.

When Dad stepped down as Corp’s president, Son became the CEO and was issued shares of Corp stock.

The “Options”

Shortly thereafter, unrelated Shareholder granted Dad the right to purchase Shareholder’s shares of Corp stock, representing 43 percent of the total outstanding shares, either at Shareholder’s death or by a right of first refusal for a specified price (the Shareholder Option). There was no specific termination or exercise date for purchasing the shares in the agreement.

Dad assigned the Shareholder Option to Son, who later exercised his assignee rights thereunder. As a result of the purchase, Son became the single largest shareholder of Corp, owning 43.7 percent of the total outstanding shares.

Son then entered into two additional right to purchase agreements (the Options) – one with an S corporation owned entirely by Mom (S Corp), and another with Trust. S Corp owned 40.5 percent of the total number of Corp shares outstanding, while Trust owned 15.8 percent. One purpose of these Options was to retain the ownership of Corp within Dad and Mom’s Family; undoubtedly, another was to act as an incentive for Son to increase the value of the business as doing so would redound directly to Son’s benefit.

The Options gave Son the right to purchase S Corp’s and Trust’s Corp shares for a price not to exceed $3.6 million and $1.4 million, respectively, upon the death of Dad and Mom. The Options were later amended to provide Son with the rights to purchase the shares at any time. They also prohibited Son from transferring his rights thereunder without the consent of S Corp or Trust, as the case may be.

Build It and They Will Come[iv]

Under Son’s leadership as CEO, Corp expanded its product offerings, expanded its customer base, expanded its human capital, and enhanced its profitability.

In addition, Son networked extensively, joining organizations to which the leaders in Corp’s industry belonged. This allowed Son to meet and develop personal relationships with customers and competitors alike.

Over the years, members of the Family formed and acquired various business entities to support Corp’s operations. For example, Son formed LLC as a holding company for various intellectual property assets, including several licensing agreements. LLC entered into sublicensing agreements for the licenses with Corp and with another affiliate (Sales) that acted as a distributor for Corp.

LLC later acquired the assets of unrelated Target corporation, then organized a new corporation to which it transferred all of the acquired tangible operating assets. Members of the Family formed three business entities to lease employees and manufacturing equipment to Corp, which was their only customer.

Shopping the Business

At some point, Son decided the business was ready to be sold. He entered into an agreement on behalf of Corp with Firm to assist Corp in marketing the business, selecting a buyer, and performing due diligence.

In addition, Son exercised the Options to purchase all of the Trust’s and S Corp’s shares of Corp stock for $1.4 million and $3.6 million, respectively, following which Son owned 100 percent of the outstanding stock of Corp. Son also formed Corp Group LLC, to which he contributed all of the stock of Corp and Target to Corp Group in exchange for 100 percent of its membership interests.[v]

Son then caused LLC and the affiliated leasing companies to enter into asset purchase agreements with Corp, pursuant to which Corp would pay specified sums for their assets. Certain intercompany indebtedness would be eliminated, and the parties would void their intercompany agreements.

Eventually, Firm identified Buyer, with which Corp eventually entered into an asset purchase agreement (APA). The APA provided for a $95.75 million purchase price. In addition to this base purchase price, the agreement provided Corp with an earn-out of up to $60 million.

Personal Goodwill

The assets sold as part of the APA included goodwill, which the APA defined as “[a]ll goodwill associated with the Business,  including any personal goodwill of [Son] … as it relates to the Purchased Assets and the Business.” Buyer engaged an investment banking firm (IB) to prepare a valuation of the purchased assets and allocate the purchase price among those assets.

Corp also engaged a valuation expert to determine what portion of the purchase price allocated to overall goodwill by IB should be considered Son’s personal goodwill versus the company’s enterprise goodwill. The final allocation of the purchase price was to be binding on the parties.

IB allocated $50.042 million to goodwill. The appraisal firm engaged by Corp found that Son’s personal goodwill accounted for $21.8 million of the total value for goodwill, of which $17.4 million was attributable to Son’s relationships with clients and $4.4 million to Son’s relationships with Corp’s key employees.[vi]

As part of the APA, Son entered into a 4-year noncompete agreement with Buyer and Buyer Sub.

Not long after he stopped working for Buyer, Son, Corp, and Target filed a complaint against Buyer asserting claims relating to the APA. The parties eventually settled the matter, agreeing to extend the term of Son’s noncompetition agreement and requiring him to sell his interest in Sales, among other terms.

Tax Court

LLC reported gain from the sale of its intellectual property assets, which in turn was reported by Son on his IRS Form 1040.[vii]

After examining Son’s and LLC’s (the Taxpayers) respective income tax returns for the year of the sale to Buyer, the IRS issued notices of deficiency to the Taxpayers, who then petitioned the Tax Court.   

According to the Court, the two primary issues for its consideration were: (1) whether Mom and Dad made a taxable gift when Son exercised his rights to purchase S Corp’s and Trust’s shares in Corp for $5 million; and (2) whether the Taxpayers properly reported the gain related to the sale of Son’s personal goodwill, and of LLC’s intellectual property assets, to Buyer.

Taxable Gift

The IRS asserted that Mom and Dad were liable for gift tax arising from the sale of Corp shares to Son when he exercised the options. To that point, the IRS argued that the Options’ exercise price was not controlling as to the fair market value of the shares, i.e., the shares were not in fact worth $5 million at the time of exercise.

Instead, the IRS contended that the Corp shares were worth $31.3 million, and the differential value between the purchase price and the “true” fair market value should be deemed a taxable gift.

Taxpayers maintained that the Options were valid business arrangements and, therefore, should be conclusive as to the value of the Corp shares.

After an exhaustive[viii] analysis of the applicable provisions of the Code and of the regulations promulgated thereunder, the Court agreed with the IRS that the Options should be disregarded in determining the fair market value of the gifted Corp shares.

The Options and Stock Value

In brief, the Code provides that 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.”[ix] 

That said, the Code also provides an exception for any option, agreement, right, or restriction that meets 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.[x]

If these requirements are satisfied, then the price established under the agreement may be respected for valuation purposes. The Court addressed each requirement in turn.  

To meet the first requirement, the Court stated, an “agreement must further some business purpose.” The IRC conceded that maintaining managerial control or family ownership of a business satisfies this test.  

For the second requirement, the Court considered the totality of the facts and circumstances. Whether an agreement constitutes such a “device depends in part on the fairness of the consideration received by the transferor when it executed the transaction.” 

As for the third requirement, according to IRS regulations, a right is treated as comparable to similar arrangements entered into by persons in an arm’s length transaction if the right is one that could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arm’s length.[xi]

A right is “considered a fair bargain among unrelated parties in the same business if it conforms with the general practice of unrelated parties under negotiated agreements in the same business.” This determination generally entails consideration of the following factors: (1) the expected term of the agreement; (2) the current fair market value of the property; (3) the anticipated changes in value during the term of the arrangement; and (4) the adequacy of any consideration given in exchange for the rights granted.  

Turning to the Options, and noting the relationships of the parties thereto, the Court explained that it had to apply a heightened level of scrutiny.[xii]  

The IRS asserted that Son paid less than adequate consideration with respect to the Options.

The Taxpayers countered that Son did in fact pay full consideration. Alternatively, Taxpayers asserted that notwithstanding the higher valuation proposed by the IRS, Son still paid full consideration, not in dollars up front but in reduced compensation from the time he became CEO until the time he sold the company.[xiii]

The IRS disagreed that reduced compensation could have formed part of the consideration that Son paid for the Options, pointing to the text of the agreements, which stated that “this Agreement is not compensatory in nature, rather the purpose is to retain the ownership of” Corp within the Family.[xiv]

The Court agreed with the IRS that the rights associated with the Options were worth substantially more than the amount stated therein. Still, the Court found that the Options were not a device by which Dad and Mom attempted to pass assets to Son for less than adequate consideration.  

Moreover, the Court found that Son accepted a reduced salary during his years as Corp’s CEO. Given Son’s significant contributions to the company, the Court concluded that the reduced salary should be deemed consideration for the Options.[xv] The Court also noted that the Options – though negotiated among family members – had the characteristics of an arm’s-length transaction.[xvi]

Taking these facts together, the Court did not think that the Options were a device by which Dad and Mom transferred Corp shares to Son for less than full consideration. In other words, the second requirement was satisfied.

However, the Court rejected Taxpayers’ argument that the final, “comparability” requirement was satisfied. Specifically, Taxpayers asserted that the Shareholder Option (which concededly involved unrelated parties) was comparable to the Options, noting that it contained the following provisions, which were also included in the Options: (1) a right to purchase on the death of the grantor and by a right of first refusal; (2) a maximum purchase price; and (3) no specific termination or exercise date.

Instead, the Court agreed with the IRS that, because of the differences between the Shareholder Option and the Options, the former not a good comparable. The differences noted were that (1) Dad was allowed to freely transfer his rights whereas Son had to obtain consent from the owners; (2) the right of first refusal in the Options exempted offers from Son’s brothers; (3) the Options had an addendum that granted Son the right to purchase the shares at any time at his discretion; and (4) the stated purpose of the Options was to retain ownership of Corp within the Family.

On the basis of the foregoing, the Court determined that Taxpayers failed to satisfy the final requirement and, therefore, the Options had to be  disregarded for purposes of valuing the Corp shares that Son purchased.

With that, the Court turned to the valuations of Corp and its stock prepared by the parties’ respective appraisers. After considering the two reports, the Court found that Taxpayers failed to meet the burden of proof regarding why their expert’s valuation was correct. The Court also found that the IRS expert’s report was proper.

Based upon these findings, the Court explained that 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.[xvii] Thus, the amount paid by Son for the Corp shares acquired from S Corp and Trust should be deducted from the value established by the IRS and the remaining amount was subject to gift tax.

Income Tax Issues

The next issue before the Court concerned the income tax treatment of the sale proceeds and the gain from the sale of Corp’s business to Buyer.

The Court considered whether Taxpayers properly reported the portion of the sale proceeds attributable to LLC’s intellectual property assets (i.e., the licenses). Second, it considered whether they properly valued and reported the sale proceeds associated with Son’s personal goodwill.

In each case, Son reported the sale proceeds and income on his individual income tax return.

The IRS, however, contended that all of the income should have been reported by Corp as capital gain income and then by Son as ordinary dividend income.

Constructive Dividend

According to the IRS, the gain from the sale of the LLC’s licenses should have accrued to Corp and, thereafter, was a constructive dividend to Son because he was Corp’s only shareholder and he ended up with the proceeds.[xviii]

The IRS asserted that Corp was the proper party to report the gain because LLC had sold the assets before the APA was executed. The IRS contended further that the LLC-Corp agreement controlled the “methodology” of the asset transfer and, by the terms of that agreement, the only consideration was Corp’s forgiveness of a debt in addition to certain nonmonetary considerations. Therefore, no portion of the gain should have been reported by LLC.

Taxpayers acknowledged the LLC-Corp agreement, but asserted that it was never fulfilled, the afore-mentioned debt was never forgiven, and LLC continued to own the licenses until the sale to Buyer. What’s more, the terms of the LLC-Corp agreement were modified to extend the effectiveness of the agreement to the date of an eventual sale to a third party (which turned out to be Buyer) and increased the consideration to the fair market value of the licenses then owned by LLC.

The IRS countered that neither of these amendments was effective.

In response, the Court began by explaining that “[t]he first principle of income taxation is that tax must be imposed on income to the party that earned it.” The Court then continued, “[t]he choice of the proper taxpayer revolves around the question of which person or entity in fact controls the earning of the income rather than the question of who ultimately receives the income.” 

The Court agreed with the IRS that LLC did not directly sell the licenses to Buyer – LLC was not a named party to the APA agreement, nor was it to be specifically allocated any of the purchase price.

Nonetheless, the Court concluded that Son properly reported the gain.

The Court based its conclusion upon its finding that the LLC-Corp transaction never occurred; thus, the licenses were still listed on LLC’s tax return, as was the loan owing to Corp.

The Court also determined that the effectiveness of the LLC-Corp agreement was extended until the date of an eventual sale, which the Court stated was consistent with Son’s strategy in keeping the licenses separate from the operating business. It observed that creating a mechanism by which all the assets of the business would eventually come under the same corporate umbrella was plausible.

On that basis, the Court agreed that LLC – and not Corp – was the proper party to report the gain from the sale. Thus, Son was not liable for dividend income related to the sale proceeds received for LLC’s licenses.

Sale of Son’s Personal Goodwill

The next issue before the Court was the treatment of the APA sale proceeds that were allocated to Son’s personal goodwill. On his tax return for the year of the sale, Son reported approximately $21.8 million as the sale price attributable to Son’s personal goodwill. Of that amount, Son reported $19.4 million as installment sale gain.

The IRS argued that no amount of the sale proceeds could be attributed to Son’s personal goodwill, so it was improper for Son to report the gain. 

The IRS asserted that Son was not a party to the APA. Therefore, the IRS continued, the “personal” goodwill either was not properly transferred to Buyer via the APA or it was already owned by Corp before the sale. In either case, the IRS argued that the income should have been reported instead by Corp.

Son argued that he and Corp properly reported the income according to the terms of the APA, which described the purchased assets as including goodwill, which the APA defined to include “[a]ll goodwill associated with the Business, including any personal goodwill of [Son], the sole member of [Corp] Group, as it relates to the Purchased Assets and the Business.”

The APA further required that the parties engage investing banking firm, IB, to allocate the purchase price among the purchased assets, and that the sellers hire an independent valuation expert to prepare an allocation of the goodwill between enterprise goodwill and Son’s personal goodwill. If Buyer disagreed with the suballocation, it could hire a different valuation firm to provide the analysis. Otherwise, the decision reached by the appraiser was to be binding on the parties. The APA finally provided that “[t]he Sellers will allocate the Adjusted Purchase Price between them and [Son] with respect to the personal goodwill, if any, as they agree and in a manner consistent with this Section.”

Son and Corp asserted that the parties followed these provisions to the letter.

Still, the IRS determined in the notice of deficiency that Son’s personal goodwill had no value. According to the IRS, the Taxpayers’ expert’s report could not be relied upon because their appraiser was not competent and lacked credibility.

In the alternative, the IRS asserted that if Son’s personal goodwill had some value, it was worth no more than $3.9 million. The IRS’s expert assumed that Son offered the most value to Corp in connection with generating new business. The expert concluded that it was unlikely Corp would have had fewer opportunities if Son were no longer with the company, stating that Corp would likely have hired a qualified replacement to mitigate the damages created by Son’s lack of engagement with the business.

The Court Explains Goodwill

The Court disagreed with the IRS, finding that Son had personal goodwill and properly reported the gain attributable to the goodwill.

The Court explained that goodwill has been defined as “the expectation of continued patronage.”  It has also been defined, the Court stated, as “the sum total of those imponderable qualities which attract the custom of a business – what brings patronage to the business.”

According to the Court, “[g]oodwill can generally take two forms: (1) personal goodwill owned by key employees or shareholders and (2) corporate or enterprise goodwill developed and owned by the company or employer.”

A business can only distribute corporate assets and cannot distribute assets personally owned by shareholders.[xix] That said, the Court noted that key employees may transfer their personal goodwill via employment contracts or noncompete agreements. 

The Court determined that Son created personal goodwill through his relationships with key employees and customers during his time as Corp’s CEO. The Court also agreed, on the basis of the APA, that the parties to that transaction allocated a portion of the sale proceeds to Son as his personal goodwill.

While working for Corp, Son did not have an employment contract, nor was Son subject to a noncompete agreement. For that reason, the Court disagreed with the IRS that Son had somehow transferred his goodwill to Corp before the acquisition. Rather, Son continued to own his personal goodwill up until the sale to Buyer; to that end, as part of the APA, Son entered into a noncompete agreement. Thus, any gain on the sale of that personal goodwill would have been reported by its owner; i.e., Son. 

The Court then turned to the report prepared by Taxpayers’ expert, which considered the revenue that would be lost if Son did not remain in the business. The report indicated which clients would be vulnerable to Son’s influence, including those from whom revenue would decline in Son’s absence. It also considered the values attributable to Son’s relationships with key employees.

While the Court found the expert’s methodology sound, it believed that the report overestimated the percentage of revenue that would be lost as a result of Son’s absence, stating that Son’s true value came from his ability to generate new business, be that from existing clients or new ones. Once the clients were obtained, keeping them was more a matter of continuing to provide quality products timely, which was not an area in which Son himself had a direct influence. Consequently, the value of Son’s personal goodwill was reduced.

The amount by which the value of Son’s personal goodwill was adjusted downward, the Court continued, should have been attributed to Corp’s enterprise goodwill. Because this amount was paid to Son instead of Corp, it had to be reclassified as a constructive dividend.[xx] 

Thus, Son had ordinary dividend income to the extent of Corp’s earnings and profits. Any excess was a nontaxable return of capital to the extent of Son’s stock basis, and any remaining amount received was taxable as capital gain from the sale or exchange of a capital asset.[xxi] 

Because a portion of the sale proceeds attributed to Son’s personal goodwill was actually enterprise goodwill, Corp understated its capital gain net income from the sale. The amount by which Son’s personal goodwill was overvalued should have been reported by Corp with the rest of the sale proceeds. Corp was therefore liable for tax on an increase to capital gain.


It is almost always interesting when both the gift tax and the income tax are implicated in the context a family-owned business, especially when the business is a taxable C corporation. This is especially so upon the sale of the corporation’s business, at which point the effects of earlier “internal” transactions may have to be reconsidered.

The focal points of the decision described above were as follows:

  1. the value of Corp before Son assumed control of the business, as reflected in the exercise price for the Options, which determined the presence of a gift (or of compensation in another setting), and which set a base from which to assess the measure the success of Son’s efforts;
  2. the effect that Son’s efforts had on the value of Corp, and the assessment of whether he was properly incentivized; and
  3. whether those efforts may have created another asset, one that was personal to Son but from which Corp also benefitted, the value of such asset and whether the manner by which the economic benefits realized were shared indicated a constructive transfer to the non-owner.

Based upon the Court’s analysis, it is prudent when passing the torch to the next generation that one consider the ultimate sale of the business and its effect upon all the shareholders.

In the case of a C corporation, for example, the opportunity to avoid the double tax may influence the “creation” of extra-corporate or personal assets. Thus, the fact that Son had neither an employment agreement nor a non-compete with Corp supported his claim of personal goodwill, as did the APA’s specific reference to this personal asset and Son’s agreement not to compete with Buyer.

On the other hand, the other shareholders of the corporation[xxii] would likely prefer that any goodwill associated with the business reside in the corporation in order that they may benefit from its sale.

The presence of an earn-out may further complicate the matter if the key shareholder-employee is required to remain with the business for the earn-out period.[xxiii]

As always, it behooves the business owners to consult experienced advisers as early in the process of transitioning or selling the business as possible.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Of course they do, and in a big way. The often inflated sense of self that one encounters all too frequently calls to mind Veruca Salt from Willy Wonka and the Chocolate Factory: “But I want it now!”

[ii] Huffman v. Comm’r, T.C. Memo. 2024-12.

[iii] Or, for that matter, those of any other key business owner or employee.

[iv] “Field of Dreams” is one of the greatest movies of all time. Don’t tell me you can hold it together when Ray Kinsella says to John, “Hey, dad, you wanna have a catch”?

[v] Corp Group LLC was treated as a disregarded entity for tax purposes. Reg. Sec. 301.7701-3.

[vi] Shortly before trial, this figure was revised to $19.2 million to account for an 18-month expected lag time in Son’s ability to compete.

[vii] U.S. Individual Income Tax Return.

[viii] And exhausting.

[ix] IRC Section 2703(a)(1) 

[x] IRC Section 2703(b).

[xi] Treas. Reg. § 25.2703-1(b)(4)(i).

[xii] “In evaluating whether buy-sell agreements were substitutes for testamentary dispositions, greater scrutiny was applied to intrafamily agreements restricting stock transfers in closely held businesses than to similar agreements between unrelated parties.”

[xiii] Taxpayer contended that the Options 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” – the “other good and valuable consideration” was the reduced compensation.

[xiv] A non-compensatory, perhaps in the money, option granted to an executive employee? Those of us who work with IRC Sec. 409A would have something to say about that.

[xv] In support of its conclusion, the Court noted that a significant amount of earnings growth that would have had to occur for the Options to become “in the money.” This level of growth, it stated, was unusual and unexpected. The Court also found support in the amount paid by Son to purchase Corp shares from Shareholder, who was an unrelated person. 

[xvi] Both parties were motivated to reach a fair price. Dad and Mom were willing to part with their shares only for $5 million – an amount which they considered sufficient for their retirement. Son on the other hand was incentivized to drive this number down so that he could reach the “in the money” value sooner. This incentivized Son to stay with the company and to increase its per-share value.

[xvii] IRC Sec. 2512(b).

[xviii] In other words, the gains were misreported on LLC’s Form 1065 and on Son’s Form 1040.

[xix] Bross Trucking, Inc. v. Commissioner, T.C. Memo. 2014-107; Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998).

[xx] “The crucial concept in a finding that there is a constructive dividend is that the corporation has conferred a benefit on the shareholder in order to distribute available earnings and profits without expectation of repayment.”

[xxi] IRC Sec. 301.

[xxii] Son was fortunate to be the only shareholder.

[xxiii] Which may raise questions of compensatory treatment in certain circumstances.