Crossing the Streams[i]

It is not uncommon, in the context of a business entity in which a family owns a controlling or substantial interest, for an adviser to encounter intersecting gift and income tax issues.

This week’s post will consider one such instance in which the IRS was asked to determine the tax consequences of certain transfers of stock by an individual shareholder of the issuing corporation and by the trusts created for the benefit of the shareholder’s family.[ii]  

Before describing these transactions, it may be helpful to briefly review some of the applicable tax principles.

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]

Heads I Win, . . .

When closely held corporations that are under common control engage in any intercompany transaction, it is prudent for the corporations and their shareholders to ensure that the transaction is being undertaken for a bona fide business reason. It is also important that the form of the transaction, and the parties’ intent for engaging in such transaction, as manifested by its form or structure,  be consistent with the income tax consequences arising therefrom as reported by each of the parties.   

It’s not enough for the founder of a closely held business to have successfully established the business. The business has to grow, not only to increase profits, but also to make it more competitive and to diversify its customer base. Such “smart” growth will attract talented employees to the business, facilitate borrowing, prepare the business to withstand economic downturns, and make it more attractive to potential buyers.

Ups and Downs

It’s wonderful to be part of a successful business, especially in a strong economy. The owners are probably enjoying a more than just decent return on their investment and, in most cases, are getting along well enough. The business’s employees feel secure in their position; hopefully, they also feel valued.

This rosy picture can change rather quickly, however, when the overall economy, or the industry in which the business operates, experiences a downturn.[i]