There was a time, and there may well be one again (see Bernie’s plan), when each person did not have an $11.4 million (in 2019) federal gift tax exclusion amount. In 1995 the federal gift tax exclusion amount was $600,000. That is significant, because the U.S. Tax Court recently confirmed in William Cavallaro v. Commissioner that an indirect gift of stock to a married couple’s three children during the merger of two family companies resulted in a $22.8 million taxable gift in 1995. The maximum federal gift tax rate in 1995 was 55%, meaning the Court’s finding resulted in a roughly $12,540,000 tax.
Mr. and Mrs. Cavallaro formed Knight Tool Co., Inc. (“Knight”) in 1979. Mrs. Cavallaro owned 51% of the shares of Knight stock and Mr. Cavallaro owned 49%. Their three sons—Ken, Paul, and James—formed Camelot Systems, Inc. (“Camelot”). Ken and Mr. Cavallaro worked for Knight and developed a liquid-adhesive dispensing machine called CAM/A LOT that Knight manufactured and Camelot sold.
In 1995, the family merged the two companies. In the merger, Mrs. Cavallaro received 20 shares of stock in the new company, Mr. Cavallaro received 18 shares, and Ken, Paul, and James split 54 shares. As a result of the merger, Mr. and Mrs. Cavallaro received a total of 19% of the shares in the new company. The IRS expert, whom the Court ultimately followed, valued the combined companies at $70 million, and the Court concluded that because Mr. and Mrs. Cavallaro received only 19% of the shares in the new company, they therefore shifted 32% of the ownership of the companies to their sons, resulting in an indirect gift to the sons. Although those numbers would lead to a $22.4 million gift, the IRS expert’s opinion, after adjusting for a calculation error, reached a $22.8 million valuation on the gift, which the Court ultimately adopted as the final gifted amount.
Capital Shifting is Usually a Gift or a Sale
The kind of capital shifting in the Cavallaro case is usually a gift (if family members are involved) or a sale (if investors or business partners are involved). The sale side of things is beyond the scope of this post, but on the gift side of the equation, even innocuous shifts in the capital structure of a family company that are not supported by actual contributions to the economic structure of the company are a gift when individuals who did not pay for the shift and are not employees receive the benefits. While federal gift tax exemptions are high, this might not be a problem for most families. In a lower gift tax exemption environment, or when the gifting precedes a lower estate tax exemption environment, it can be problematic.
It is probably obvious that with a lower gift tax exemption a shifting of capital in a family company that results in a gift could trigger a taxable gift. The gift itself also may not be easy to value, which makes the reporting and planning for that kind of transaction challenging. Often, when gifting interests in family companies, owners will use a gifting agreement that includes a clause meant to limit the gifted amount to a particular value (a so called defined value clause in the mold of Wandry v. Commissioner). When the gift is accomplished through pure capital shifting, as in Cavallaro, this kind of planning is difficult, if not impossible. It can, therefore, lead to surprising results, as the Cavallaro’s found out.
When an indirect gift is made through capital shifting while gift tax exemptions are high, resulting in no gift tax, the structure of the gift can cause estate tax problems if the owners die in a lower estate tax exemption environment. Although the current federal estate tax exemption is $11.4 million (in 2019), it was as low as $600,000 in 1997, and $3,500,000 in 2009. Many of the current Democratic presidential candidates are suggesting lowering the estate tax exemption back to 2009 levels. If a capital shifting transaction involves an indirect gift to a trust, there is a risk that, without planning, the owners could be treated as still owning the gifted amounts in the trust for estate tax purposes. This can be the case if the owners retain certain powers over the trust (commonly called string powers and found in Internal Revenue Code Sections 2036 and 2038). Thus, even if an indirect gift escapes gift tax because of current exemptions, if estate tax exemptions fall in the future the gifted amount could be subject to estate tax at the time of a later death.
Restructuring transactions in family businesses require thoughtful planning to avoid unintended gifts, especially for family companies worth more that $3,500,000. If the restructuring results in the owners retaining interests in the business, then estate tax concerns may exist that also need to be addressed at the time of the restructuring transaction.