Cancellation of debt as a gift.

When parents are asked to help their children financially, they frequently respond with gifts and loans. Sometimes, the loans may be to businesses the children own. What is the tax effect if a parent cancels or forgives a loan made to a child's corporation?

On June 17, 1981, Lavonna Stinson sold property to a corporation owned by her children and grandchildren. In exchange, she received cash and a corporate note. From 1982 through 1985, Stinson forgave $147,000 of the corporate debt. She paid gift tax on that amount as if it were a gift of a present interest. Following her death, the IRS audited the estate and determined the gifts were not of a present interest but, instead, of a future interest, which meant additional gift taxes were due. The estate paid the taxes and sued for a refund.

Result. For the IRS. The district court said neither the code nor the regulations address gifts to corporations. In addition, there was no binding precedent the court could apply. However, other courts have dealt with gifts to corporations, and revenue ruling 71-443 also covers the issue.

The regulations define the gift of a present interest as "an unrestricted right to the immediate use, possession or enjoyment of property or the income from property." Previously, the Ninth Circuit Court of Appeals ruled that a gift of land to a corporation was not a present interest because the individual donees could not enjoy the land unless the corporation declared a dividend or liquidated itself. The court based its ruling on a U.S. Supreme Court decision that a gift to a trust was a future interest because it took joint action by two trustees for the beneficiary to gain possession of the property; the Tax Court and the Court of Claims reached similar conclusions about gifts to corporations. In revenue ruling 71-443, the IRS adopted this reasoning in holding that gifts to corporations were gifts of future interests.

The Stinson estate argued the debt cancellation was a gift of a present interest because it immediately increased the value of the corporation's stock. It tried to distinguish the situation from prior cases on the grounds those cases all derived from gifts to trusts, which differ significantly from corporations. But the district court accepted the reasoning of the Ninth Circuit and the revenue ruling in concluding that cancellation of corporate debt was not a gift of a present interest. The only way the shareholders could gain possession of the property was for the corporation to distribute it or to sell their shares. Each required action before the donee could enjoy the property. The court also pointed out that to accept the estate's argument would effectively convert all gifts to present interests because a beneficiary can always obtain a current benefit by disposing of his or her interest in the gifted property or in the entity receiving the property.

The estate also raised a second argument. Since the gift was made to a corporation, the estate maintained that minority and lack-of-marketability discounts should be taken into consideration in establishing its value. The court rejected this argument since gift taxes are imposed on the property given and not on the property the donee receives.

Based on this case and prior decisions, taxpayers can save on gift taxes if they make gifts only to individual donees, not to corporations. A recipient could then transfer the gift to a corporation.

* Estate of Lavonna Stinson v. United States (DC Ind. 1998) 82 AFTR 2d 98-6714.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.