Letter Ruling 9420001: a taxable gift on conversion of preferred stock to common stock.

Gifts come in many forms. A taxpayer may be deemed to have made a gift by failing to act, as certainly as if he handed property to his chosen donee. The basic rule for gifts is found in Sec. 2511, which provides that a gift tax applies to a transfer in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. Regs. Sec. 25.2511-1(c)(1) provides that any transaction in which an interest in property is gratuitously passed or conferred on another, regardless of the means or device employed, constitutes a gift subject to tax.

Letter Ruling (TAM) 9420001 illustrates how far-reaching this rule can go and is a reminder that all transactions (and nontransactions) should be reviewed for gift tax implications.

Facts

In 1984, a taxpayer owned 100% of the 12,000 voting common shares of a closely held corporation, with each of the taxpayer's four adult children owning 1,000 nonvoting preferred shares. The corporation could redeem the preferred shares at any time by giving 60 days' notice; redemption was to be the par value of $100 per preferred share.

In 1964, the corporation's certificate of incorporation had been amended to include a conversion right for the preferred shares. The conversion right was to be effective on Feb. 1, 1985, and provided for conversion of two shares of voting common stock for each share of preferred stock.

None of the preferred shares had been called for redemption by Jan. 31, 1985. Therefore, on Feb. 1, 1985, each child's preferred shares became convertible into common shares. Three months later (in April), each child converted his preferred shares to 2,000 voting common shares. The corporation had $900,000 in unrestricted cash and had current liabilities of $90,528 on the date of conversion. Thus, the corporation could have redeemed the preferred shares.

The corporate structure before and after conversion was as follows:

                 Before   After

Common shares:
 taxpayer        12,000   12,000
Preferred shares:
 children         4,000        0
Common shares:
 children             0    8,000

The Service obtained an appraisal that determined the total value of the newly issued voting common shares was $671,280 at the time of the conversion. As indicated, the value of the preferred shares was $400,000 (1,000 shares x $100 par value x 4 shareholders). Thus, the children's interest was increased by $271,820 due to the conversion.

Also important to the result were the following facts:

1. "the $400,000 of cash assets, which would have been used in a full redemption of the preferred shares, were not needed for the operation of the corporate business .... Further, the $400,000 was not thereafter used for any corporate business purpose or activity."

2. "the taxpayer ... failed to act, and she did so with the knowledge and expectation that her children would benefit."

Based on these facts, it seems easy and logical to see that the taxpayer made a gift. Additionally, the IRS also mentioned Snyder, 93 TC 529 (1989), Rev. Ruls. 89-3 and 84-105. In each of these situations, the taxpayer failed to exercise some right and by doing so indirectly enriched his heirs.

It is incumbent on tax advisers to watch for both direct and indirect gifts. How will decisions of the controlling shareholder indirectly and disproportionately enrich related minority shareholders? If these decisions enrich the related shareholders, is there an ultimate business reason that may negate what appears on its surface to be a gift? Certainly, if the facts of this ruling had included a business purpose for the retention of the $400,000 or a use of that $400,000 shortly after (or before) the conversion, the result may have been significantly different. The children's shares may be enhanced, but if by doing so the value of the parents' shares is also enhanced there may be no gift.

One other way practitioners can potentially help in these situations is to have valuations done before and after the transactions, supporting the enhancement of value to the parent or a business reason for the failure to act.

Form James Thompson, CPA, Ehrhardt Keefe Steiner & Hottman P.C., Aurora, Colo.