The IRS's ability to attack S corporation stock transfers.

There is nothing unethical, let alone fraudulent, in engaging in business succession and/or estate planning by transferring S stock from a high-marginal-income-tax-rate parent to a low-bracket child. Barring application of the Kiddie tax in Sec. 1(g), income can effectively be split through such a device, presuming that there has been an effective transfer of the underlying income-producing property (i.e., the S stock). Indeed, Sec. 1366(e) (and the analogous Sec. 704(e)(2) for family partnerships) is premised on the notion that a legal transfer of ownership from a higher- to a lower-bracket family member has been made. However, this has not stopped the IRS from challenging these transfers.

Attacking the "Substance" of the Transfer

There are two separate and distinct means by which the Service can attack a transfer of S stock. The first deals with the IRS's power to reallocate income to properly reflect deductible compensation for services rendered by the transferor/parent. As noted, Sec. 1366(e) contains the rules applicable to S corporations.

In addition to Sec. 1366(e), the Service has attacked the economic reality and substance of stock transfers from parents to children; see, e.g., Beirne, 52 TC 210 (1969).

Beginning with Duarte, 44TC 193 (1965), the courts have generally used the following four factors to determine whether there was a substantive transfer of stock (i.e., one imbued with economic reality): (1) were the transferee children able to effectively exercise their ownership rights directly (if adults) or through a custodian (if minors); (2) did the transferor/parent continue to exercise complete dominion and control over the purportedly transferred stock; (3) did the transfer-or/parent continue to enjoy the unfettered economic benefits of ownership; and (4) did the transferor/parent otherwise deal at arm's-length with the S corporation?

Currently, Sec. 1377(a)(1), which generally requires a daily pro rata allocation of income items to any S shareholder during the tax year, governs these situations. However, previously, Sec. 1373(b), under which only S shareholders on the last day of the entity's tax year were treated as receiving distributive shares of income items, applied. This was the case despite the fact that under prior law, net operating losses were allocable on a daily basis to all shareholders throughout the tax year. Thus, there was an incentive built into the old law to transfer stock at or near the end of a tax year if an inordinate amount of income would otherwise flow to high-bracket family members. This quirk in the law did indeed induce many high-bracket parents to attempt income shifting by transferring their S stock to lower-marginal-rate children. All of the cases addressing this issue dealt with old Sec. 1373(b).

Old Regs. Sec. 1.1373-1(a)(2) stated:

A donee or purchaser of stock in the corporation is not considered a shareholder unless such stock is acquired in a bonafide transaction and the donee or purchaser is the real owner of such stock. The circumstances, not only as to the time of the purported transfer but also during the periods preceding and following it, will be taken into account in determining the bonafides of the transfer. Transactions between members of a family will be closely scrutinized.

Despite the fact that the IRS is probably no longer as eager to scrutinize intrafamily S stock transfers, the rules of those cases should apply under current law. While the Taxpayer Relief Act of 1997 (TRA '97) leaves ordinary income rates unchanged and has provided some subtle relief for regular and alternative minimum taxpayers contending with the Kiddie tax for unearned income of children under the age of 14, it has done nothing to discourage parents who wish to transfer ordinary income-producing property to children for business, gift or estate planning purposes.

Duarte

In Duarte, the sole shareholder of an S corporation transferred 50% of his stock ownership equally to his two minor children. The form of the transfer reflected a valid gift. However, on closer examination, the substance of the transaction broke down. Although the transfers nominally conformed to the New York Uniform Gifts to Minors Act, there was no evidence that the wife/custodian ever attempted to exercise any ownership rights on behalf of her children. No action as a shareholder representative occurred, nor were bank accounts ever established by the custodian for her children. Rather, the transferor/father continued to exercise complete dominion and control over the stock and management and control of the business. Although the Schedule K-1 informational returns showed appropriate flow-through income and that cash distributions had been paid to the two children, the court determined that they had not actually received any distributions from the corporation. The father paid the children's resulting tax liabilities with his own personal checks.

Another case along similar lines, but providing more definition, is Beirne. In Beirne, the taxpayer had organized a newly formed S corporation in return for 100% of the issued and outstanding stock. He then transferred 90% of the stock ownership to his wife as custodian for his three minor children. Later, after the birth of his fourth child, he caused the transfer by the children through his wife of one-third of the stock owned by each child to the newly born fourth child.

With regard to the four criteria, the mother never attempted to assert any rights as a custodian of the children/ shareholders; rather, the father asserted total control over the corporation's policies and operations at ad times. With regard to economic benefits, distributions from the corporation were made to the children's accounts only in amounts sufficient to cover their tax liabilities for the years in question; the additional retained earnings were borrowed by the father on an unsecured open account for his personal use. All of these facts allowed the court to conclude that the father had not dealt at arm's length with the corporation in a way that reflected the purported transfer's economic substance.

Conversely, in Kirkpatrick, TC Memo 1977-281, the court found that transfers of S stock by a father and mother to their minor children were economically substantive and bona fide. The mother, who was the custodial owner of the children's stock, took an active role in corporate governance and general corporate affairs. Although (as in Beirne) only small cash distributions were made to the children s accounts to accommodate their tax liability (with the father borrowing large amounts of the retained earnings), the father had executed promissory notes evidencing the loans and had paid principal and interest in repayment of those loans. On these facts, the Tax Court found that the parents had dealt at arm s length with the corporation.

Post-Duarte

The holdings in these cases emphasize the importance of diligent attendance to documenting corporate governance and the underlying stock transfers. Clearly, corporate minutes should unambiguously document the transfer or original issuance of shares to the proper legal owners. In the case of minor children, attendance to effective transfers under the local version of the "Uniform Gifts to Minors Act" is necessary. Bank accounts should be established in the name of each custodian/child. Apart from the documents clearly reflecting various stock ownerships, ongoing corporate documentation should a so reflect the rights of the various stockholders. Applicable shareholder and director minutes should be prepared annually and conform to the requirements of local law. Distributions of wealth to the shareholders should be unambiguously memorialized and actually made to segregated accounts. To the extent a transferor parent is inclined to dominate governance without necessarily attending to systematic and periodic shareholder and director meetings, the adviser may be well-advised to memorialize that scenario pursuant to a close corporation agreement (if available under local law).

Tax Fraud Implications

These cases examine on y the basic tax issue of who is the proper taxpayer within the meaning of old Regs. Sec. 1.1373-1 (a)(2); the Service has not brought up the issue of tax fraud. Surprisingly, even in the most egregious facts and circumstances, the IRS has been reluctant to add a tax fraud allegation to an attempt to prevent income-splitting. Of a the tax cases analyzing the economic reality issue of S stock transfers, only one has additionally incorporated a fraud argument.

In Barrier, TC Memo 1983-258, along with other claimed deficiencies, the Service argued that the taxpayers had filed fraudulent income tax returns for the three tax years in issue. The fraud asserted by the IRS was civil fraud under Sec. 6653(b) (current Sec. 6663), which the Service had to demonstrate by a mere preponderance of the evidence.

The facts in this case demonstrated shoddy recordkeeping practices on the part of the taxpayer, with numerous indications of underpayment of tax liability. The IRS took a shotgun approach in alleging fraud relative to these many poorly recorded transactions. The court, however, found no clear intent on the part of the taxpayer to fraudulently cheat the government.

The transfer of S stock was analyzed first as to the bona fides of the transfer as to who was the appropriate taxpayer, and second as to whether such a situation (which clearly lacked economic reality) could, largely on an ipso facto basis, indicate fraud on the taxpayer's part.

An analysis of Barrier provides an excellent review of the Duarte criteria pertaining to the economic substance of an underlying stock transfer. Noting that the economic reality analysis required that the correct taxpayer be the "real owner" of the stock, the court noted that there was no effort made to comply with the state Uniform Gifts to Minors Act by registering the purportedly transferred stock to minor children in the name of a custodian. There was no evidence indicating that anyone either voted the shares or received wealth distributions on behalf of the children. Stock certificates representing the children's interest in the company were "lost." Having established that the stock transfers lacked economic substance, the court concluded that the transferor/father was the "real owner" of all of the stock in the corporation and, therefore, all income attributable to it was properly attributed to him alone.

Once the court found there was no economic substance to the stock transfer, it then went on to address the fraud argument. With regard to whether these types of facts were self-evident of fraud, the court stated:

This interfamily transfer, however, is not materially different from many others that have been disallowed by the courts without any finding of fraud. We do not think it has been shown that this transfer was so devoid of economic reality as to prove that fraud was committed.

Even if a transfer of S stock were to be completely devoid of any of the requisite four Duarte criteria evidencing economic reality, the Barrier decision can be put forth for the proposition that, absent a showing of clear intent to defraud the government, a tax fraud conclusion cannot be demonstrated.

Conclusion

Despite the advent of and the publicized planning uses for limited liability companies, S corporations continue to be the flowthrough entity of choice. While the TRA '97 provides some regular and alternative minimum tax relief for unearned income of children under age 14, it has left the ordinary income tax rates untouched. Therefore, the TRA '97 has done little to blunt the current appetite that parents might have to split ordinary income off to children.

If this is done with transfers of S stock, the transferor/parent must first ensure that family members are properly compensated for services rendered or money loaned to the underlying corporation (as provided in Sec. 1366(e)). Moreover, a more fundamental issue must be clearly addressed. The transferor/parent and the tax adviser must ensure that the requisite bona fides have been followed so that the transferee/children are treated as the substantive owners of the underlying stock. Absent such a substantive transfer, the stock will be deemed owned by the parent (and the income-splitting objectives will be thwarted).

RELATED ARTICLE: Clarification

In the October 1997 issue, the article titled "The Complexities of the Sec. 165(i)(1) Disaster Loss Election" states on p. 648, under "Making the Election" that, according to Regs. Sec. 1.165-11(e), the election to claim a disaster loss in the year preceding the loss year becomes irrevocable 90 days after it is filed. In Matheson, 74 TC 836 (1980), acq., 1981-2 CB 2, the fax Court permitted a taxpayer to file an amended return revoking the election 95 days after he had feed an amended return to claim the loss in the preceding year. The court concluded that Regs. Sec. 1.165-11(e) is invalid regarding its limitation on revoking the election.

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From Mark P. Altieri, CPA, J.D., LL.M., CMA, Assistant Professor Of Taxation, College Of Business Administration, Kent State University, Kent, Ohio (Not Affiliated With AFAI)