When parent wishes to transition a business to her child be careful of imputed gifts of business goodwill.
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As a business owner you might wish to gift your business to a child or other designated heir. The problem is that if you make a gift you might trigger gift tax once your exemption is used ($15 million in 2026). Another approach, that may be part of an overall transfer strategy is to shift business opportunity to a business created by your child. For example, parent may train child in the nature of the business so that the child can begin growing her own business. Parent might introduce child to certain business contacts, provide guidance and advice on how the child can grow her business. Parent might guide child to pursue new business opportunities, markets, or vendors that the parent’s company has not dealt with. When the parent is providing general guidance and ideas, and encouraging the child’s business success, that should not raise any tax issues. On the opposite extreme, if child purports to start a new independent business but hires employees from parent’s company, sells to the same customers and uses the same vendors, the transaction begins to appear more like the existing business or parent has merely shifted goodwill from the parent’s business to the child’s business. That might raise the specter of a taxable gift transfer to the child.
All these types of situations are very fact sensitive. There is no specific rule of how much can be shifted from an existing business or parent to the child’s new business. So, how the child’s business is started and grown, what transfers if any are made, what actual involvement the parent may have, could all be relevant. Thus, the more attention that is paid to how details are handled, and the corroboration that it was not a gift transfer, to the child’s business the greater the likelihood of avoiding a taxable event.
This article will explore these concepts and a few key cases that addressed it in hopes of providing a roadmap of how to address this one aspect of a business transition.
Key Case
One key resource is a case Bross Trucking v CIR TC Memo 2014-107 (Bross) that addressed this type of situation. Be careful interpreting and applying the Bross Trucking case as it had some unique circumstances with the father’s company facing regulatory and other issues.
In Bross the father who was a key employee and the only shareholder never signed any employment or noncompete agreement with the company. Because of this, the company had no legal rights to constrain his activities, nor could the company be said to own certain aspects of the goodwill which would have remained with the father personally. So, the company could not prevent his competing with it, or helping a new company started by the child competing with it. Thus, the father could legally use his contacts and knowledge to help the child’s business. Thus, when the IRS argued that the company distributed intangible asses including goodwill to the father and in turn he gifted those valuable assets to the child’s company, there argument failed because the company could not assert that it owned rights that remained personal to father. It might be helpful to understand the assets that the IRS argued were company assets. These included: relationships with vendors, customer list, existing employees, ongoing income. These assets, the IRS asserted, demonstrated the goodwill that was transferred. Somewhat unique to the Bross case is that the company faced significant regulatory issues that jeopardized its continued functioning. That is not likely to be a common scenario. The challenges the company faced may have negated any goodwill it had.
The child’s company also took several proactive steps that demonstrated its independence it secured its own business licenses, insurance coverage, and customers. While it hired new employees, half of its workforce were previously employed by the father’s company. That well could have been viewed as a transfer of an in-place workforce. That could have demonstrated a transfer of goodwill from the father’s business to the child’s business. But the court did not find that to be the case.
This case is an example of how every case of a parent helping a child start a business is different. Can you transfer half the employees from the parent’s business to a new business and avoid a gift tax on a goodwill transfer? Maybe. There is no magic percentage. Certainly, the more new employees hired by the new business, and the more independent steps the child’s business takes on its own in contrast to using what the parent’s business had, the better.
Steps To Consider
- Child Start’s Business. The child should retain counsel to assist, on her own form the business, contribute initial capital, etc.
- Goodwill. To the extent feasible, try to avoid or minimize any transfer of the parent’s company goodwill to the child’s business. Have the child’s company create its own name, logo, slogan, website and other intellectual property rights on its own and from inception. For example, the child’s company could hire its own graphic designer, web designer, and an intellectual property attorney to protect these rights independently of whatever rights the parent or parent’s company had. That branding should be distinct from the parent company’s intangibles.
- Contracts with Parent. Avoid the parent having an employment or noncompete agreement with her company. That might deflect an IRS argument that the company transferred its goodwill to the parent as owner and that then the parent gifted that goodwill to the child or child’s new business. This may help the parent arguing that the goodwill was hers and not her company’s. While that may avoid an IRS argument that there was a taxable distribution of those asset from the company to the parent, it won’t negate the risk of an IRS challenge that the parent made a gift of valuable intangible assets to the child or the child’s company.
- Minimize Shared Resources. The child’s company should ideally hire its own employees, develop its own customers, find its own vendors, and secure its own facilities. While some overlap may be permissible, like the 50% employee carryover in Bross, the less the better. There is no specific percentage and this will all be case specific. Whatever is done should be documented as if between independent companies, and should be commercially reasonable. But merely documenting the shared relationships and having them addressed by payments between the parent and child’s companies may not suffice to demonstrate the independence and viability of the child’s company.
- Document No Transfer. If feasible and commercially reasonable endeavor to document that new or few transfers of intangible or other assts were made from the parent or the parent’s company to the child’s new company.
- Consulting. If the parent provides consulting to the child’s company have an independent appraiser determine an arm’s length fee to pay for those services, document the services in a written agreement and pay for them.
- Value Actual Transfers. If any tangible or intangible assets were in fact transferred from the parent or the parent’s company to the child’s company approach it proactively. Rather than take the position that no intangible or other assets were transferred identify what you know was transferred, have appropriate legal documentation prepared for the transfer, and get a qualified appraisal of those assets. It may be strategically better to identify and address some transfers rather than maintain there were none when in fact there were some. That may deflect an IRS challenge. The optics of that may also be better than the rigid “no transfer” position.
Conclusion
It is common in many family businesses to transition some or all of the business from a parent to a child or other heirs. While gifts and sales of business interests are common (typically to trusts for the child, and typically grantor trusts to avoid triggering gain on a sale), these approaches can be augmented by a child who is a designated successor beginning their own business. When that occurs, caution should be exercised to demonstrate the independence of the child’s business and to deflect a challenge by the IRS that a taxable gift was made. Properly done providing business opportunities to a child may be a valuable to have future business value inure in the child’s name (or a trust the child creates) rather than in the parent’s name where it may then have to be transferred.
