In Huffman v. Commissioner of Internal Revenue,1 the tax court found that when a son exercised an option to purchase shares from his parents in a family business, the valuation of the shares did not meet Internal Revenue Code requirements and was not comparable to an arm’s length transaction between unrelated parties.
Background
The taxpayers in this case were Lloyd and Patricia Huffman, both long-time employees of Infinity Aerospace, Inc., formerly Dukes, Inc. (Dukes). Lloyd Huffman was a design engineer and Patricia Huffman had been a bookkeeper. In 1970, Lloyd Huffman became president and acquired 113,365 shares in Dukes. In 1979, Lloyd Huffman and Patricia Huffman formed the Huffman Family Trust, appointing themselves as trustees, and Lloyd Huffman had his Dukes shares reissued to the trust. In 1987, Lloyd Huffman was involved in a near-fatal car racing accident, and their son Chet Huffman became CEO and issued 5,000 shares of Dukes.
The trust acquired 5,000 additional Dukes shares in 1990. Also in 1990, Lloyd Huffman entered into an agreement with the majority shareholder, Robert L. Barneson, granting Lloyd Huffman the right to purchase Barneson’s 322,241 Dukes shares upon Barneson’s death or by right of first refusal for a price not to exceed $2 per share. The agreement did not have a specific termination or exercise date for purchasing the Barneson shares. In June 1993, Lloyd Huffman assigned his rights in the agreement to Chet Huffman. In August 1993, Chet Huffman exercised the purchase rights and agreed to pay Barneson $150,000 for his 322,241 shares. This purchase made Chet Huffman the majority shareholder in Dukes with 43.7% of the outstanding shares.
In August 1993, Chet Huffman entered into additional right-to-purchase agreements with the trust (15.8% of Dukes shares) and with an S corporation owned by Patricia Huffman called Dukes Research and Manufacturing, Inc. (DRM) that owned Dukes shares (40.5% of Dukes shares). For nominal initial consideration, these agreements gave Chet Huffman the right to purchase the DRM shares for $3.6 million and the trust shares for $1.4 million, upon the deaths of Lloyd and Patricia Huffman or by right of first refusal, except for family purchase offers. A later addendum gave Chet Huffman the right to exercise the right-to-purchase agreements at any time. Chet Huffman’s rights under the agreements were not assignable without mutual consent. The agreements specifically stated that they were for family ownership retention and were not compensatory, and Chet Huffman obtained a tax opinion letter confirming that the purpose of the right-to-purchase agreements was not compensatory.
Chet Huffman significantly grew the Dukes business as CEO, expanding product offerings and acquiring a strong workforce. For the fiscal year 2006, Dukes had revenue of $28 million. Chet Huffman exercised his purchase rights under the right-to-purchase agreements in 2007, purchasing the DRM shares for $3.6 million and the trust shares for $1.4 million, about $11.83 per share.
The IRS determined a gift tax deficiency and penalties with respect to Patricia Huffman’s 2007 tax return, asserting that Chet Huffman received a taxable gift when he exercised his purchase rights under the right-to-purchase agreements.
Statutory background and positions
Section 2512(b) of the Internal Revenue Code provides that property transferred for less than adequate and full consideration results in a deemed gift to the extent the value of the property transferred exceeds the value of the consideration.
For gift tax purposes, § 2703(a)(1) provides that the value of property is to be determined without regard to options, agreements, or other rights to use the property for a price less than fair market value. Section 2703(b) provides an exception for any option, right, or restriction that (1) is a bona fide business arrangement; (2) is not a device to transfer the property to family members for less than full and adequate consideration; and (3) has terms comparable to similar arrangements in arm’s length transactions.
The IRS argued that the second and third requirements in § 2703(b) were not met by the right-to-purchase agreements. The IRS asserted that the value of the shares transferred pursuant to the agreements was about $31.3 million, and that the excess of this value of the $5 million paid should be deemed a taxable gift.
The taxpayers, Patricia and Lloyd Huffman’s estate, argued the right-to-purchase agreements represented valid business arrangements, and that Chet Huffman paid additional consideration for the shares in reduced compensation over the years rather than full value at the time of purchase. Chet Huffman’s salary from 1993-2006 was $65,000-85,000. His salary in 2007 increased to $147,000 but that was still significantly less than another Dukes officer salary of $243,300. The taxpayers thus argued that Chet Huffman had forgone approximately $3.5 million in prior year compensation. The taxpayers also argued that the right-to-purchase agreements were comparable to the agreement with Barneson, which they asserted was an arm’s length transaction.
Tax court analysis
With respect to the right-to-purchase agreements, the tax court first found the agreements were not a testamentary device to transfer the shares for less than full consideration under § 2703(b)(2). Even though there was a prior opinion that the agreements were not compensatory, the court found that Chet Huffman’s reduced salary over the years should be deemed consideration for the right-to-purchase agreements. The court also found that Chet Huffman’s purchase of shares in 2007 for $11.83 per share represented an increase in value of 2,414%, which the court viewed as unusual and unexpected. The court finally noted the right-to-purchase agreements have some characteristics of an arm’s length transaction, including Lloyd and Patricia Huffman’s desire to obtain enough from the shares for retirement and Chet Huffman’s desire to pay a lower price and obtain a profitable return in a shorter period of time.
However, the tax court next determined that the right-to-purchase agreements were not sufficiently comparable to arrangements in other arm’s length transactions to meet the requirement under § 2703(b)(3). The court noted there were similarities with the Barneson agreement but ultimately found there were material differences and this was only one isolated comparable agreement. As a result, the court held the right-to-purchase agreements were to be disregarded for purposes of valuing the Dukes shares that Chet Huffman purchased in 2007.
The tax court then turned to the IRS and taxpayer valuation opinions and evidence. As noted, Chet Huffman had paid $5 million for the shares but the IRS expert concluded the value of the Dukes shares in question was $31.3 million. The taxpayers argued the proper value was $5 million under the right-to-purchase agreements, but also offered an expert valuation of about $16.1 million at trial. After comparing the valuation reports and testimony in some detail, the court found the IRS expert’s valuation was proper with an adjustment relating to revenue assumptions.
Importantly, the tax court found the taxpayers had reasonable cause in failing to file gift tax returns and pay gift tax due because they reasonably relied on their professional advisors and provided them with all necessary information to determine a potential gift tax liability.2
Conclusion
Huffman is a detailed opinion that may help identify key considerations for family buy-sell agreements and transition planning, particularly in the context of potentially taxable gifts. The opinion also provides good insight into the tax court’s view of expert valuations and the importance of obtaining expert opinions and advice to avoid potential penalties.
Endnotes
1 T.C. Memo. 2024-12.
2 Of note but not addressed in this article, the tax court found in favor of the IRS on some income tax issues relating to a subsequent sale of Dukes.
Original source can be found here.