Gifts of Business and Investment Opportunities and Uncompensated Services: A Loophole?
A parent or grandparent with high net worth, i.e., more assets than they will need to do whatever they desire to do for the rest of their lives, can achieve significant estate and gift tax savings through the transfer of ideas, knowhow, opportunities and uncompensated services to trusts for their descendants.
One of the more seldom recognized forms of gift is the transfer of a business or investment opportunity or the gift of uncompensated services. Such a gift is typically made when a parent or grandparent transfers to his or her children or grandchildren ideas, knowhow, opportunities and uncompensated services.
Good planners should ask their already wealthy clients who are planning a new venture (serial entrepreneurs) such as starting a new business, do you have enough? That is, do you have more assets than you will need to do whatever you desire to do for the rest of your life? If the answer is yes, then the new venture they are planning is for their partners, their children and grandchildren and the Internal Revenue Service. This article is designed to usher the IRS out of this partnership.
The Internal Revenue Code imposes gift tax on the transfer of property by gift. By using the word “property,” Congress inherently exempted gifts of ideas, knowhow, opportunities and uncompensated services from gift tax. Taxpayers who manage their children’s property or work without compensation for a Family Entity (an entity owned by their children or an entity owned by a trust for their children) or gratuitously provide to a Family Entity ideas, knowhow, or opportunities, obviously confer economic benefit on their children but this economic benefit is not subject to gift tax. More importantly, the results, i.e., the resulting valuable business or fortuitous investment is not subject to estate or gift tax in the parent’s estate (and, perhaps forever, i.e., 360 years in Florida, if a Florida generation-skipping “dynasty” trust vehicle is used).
Is this a loophole? Not really. A loophole is an unintentional omission or obscurity in the law that allows the reduction of tax liability to a point below that intended by Congress. This is not an unintentional omission. It is a prudent decision by Congress not to tax the transfer of ideas, knowhow, opportunities and uncompensated services. If Congress tried to plug this loophole by attempting to subject to gift tax anything of value transferred to children, ideas, knowhow, opportunities and uncompensated services would have to be valued (not an easy feat), and Congress would have to decide whether to pursue the issue to its logical extremes. For example, if grandparents provide free child care to their grandchildren so that their children can work, should the value of the grandparent’s services be a taxable gift to the grandchildren’s parents? Plus, even if Congress attempts to plug this loophole, the appraised value of the ideas, knowhow, opportunities and uncompensated services that are transferred still will result in a value that is far, far less than the resulting value of the exploited ideas or resulting value of the businesses or investments made possible by the transfer of the ideas, knowhow, opportunities and uncompensated services.
An example of this technique came to light in 1974 when the Joint Committee on Taxation conducted an audit of President Nixon’s income tax returns. Among other things, the Joint Committee found that Mr. Nixon had entered into a joint venture with his daughter, Tricia, to develop land in Florida. Mr. Nixon made a personal investment and his daughter invested $20,000 borrowed from a trust established for her benefit. The combined joint investment was worth $38,000 in 1967. In 1972, the property was sold for $150,000, with $65,000 paid to Mr. Nixon’s daughter. The $45,000 difference between what Tricia received and invested was not a gift, rather, it was gain taxable to her. In today’s Dollars, that was a transfer of $250,000 by Mr. Nixon to his daughter without gift tax.
Another example: Jack and Jill were worth approximately $30,000,000. Jack was a developer who had developed several successful projects on an island next to a large Florida city. Jack had one more piece of land on the island that he was about to develop. He contemplated that his net profit on the project would be $15,000,000. Jack and Jill agreed that their current wealth was sufficient to allow them to live in the comfort they desired for the rest of their lives. Jack realized that he was now working for his partners, his kids and the IRS. Jack wanted to cut out the IRS.
Jack estimated that he needed $1,000,000 in capital plus bank loans to develop the project. Jack established an irrevocable generation skipping trust for his descendants. Jack contributed $99,000 to the trust, filed a gift tax return using a portion of his lifetime gift tax exemption and allocated generation skipping exemption to the gift.
The trust formed a family limited liability company, a FLLC, to develop the project. The FLLC had one voting unit and 99 nonvoting units. The FLLC admitted the trust as a member which contributed $99,000 to the FLLC in exchange for 99 non-voting units. Jack was admitted to the FLLC and he contributed $1,000 for 1 voting unit. The FLLC obtained sufficient loans to complete the project with the help of Jack’s personal guarantee. Jack was paid a fee of 1% of the loan balance per year in exchange for the personal guarantee. Jack also loaned the FLLC $900,000.
The FLLC successfully completed the project in 2007 and netted $15,000,000 as contemplated. The trust repaid its loan from Jack with interest. The trust for Jack’s descendants ended up with $14,100,000 and Jack only used $99,000 of his gift tax and generation skipping tax exemptions. More importantly, the resulting funds in the trust will not be subject to estate or gift tax for the life of the trust (up to 360 years in the State of Florida).