Modifications of legal relationships can have Chapter 14 implications.

• Author: Teresczuk, Timothy G.

In Letter Ruling (TAM) 9352001, a decedent owned approximately $3.2 million of property. Included in those assets were 1,829 acres of ranch land, $1.6 million of readily tradeable stocks and bonds, and $900,000 of bank deposits and Treasury bills. The decedent's child transferred all of these assets into a company owned by the decedent that had previously not owned any property. Soon after the transfer, the company employed the child's spouse under an employment agreement and at the same time entered into a recapitalization under which voting stock was given in a compensatory transaction to the child's spouse and the decedent was left only with nonvoting stock.

The IRS ruled that because the employment agreement called for a salary payment to the child's spouse that it deemed to be excessive, a gift under Sec. 2511 was made to the child's spouse. The gift occurred at the time of the execution of the employment agreement.

In addition, the recapitalization coupled with the execution of the employment agreement was held to have the effect of the decedent giving up a liquidation right in the corporation. As a consequence, under Sec. 2704, a lapse of a liquidation right was held to have occurred and a valuation issue under Chapter 14 was created.

As to the first issue, it is not surprising that the Service would consider an employment agreement that paid unreasonable compensation to a family member to be a gift. There is certainly precedent for this position. It does, however, require taxpayers to be very careful when executing and changing contractual arrangements among family members, and between family members and the family business. The fact that no outright transfer appeared to have occurred did not change the fact that something of value had been transferred, possibly gratuitously, from an older generation to a younger generation family member. When this transfer is obvious, taxpayers can expect the IRS to take the position that a gift has been made. Other situations may be more subtle but may nevertheless cause gift tax exposure. Therefore, taxpayers should be very careful when modifying legal relationships in family situations.

With regard to the second issue, the letter ruling stated, "Because 1) the Employment Agreement conferred a preferred equity interest on Child's spouse that was senior to the decedent's retained interest, and 2) the decedent's liquidation right (that was inherent in his retained interest) lapsed as a result of...