The Hoensheid Case and the Assignment of Business Income for a Sale

Nov 14, 2023 | Business Planning, General Estate Planning, IRS / Tax Guidance, Podcasts, T&E Litigation

“The Hoensheid Case and the Assignment of Business Income for a Sale,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

Background on the Hoensheid Case

This is Travis Hayes, ACTEC Fellow from Naples, Florida. As estate planning and tax advisors, we are often contacted by business owners preparing their companies for sale. Recently, the Tax Court issued a ruling in the Estate of Scott M. Hoensheid v. Commissioner case regarding the sale of a business. Many practitioners are now left wondering how the decision in Hoensheid could impact other assignments of business income. ACTEC Fellow Gray Edmondson of Oxford, Mississippi is joining us today to discuss the Hoensheid case and share his takeaways from the ruling. Welcome, Gray.

Understanding Income Assignment

Gray Edmondson: Thank you, Travis. And it’s certainly true that the Hoensheid case has shaken a lot of peoples’ belief in how assignment of income is treated in gifts of equity interest before, primarily a liquidity event, a sale of a business or a sale of a piece of real property. Traditionally, most of us have believed that the law required there to be some level of a binding commitment to sale before we would be in a problem from an assignment of income perspective.

The Humacid Co. v. Commissioner Precedent

And so, stepping back from that briefly to just, what is an assignment of income as sort of a fundamental matter? The notion is that going back to the 1960s case called Humacid, the rule is that a taxpayer is allowed to gift an asset, before it is sold ultimately to a third party, to a charitable organization and get two benefits, effectively. A deduction for the asset’s value gifted, subject to certain exceptions that could limit that deduction to a cost basis, as well as avoidance of capital gains on that particular asset.

And so, it’s really common to engage in a strategy whereby you gift of an interest in a business, a piece of real property, or another asset that’s being sold to a charity before that sale to take advantage of those double benefits. To get a fair market value deduction, and then also to avoid capital gains on that income. And so, the test for assignment of income and where the rules that were sort of initially laid down on that Humacid case come out of is, how do you know whether you get the double benefit of a fair market value deduction as well as avoiding the gain?

And so, what the Humacid case says we look at is we can avoid the gain if the gift of the appreciated property is given away absolutely with a full divestment of title to that asset, and it’s done before the property gives rise to income by way of sale. And so, the real question on the second part of that Humacid test is, when in the spectrum of a sale transaction have we gone too far so that we now, as the taxpayer who intends to get the benefit of avoiding that gain, have already received the right to that taxable income? And once we cross that threshold, that becomes taxable to us, notwithstanding the charitable gift.

And so, going back to a few different authorities that are out there, the Palmer case, IRS Revenue Ruling 78-197, and then the Rauenhorst case, all were in a string of authorities that indicated that when there’s not a binding, legally enforceable obligation to sell that asset, as long as we make the transfer before it becomes binding and before there’s a written binding obligation to sell, we’re fine. That was essentially thought by many planners to be a bright line rule, so as long as we were before one end of that bright line and not after it, we were good.

Reassessing Assignment of Income

The Hoensheid case sort of shook that up and said, “We’re not going to look at a bright line test, we’re going to look at this from a facts and circumstances basis.” A point of disagreement I think some of us in the planning world have, I can speak specifically of Steve Gorin, another ACTEC Fellow, who I have spoken with about this case extensively and who has given a couple of presentations about it. He sees the Hoensheid case as a major change in the law. I think it’s the first time the Tax Court has reached this outcome. But in that prior Rauenhorst opinion that I mentioned, I feel like the Tax Court left its foot in the door by saying in some of its language in that case, “We don’t think this is the case to upset the bright line rule that’s been out there, but we do think on the right facts that we will look beyond this bright line test.”

Interpreting the Court’s Decision

And so, is that a change in the law?  Was it really the law from Rauenhorst forward and this is just the first time the courts viewed it this way? You be the judge of that. But, at any rate, what the court said is, “We’re going to look and see, had we gotten too far gone?” And the court looked at four factors. Was there a legal obligation to sell? They admitted in Hoensheid there wasn’t yet. But they also looked at three other factors: (1) what actions had been taken by the parties to effectuate the transaction?; (2) what remaining transactional contingencies existed?; and (3) what was the status of the formalities required to complete the transaction?

When we look at those factors, the steps are already taken – the buyers and the sellers here had received all of the regulatory authority they had to obtain to engage in the transaction and all of the corporate requirements they had to fulfill to engage in the transaction. They had notified third parties of the transaction.  So, the actions that were taken were pretty far along. In addition, the corporation that was going to be sold had distributed all of its cash before the sale occurred or substantially all of its cash such that it could not have continued to do business without more cash being infused than was anticipated as a result of the sale.

The next one is unresolved transactional contingencies. The facts decided by the case show that at the time this gift was made, only one red line remained in the purchase agreement that was being negotiated to be signed. It was a transaction where the contract was going to be signed contemporaneously with the closing. Instead of having a contract with a period between the contract date and the closing date, it was all going to be contemporaneous.

But at the time the gift was made, there was only one item being negotiated, and it was a non-substantive item dealing with some language around how one employee was going to be treated at that employee’s request, I believe. So that really wasn’t anything that was going to hold up the deal.

And the status of formalities, as I mentioned – everything had been approved at the corporate level on both sides. Acquisition subsidiaries formed. Regulatory approvals made. Distributions were made to fund dividends to the shareholders, and in addition to dividends to the shareholders, payment of a change of control bonus to employees. And so, when the Tax Court looked at this and saw we had gotten so far along in the transaction, the language the court used there was that it was a foregone conclusion that this was going to sell and that there were only ministerial acts remaining. And when that’s the case, the court said, “We’re going to render this to be an assignment of income.”

Repercussions of Decision for Tax Planning

So, where does that leave us?  I think where it leaves us as planners is that we have to ask the question when we’re advising clients about making gifts of assets before a sale transaction, not “are you legally obligated yet to sell this asset?” But we have to go through these facts and circumstances tests to say, “Are there any contingencies that remain outstanding? Are there formalities that remain outstanding that would have to be completed? Have you done other things that would make this transaction too far gone to turn away from, and if so, notwithstanding the lack of there being a binding obligation, maybe you’re too far along?”

Final Thoughts and Implications

I think that’s really the nutshell of Hoensheid, and really, aside from the assignment of income case, I’ll just put a sort of another note out there: this taxpayer not only lost their ability to avoid the gain on those shares that were gifted to charity before the transaction. He also lost – Mr. Hoensheid lost- the ability to take a deduction whatsoever because he obtained a valuation from someone who was not a qualified appraiser. And so, he also messed up the charitable gift substantiation requirements, and so it was sort of a total whip-saw for the taxpayer.

And really, on the assignment of income, maybe not his doing, his lawyers were giving him advice that, “If you don’t have a legal obligation to sell, you’re not too late, probably.” But they certainly never told him to get a free, unqualified appraiser to value his stock, which is what he did. And so, you know, he kind of lost across the board. And so, I think it’s a lesson both to planners and taxpayers about the facts and the circumstances you have to look at in determining whether an assignment of income would be a problem beyond just a legal obligation to sell. And then also a lesson about don’t cut corners on charitable gift substantiation.

Travis Hayes: Thank you, Gray, for discussing the Hoensheid case and what practitioners should take away from the Tax Court’s ruling.

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