This is an idea I had for a story, and I was curious is there was any basis for it in fact within the law in the U.S… My understanding is that transfer of wealth between parents and children is subject to all kinds of taxes, whether done when the parents are alive or dead. Presumably huge windfall penalties if gifted to the kids while the parents are alive, and large estate taxes if done after death of the parents.
But what happens if the children were to sue the parents in what was essentially a phony lawsuit? Let’s assume they have a good cover story both parties agree to, which is a ‘family business’ that fails and one business partner (the kids) sue the other business partner (the parents). Assume these are very wealthy people and the amount of the lawsuit is $100 million and that the lawyer fees are minimal since both parties are colluding. Presumably, because they are wealthy, they didn’t need a loan, so there isn’t a lot of expensive paperwork or a business plan for this phony business, other than perhaps a corporate filing of some kind to establish the business. Now the ‘lawsuit’ happens, the phony business dissolves, and the parents ‘settle’ the lawsuit with the kids for the $100 million they intended to give their kids all along as a gift, unbeknownst to the IRS. Assume both the parents and kids are in on the collusion with whatever unscrupulous lawyers are required to make the scam airtight.
In this scenario, have both the parents and kids avoided most of the taxes? For example, can the parents deduct the loss of the ‘settlement’ from their taxes or will the kids pay less of a tax on the ‘winnings’ from the lawsuit then they would if the money was just gifted to them?
First of all, if the parents gave a substantial gift to their children, the parents would be subject to a “gift tax” not a “windfall tax.”
The proceeds of a lawsuit are generally taxable. For example, if the claim was lost wages, the proceeds would be taxed as wages. If the theory were diminished value of the children’s share of the company, it could be taxable as capital gains. Personal injury settlements are generally not taxable, but economic injury settlements are taxable in the same manner as the claimed economic loss would be.
But, you say, income tax rates are generally lower than gift tax/estate tax rates, why not go ahead with the plan?
If I were the IRS I would invoke the economic substance doctrine. IRC Section 7701(o). The corporation and the whole transaction was set up without “substantial purpose (apart from Federal income tax effects) for entering into such transaction.” I would deny the parents any tax deduction for the settlement and hit them with a 40% accuracy-related penalty for even trying.
Having denied the deduction I would recharacterize the whole thing as a sham transaction and go after them for the gift taxes plus penalties for failure to file, late payment, and possibly some other miscellaneous penalties.
At the trial court level, the parties may have instructed their attorneys to deliberately throw the case, but if they want to appeal the IRS’s decision, they will have to justify the economic substance and the damages in front of a tax court judge where the opposing party will be an IRS lawyer. And he/she won’t throw the case.
Contrary to popular belief, trust funds don’t magically do away with estate taxes. Although depending on how it’s setup, the taxes may end up being more or less than if the equivalent assets passed through probate.
A better plan would be for the rich parents to just start a company and give their kids do-nothing jobs.
Even if the attorneys on both sides at the civil trial are in on it, I imagine if the trial court judge figures out what’s going on, she won’t be exactly pleased to be wasting her time on a sham. The lawyers would be taking a big risk, staging a phony lawsuit (potentially, I imagine they could even be disbarred, leaving them career-less).
So, you’d need to have the lawyers doing enough work to make the lawsuit look serious to the judge, and you’d need to pay the lawyers a really big hazard premium because they’re basically doing something highly unethical that could still be uncovered. So legal fees are not going to be minimal.
But of course, the whole premise is flawed. A civil trial isn’t going to just create a transfer of money out of thin air: the point of a civil trial is just to have the court enforce a contract (or award compensation for damaged property, but that wouldn’t make any sense in this case, because the whole point is to leave the children better off than before). So the only end result of a trial would be the court to order the parents to follow through on an agreement, which would leave everyone in the exact same tax situation as if the parents had followed through on the agreement without anyone going to court about it.
Yes, crime can be very profitable, if you get away with it. (I should imagine the colluding lawyers would want to be very well compensated for the risks they would be taking, though.)
One possible way to do this without a corporation could be a bogus personal injury lawsuit. E.g. parents take kids for a drive around town, drive back home, and, at 5 mph, “accidentally” hit a cinderblock that the parents “negligently” left in the driveway. Kids allege whiplash, parents instruct their attorneys to settle the case at all costs, not demand medical substantiation, etc. Sure, the judge might suspect shenanigans, but would he have standing to interfere with the lawsuit? Last time I checked, as long as a defendant is mentally competent, they have the right to lose their case in the most embarrassing and apparently incompetent manner possible.
Well yes, it was obviously tax fraud if that wasn’t clear from the question. And it sounds like the tax advantage wouldn’t be great enough to justify it as a viable scenario. I just assumed that when the sum of money was large enough (in this case $100M), that discounting the lawyer fees, this might have been a feasible ‘crime’ for a story. I don’t know much about trusts and assumed they were a legal tax dodge to a degree. I was just wondering if this hypothetical lawsuit, while illegal, was a greater tax dodge. Since both parties in this scenario are colluding, presumably neither party is telling law enforcement what is going on. I’m not convinced that the IRS or courts would be smart enough to know it was a fraud as opposed to just a bunch of “pissed off rich people arguing over a failed business”. In the long run, I would think the courts opinion was “thank God it settled so this crap isn’t clogging up my docket”. If nothing else, I would think the fact the parents could deduct the lawsuit loss (even if the kids pay the full income burden of the taxes on their end) might make this feasible and a way to trasnfer all the money at once. I presume a trust is some kind of ‘pay large sums of money to my kids over an extended period of time’ scenerio, which might not work if the parents are very old and close to death.
When IRS asks for proof of economic substance, they’ll certainly want to see things like medical substantiation.
Remember, you can only exclude income up to the value of damages. Thus, it would be up to the kids to prove that the proceeds of the lawsuit were covered by damages. And when they show that $100 of medical fees produced a $100 million settlement, the IRS will start asking about economic substance. The IRS may well decide it’s not income tax from the kids they want, it’s gift tax from the parents, and the law would support them in taking that position unless there are facts stating otherwise.
After all, we’re dealing with related parties. You can’t pretend that this was a lawsuit between two strangers that was settled out of court in so that both parties agreed to the fair value of the settlement.
The point is that a lawsuit won’t change anything. If the parents agree to buy the kids fingerpainting collection for $100M, from a tax perspective it doesn’t matter whether the parents immediately write a check, or the kids file a lawsuit asking the judge to seize $100M of the parents’ property and give it to the kids. In both cases, it’s still a simple purchase, from a tax perspective, and the IRS will want the kids to file taxes on their $100M of income (OK, $100M less the cost of the fingerpaint).
Many years ago, I read how the DuPont family avoided estate taxes. At the time, there were about 300 family members and each year, each of the 300 (save the youngest) gave each of the younger ones $10,000 (then the gift tax exemption) so each one, expecially the older ones, transferred up to $3 million and each one, especially the younger ones, received up to $3 million. This way, the older members of the family succeeded in transferring most if not all of their wealth to the next generation.
Not sure how that works in the USA, but an accountant friend of mine told me that Revenue Canada looks for that kind of trick. If the owner pays the wife or kids far beyond the demands of the job or for doing nothing, then essentially they are trying to “income split” and avoid taxes. Not allowed.
You can pay handsomely, you might even pay two or three times the going rate for the wife to provide “janitorial services” (many small businesses do) but the service or job has to be legitimate and the person actually has to do it. Junior can be a 'sales rep" but he actually has to show up at work and actually has to do something resembling the job description, and the pay has to be at least somewhat close to reasonable. A million dollars a year and you don’t have to show up? Daddy will be paying his marginal rate on that money instead.
Although, you can do anything until you get caught.
The same here. While you have a lot of leeway in defining work and compensation, the IRS does check that compensation is reasonable for the hours/duties performed. If nothing else, it comes back to the economic substance rules described earlier. A transaction only has economic substance if an person is in fact acting as an employee under the law and is receiving compensation for their services.
In US tax law, the economic substance doctrine is pretty much a catchall for every “I want to do x, but I’ll call it y” scenario.
No it’s not a simple purchase. If this were the way it worked, the gift tax would never apply. If I write you a check for $100M, it’s subject to a gift tax of up to 40%. But if you hand me a stick of gum at the same time, it’s ordinary income? And if the stick of gum is over one year old (and you are not a gum dealer), it’s a long term capital gain taxable at up to 20%? Congress wasn’t this dumb.
IRC § 2512 - Valuation of gifts says:
Treas Reg §25.2512-8 Transfers for insufficient consideration says:
A purchase of your child’s fingerpainting collection is generally not at arm’s length and unless you are in the art business probably not free from any donative intent.
I think Jeffrey Archer sort of beat you to it. I recall reading a short story of his where one person sued another for some reason or other for this very reason. I think the story was framed around a golf club, BICBW.
Forget hiring your kids as janitors. Appoint them to the board of directors.
One of the cleverest gifting schemes I read about was to buy or lease potential oil sites. Each site is then divided into parcels with the parent keeping one parcel and the neighboring parcels are given to the kids. Then the parents drill exploratory wells on their parcels. The kids then know “for free” which parcels of theirs they should construct development wells on.