Rev. Rul. 81-54

(1) What are the federal gift tax consequences of a transfer of stock in a newly formed Domestic International Sales Corporation (DISC)?

(2) What are the federal gift tax consequences of the continued contractual relationship between the manufacturing corporation and the DISC?

FACTS

Corporation M, a domestic manufacturing business, was oragnized in 1972. All of M's stock has been continuously owned in equal shares by individuals A, B, and C. M sells one-half of its products outside the United States.

In January 1978, the three shareholders of M formed a DISC in order to maximize the profitability of export sales transactions by M. A, B, and C each transferred $1,000 in cash to the DISC in exchange for equal shares of the stock of the DISC. Immediately thereafter, A, B, and C made gifts of all of their DISC stock to three irrevocable trusts created for the benefit of their respective minor children. Each of the spouses of A, B, and C was designated as sole trustee of the trust for their respective children. The trustees of the three trusts were given full power to deal with the trust assets as if they owned those assets outright.

After the DISC stock was transferred to the trust, M and the DISC agreed in writing that the DISC would be the exclusive agent of M with respect to all export sales of M products. Under the terms of the agreement, the DISC is to be paid a commission for each export sales transaction. The amount of the commission on each sale is stated in the agreement to be the "maximum amount permitted under the intercompany pricing rules of section 994 of the Internal Revenue Code."

The agreement requires that all commissions on sales of M products during a taxable year of the DISC be paid to the DISC within 30 days after the end of that taxable year. The agreement provides that it shall terminate immediately at the will of either party. Upon termination, a final payment of all outstanding obligations between M and the DISC is to be made.

The taxable year of the DISC ends on December 31. The DISC performed no significant services.

LAW AND ANALYSIS

Under section 2501 of the Code, a tax is imposed on the transfer, by any individual, of property by gift during each calendar quarter. Section 2511 provides that the gift tax shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the transferred property is real or personal, tangible or intangible.

Section 2512(b) of the Code provides that if property is transferred for less than adequate and full consideration, the excess of the value of the transferred property over the value of any consideration received is includible in determining the amount of a donor's taxable gifts.

Section 25.2512-8 of the Gift Tax Regulations provides that a transfer of property made in the "ordinary course of business" is presumed to have been made for adequate consideration in money's worth. Under the regulation, a transfer in the "ordinary course of business" is one that is "bona fide, at arm's length, and free from any donative intent."

Under section 25.2511-2 of the regulations, a transfer is complete, for federal gift tax purposes, when the donor has so parted with dominion and control as to leave the donor no power to change its disposition.

In the present case, the three shareholders of M made gifts of the shares of the DISC stock when they transferred the shares to the trusts for their respective children. The value of the transferred DISC stock was equal to the value of the underlying assets of the DISC on the date of the stock transfers.

Transactions completed pursuant to the written agreement resulted in a continuing transfer of a portion of M's income to the trust beneficiaries via the DISC commission arrangement. This transfer of income is not in the ordinary course of business under section 25.2512-8 of the regulations. The creation of the DISC by A, B, and C was founded on a valid business purpose in view of the income tax advantages generally associated with the formation of DISCs. However, under these facts, the transfer of M's income to the DISC, and thus, indirectly to the trust beneficiaries, as a result of the trust's ownership of the DISC stock, was not required in the course of M's business and had no valid business purpose in regard to M.

M's retained right to unilaterally terminate the agreement with the DISC makes any transfer of commission that the DISC may receive from future transactions incomplete until the transactions take place. Upon completion of each transaction, the owners of M no longer retain any dominion and control over the payment of commissions to the DISC, because under the agreement, the DISC is entitled to a commission on each sale. Therefore, under section 25.2511-2 of the regulations, discussed above, the donor's gifts occur as each transaction through the DISC is completed. The measure of the gift is the amount transferred to the DISC on each sale.

HOLDINGS

(1) A, B, and C each made taxable gifts of shares in the DISC to the trusts created for their children upon the transfer of those shares. The value of each donor's gift is the aliquot portion of the DISC's asset value at the date of transfer.

(2) A, B, and C have made and will continue to make gifts of profits that would otherwise flow to M in the absence of the agreement with the DISC. These gifts occur each time M sells its products by way of the DISC. See section 25.2511-1(h)(1) of the Gift Tax Regulations. The gifts continue as long as the agreement is in effect. The total value of the gifts by each donor is one-third of the amount transferred to the DISC on each sale.

Holdings (1) and (2) above would be the same if the contract between the DISC and M had been entered into prior to the transfer of the DISC stock to the trust.