Lifetime Gifts of Closely Held Business Interests – Use a Trust

Take-Away: A gift of closely held business interests to a child or grandchild is a key component of many estate plans. The problem arises if the donee of that gift, who works in the business, is later in a divorce.  A Michigan divorce judge can treat that gifted interest in the closely held business as a marital asset that is the subject to the divorce court’s equitable distribution powers. While the judge will not actually award part of the closely held business interest to the former son or daughter-in-law, the result is that more martial assets will be awarded to the non-donee former spouse.

Background: Recently the Michigan Court of Appeals issued an opinion that reminds us that closely held business interests, even those that were acquired by gift or inheritance, can be subject to a divorce court’s equitable powers. This is important to keep in mind in this period of large lifetime federal gift tax exemption amounts [$11.6+ million per person], where parents and grandparents are encouraged to make lifetime gifts of their hard-to-value closely held business interests to their children and grandchildren, before the federal gift tax exemption falls back to the lower amount in 2026 [$5.0 million adjusted for inflation.]  Normally property that is the subject of a lifetime gift, or inheritance, is treated as separate property of the spouse who receives the gift or inheritance. In addition, normally, that separate property is not supposed to be treated as part of the marital estate. This general statement of law is mitigated to a degree, however, by a Michigan ‘contribution’ statute that provides that the increase in value of one spouse’s separate property can be deemed marital property when the other spouse assists, directly or indirectly, in the growth or acquisition of that asset. [MCL 552.401.] In addition, Michigan Courts have held that separate property assets may lose their character as separate property and transform into marital property if they are commingled with marital assets and treated as by the parties as marital property. Cunningham v Cunningham, 289 Mich App 195, 2020 (2010.)

In a recent reported case the Court of Appeals was asked, but declined, to apply a case decided 25 years ago in a divorce setting that applied the Michigan ‘contribution’ statute to gifted closely held business interests. Frankly, this same 1995 case gave me nightmares in two large divorces that I handled. Since it was a published decision, that meant that it was binding precedent on the trial judge who I appeared before, both of whom included gifted corporate stock in the divisible marital estate. In both divorce cases, the father had gifted substantial stock in family owned businesses directly to his son who worked in the business, gifts that were part of a well-thought-out estate planning strategy to reduce the father’s taxable estate. I have painful memories of both of those contested divorces.

Hanaway v Hanaway, 208 Mich App 278; 527 NW 2d 792 (1995):  In the Hanaway decision, the Michigan Court of Appeals held that the husband’s stock in a family-owned company, gifted to him by his father, was available for division as marital property because the wife’s handling of child-rearing and domestic duties had freed the husband to concentrate on growing the value of the corporation. That Court found that the husband’s stock had “appreciated because of defendant [husband’s] efforts, facilitated by plaintiff [wife’s] activities at home.” In Hanaway, the wife was a homemaker while her husband worked, per the Court, seven days a week and many late hours at his family business- facts that can be found in almost every family-owned business setting, not to mention the omnipresent goal to grow the value of the family-owned business. The husband, who became president of the business, had been given stock in the company over a period of many years by his father through annual exclusion gifts, so that by the time of the husband’s divorce, he owned 41.23% of stock in the corporation. The trial judge found the company stock to be the husband’s separate property, as it came to him as a gift over the years from his father, and thus the stock was not part of the marital estate. That, along with the fact that the stock always remained in the husband’s name alone. The Court of Appeals panel found differently. That panel reasoned that although the husband was initially gifted the stock in the family run business, the wife’s long-term commitment to running the household facilitated her husband’s ability to increase the business’s value, which in turn profited the couple through the receipt of the husband’s growing salary. Hanaway was the decision that gave me (and still gives me) nightmares, considering the number of clients over the decades who I encouraged to gift stock in their family businesses to their children to reduce the size of their taxable estates.

Gappy v Gappy:  In the recent decision by the Court of Appeals in Gappy v Gappy, No. 342861 (September 19, 2019, Unpublished) the husband worked free in his businesses, including the father’s gas station on weekends, despite the fact that the husband was also an attorney. His wife, also an attorney, claimed that her husband had acquired a ‘deemed interest’ in his father’s gas station business through his weekend  employment, along with the fact that he provided free legal services to his father’s other business interests. The Court of Appeals rejected the wife’s effort to apply the Hanaway principles to her marriage because her husband never acquired an interest in any of his father’s businesses. And while her husband might, at a future date, inherit an interest in those businesses, discerning the probable amount of his inheritance, if any, would be speculative, especially because the husband’s mother would inherit if his father dies first, not to mention that there were other children who would also be expected to receive an inheritance on the deaths of their parents. As an aside, the Court also found it irrelevant that at the time of trial the husband was working full time at the gas station. [I am more interested in knowing why a licensed attorney would work full time at a gas station, but that is just me. I wonder what his clients thought when they pulled into the station on weekends for a fill-up and their attorney worked the pump. I suspect many quips about going from billing by the hour to billing by the gallon. But I digress.]

Conclusion: In light of the Michigan Court decision in Hanaway and its finding of a spouse’s indirect contributions to the value of a gifted closely held business interest held by their spouse, there looms the risk that part of that gifted business interest, or its appreciation in value, will be included in the marital estate of the donee-spouse. Consequently, while many business owners are now encouraged to take advantage of the currently large $11.6+ million federal gift tax exemption and to make gifts of hard-to-value business interests to their children and grandchildren who may work in the family-business, thought also needs to be given to the repercussions of a future divorce of the donee of that business interest. One option is to make the gift of the family business interest to a discretionary trust established for the benefit of the intended donee family member, where the donee is not treated as possessing any property interest in the trust. [MCL 700.7815(1).] If it is not property, there should be nothing to include in the donee’s marital estate in the event of a later divorce. Such a trust could also be established as a grantor trust for income tax reporting purposes, which would permit the income generated by the gifted closely held business interest to be taxed to the settlor of the trust, and thus not cause any income tax consequences to either the trust or to the trust beneficiary, to avoid the non-donee spouse’s claims that the marital estate was depleted in paying income taxes on the gifted asset, or the donee’s interest in the trust if it holds S stock. Another option would be to gift the closely held business interest to a Michigan Qualified Dispositions in Trust, aka the Michigan asset-protection trust. That statutory trust clearly directs that a beneficiary’s interest in that qualified dispositions trust is not to be considered, directly or indirectly, in a beneficiary’s future divorce, either as property or for purposes of setting any spousal support or child support obligation on the income the beneficiary can expect to receive from the trust. MCL 700.1045(4) (a.)]