On Documenting Stock Gifts: Knop v. Knop.

What if you (and everyone else) thought that your father gave you stock in the family business, and then years later, when it really mattered, you found out that you didn't own the stock, just because your father never actually handed you his stock certificate?  That's basically what happened in a case called Knop v. Knop, decided by the Supreme Court of Virginia in 2019.  When engaging in family business succession transactions, you should employ the same kind of formalities, including proper documentation, as you would in an arm's-length transaction.  Otherwise, the transaction might fail or might have unintended consequences.

The Knop case involved a family business call "Ticonderoga Farms," which operated as an S corporation in the State of Virginia.  The father owned 72.76% of the outstanding stock, and his three children, collectively, owned the remaining 27.24%.  In 1989, the father expressed an intention to start making annual gifts of stock to his children, as part of his estate planning.  Each year thereafter, when the company's accountant prepared the company's federal income tax return (IRS Form 1065), the accountant evidenced the annual stock gifts by increasing the percentage of each child's ownership interest shown on the child's Form K-1 (i.e., the statement of the child's share of taxable income from the company).   Further, the children received emails from their father indicating his intention and belief that he was making annual stock gifts to them.  By 2004, each child's K-1 indicated that the annual gifts had increased his or her ownership interest to 14.687%, or roughly 44% for the three children in the aggregate.

Years later, the father wanted the company to transfer some of its property to create a scenic easement, but the children opposed the measure.  Under the company's bylaws, the company could not transfer the property without approval of shareholders owning at least 90% of the stock.  The father sought to circumvent this requirement by converting the corporation to a limited liability company, under whose governing documents he would have unilateral control to transfer the property.  The conversion to an LLC under Virginia law required approval of shareholders owning two-thirds of the corporation's stock, so the father asserted that he still owned 72.76% of the stock (i.e., more than two thirds) and that the annual stock gifts made from 1989-2004 were not valid.  The father took the position that although he had intended to make the stock gifts, he had never delivered the gifts by surrendering his stock certificate.

Under Virginia law, as under the law of many states, a gift requires (i) donative intent and (ii) actual or constructive delivery of the gifted property.  Although the father clearly intended to make the gifts, he did not actually deliver the stock because, according to Virginia's statutes, a certificated security is deemed to be transferred when the transferee obtains possession of the certificate.  Although the children attempted to argue that the father's acquiescence in the stock gifts reflected on the children's K-1s was "constructive" delivery, the Court held that a transferor's actions do not constitute constructive delivery unless the transferor, in the process, gives up his own dominion and control, such as by giving the certificate to the transferee's agent or even locking the certificates in a chest and giving the transferee the only key.

For these reasons the Virginia Supreme Court held that the annual gifts of stock were invalid and, as a legal matter, the father and children, respectively, held the same number of shares as they held before the annual stock gifts purportedly occurred.

You can imagine how disruptive it could be to the governance and management of a company, as well as the estate planning of the owners, if substantial stock transfers were found to be invalid many years after everyone thought they had been accomplished.  That circumstance could give rise to a sudden and shocking change of control and could invalidate the election of certain directors, the acts of the governing board, or any past acts that required shareholder approval.  Further, it could nullify stock transfers that were part of a plan to reduce estate taxes and thus could cause substantial additional value to be included in the purported transferor's taxable estate.

Sometimes family business owners and their advisors are tempted to take short cuts when executing or documenting a transaction among family members because all the parties are "on the same page."  If you skip some of the details in a family transaction, however, you might miss a key element of the transaction and that could cause trouble in the case of a subsequent dispute, or in an IRS audit, or when a potential buyer does his or her due diligence.

LESSON: Always document and carry out your transactions among family members with the same care and attention to detail as when you engage in transactions with unrelated third parties.