Charitable Gifting With Closely-Held Business Interests

Charitable Gifting With Closely-Held Business Interests by Salvatore J. LaMendola, Esq.

Major Issues That Affect Giving • Contribution Issues (from the kind of asset donated) • Self-Dealing Issues (from the plan of disposition for the asset donated) • Excess Business Holdings Prohibitions • Unrelated Business Income

Contribution Issues • Will deduction be for fair market value (FMV) or adjusted cost basis (ACB)? • Contributions of closely held business interests to private family foundations (PFFs) and charitable remainder trusts (CRTs) that allow a PFF to be named as a remainder beneficiary result in deductions based on ACB only. • Contributions to CRTs that prohibit PFFs as a remainder beneficiary result in deductions based on FMV. • Contributions to grantortrust CLTs result in deductions based on the present value of the payments to the lead charity, subject to “for the use of” 30%/20% AGI limitations. • Contributions to CLTs that are notgrantortrusts result in no deduction to the CLT donor. • Donations of partnership and LLC interests, even if based on FMV, must be reduced by the gain attributable to unrealized receivables and substantially appreciated inventory (Section 751 property).

Contribution Issues • Will bargain sale treatment occur? • A donation of a partnership or LLC interest that holds property subject to indebtedness could result in the recognition of income to the donor equal to the indebtedness. • Will a tax election be affected? • For example, a contribution of S corporation stock to a CRT terminates the S election • A contribution of S corporation stock to a PFF, a grantor trust CLT or to a non-grantor trust CLT (that makes an ESBT election) does not terminate the S election • Will a transfer restriction be violated?

Contribution Issues • Can the contribution deduction be fully used? • Will AGI limits result in unusable deductions? • How much deduction will be lost to the phase-out of itemized deductions for high income taxpayers? • Will inadvertent income recognition occur? • The transfer of a partnership or LLC interest that owns an installment obligation accelerates any gain attributable to the installment obligation to the donor. • A violation of the Anticipatory Assignment of Income Doctrine will result in gain to the donor upon sale.

Self-Dealing Issues • Transactions between PFFs, CLTs and CRTs and Disqualified Persons (DPs) are prohibited • Disqualified persons: • Substantial contributors (founder and >$5,000 contributors) • Foundation officers and directors • More than 20% owners/beneficiaries of substantial contributors • Family members of any of the above • A corporation, partnership trust or estate in which any of the above four owns more than a 35% interest • A government official

Self-Dealing Issues • Family members: • Spouse • Ancestors • Children • Grandchildren • Great-grandchildren • Spouses of children • Spouses of grandchildren • Spouses of great-grandchildren

Self-Dealing – Key Exceptions • “Palmer” - A transaction with a corporation which is a DP and is pursuant to a liquidation, merger, redemption, recapitalization, or other corporate adjustment, organization, or reorganization, is not self-dealing so long as all of the securities of the same class as that held (prior to such transaction) are subject to the same terms and such terms provide the payment of no less than fair market value. 4941(d)(2)(F).

Self-Dealing – Key Exceptions • Certain Indirect Transactions • Indirect self-dealing doesnot include certain transactions with respect to an interest or expectancy in property held by an estate (or revocable trust) where the transaction is approved by the probate court having jurisdiction over the estate or trust. • This exception can be used by family members to purchase assets that present problems for CLTs and PFFs from the deceased’s estate, substituting instead non-problematic cash or a promissory note.

Excess Business Holdings • More than “Permitted Holdings” is prohibited • 20% of outstanding voting stock- % of voting stock owned by all DPs= Permitted Holdings • Actual Holdings- Permitted Holdings= Excess Holdings • However, in any case in which DPs together do not own more than 20% of the voting stock, nonvoting stock is also treated as permitted holdings.

Excess Business Holdings – Key Exceptions • 5-year period beyond the date of the gift to dispose of excess business holdings • IRS has the statutory power to extend the initial 5-year period, for unusually large gifts or bequests of diverse holdings or holdings with complex corporate structures, for up to an additional 5 years. • Under certain circumstances, the permitted holdings may be increased from 20% to 35%. Such an increase is permitted if: • (i) persons other than the PFF/CLT(>60) and DPs have "effective control" of the company, and • (ii) the PFF/CLT(>60) establishes to the satisfaction of the IRS that effective control is in one or more persons (other than the PFF itself) who are not DPs.

Excess Business Holdings – Key Exceptions • If 95% or more of the gross income of a business enterprise is "passive," the entity will not be deemed to be a business enterprise. • See below under Unrelated Business Income for kinds of passive income. • A “de minimis” rule is provided in which DPs may retain any percentage of holdings, so long as the PFF/CLT(>60) holds no more than 2% of the voting stock or 2% by value of all outstanding shares. • Does not apply to CRTs. • Does not apply to CLTs with 60% or less lead interests.

Unrelated BusinessTaxable Income • If a PFF incurs unrelated business taxable income (UBTI), it must pay income tax on the UBTI at the underlying corporate or trust tax rates. • In computing UBTI, all deductions allowed under the general income tax provisions that are directly connected with the carrying on of the unrelated trade or business may be subtracted. • A CRT that incurs UBTI loses its tax-exempt status in that taxable year, so UBTI could be particularly devastating in a year when an appreciated asset is sold.

Unrelated BusinessTaxable Income • A non-grantor CLT is permitted to deduct payments of UBI actually made to charity subject to the percentage limitation rules applicable to individual taxpayers. • Accordingly, if the distributions consist of cash payable to a public charity, the trust can deduct distributions of UBI to the extent of 50% of the trust's contribution base. • If the payments are made to a private non-operating foundation, the percentage limitation is 30%. • A non-grantor trust CLT that makes an ESBT election isnot allowed a deduction for its payments to charity.

Unrelated BusinessTaxable Income • UBI generally means income earned from the active operation of a business enterprise. • The following and their related deductions are excluded from the UBTI calculation: • Dividends • Interest • Annuities • Payments with respect to securities loans • Loan commitment fees • Royalties

Unrelated BusinessTaxable Income • Rents, if: • they are rents from real property, or • rents from personal property leased with the real property, provided that the rents attributable to the personal property are an incidentalamount of the total rents under the lease. • The rental exclusion is not available if: • more than 50% of the total rent under a lease is attributable to personal property, or • if rent is determined by net income or profits derived from the leased property, or • if the organization renders services in connection with the lease.

Unrelated BusinessTaxable Income • Gains and losses from the sale, exchange, or other disposition of property, otherthan inventory and property held primarily for sale to customers in the ordinary course of a trade or business. • If an exempt organization is a member of a partnership/LLC that regularly carries on a trade or business that is an unrelated trade or business with respect to the organization, the organization must include in UBI its share, whether or not distributed, of the gross income of the partnership/LLC from the unrelated trade or business and its share of the partnership/LLC deductions directly connected with the included income.

Unrelated Business Income • Stock in an S corporation is treated as an interest in an unrelated trade or business, and all items of income, loss, or deduction taken into account under the S corporation rules are required to be taken into account in computing UBTI notwithstanding the exclusion that would otherwise be available for passive income. • The proceeds from the sale of S corporation stock is also treated as UBI. • Notwithstanding any other exclusion otherwise available, a portion of income and deductions from debt-financedproperty must be included in UBTI. • Investments acquired through the incurrence of "margin" debt.

Unrelated Business Income • Mortgaged property unless acquired by gift, and: • the transferor held the property for at least 5 years before the transfer, and • the mortgage was placed on the property at least 5 years before the transfer, and • the organization does not assume the mortgage. • If mortgaged property is acquired by bequest, no acquisition indebtedness for 10 years after the testator's death provided the organization does not assume the mortgage.

Summary Chart

Potential Situation 1. Business Interest Estate Purchaser 2. Note 3. Distribution of Note 4. Note Payments Private Foundation 5. Distributions Charity IRS : -$0-

Potential Situation • Purchaser Options • Children • Business • Dynasty Trust • Note Funding Options • Business Profits • Life Insurance

Potential Situation • Charitable Donees • Public Charity • PFF • T-CLAT • Eliminates possibility of balloon note. • May be “cheaper” if 7520 rate (120% of Mid-Term AFR) is lower than Long Term AFR. • “Wait and See” Approach • Disclaimer to charitable donee is possible. • If charitable donee is a PFF, disclaimant cannot be a director over disclaimed assets received by PFF. • If charitable donee is a T-CLAT, disclaimant cannot be a T-CLAT remainder beneficiary.

Charitable Gifting With Closely-Held Business Interests