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Monday September 6, 2010
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April - 2007
Active Businesses Transferred to Unitrusts
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Unitrusts and Unrelated Business Income (UBI)
A common challenge for owners of ongoing businesses who would like to use a charitable trust is that the business may not be held in a charitable trust. Charitable trusts are exempt from tax under Sec. 501(a) and Sec. 508(e). They also are subject to the private foundation rules on self-dealing, excess business holdings and taxable expenditures. Sec. 4947(a)(2).
Charities and charitable trusts are normally tax exempt. However, if they are regularly conducting a trade or business that is not substantially related to the exercise of their exempt purpose, they are subject to unrelated business income tax. Sec. 513(a).
Since a charitable trust will never be able to claim that an active trade or business is related to its exempt purpose, the transfer of an operating business to a charitable remainder trust results in unrelated business income. However, there are exceptions to the unrelated business rules. Among the various exceptions are the receipt of rent from real property and the payment of royalties and lease returns. These exceptions require the payouts to be fixed. If the payments are dependent upon earnings and profits, then the trust is in effect a partner and again subject to UBI. Sec. 512(c).
If an active trade or business is involved, transfer of these assets to a CRT could subject the unitrust to a 100% excise tax on the UBI. Sec. 664(c)(2)(A). While the tax may not be large if the assets are sold quickly, many grantors prefer to avoid the tax on UBI.
Avoiding Unitrust UBI
To avoid UBI, a donor who plans to contribute active business assets to a CRT may lease those assets to a third party prior to making the contribution. If this lease is in place before the assets are contributed to the CRT, the only income the CRT will ever receive from the assets is fixed rent from the lease. Rents are passive income and not taxable UBI.
Therefore, there are two possible solutions for active businesses. First, if there is a buyer "waiting in the wings," then the business interest may be transferred into a charitable trust and quickly sold to the buyer waiting to purchase. While it will be essential to avoid a prearranged sale, the time that the business is held in the trust may be just a few days. As a result, there may be a very modest amount of unrelated business income subject to the 100% excise tax.
The "near zero" tax of a unitrust for the sale of an operating business will provide over 99% of the unitrust benefits to business owners. There will still be the bypass of capital gain and a charitable income tax deduction, plus the favorable tax benefits of an operating unitrust. With the possible cost of very modest excise tax when the trust is created, nearly all business properties may now be sold with a "near zero tax" unitrust.
How to Avoid UBI - Examples
UBI may be present in several situations. Commercial buildings may have small amounts of active income from vending machines. Proprietorships and partnerships may have UBI from various business activities. Professionals who do not operate with a professional corporation will nearly always create UBI.
Prior to the passage of Sec. 664(c)(2)(A), many professional advisors avoided selling business assets through remainder unitrusts due to the risk of loss of tax exemption and potential tax on the capital appreciation. However, under Sec. 664(c)(2)(A) the tax exemption is retained and only the UBI is subject to the 100% tax, there now is an ability to transfer and sell nearly any business asset. The only cost may be a small UBI tax on active business income earned during the sale process.
Example A - Erwin's Apartment Building
Erwin Investor bought an apartment building ten years ago for $500,000. On the advice of his CPA, he took accelerated depreciation. His depreciation would have been $20,000 per year under straight line depreciation, but he now has taken approximately $30,000 per year. The adjusted basis is now $200,000 instead of the $300,000 that it have been with straight line appreciation. The property over that period of time has appreciated to $1,000,000.
Erwin rents all of the apartments under fixed leases. However, he also operates a laundromat in the basement. Tenants may use the washers and dryers for $1.25 per load.
Erwin is age 73 and has Parkinson's disease. He would like to retire and be relieved of management responsibilities. His wife Sally does not want to manage the property if Erwin is no longer able to handle that effort.
He thinks it would be attractive to transfer the apartment building to a unitrust for himself and his wife. After they receive income for two lives, the remainder will be distributed to charity. However, his CPA is concerned that the coins collected from the laundry would constitute unrelated business taxable income. The laundry does produce regular income and it is potentially therefore defined as an active business on the premises.
However, under Sec. 642(c)(2)(A), the risk is minimal. First, if Erwin were to sell the property without a CRT, there would be $200,000 of basis, $100,000 of accelerated depreciation recaptured as ordinary income, $200,000 of straight line depreciation taxed at 25% and $500,000 of long-term capital gain taxed at 15%. Since $100,000 of the value represents ordinary income, Erwin will find that his charitable deduction is reduced by $100,000 divided by the fair market value of $1,000,000 or 10%. Because the charitable deduction would otherwise been $400,000 on the 5% unitrust, it is instead reduced to $360,000 because of the potential recapture of excess depreciation as ordinary income. Nevertheless, Erwin is very pleased that he will be able to sell tax-free and still receive a deduction of $360,000.
Erwin and his wife Sally transfer the apartment building into a 5% unitrust for their two lives with Harry their CPA as initial trustee. The apartment building is debt free and there is a willing buyer waiting in the wings, but no binding contract. Harry advertises the building for sale on Wednesday, and signs a sale contract with buyer on Friday. Because there was an independent trustee and no binding agreement prior to signing the sale contract, the bypass of gain benefit is preserved. The entire transaction is completed in approximately 30 days.
During that time, the laundromat was temporarily closed. After the sale, the new buyer then reopened the laundromat. However, if any laundromat revenue had been generated during that period, then that amount would be subject to the 100% excise tax. But because of the 100% UBI tax rule and the retention of the tax-free sale benefit, Erwin's advisors were willing to fund the unitrust with the apartment building.
Example B - Mary Wilson's Strip Mall
Mary Wilson has been an entrepreneurial investor her entire lifetime. A number of years ago she acquired a small strip mall with ten commercial tenants. Each month she collects fixed rents from the tenants. However, three of the tenant leases also included a small percentage of tenant annual profit as additional lease income.
Mary would like to transfer the strip mall to a charitable remainder trust. The mall is now valued at $3M. Using straight line depreciation, her basis has been reduced to $300,000.
Under Sec. 512(c), fixed payments are excluded from unrelated business taxable income. However, if the payments are defined as a share of profits, then the recipient is in effect a partner in the operation. Since the profits are derived from an active business that is regularly conducted, these payments constitute UBI. Under this rule, the excess payments under the three leases related to store profits are UBI.
As a result, Mary can transfer the strip mall into a unitrust, but the payments that constitute UBI will create a 100% tax. Mary transfers the strip mall into a unitrust with Susan her financial planner as trustee. She then sells to buyer "waiting in the wings" within 30 days. During that period of 30 days, additional payments on the three leases amounted to $2,422. This amount is unrelated business income tax and must be paid as tax to the Internal Revenue Service.
Mary bypassed the gain on $2,500,000 and also received a charitable income tax deduction of over $1,000,000. Her total tax savings were over $800,000. As a result, she did not object to the payment of a small amount of excise tax to the IRS.
Example C - The Green RV Park
Willard and Clara Green grew up in a rural area about one hour from a large city. As the city continued to grow, they decided to benefit from their pastoral setting by creating an RV park. Willard and Clara developed and now operate a successful RV park with over 300 parking spaces for RV's. Most of the park has been improved with an office, laundromat, a recreation center, and water, electric and sewer connections for the RV spaces.
Willard and Clara advertise in Trailer Life and other RV guides. Thousands of people rent RV spaces on a daily basis each year.
The RV park now has a fairly low basis of $200,000, since the various improvements have been depreciated using the straight line method. There is a prospective buyer willing to pay $4M for the RV park. Willard and Clara hold the RV park in an LLC. They own all of the LLC units.
Since the LLC is taxed as a partnership, under Sec. 512(c) any UBI in the park would flow through to a charitable remainder unitrust if it owns the LLC. Willard and Clara transferred the LLC to a charitable remainder unitrust for two lives. They then made contact with the prospective buyer and sold the park within the next four weeks. Since February is the month of lowest park usage, the park expenses nearly equal the park revenue for that month. After allocating all of the expenses against revenue, the park had a net profit of $1,022 for the month of February.
Willard and Clara bypass gain on $3.8M and also receive a charitable deduction of $1.7M, based on their age and the 5% unitrust. Their total tax savings are substantially over $1M. Since there was $1,022 as UBI, this is paid as a tax to the IRS.
Example D - Medical Practice
Dr. Denny Driller is a very successful dentist. He has built up his practice and is ready to retire. Dr. Driller leases his office, has medical equipment valued at approximately $100,000 and has thousands of patient records. A new dentist is interested in purchasing his practice for $600,000. The $600,000 purchase would be allocated $100,000 to the equipment and $500,000 to goodwill (patient record and relationships.)
Since Dr. Driller is operating the practice as a proprietorship, he transfers the entire practice into a charitable remainder trust on Friday of a three-day weekend at 5:05 p.m.
The new dentist, Dr. Bridge, purchases the practice from the trust at 7:30 a.m. on the following Tuesday and the practice is open for business at 8:30 a.m. the same day.
Dr. Driller's unitrust receives the $600,000 in payment in exchange for sale of the practice. Since there was no business conducted during the three-day weekend there is no UBI tax. The primary benefit of the Sec. 664(c)(2)(A) rule is that Dr. Driller can rest secure knowing that even if the IRS were to claim UBI for any patient payments mailed during the weekend, the amounts involved would be the extent of the potential UBI tax. In all probability, since there was no activity to generate revenue during the three days, the sale of the practice will be tax-free.
Avoiding a Prearranged Sale of a Business
Because there is a 100% tax on UBI under Sec. 642(c)(2)(A), advisors will strive diligently to minimize that income and the resulting tax. The logical solution is to sell as quickly as possible while avoiding a prearranged sale. The favorable end result is a bypass of capital gain with minimal or no tax on UBI.
With an outright gift to the charity or a gift to a charitable remainder unitrust with the charity serving as trustee, there are several potential strategies to sell quickly and still preserve the bypass of capital gain. These include a no negotiations strategy, a buyer waiting in the wings, a contingent oral agreement or a contingent escrow agreement.
No Negotiation Strategy
The best strategy is for the donor to transfer the property to the charity outright or in trust prior to any negotiations with prospective buyers. Under Rev. Rul. 78-197, there clearly is "no binding agreement" and the charity or trustee may then list the property for sale. After a period of negotiation with various buyers, the property may be sold. This arrangement is clearly within the bounds contemplated by Rev. Rul. 78-197, since there is no "binding agreement" as of the date of the gift.
What if the property has been listed with a business broker? What if there is an offer on the property? Under the "no binding agreement" test, the listing does not create a binding legal right with respect to a buyer. Although the listing may create a legal obligation to pay a commission to the real estate agent, this is merely a specific cost of the sale and does not cause a ripening of the gain. Therefore, property subject to a listing, but not under contract, can be transferred into a charitable trust or outright to a charity.
If there has been an offer or multiple offers without acceptance by the seller, once again there is no binding agreement under Rev. Rul. 78-197. Therefore, the mere presence of offers does not preclude transferring the property to a charity or a charitable remainder trust.
Buyer Waiting in the Wings
What if the property has been listed and one or more buyers have made offers near the listing price? Does the ability of the charity to receive the property and quickly sell to an available buyer cause a ripening of the capital gain?
Fortunately, it is permissible to have buyers waiting in the wings. Hopefully, there is more than one potential buyer. Since this is to some extent a matter of practical proof, it is very helpful to show that two or more prospective buyers were waiting in the wings when the property was transferred. If several buyers are vying for the property, there clearly is no binding agreement under Rev. Rul. 78-197.
An excellent strategy to follow with a buyer waiting the wings is to transfer the property to the charity outright or to the trustee on day one. On day two, the charity or trustee lists the property for sale in an appropriate public newspaper or other venue. On day three, there is no activity. On day four or later, the charity or trustee makes contact with the prospective buyer and both parties sign a sale agreement. If the charity or trustee desires additional safety, it merely can extend the period of time before signing the agreement with prospective buyer. The purpose of the four day process is to establish a clear record that there is no binding agreement under Rev. Rul. 78-197.
Contingent Oral Agreement
A more aggressive donor may permit the charity or trustee to explore the potential sale of the property with purchasers prior to the actual gift. The charity or trustee offers the property for sale on a contingent basis and discloses that it does not own the property, but if it acquires the property during the future identified period, it is willing to sell the property.
Through the contingent listing, the charity or trustee may find prospective buyers. In some cases, the charity or trustee may even enter into a contingent sales contract with a specific time limitation and with an identified buyer.
Under the principles of the Palmer case and Rev. Rul. 78-197, there is no binding agreement between the donor and the buyer. In this case, the donor has not met the buyer and has had no contact. Since the donor has no contact with the buyer, there cannot be a binding agreement between the donor and the prospective purchaser.
It should be noted that this strategy has not been tested in Tax Court. It relies on a reasonable interpretation of Rev. Rul. 78-197.
Contingent Escrow Agreement
The contingent sale to a buyer strategy may be taken one step further. The charity or trustee can also enter into an actual contingent escrow. Both the charity or trustee and prospective buyer complete the customary escrow processes, as though the charity or trustee actually owns the property. However, all parties are under notice that any actions taken are explicitly contingent upon the charity receiving the property. A few days before the anticipated closing, the donor then gives the property to charity outright or in trust. In two to five days, the property is sold and proceeds are available to the charity or trustee.
Once again, this strategy has not been tested in Tax Court. However, the donor has no contact with the buyer. Therefore, the donor may reasonably maintain that there is "no binding obligation" between the donor and prospective buyer. Because there is no obligation for the donor to make the gift to the charity, this transaction should pass the test of Rev. Rul. 78-197.
CRT Payout Accounting and UBI
Unitrust payouts are subject to complex accounting rules under Sec. 664. Specific unitrust distribution rules are set forth in Reg. 1.664-1(b). Distributions from unitrusts are first ordinary income, then capital gain, then tax-free income and finally corpus.
The distribution method is commonly described as the "Four-Tier" structure. In truth, the distribution rules have been made somewhat more complex by the different capital gains rules. The capital gain tier is further subdivided into the four levels for capital gain. The actual final structure is as follows:
Category Tax Rate
Ordinary Income/Dividends 35% / 15%
Capital Gain -
- Short-Term Gain 35%
- Tangible Personalty Gain 28%
- Depreciation Gain 25%
- Long-Term Gain 15% / 5%
Tax-Free 0%
Return of Principal 0%
The process and accounting can be complex, but the concept is simple. The distribution to the recipient will require payment of tax at the highest possible rate. Thus, all ordinary income earned by the trust must be distributed before any capital gain is paid out.
Since the goal for most trusts is to distribute capital gain, the trust investments are carefully selected to minimize production of ordinary income and maximize recognized capital gain. Of course, creation of capital gain return involves inherent risk-return issues.
The Tax Relief and Healthcare Act of 2006 included a provision creating a 100% excise tax on unrelated business income (UBI) of charitable remainder trusts. Sec. 664 (c)(2)(A). This tax is levied on any unrelated business taxable income as defined in Sections. 512-514. Unrelated business taxable income is the gross income from an unrelated trade or business, reduced by deductions that are attributable to producing that UBI. Reg. 1.512 (a)-1(a).
In a 1993 IRS Memorandum authored by Senior Technician Reviewer Frances Schafer, there is an explanation of the difference between the UBI calculation by a charitable remainder unitrust and distribution reporting on IRS Form K1 for a unitrust income recipient.
Ms. Schafer notes that the Sec. 664(d) provisions that create the four-tier accounting structure for unitrust recipients "are applicable irrespective of whether the trust is required to pay tax in a particular year because it has unrelated business income."
Therefore, the four-tier structure will apply to beneficiary distributions while the complex trust rules of Sec. 662 (d) will apply to the trust calculations of UBI.
Since 100 % of UBI is now subject to tax, it appears that the gross income less attributable expenses will be the correct tax amount for a unitrust with UBI. However, even though UBI is paid from corpus under Reg. 1.664(d)(2), the income generated by UBI is reflected in tier-one ordinary income and will still require payment of tax by the beneficiary.
Conclusion
The UBI rules will cause trustees to avoid any investments that could lead to unrelated business taxable income. In addition, assets transferred to a charitable trust that could lead to potential UBI should be sold quickly to minimize the UBI risk.
However, the 100% UBI rules are a very welcome addition to the Code. Because the trust is still exempt even with a small amount of UBI, CRTs may now be funded with many of types of real property, active businesses, medical practices and other assets that previously were not eligible properties for charitable remainder trusts.
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| March - 2007 - Charitable Life Insurance (CHOLI)
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| February - 2007 - Supporting Organizations After PPA 2006
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| January - 2007 - Donor Advised Funds After PPA 2006
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| December - 2006 - Charitable Changes in PPA 2006
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