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Monday September 6, 2010
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June - 2007
Gifts of C Corporations Part II – Stock Sale with Unitrust
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Part Two of Three Parts - Stock or Assets to Unitrust
I. Stock Sale with Unitrust
Sale of C Corporation
A C corporation may be subject to a double tax. There is potential tax at corporate tax rates on the gain inside the corporation and potential tax at the shareholder capital gain rate on the sale of stock by the shareholder.
However, if the C corporation is the type of business that may be sold as a corporation, generally to a larger C corporation, then a very attractive option exists. In this circumstance, the taxpayer may transfer part or all of the C corporate stock into a charitable remainder unitrust. If the stock is transferred to a unitrust and then sold by the unitrust to the new purchaser, there will then be a complete bypass of capital gain.
Avoiding A Prearranged Sale
The major challenge in selling stock to a larger corporation is to avoid a prearranged sale. In order to bypass the capital gain, there may not be a prearranged sale when the stock is transferred into the unitrust. The prearranged sale is generally avoided if there is no binding obligation for the trustee of the charitable trust to sell to a purchaser. Rev. Rul. 78-197,1978-1 C.B.83.
Business owners understandably wish to be in control of the sale process. Thus, it is quite possible that the business owner will prefer to delay the transfer of the stock into the charitable trust as long as possible. While this strategy can be successful, there is an increasing risk level as the sale progresses.
Sale of a C Corporation
There are four specific steps to sale of a business. At each level, the risk level increases.
First, there is generally a period of negotiations with offers and counter offers made orally. The risk is very low in transferring the stock at this time. Second, there frequently is a Letter Of Intent. The Letter Of Intent is signed by both parties and describes the general terms for the sale of the corporation. In most cases, it is not legally binding. The risk level is again quite low when the Letter Of Intent is signed.
Third, there is a vote by the directors. If the directors hold over 51% of the stock, the vote by the directors is equivalent to a vote by the shareholders. However, if the stock is widely held, then the vote by the directors may raise the risk, but it frequently is permissible to transfer the stock into a charitable trust even at that point.
Fourth, there is a vote by the shareholders. After 51% or more of the shareholders have voted to accept the offer, then the gain has "ripened" and may not be avoided by transfer of stock either outright to a charity or to a charitable remainder trust.
In the Ferguson case, the shareholders had indicated an intent to transfer the stock in August of 1988. However, due to a delay in receiving approval from a large financial services company, the shareholder vote was conducted before the gift to charity. On August 30, 1988, 85% of the shares had voted in favor of the merger. When the actual stock was gifted to charity on September 12, 1988, over 95% of the shareholders had voted in favor of the transfer. Since over 51% of the vote had been tendered, the court determined that it was now too late to bypass the gain.
As a result of the Ferguson decision, the 51% rule is now clearly important. If stock is to be transferred into a unitrust, the gift must occur before 51% of the shareholders have voted to accept an offer.
Unitrust Design
If the business owner desires to maintain control as long as possible, there are several steps that can be taken. First, the business owner should be cautioned not to sign any legally binding agreement prior to transfer of stock into the trust. A Letter Of Intent may be permissible after review by counsel, but any other agreement should not be signed. Second, there should be a third party trustee of the charitable trust. The donor and spouse should not serve as initial trustees of the trust. If the donor does not prefer a corporate trustee, then a third party private trustee may be selected. This third party trustee is key to demonstrating that there has been a transfer of stock to the third party prior to the sale.
Third, after the negotiations have proceeded to a point at which the shareholder believes that a sale is imminent, the stock is transferred to a unitrust with the third party trustee. Normally, a FLIP unitrust will be used, since there is no income earned by the shares of stock. After the C corporation stock is sold by the trustee to the new buyer, the trust will FLIP to a straight trust the following January 1.
After the stock is transferred to the charitable trust, it is preferable to wait a reasonable period of time, perhaps 4-8 weeks, prior to completing the transaction. This also allows the third party trustee an opportunity to explore sales to other potential purchasers and demonstrates the lack of prearrangement for the sale.
Upon sale of the stock to the new buyer, the trust receives the sale proceeds. The donor benefits from a bypass of capital gain and receives charitable income tax deduction based upon the applicable federal rate, the unitrust payout rate and the ages of the donors.
Example A. An Environmentally Sound Sale
Alex and Bob both attended university together. After working in two different companies for several years, while in their 30's, they decided to start a new company to produce environmental devices.
Alex is an experienced environmental engineer and believed that it would be beneficial to develop devices that measure levels of industrial pollution. Alex and Bob worked very hard over the years and have built a small high technology company. The company produces several devices for measuring industrial pollution.
As the requirements for limiting pollution by the Environmental Protection Agency have increased, so has the demand for their products. The business has grown and now has over 70 employees.
A large company is very interested in acquiring Alex and Bob's C corporation. Since they now are age 62 and plan to retire during the next three years, they have entered into negotiations for purchase of the company.
Bob and his wife Sue have always had a close relationship with their local charities. They explored options with their CPA and discovered that it would be possible for them to sell tax-free. While they do have children, they are planning to create an insurance trust that will provide a very substantial inheritance for their two children.
During the time that negotiations are under way, Bob and Sue Manager transfer their stock into a 6% charitable remainder unitrust. The unitrust will make payments to them for their two lives and then the principal will be transferred to their favorite charities. Since Bob and Sue also have a large pension plan and own their home, they decide to transfer all of their stock into the charitable trust.
The charitable trust, with their financial advisor as trustee, then offers the stock for sale to the large company. The trust receives $2 million from the large C corporation for the stock.
Since the cost basis of Bob and Sue was $1,000 in the stock, they bypass the gain and save almost $400,000 in capital gains tax. There also is an income tax deduction of over $600,000. During the next 5 years, this will save approximately $45,000 of tax each year, for a total saving of about $225,000. Since this is an appreciated tax deduction, their deduction will be limited to 30% of their adjusted gross income each year. Fortunately, the deduction may be stretched over as many as 6 years.
Bob and Sue are very pleased with the plan. They bypassed the $2 million capital gain and enjoy very substantial tax deductions. In addition to the IRA income that will start next year, Bob and Sue will receive approximately $120,000 annually from the charitable remainder unitrust. If the trustee invests in an equities portfolio, perhaps half of this payout can be distributed at capital gain rates. Finally, the additional income after tax will provide them with more than sufficient resources to fund the insurance trust for the inheritance of their two children.
II. Assets to Charity or CRT
Gift of Assets to Charity
As an owner approaches retirement, there may remain significant liquid assets in a C corporation. For example, the owner may have been in the construction or sales business and have accumulated significant liquid assets in the C corporation. However, when he or she retires, there is no longer active income, but the cash and liquid assets remain.
If the owner is quite philanthropic, one option is to transfer by gift a major portion of the assets to charity. While there is a 10% deduction limit for the corporate return, the philanthropic person may determine that it is appropriate to give a substantial portion outright to charity.
This option may also be of interest for donors who have a donor advised fund or supporting organization. The gifts may then be transferred into an entity that is influenced by family members and used for future charitable gifts.
Assets to Charitable Remainder Trusts
If there are liquid assets, but children or other family members are planning to continue the operation of the business, then a charitable remainder trust may work well for the retirement plan of the founders. The liquid assets or securities may be transferred to a charitable remainder unitrust, with the corporation as the grantor and the income recipient. Since a corporation does not have a specific life span, a term of 20 years unitrust will be the selected option. The appreciated land or stock transferred to the unitrust may be then sold, with a bypass of capital gain at the higher corporate rates. In addition, the charitable deduction may be usable up to 10% of taxable income, with a carry forward for 5 years.
Since the corporation will have taxable income upon receipt of the distribution from the trust, it would be desirable if a consulting contract with the founders can be justified and maintained. The income will then be received by the corporation and distributed as income to the founders. The corporation thus would have both income and an offsetting deduction. Presumably, the founder in retirement is now in a lower tax bracket and will not pay tax at a high rate.
This plan provides for a secure retirement source for income payments. It is necessary for the company to continue as an active operating entity for the 20 years for this plan to be successful.
Personal Holding Company
If 60% or more of a corporation's adjusted ordinary gross income is dividends, interest, royalties and other types of passive income, then the company may be deemed a Personal Holding Company. Sec. 542(a)(1). If a company is held to be a PHC, then income is generally taxable at the top personal rate for that year. Thus, if the CRT retirement plan is contemplated, it is essential that the majority of income for the corporation be produced through active business operations.
Reg. 1.337(d)-4 Gain Recognition
When a corporation is liquidated, there is potential tax payable at the corporate level. If it were permissible for a corporation to distribute all of its assets to charity or to a charitable trust, then this tax could be avoided. In order to limit this type of transaction, Sec. 337(b)(2) requires recognition of gain at the corporate level if "substantially all" the assets are given to charity or to a charitable remainder trust.
The phrase "substantially all" is not defined in Sec. 337(b)(2) or in Reg. 1.337(d)-4. However, there are several other places in the Code in which the phrase "substantially all" is interpreted to mean 85%. Reg. 1.514(b)(1)(B)(ii). Reg. 53.4942(b)(1)(C). Reg. 53.4946-1(b)(2). Reg. 1.401K-1(d)(1)(ii). While these regulations cover a variety of tax issues, it is significant that they uniformly interpret the phrase "substantially all" to mean 85%.
Since the exception under Sec. 337 refers to "an 80%" subsidiary, some counsel have also expressed the belief that "substantially all" could be interpreted to be 80%.
Regardless, it is apparent that a transfer of perhaps 65% of assets to charity or to a charitable trust would be permissible under Reg. 1.337(d)-4. Cautious counsel would be prudent in remaining at or below that level with transfers to charity.
Example B. Unitrust Retirement Plan
Sam and Mary Wilson started a small manufacturing business many years ago. Sam is now 70 and Mary is 65. While they also have a pension plan that Sam recently rolled over into an IRA, they would like additional income from the business. In addition, Sam and Mary would like their children to take over the business.
The business is valued at approximately $3 million. Sam and Mary have been making gifts of stock to the children. They currently own approximately one-third of the business, with the remaining two-thirds owned by Sam and Mary.
Sam and Mary create a family limited partnership and transfer the balance of their stock to the family limited partnership. They plan to use their estate exemptions and annual exclusions to transfer the balance of the FLP units to family members.
Sam plans to retire, but expects to be employed by the company in a consulting role. Since the company had purchased land for a plant many years earlier, the company does have an available asset. Due to changes in business circumstances, the land will no longer be required for a new plant. The property was originally purchased for $100,000 and has increased in value to $500,000.
The corporation transfers the $500,000 parcel of land into a 6% unitrust for a term of 20 years. When the trustee sells the property, the corporation bypasses gain on $400,000 and saves approximately $160,000 at the corporate rate. The income tax deduction of over $150,000 will save taxes for the next 5 years.
Each year, the unitrust will distribute income of $30,000 to the company. With growth, this income could increase to approximately $45,000 over the 20 years. Under his consulting contract, Sam will receive approximately $35,000 per year for the 20 years. This payment will be a very good supplement to his IRA distributions.
The company will have both income from the trust and a compensation deduction for the payment to Sam. His children are particularly pleased that the company will not be required to make payments out of company income to Sam for his supplemental retirement plan.
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| May - 2007 - Gifts of C Corporations Part I – Double Taxation
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| April - 2007 - Active Businesses Transferred to Unitrusts
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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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