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Tuesday February 9, 2010
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July - 2007
Gifts of C Corporations Part III – Charitable Bailouts
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Part Three of Three - Charitable Bailouts
I. Charitable Unitrust Bailout
The majority of family businesses are sold when the founders retire. However, perhaps one-third of the time children or other heirs will be capable of taking over the business. Normally, one or more children will show the aptitude and skills necessary to acquire and operate the business successfully.
In this circumstance, the parents typically have three goals. First, they desire to have a secure source of retirement income. As business owners, they understand that there is risk. Technologies and businesses and markets do change--the children may or may not be successful operating the business. Therefore, it would be desirable if there were a source of income other than just the business to secure their retirement.
Second, there is the desire to transfer the business to children. However, in most circumstances, some children will be operating the business and other children will be pursuing independent lives and careers. For most small businesses, the children operating the business will need to have both control and ownership to assure the long-term success of that business. Thus, goal number two is to achieve transfer of the business to children, generally with zero gift or estate taxation.
Third, there are usually other children who will not be involved in the business. Since children view an inheritance from the parents as a representation of the love of the parents, it is desirable for there to be at least general equivalence in the overall inheritance. Therefore, the third goal is to acquire resources appropriate to provide a substantial inheritance for children who are not involved in the business.
Avoiding Conflict Among the Children
If the parents transfer non-voting stock or minority interest in stock to the non-business-owner children, there is a high probability of future conflict. The children who are involved in the business will frequently receive moderate to large salaries. Since most small businesses do not pay dividends, the children who are not involved in the business may receive nothing. This is a clear prescription for major family conflict.
Therefore, it is nearly always preferable to provide an inheritance from other sources for children who are not going to be operating the business. This method will certainly facilitate family harmony and may also be very important in the successful operation of the business.
Retirement Income-Two Life Unitrust
The first part of the plan is to create a secure base for retirement income. The business founders create a 5% or 6% unitrust with a duration of two lives. Then they transfer stock each year into the charitable remainder trust. Since there is no income from the stock, the preferred payout method is a FLIP unitrust.
After the transfer of shares of stock into the charitable remainder trust, there is still no income. However, the corporation generally has liquid assets and generates additional after-tax cash each year. Thus, the corporation could redeem shares from the charitable trust.
However, the self-dealing rules normally prohibit any transfer between a trust funded by a disqualified party and the family business. Sec. 4941(d)(1)(A) and Sec. 4946(a)(1). Under the statutes, the donors are disqualified persons due to their transfer to the trust. In addition, their ownership of the family business, with the attribution of stock interests of children, also makes them disqualified persons.
Fortunately, there is an exception that permits redemption of stock from the unitrust at fair market value. Sec. 4941(d)(2)(F). At the time the stock is transferred to the trust, there is no binding agreement for the corporation to purchase the stock. Rev. Rul. 78-197,1978-1 C.B.83. After a reasonable period of time, the trustee offers to sell the stock to the corporation. The corporation must be willing to purchase the stock from all shareholders and must be willing to pay fair market value. Since it was necessary to obtain an appraisal to qualify for the charitable income tax deduction, there is a clear determination of fair market value for the stock. Finally, with all stock held by family members, no one except the trust is willing to sell at the fair market value and the corporation may then purchase the shares of stock from the trust.
This gift and redemption process will occur on an annual basis. The cost of the appraisal is minimized if the same appraiser updates the company valuation each year. If the period of time between the gift and redemption is approximately 4-6 weeks, normally the same valuation will be used for both charitable deduction purposes and the redemption.
Over a period of time, a significant proportion of the parents' stock (perhaps one-third or more) is transferred into the charitable remainder unitrust and redeemed by the corporation. The unitrust now acquires securities with the cash transferred and is able to produce a secure retirement income for the parents.
Transfer to Children
The second part of the plan is to transfer a block of stock to the children. In some circumstances, the parents desire to retain voting control. One option is to conduct a Sec. 368(a)(1)(E) recapitalization from all voting stock into both voting and nonvoting common stock. The parents may retain a majority of the voting stock and transfer the nonvoting stock to the children. There also will be an additional discount in the valuation of the nonvoting stock for lack of control.
The nonvoting stock may be transferred to children through several means. In some circumstances, the use of the annual gift exclusion may be quite helpful. However, it is probable that the parents will also use their exemption equivalents for this transfer.
It is possible to leverage the transfer. A family limited partnership (FLP) can reduce the value transferred by approximately 30%-40% or more. The FLP may be combined with a grantor retained annuity trust or a charitable lead annuity trust. Through a combination of these various methods, $2 million to $10 million in stock may be moved through to children with no gift or estate tax.
Inheritance for Remaining Children
If there are three or four children, the probability is that one or two will be involved in the business and the remaining children will pursue other occupations and activities. Fortunately, the charitable trust also facilitates another option. A portion of the income from the charitable trust may be used by the parents to create an irrevocable insurance trust. The irrevocable insurance trust typically uses a "Crummy" power. Since the parents also have annual gift exclusions for the remaining children, these exclusions are used to cover the transfers of funds into the trust each year. The remaining children are given a right for 30 days to withdraw the funds from the insurance trust. If they do not exercise that power, when the power lapses, the funds may then be used to purchase insurance. See Crummy v. Commissioner, 397F.2d82 (9th Cir. 1968.) Rev. Rul. 81-7, 1981-1 C.B.474.
Example A. Clarke Company Charitable Bailout
Steve and Jody Clarke started the Clarke Children's Clothing Company 30 years ago. They now are both age 65 and are interested in retiring. Two of the four Clarke children are currently involved in the business. Their daughter Susan is company President and son Michael is Vice President and Director of Marketing.
The Clarke Clothing Company is now valued at approximately $5 million. By specializing in children's clothing and opening several stores in suburbs with young families, they have gradually expanded. The company is producing a substantial profit each year and holds approximately $800,000 in reserves. Since these reserves are well in excess of the $250,000 permitted amount for accumulated earnings tax purposes, it is necessary each year to justify the retention of the larger sum.
In order to facilitate their retirement plan, Steve and Jody recapitalized the company into 1,000 voting shares and 20,000 non-voting shares of common stock. They then created a two-life charitable remainder trust. This trust will pay 6% to them for their lifetimes. Steve and Jody transferred non-voting shares valued at approximately $500,000 to the charitable trust. They anticipate transferring similar amounts each year for the next four years to the trust.
The $800,000 in liquid assets plus accumulated profits over the next five years will be sufficient to cover the anticipated $2.5 million. Each year, there will be an appraisal to determine the number of shares that equal $500,000. The appraiser will be required to complete Form 8283 and support the charitable deduction. It also will substantiate the redemption under the Sec. 4941(b)(2)(F) exception for self-dealing.
Over five years, $2.5 million plus growth is accumulated in the unitrust. This is then invested to produce a substantial retirement income for Steve and Jody.
At the same time, Steve and Jody transfer approximately one-half of their stock into a family limited partnership. Over the five years, they use their annual exclusions and their exemption equivalent to transfer this stock to Susan and Michael. By the end of five years, the full amount of the stock in the family limited partnership has now been transferred. With the redemption of the stock from the unitrust and the transfer of the balance of the non-voting stock, Susan and Michael now own all of the non-voting stock. However, Steve and Jody continue to own 1,000 voting shares until year six. In year six, they transfer the 1,000 voting shares to Susan and Michael. Steve and Jody are now completely retired from both the business and stock ownership.
With the increase in the exemption equivalent, Steve and Jody still have available exemption and so will be able to provide substantial additional retirement with no gift or estate tax. They are very pleased with the plan. They saved substantial capital gains and income taxes, have a generous retirement payout from the unitrust and moved Clarke Clothing Company through to Susan and Michael with no gift or estate tax.
The Clarke Insurance Trust
Steve and Jody create an irrevocable life insurance trust. The trust purchases a second to die survivorship variable universal life plan. They fund the plan with approximately $75,000 per year. Since the unitrust income when the trust is fully funded will be approximately $150,000 or more per year, this amount is deemed acceptable. This funding will support a policy of approximately $3 million.
The goal is to have general equivalence to the inheritance plan. Business owners Susan and Michael received stock valued at approximately $3 million, while their other two children will receive the $3 million from the life insurance trust. Of course, if the business prospers and does well, the shares of Susan and Michael could increase in value, but that will be largely as the result of their diligence and personal efforts. Steve and Jody Clarke believe that this is a very fair and appropriate plan for everyone.
They have achieved a secure retirement income, transferred the business to Susan and Michael and provided a very substantial inheritance for their other two children. With this plan, they have saved very large income and capital gain taxes, and completed their entire transfer plan with zero gift and estate tax.
II. Gift Annuity Bailout
Gift Annuity Description
A gift annuity is a contract between the charity and the donor. The donor transfers property to the charity and the charity promises to pay the annuity for one-life or two-lives. Sec. 514(c)(5).
As a contractual obligation, the annuity payments are secured by the assets of the charity. Most charities maintain an annuity reserve fund, which is required by some state insurance commissioners. However, the endowment and even all of the real property and other assets of the charity stand behind the promise to pay a gift annuity.
From the perspective of the donor, a gift annuity is a relatively simple agreement. He or she transfers cash, securities or other assets to the charity and receives a payment for one or two lives. The payment may be made monthly, quarterly, semiannually or annually. In addition, there is an income tax deduction and partially tax-free payout from the annuity contract.
When the gift annuity is created, part of the value represents a charitable gift and part is the amount exchanged for the annuity contract. There are several specific Treasury requirements for qualification as a gift annuity. A qualified gift annuity must be for one or two lives, there must be a minimum 10% charitable deduction, there can be no guaranteed minimum or maximum payments, and the annuity may not be adjusted based on the income earned on the transferred property. Sec. 514(c)(5).
Business Background For Annuity Bailout
The gift annuity bailout functions very well when the owners have both a C corporation and real property. Many businesses use a C corporation for the operating entity. However, in order to pass through depreciation to the owners, the real estate is owned personally.
Goals of Business Founders
The business founders typically have four goals in this situation. If they are now at retirement age, they would like to do the following:
Obtain secure income.
Pass business to children with no tax.
Facilitate an incentive plan for the good of the children.
Obtain a double depreciation benefit.
The secure income can be obtained through a charitable gift annuity. The business can be transferred through various leverage means to children. A depreciation benefit will be available also for children.
But the key goal is the incentive plan. Since the parents started a business and over the years built it up, they understand very clearly how challenging it is to operate a successful business. If the children receive the business without the lessons learned by the parents along their life path, they fear the business will not be successful. In addition, it is essential for the children to have a sense of ownership. They will be far more successful in the future if they perceive correctly that they have participated significantly in the growth of the business.
In order to create an incentive to acquire business skills by children, the parents are opposed to an outright gift of the business to children. This is true even if that can be done with zero gift or estate tax. Rather, they would like a plan that provides them secure income, transfers part of the business to children and allows the children the benefit of acquiring for themselves the balance of the business.
The Gift Annuity Bailout Achieves All Four Objectives
First, the C corporation is transferred to a family limited partnership. Through the FLP or other leveraged-giving devices, this entity is then given to children. While the cost basis in the C corporate stock will be quite low, it is contemplated that the children will be operating the business for many years. If the business is successful, there would be significant additional appreciation and the initial low cost basis is not a significant issue.
Second, the real property is then transferred to charity for a gift annuity. Since the charity is receiving a less desirable asset than cash or public stock, there will usually be a discount applied. Part of the property, perhaps 15% or 20%, is transferred outright to charity and the balance is transferred in exchange for the charitable gift annuity.
Third, the charity is then able to sell the property to the children. Normally, the children will not have the cash to purchase the plant outright. However, the plant may be purchased on an installment note. Over a period of years, the children use profits from the business to acquire the plant. The acquisition of the plant requires the children to operate the business successfully in order to generate these profits. Thus, is an incentive for the children to learn and apply good business management principles.
Double Depreciation
The business founders were able to build the existing plant and depreciate it. Since the children are purchasing the plant from the charity at fair market value, they acquire a new stepped-up basis in the building. Therefore, they are able to depreciate the building a second time.
Example B. Wallace Gift Annuity Bailout
Larry and Pam Wallace started a small manufacturing business when they were in their late 30's. Larry and Pam have operated the business for over 35 years and are now both age 75. They would like to retire and receive secure income.
Their two children Sam and Alice are both involved in the business. Sam and Alice would like to acquire ownership in the business and operate it as a second-generation family business. Larry and Pam set up a C corporation to minimize liability from the manufacturing business, but have always owned the land and building individually. Larry was very pleased that they have been able to depreciate the building over the last 20 years of operation.
After discussing the gift annuity bailout with their tax advisor, Larry and Pam decide that it will meet all of their objectives.
Gift Annuity Bailout Steps
First, the C corporation, which is valued at $3 million, is transferred to a family limited partnership. With the FLP discounts, annual gift exclusions and their exemption equivalents, they are able to gift this family limited partnership to Sam and Alice over a period of two years. While Larry and Pam now have used their exemption, they are not concerned, because they anticipate an increased exemption in the future.
Second, the real property (including the manufacturing building) is transferred to a major charity in exchange for a charitable gift annuity. The real property is appraised at $2.5 million. Larry and Pam transfer 20% outright, for an immediate gift of $500,000 in value and 80% in exchange for a $2 million gift annuity. Based upon their age, the gift annuity will pay 7% or $140,000 per year. They especially enjoy their tax benefits. The charitable deduction of over $600,000 is an appreciated or 30% type deduction. They will be able to write off approximately $100,000 per year for the next six years. In addition, the $140,000 in income will be about $58,000 of ordinary income, $78,000 of capital gain and $4,000 tax-free each year. The combination of the charitable deduction and the capital gain and tax-free income will enable them to have significantly increased after-tax income.
Third, there is excellent incentive in the plan. The major charity then sells the property to the family corporation cash plus note totaling $2.5 million. Over a period of 15 years, Sam and Alice will use company profits to pay off the note and acquire the building. This natural incentive will enable them to learn good business skills and to feel that they did through their own efforts acquire a major portion of the business. This sense of ownership will be very helpful in facilitating their long-term success.
Fourth, there is the double depreciation benefit. Larry and Pam depreciated the building over a period of 20 years. With the acquisition of the building by the corporation, Sam and Alice have a new basis and will be able to depreciate it a second time.
The plan achieves all of the objectives of Larry and Pam. It provides a secure retirement income, transfers the business to their children Sam and Alice, encourages the development of good business skills and leaves Sam smiling over the double depreciation benefit.
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| June - 2007 - Gifts of C Corporations Part II – Stock Sale with Unitrust
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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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