The owner of a closely held business needs to clear two very high tax hurdles to reach the destination of a secure retirement.
The first hurdle is federal income taxes. Any lifetime sale of business assets will receive Internal Revenue Code Section 1231 capital gains treatment, though any gain from depreciation is recaptured at a 25 percent rate for realty and at an ordinary income rate for personalty. If the owner of the business can convince a buyer to assume the liabilities both known and unknown, any sales of stock will be preferentially taxed as capital gains to the seller. However, a potential purchaser will be more interested in amortizing the cost of the acquisition through an asset purchase, which is essentially unavailable with a stock purchase.1
The second hurdle is federal transfer taxes. For owners of a very lucrative business, the current exemption from federal and gift taxes, while historically high, still may be insufficient to avoid the imposition of transfer taxes. Gifting to family members may generate gift tax notwithstanding the lack of marketability and minority status of the gifted shares. The carryover basis constrains the donee’s ability to redeem or sell to another investor because the donor’s appreciation is now the donee’s tax issue to navigate. Even the owner’s inaction comes at a price of leaving heirs with the likely liquidity crunch from owning a privately held asset generating federal estate tax.
Planning Rules of Thumb
Outright gifts of either C corporation or S corporation stock to charity will be especially useful as part of a donor’s plan to reduce his ownership and increase the ownership share of family members in a transfer-tax-efficient manner. However, gifts of C corporation stock present fewer complications than gifts of S corporation stock.
Split-interest gifts of C corporation stock to fund a charitable remainder trust (CRT) or charitable gift annuity (CGA) or split-interest gifts of S corporation stock to fund a CGA will be appropriate as part of a plan to sell a closely held business. Let’s apply these rules of thumb to a common planning need.
Typical Fact Pattern
Edgar and Erin, husband and wife (ages 68 and 65 respectively), jointly own 80 percent of their business (Everprotecto, Inc.), which sells and installs office security alarms for small retailers. Their adult twin daughters, Elizabeth and Eileen (age 45), are respected within the industry for their skills as executives at Everprotecto, Inc. They each own 10 percent of the company. The company has been conservatively valued at $25 million. Edgar and Erin seek to pass on during their lifetimes at least some of their business to their children as part of a plan to minimize the federal estate tax. They’re open to the idea of selling their company either to their children or to a strategic buyer in the security alarm business. Selling the company would be especially attractive, as Edgar and Erin would like to semi-retire soon. Maximizing the after-tax sales proceeds of the business is critical. They also aspire to endow their annual gifts to charities; namely, the local hospital and various social service organizations.
What are the consequences if Edgar and Erin make outright and life income gifts to charity?
Outright gifts. Gifts of either C corporation or S corporation stock to charity will reduce Edgar and Erin’s ownership percentage. The net effect will be to increase the ownership interests of their adult children from 20 percent to whatever percentage Edgar and Erin desire, without them having made a taxable gift.
Presumably, the charity will at some point in the near future arrange for the cashout of Edgar and Erin’s shares, either through a redemption by Everprotecto, Inc. or a sale to the children. So long as the charity isn’t under a legal obligation to redeem, Edgar and Erin won’t realize income on the transfer.2 If the arrangement isn’t treated as arm’s length, then Edgar and Erin will recognize gain under the anticipatory assignment of income doctrine. They’ll be treated as, in effect, having sold the stock and contributed the sales proceeds to charity.
While a charity may be a shareholder in an S corporation,3 income tax complications abound for the charity and donor. The charity must address the issue of unrelated business income (UBI). The charity will have UBI to the extent of its distributive share from Everprotecto, Inc.4 and will have its gain from either the redemption or sale to another party taxed as UBI.5
The amount of the donors’ charitable deduction would be reduced to reflect the ordinary income items, such as unrealized receivables, depreciation recapture or substantially appreciated inventory, attributable to the S corporation stock.6
Split-interest gift CGA (C corporation and S corporation stock). While a charity may be a shareholder of an S corporation, all items of S corporation income, loss or deduction passing through to the charity under IRC Section 1366(a) still are treated as unrelated trade or business income.
These consequences may compel a charity either to have a formal policy of rejecting gifts of S corporation stock to fund CGAs or to mandate its due diligence in determining its tax exposure before an acceptance. The charity may insist on receiving enough cash to cover the UBI tax imposed on its distributive share.
Furthermore, the charity may insist on a lower payout rate to reflect the S corporation stock’s lack of marketability and minority voting status. The charity could also justify a lower rate if part of the stock’s value reflects ordinary income items such as inventory. Of course, its obligation to pay Edgar and Erin can’t be linked to the specific property.
If the charity does accept S corporation stock in Everprotecto, Inc., the net proceeds ultimately available to it would be reduced not only by UBI tax from the sale, but also by the present value of the annuity obligation to Edgar and Erin.
None of these complications exist with C corporation stock.
Everprotecto, Inc. can redeem the charity’s shares so long as it has sufficient surplus.
Split-interest charitable remainder unitrust (C corporation stock only). While tax-exempt organizations may own S corporation stock outright, split-interest charitable trusts aren’t permissible shareholders.7 However, a CRT may be funded with C corporation stock. In fact, there won’t be the unfavorable characterization of the income as UBI or as a distribution subject to UBI tax.8 The stock may also be redeemed at fair market value without violating the self-dealing rules.9
Even better, the gifted shares may be subject to the restrictions of a buy-sell agreement. So long as the CRT isn’t required to sell at the time of contribution, the trustee can be required to offer the gifted stock to the corporation or to the shareholders.10 The redemption proceeds won’t be taxed to Edgar and Erin. The restrictions from the buy-sell agreement assure Elizabeth and Eileen that the stock remains in “friendly” hands.
Because Edgar and Erin will be able to monetize the full value of their stock contributed to the CRT, they’ll have more principal generating a cash flow to them in retirement. They also know that any redemptions of their stock by the CRT will result in the transfer of a greater percentage of the company to their children gift tax-free and estate tax-free.
While the virtue from philanthropic good works can be its own reward, careful planning can make it integral to achieving a business owner’s dream of a business succession plan most likely to produce a secure retirement.
1. A purchaser of stock could make a timely Internal Revenue Code Section 338 election, treating the stock acquisition as an asset acquisition. Seldom would it be economically justified to incur a tax (from the “deemed sale” of assets) for the purpose of increasing basis by the fair market value of the asset.
2. See Revenue Ruling 78-197. See also Rauenhorst v. Commissioner, 119 T.C. 157 (2002).
3. IRC Section 1361(c)(6) allows certain IRC Section 501(c)(3) organizations to be eligible shareholders in an S corporation. However, charitable remainder trusts (CRTs) aren’t so listed.
4. See IRC Section 512(e)(1)(B)(i).
5. See Section 512(e)(1)(B)(ii).
6. See IRC Section 170(e)(1).
7. See supra note 3.
8. The CRT must not own 50 percent or more of the stock. See Section 512(b)(13).
9. See IRC Section 4947(a)(2)(A).
10. See Private Letter Ruling 200321010 (May 23, 2003).