CGNA: Chapter 2 - C Corporations | Advanced, Part 1 of 2

CGNA: Chapter 2 - C Corporations | Advanced, Part 1 of 2

Article posted in General on 8 November 2017| 1 comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 8 November 2017
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Summary

Gifts of C Corporations explored in great depth as we continue through Gifts of Noncash Assets.

This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

By Turney Berry and Jeffrey Thede

Below is an in-depth examination on gifts of C corporations. C corporation topics are based on Turney Berry and Jeffrey Thede’s “Giving the Business to Charity: Charitable Planning with Closely Held Businesses,” and Turney Berry’s “Charitable Planning with Closely Held Businesses.” For quick take-aways on C corporation gifts, see C Corporations Quick Take-Aways. For a review based on the articles, see C Corporations Intermediate. For an in-depth examination adapted and excerpted from the articles, see C Corporations Advanced. For further details, see C Corporations Additional Resources

Unlike charitable gifts of partnership or LLC interests or S corporation stock, gifts of C corporation stock generally are straightforward and do not involve the phantom income, unrelated business income, and donee liability problems discussed in other chapters.

Overview of C Corporation Donations

A successful, closely held C corporation can lead to a significant tax bill for either dividend-receiving owners, or the C corporation subject to the accumulated earnings tax. C corporations do not receive pass-through tax treatment (like a partnership would, for example), so owners are taxed on dividend income they receive from the business. Similarly, an owner facing the sale or transfer of a C corporation would be subject to capital gains tax on appreciated corporate stock. In either case, the owner may be able to avoid that tax burden by donating some or all of his or her stock.

Donating stock in a closely held C corporation is appealing in many cases because it achieves charitable objectives while improving the donor’s tax position. Not only are capital gains or dividend taxes avoided, donations of stock held for over one year to public charities may be eligible for income tax deductions for the fair market value of the stock. Public charities like these donations when there are either dividends to be paid, or an easily arranged sale of the donated stock.

The owners of the C corporation (including the donor) typically will not want a charitable organization influencing business affairs, and charities similarly do not want to get involved in such a business—particularly when the corporation produces little dividend income. Therefore all parties involved in the transaction are typically eager to minimize the holding period.

In the case where the nonprofit sells the donated stock, there are usually only a few possible buyers. This is because it is often difficult to find a buyer for closely held stock on the open market. Instead, the buyers are typically limited to the corporation itself (a corporate redemption), an acquirer in a merger or acquisition, or a new/existing share- holder. The new or existing shareholder may be a family member—this is one way the C corporation donation can be part of a family business succession plan.

Charitable Bailout

In any case, since the corporation is closely held, the donors are likely to be in a good position to ensure that the donated stock is purchased, so that the donee receives cash it can use for its charitable purposes. Since the nonprofit is tax-exempt, it will not typically be subject to capital gains tax. If the corporation is redeeming the shares (a charitable bailout), it allows a tax-free distribution of excess cash the corporation has accumulated.

The bailout is another way to put succession plans into effect. If the donor’s successors (often children) already owned some interest in the business, the corporate redemption will increase their proportionate holding in the business. This transfer is achieved free of any transfer taxes (gift or estate).

This charitable bailout means that both the charitable gift and the subsequent redemption would be completely income tax free, and the corporation would be able to “bail out” its accumulated cash. In the case of gifts to a private foundation or charitable remainder trust, the redemption must comply with the “corporate adjustment” exception to the self-dealing rules. That exception requires that 1) the corporation offers the redemption to all shareholders on the same terms, 2) the offer is a “bona fide offer,” and 3) redemption price is not less than fair market value.

Transfer Considerations

There are some relevant transfer factors for both the donor and nonprofit donee alike once the planning is complete. The nonprofit should review corporate governing documents, particularly shareholders’ agreements, to understand any restrictions or approvals on both the initial donation and the charity’s eventual sale of the stock. If the nonprofit’s holdings in the company will be part of a sale to or merger with a third party, it may be required to make representations and warranties, potentially exposing itself to liability.  For this reason, it might seek indemnification from the donor.

For the donor, there are the same appraisal and substantiation requirements as with other asset types. As mentioned above, the lack of marketability may reduce the value of the gift. Further, minority interests are usually discounted as well. These valuation discounts will affect the donor and the selling nonprofit.

Prearranged Redemptions and Assignment of Income Issues

As discussed above, upcoming taxable events often prompt charitable gifts. For example, an owner in the process of selling a business may wish to make a gift of stock to charity to (a) obtain a charitable income tax deduction to offset income the sale generates, and (b) avoid the capital gain income that the owner would have realized as taxable income if he or she still held the stock at the time of the sale. The latter objective frequently triggers issues in connection with timing. Similar issues also arise frequently with gifts of real estate or other assets. The question is, at what point in the sale process is it too late for the donor to avoid the realization of capital gain income by giving the asset to charity?

Under the anticipatory assignment of income doctrine, the IRS will tax a taxpayer who earns or otherwise creates a right to receive income on any gain he or she realizes from that right if, based on the realities and substance of events, the receipt of income is practically certain to occur, even if the taxpayer transfers the right before receiving the income. The related step transaction doctrine similarly prevents a taxpayer from escaping taxation by collapsing a series of substantially linked steps into a single overall transaction.

After a series of court decisions, a general rule for corporate stock bailouts emerged. If there is a binding agreement, or some quid pro quo transaction, and the donee non-profit is obliged to sell the shares back, the IRS will characterize the transaction as a taxable sale and donation of the proceeds. Courts have repeatedly looked to whether the nonprofit has a binding obligation to sell—this is the “bright line” rule of Palmer

Redemption for a Promissory Note

Redemptions from a public charity may be for cash or in exchange for the corporation's promissory note. In the case of redemption from a private foundation or charitable remainder trust, a continuing question is whether and under what circumstances the redemption can be for a note, because loans from a private foundation to a corporate disqualified person are impermissible self-dealing. Private Letter Ruling 9347035 approved an installment redemption under the corporate adjustment exception to self-dealing. However, several years later, the Service revoked that ruling in Private Letter Ruling 9731034. The answer thus appears to be a resounding “no.”

It is clear that a redemption in exchange for a promissory note of a disqualified person is permissible if a court approves as part of the probate exception. The probate exception states that a transaction relating to a foundation's interest in property, which an estate holds (or a revocable trust becoming irrevocable upon a grantor's death), is permissible if the following applies:

  • The personal representative or trustee either
    • has a power of sale with respect to the property,
    • has the power to reallocate the property to another beneficiary, or
    • is required to sell the property under the terms of any option subject to which the estate or trust acquired the property
  • Such transaction is approved by the court having jurisdiction over the estate or trust (or the foundation).
  • Such transaction occurs before the IRS considers the estate terminated for federal income tax purposes, under the rules of Treasury Regulation section 1.641(b)-3 (or in the case of a revocable trust, before it is considered subject to IRC section 4947.
  • The estate or trust receives an amount that equals or exceeds the fair market value of the foundation's interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the estate (or trust) acquired the property.
  • The transaction either
    • results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up,
    • results in the foundation receiving an asset related to the active carrying out of its exempt purposes, or
    • is required under the terms of any option which is binding on the estate (or trust)

Many private letter rulings approved redemption for a note, but without comment on whether subsequent note payments similarly would not be self-dealing. The answer should be that payments are permissible, and certainly that result is within the spirit of the rulings.

There are rulings approving the distribution of an existing note under the probate exception. In Private Letter Ruling 200729043, for example, a decedent’s revocable trust received notes of a disqualified person upon liquidation of a corporation. The trustee proposed allocating the notes to the share of a private foundation. The Service ruled that the private foundation’s receipt of the notes would not be an act of self-dealing. None of these rulings involved a redemption or other “transaction” in the estate or trust that would be part of the probate exception, but instead merely addressed a discretionary allocation of an existing note. For that reason, some planners take little comfort from them, and particularly in light of the recent rulings approving the use of an LLC to receive and hold notes of a disqualified person.

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Re: CGNA: Chapter 2 - C Corporations | Advanced, Part 1 of 2

Great and useful article for an underutilized and powerful planning tool.

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