Case Study: Converting Taxable Corporate Assets into Partially Tax Free Corporate Income

Case Study: Converting Taxable Corporate Assets into Partially Tax Free Corporate Income

Case study posted in Charitable Remainder Trust on 22 March 2005| comments
audience: National Publication | last updated: 18 May 2011
Print
||
Rate:

Abstract

The majority of U.S. wealth is held in the form of closely-held and illiquid business operations. Just like individuals, such entities often own highly appreciated capital assets and desire to make charitable gifts. This case study illustrates how a C-corporation can utilize a charitable remainder unitrust to sell non-inventory assets on a tax-free basis and how the corporation might also be able to enjoy partially tax-free income distributions.

By Vaughn W. Henry and Marc D. Hoffman
Editorial review by Ronnie C. McClure, Ph.D., CPA


Planning Goals

  • Reposition corporate assets without incurring tax liabilities
  • Create tax-free or more tax efficient income
  • Generate more income and control more capital
  • Fund corporate foundations and community philanthropy

Facts

As the ABCD Corporation (a C-corporation) streamlined its revamped business operations, Rebecca Watson (corporate CFO) decided to sell a parcel of land no longer needed for plant expansion. The good news was the land had development potential and its fair market value of $3,000,000 was considerably higher than its $160,000 tax basis.

Problem

The bad news was that to sell and reposition assets in a conventional sale, Ms. Watson would create federal and state taxes on the realized gains equal to 35% of the profit in the transaction--a totally unacceptable loss of value.

Solution

Seeking tools to minimize the tax, Rebecca solicited suggestions from her CPA. The accountant suggested the corporation create and transfer the property to a charitable remainder unitrust, described in IRC section 664.

Because such trusts are tax-exempt, they can sell appreciated property without paying any income tax.

The trust would sell the property, reinvest the full proceeds of the sale, and then pay the corporation 5% of the trust's annual value each year (in quarterly installments) for a period of twenty years. The amount remaining in the trust at the end of the 20 year term would be distributed to the charitable organization(s) of the corporation's choice.

In addition to avoiding an immediate tax on sale, the corporation would also receive a current income tax charitable deduction based on the discounted present value of the future charitable gift--in this case, $1,107,336 (based on a 4.6% discount rate). The corporation could use this deduction against up to 10% of its taxable income in the year of the gift with a five-year carryover of any remaining deduction.

Social Capital

After the 20 year term the trust will terminate and distribute its assets to one or more charitable organizations of the corporation's choice. This could be the corporation's own private foundation or other community charities. Their CPA suggested the corporation consider creating a donor advised fund at a local community foundation or other public charity and thereby eliminate the expense of creating and maintaining a separate foundation.

Cash Flow Analysis

Although a charitable remainder unitrust can sell appreciated assets tax-free, the amount received by the corporation from the trust each year is taxable to the corporation according the character of the trust's assets and rules that generally consider income subject to the highest income tax rates to be distributed prior to those subject to low rates. Under these rules, all ordinary income produced by the trust from current and prior years is considered distributed first, followed by net capital gains, following by tax-exempt income, and finally trust principal.

Planning Opportunity

If the trustee reinvests the sales proceeds in assets that produce dividends (e.g., preferred stocks or mutual funds), the corporation may be able to take advantage of a special provision in the tax code that permits corporations to exclude 70% or more of certain types of dividends received from their taxable income.1 With such an investment plan, a large portion of the income received from the trust could be tax-free! 2

The following chart compares three scenarios:

  1. Outright sale of property by corporation, payment of income tax on gain (at a tax rate of 35%), and reinvestment of after-tax proceeds in a balanced portfolio of equities and fixed income instruments producing a total return of 8% (also taxable at 35%). The return is comprised of 3% realized capital gains, 2.5% interest, and 2.5% qualified dividends.
  2. Transfer of property to a charitable remainder unitrust, sale by unitrust on a tax-free basis, and reinvestment of the net proceeds at 8% as described above. The trust will distribute 5% of its annual value for a period of 20 years and then distribute its remaining principal to charity. Trust distributions are assumed to be taxed at 35%.
  3. Identical to Scenario 2; however, this scenario assumes the corporation can claim a 70% dividend exclusion under IRC §243 for dividends received from the trust.3 It is important to note that because ordinary income is considered distributed first, the 5% unitrust amount will be comprised entirely of interest and dividends. Accordingly, the corporation may be able to exclude 70% of the entire 2.5% of dividends produced by the trust.

Income Tax Consequences

Outright

Sale

Charitable

Remainder

Unitrust

Fair Market Value

$3,000,000

$3,000,000

Less:

Adjusted Cost Basis

$160,000

$160,000

Less:

Sales Expenses

$150,000

$150,000

Equals:

Realized Gain

$2,690,000

$2,690,000

Federal and State Income Tax

$941,500

$0

Net Proceeds

$1,908,000

$2,850,000

Income Tax Charitable Deduction

$0

$1,107,381

Projected Tax Savings from Deduction*

$0

$387,583

* $1,107,381 x 35% = $387,583. Corporations can claim charitable deductions against 10% of their taxable income in the year of gift with a five year carryover of any excess deduction. In order to utilize the entire deduction, this corporation would need $11,073,810 of taxable income over the first six years. Accordingly, the use of the deduction may be limited.

Projected Annual After-Tax Cash Flow


Year

Scenario 1:

After-Tax
Outright Sale

Scenario 2:

5% Unitrust

Scenario 3:

5% Unitrust
w/ §243 Exclusion

1

$110,932

$97,500

$115,875

2

110,932

95,160

113,094

3

110,932

98,015

116,487

4

110,932

100,955

119,981

5

110,932

103,984

123,581

6

110,932

107,103

127,228

7

110,932

110,317

131,107

8

110,932

113,626

135,040

9

110,932

117,035

139,091

10

110,932

120,546

143,264

11

110,932

124,162

147,562

12

110,932

127,887

151,989

13

110,932

131,724

156,549

14

110,932

135,675

161,245

15

110,932

139,746

166,082

16

110,932

143,938

171,065

17

110,932

148,256

176,197

18

110,932

152,704

181,483

19

110,932

157,285

186,927

20

110,932

162,004

192,535

Total After-Tax Cash Flow

$2,218,631

$2,487,621

$2,956,442

Tax Savings from Deduction

$0

$387,583

$387,583

Corporate Account Value at End of 20 Year Period

$1,908,500

$0

$0

Amount to Charity

$0

$5,134,266

$5,134,266

Combined Corporate and Charitable Benefit

$4,127,131

$8,009,460

$8,478,291

Summary

Rebecca and the company's Board liked the concept. By controlling more of the corporation's social capital, the business can effectively conserve between $268,990 (assuming no §243 exclusion and no charitable deduction) and $1,125,794 (including full use of charitable deduction and the 243 exclusion) and leave their foundation account with over $5.1 million.

Instead of immediately paying tax, the charitable remainder unitrust can control more capital, produce more income, and fund a corporate philanthropy. And as an option, the trustee of the charitable remainder trust can be given the discretionary power to distribute excess trust income and principal to charity each year during the 20 year trust term. Accordingly, the trust can also serve to fund philanthropic opportunities that occur along the way.4

As a matter of public relations, any activity that improves community relations and enhances corporate image eventually impacts the bottom line; so when a corporate philanthropic approach evolved that also made good economic sense, this business chose to utilize its options for enlightened self-interest.


Disclaimer: This case study is intended to provide information of a general nature only and is not intended to provide legal, accounting, investment or other professional advice. Persons mentioned within this case study are fictional with any resemblance to real persons, living or dead, coincidental. Tax law rates and federal discount rates used in examples are based on those rates in effect at the time of publishing. Those viewing this case study should always check for latest tax and other relevant state and federal laws and regulations prior to completing charitable gifts.


  1. IRC §243(a)(1) - In general, a corporation may deduct 70 percent of the dividends received or accrued from domestic corporations less than 20 percent owned by the recipient corporation; 80 percent of dividends received from a corporation that has at least 20 percent (but generally less than 80 percent) of its stock owned by the recipient corporation; 100 percent of qualifying dividends received from a member of the same affiliated group (generally 80 percent or more common ownership) to which the recipient corporation belongs; and 100 percent of dividends received by a small business investment company.back

  2. Recently issued regulations dealing with the tax treatment of dividends distributed from charitable remainder trusts to individual taxpayers confirm that dividends retain their character (subject to favorable lower income tax rates) in the hands of individual income recipients. Although this is somewhat analogous to this case, the Internal Revenue Code and Treasury regulations are silent on whether a corporate income recipient can rely on section 243 to exclude a portion of dividends received from its taxable income. In addition, informal conversations between PGDC editorial staff and the Office of Chief Counsel (Branches 9 and 2) and the Treasury's Office of Tax Policy revealed that neither had considered the issue previously. Accordingly, taxpayers desiring to utilize this technique are encouraged to obtain an advance letter ruling from the IRS.back

  3. Cash flow projections are intended to compare different planning techniques or interpretations of tax law. Actual results will vary. In addition, in this particular case, planners should consider the trust's ability to produce a competitive rate of return when limited to dividend producing investments.back

  4. See Ltr. Ruls. 9423020 and 200052035. The trust instrument must so permit.back

Add comment

Login or register to post comments

Comments

Group details

Follow

RSS

This group offers an RSS feed.
 
7520 Rates: October 2.2% September 2.4% August 2.4%

Already a member?

Learn, Share, Gain Insight, Connect, Advance

Join Today For Free!

Join the PGDC community and…

  • Learn through thousands of pages of content, newsletters and forums
  • Share by commenting on and rating content, answering questions in the forums, and writing
  • Gain insight into other disciplines in the field
  • Connect – Interact – Grow
  • Opt-in to Include your profile in our searchable national directory. By default, your identity is protected

…Market yourself to a growing industry