CGNA: Chapter 2 - C Corporations | Intermediate

CGNA: Chapter 2 - C Corporations | Intermediate

Article posted in General on 3 November 2017| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 3 November 2017
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Summary

We continue examining gifts of C corporation stock at a more advanced level.
 

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.

Below is a review 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.

This review of charitable gifts of C corporation stock has seven parts, and begins with an overview of C corporation donations and the charitable bailout or redemption generally. Next, it turns to transfer considerations, then prearranged redemptions and assignment of income issues. Following this is an examination of redemption for a promissory note. A discussion of gifts by the C corporation itself is the sixth part, and the review concludes with a look at charitable lead trusts.

C corporation stock is a relatively simple type of asset to donate when compared to other business entity interests. Unlike partnership interests, LLCs, or S corporation stock, there are no questions of liability or UBTI. Another distinction is that the

Review Part 1: C Corporation Donations Overview

C corporation stock that produces significant dividends or is highly appreciated can lead to a significant tax bill for owners. As a result, owners of closely held C corporations may donate stock to avoid taxes and receive an income tax deduction. Non- profits are typically happy to accept these gifts if there is an upcoming dividend or it can easily find a buyer.

From the donee’s perspective, it typically wants to avoid holding the stock for an extended period. The potential buyers are often limited to the corporation itself, a business acquiring the corporation, and other shareholders. This is both because there is a limited market for closely held shares on the open market, and because these donations often occur in the larger context of some business transition for the corporation.

Review Part 2: The Charitable Bailout

Most gifts of C corporation stock are structured as “charitable bailouts. “This transaction is where the donor gives the stock to the nonprofit, and the corporation proceeds to redeem the stock, leaving the nonprofit with cash in hand, the donor happy with the gift, and the corporation having made a tax-free redemption. The income tax benefits are the driving factor for the gift structure, but can also result in a gift-tax-free shift of ownership and control of a closely held corporation as part of a succession plan.

With a charitable bailout, both the gift and the redemption are tax-free, and the corporation can dispose of some accumulated cash. If the gift is made to a private foundation or charitable remainder trust, the redemption will be considered self- dealing unless it complies with the corporate adjustment exception. That exception requires a redemption offer at fair market value for all shareholders. Gifts made to donor-advised funds generally follow a similar path, using an independent appraisal process, to ensure the sale to a related or disqualified party is at fair market value.

Review Part 3: Transfer Considerations

As with other closely held businesses, it can be complicated to transfer ownership interests. Nonprofit donees should review governing documents to understand any restrictions on transfer (both on gift acceptance and on sale). They should also examine any possible liabilities—representations and warranties particularly. Donors should be aware that standard appraisal and substantiation requirements apply, but that lack of marketability and minority interest discounts may reduce the gift’s value.

Review Part 4: Prearranged Redemptions and Assignment of Income Issues

Donors often make charitable gifts, including those of C corporation stock, to obtain a tax advantage for an upcoming event or transaction. However, this can cause timing problems—sometimes it is too late to avoid realizing capital gains by giving the stock away. The assignment of income doctrine states that taxpayers who earn or create a right to receive income are taxed on that income, if the receipt of income is practically certain to occur. This is true even if the taxpayer transfers the right to the income before receiving any of it.

Also significant is prearranging the redemption. A closely held business redeeming stock from a donor-stockholder’s private foundation may get special IRS scrutiny. Initially the Service said that in such circumstances, the proceeds of stock redemption are taxable income to the donor when the donee nonprofit is legally bound or compelled to surrender shares for redemption.

However, this “bright line” rule became increasingly hazy with time. For example, a case where the charity’s proceeds from redemption were used to buy the donor’s yacht at an inflated price was held to be essentially a donor’s sale of stock and subsequent donation of the yacht. The quid pro quo of the yacht purchase in exchange for the donation-then-redemption may be a key distinction here. 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 nonprofit is obliged to sell the shares back, the IRS will characterize the transaction as a taxable sale and donation of the proceeds.

Review Part 5: Redemption for a Promissory Note

Another common feature of these donations is redemption of stock in exchange for a promissory note from the C corporation. In the case of redemption from a private foundation or charitable remainder trust, the specter of self-dealing can arise if it is considered a loan from a private foundation to a disqualified corporate entity.

Although the Service initially approved such a redemption under the corporate adjustment exception, it later reversed course. It is important to note that the self-dealing issues do not apply for direct gifts to public charities.

A redemption in exchange for a promissory note would be allowed, if approved, under the probate exception. That exception allows a private foundation’s interest in property held by a decedent’s estate or revocable trust (the note here) if certain criteria are met, including but not limited to trustee’s control over the property, sale price, and probate court approval.

Another way to avoid impermissible self-dealing is by using an LLC to hold the note. The IRS has approved this use in recent rulings. The LLC is structured so that there are nonvoting units which are distributed to the foundation or charitable trust. This allows the foundation or trust to receive the proceeds of the note, but avoids self-dealing due to the lack of control.

Review Part 6: Gifts By the C Corporation

In some cases, it is better to consider gifts of C corporation assets, if the closely held corporation is holding highly-appreciated, nonproductive property. This can be either an outright gift, or to a charitable remainder trust (which C corporations may establish). However, unlike individuals, C corporations can only deduct charitable contributions up to ten percent of taxable income.

As a cautionary note, donations of “all or substantially all” corporate assets to a tax-exempt entity or charitable remainder trust require the donating corporation to recognize gain on those assets. This determination largely depends on the circumstances, including factors such as percentage of assets transferred, types of assets retained, and purpose of remaining assets, among others. The test seems to be whether the corporation can continue its business following the donation. If the C corporation chooses to create a charitable remainder trust for the appreciated assets it donates, those assets may later be sold without recognition of gain.

Review Part 7: Charitable Lead Trusts

A charitable lead trust can hold C corporation stock, which can work very well. Since the lead distributions are made to the designated nonprofit, the CLT can deduct income in those amounts, avoiding double taxation. Further, CLTs can be used to minimize transfer and estate taxes when shifting wealth to younger generations in wealthy families. The CLT can also direct its distributions to a family-controlled foundation or donor-advised fund if the donors so desire.

The IRS heavily taxes charitable trusts with excess business holdings, meaning disqualified persons own a fifth or more of the voting stock and the CLT owns more than 2 percent. The CLT has five years within which to dispose of excess holdings. Self-dealing taxes and taxable expenditure rules still apply, but the CLT can avoid taxes on excess business holdings if the value of the income interest is 60 percent or less of the initial value of the entire trust property.

Since CLTs often run for decades, changes to the business or family naturally may occur. The IRS has allowed modification of CLT terms in some cases, where there is no disadvantage to the nonprofit donee. Instead, when the underlying CLT assets have appreciated unexpectedly, the excess can be used to make all distributions early, or to restructure the agreement.

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