Privately-Held Business Interests

Privately-Held Business Interests

Technical Report posted in Privately Held Business Interests on 2 May 2003| comments
audience: National Publication | last updated: 16 September 2012
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Abstract

Privately-held business forms include sole proprietorships, general and limited partnerships, C-corporations, S-corporations, and recently created limited liability companies. In the context of charitable gift planning, the diversity of business forms and the rules that apply to each regarding taxation, ownership, transferability, liquidity, marketability, and income producing capability place them, as a category, at the pinnacle of complexity. This memorandum focuses on outright transfers of privately-held business interests to public charities and private foundations, as well as transfers to charitable remainder trusts and charitable lead trusts.

C Corporations

A corporation is a separate entity for tax and non-tax purposes. Corporations are creatures of state law and are generally established by filing articles of incorporation with an appropriate state agency and paying the necessary registration fees. Corporations often have written by-laws that govern their operation. Owners of corporations are usually referred to as shareholders and they usually receive stock certificates to evidence their ownership interests. Each shareholder's liability for debts of the corporation is limited to his, her or its investment in the corporation. The transfer of stock in a privately-held corporation (i.e., one that is not traded publicly on an established securities market) is often restricted by means of a buy-sell agreement.

A C corporation means a corporation that is governed by Subchapter C of the Internal Revenue Code. The income of the corporation is taxed at the corporate level and most distributions are taxed again at the shareholder level.

Privately-held corporations are commonly referred to as "closely-held." Technically, a closely-held corporation is defined as any corporation other than an S-corporation of which at least 50% of the total outstanding stock is owned by or for less than five shareholders.1 Thus, although all corporations that are not publicly traded can be described as "privately-held," only certain C corporations can technically be called "closely-held." For purposes of this discussion, we will refer to C corporations as privately-held with the understanding they may be closely-held as well.

Outright Gifts

State corporate law and any stockholder agreement (commonly referred to as a buy-sell agreement) must permit the transfer of the corporate stock or permit the transfer with appropriate consent.

Self-Dealing

If privately-held C stock is contributed to a private foundation, the self-dealing rules are implicated. For further reading, see Application of Private Foundation Excise Taxes in Other Issues.

Intermediate Sanctions

If privately-held corporate stock is contributed to a public charity, the intermediate sanctions rules regarding excess benefit transactions should be considered.

Unrelated Business Income Tax

If a C Corporation is engaged in an unrelated trade or business, gross income and deductions from such trade or business will not be included within a private foundation's or public charity's computation of unrelated business taxable income. Ordinarily, a C Corporation's current distribution will constitute a dividend which does not constitute unrelated business income.2 In addition, the gain on the sale of privately-held C Corporation stock should not constitute unrelated business income.3

Dividend Treatment

The IRS will treat a charitable contribution by a closely-held corporation as a taxable distribution to its shareholders only if the shareholders or their families receive property or economic benefit as a result of the corporate contribution.4

Planned Gifts

With careful consideration of all issues, privately-held C Corporation stock may be a worthwhile consideration as a funding asset to a charitable remainder trust or a charitable lead trust. As a general rule, most charitable organization that issue charitable gift annuities or that maintain pooled income funds will, as a matter of policy and/or local law, not accept non-publicly traded business interests in connection with such gift vehicles.

Transfers of C Corporation Stock to Charitable Remainder Trusts

Stock in a C Corporation presents several unique planning opportunities and challenges in connection with charitable remainder trusts.

Unrelated Business Income Tax

If a C Corporation is engaged in an unrelated trade or business, gross income and deductions from such trade or business will not be included within a trust's computation of unrelated business taxable income. Ordinarily, a C Corporation's current distribution will constitute a dividend which does not constitute unrelated business income.5 In addition, the gain on the sale of privately-held C Corporation stock should not constitute unrelated business income.6

Self-Dealing

If privately-held corporate stock is contributed to a private foundation, the self-dealing rules are implicated.7 For further reading, see Application of Private Foundation Excise Taxes in Other Issues.

Excess Business Holdings and Jeopardy Investments

A charitable remainder trust will not be subject to the excess business holdings or jeopardizing investment rules unless it includes as an income recipient an IRC §170(c) organization. 8 Specimen trusts published by the IRS include these two prohibitions (most likely in an effort to cover the possibility that charity will be an income recipient).

If applicable, the jeopardizing investment rules could come into play if the trustee decides to hold the one issue of stock for investment purposes (due to lack of diversification). Regarding excess business holdings, the trustee has five years to dispose of the stock (with a possible five-year extension).9 Accordingly, if the transfer is followed by a sale, these two problems should disappear. Ltr. Rul. 9210005 confirms that charitable remainder trusts are exempt from the excess business holdings and jeopardizing investment rules per IRC §4947(b)(3)(B).

Stock Sale by Charitable Remainder Trust

The TRA '86 repeal of the General Utilities Doctrine makes the sale of corporate assets a two-edged sword resulting in potential taxation of sale proceeds at both corporate and shareholder levels. Can these taxes be mitigated or avoided? The transfer of stock to a charitable remainder trust followed by a sale of such stock can result in complete avoidance of capital gain at both stockholder and corporate levels. However, this is achieved at the expense of the buyer losing a stepped-up basis on the corporate assets and bearing potential liability for prior business operations.

Asset Sale Followed by Liquidation

In the event stock is transferred to a charitable remainder trust followed by an asset sale and a subsequent corporate liquidation, the corporation will pay a tax on the sale of corporate assets even though the stock is owned by the trust. However, the capital gains tax will be avoided upon liquidation and distribution of the net proceeds to the shareholder/trust (because the trust is a tax-exempt trust).

Even though tax might not be avoided at the corporate level, the impact of the tax can be mitigated by the tax savings created by the charitable contribution deduction received by the trustor outside the trust.

Case Study - Selling a Closely-Held Corporation Using a CRT

The tax and cash flow economics of selling a privately-held C corporation via a charitable remainder unitrust are compared in Gift Design Blueprints - Selling a Closely-Held Corporation Using a Charitable Remainder Unitrust

Charitable Stock Redemption

One of the more creative uses of a charitable remainder trust involves the transfer of stock in a C Corporation followed by a redemption by the corporation of the shares held by the trust. The transaction can be likened to a partial redemption on a partially deductible basis and may be an excellent method of transferring excess retained earnings from the corporation.

The Service has ruled privately that a provision that grants an independent trustee with the power to accept any offer for the redemption of shares of the company stock and to value said stock will not disqualify the trust.10

Self-Dealing and Corporate Stock Redemptions

Normally, a transfer of stock to a charitable remainder trust by an owner of more than 35 percent of the voting stock of the corporation followed by a corporate redemption is a prohibited act of self-dealing. However, a special exception applies. A redemption of stock from a charitable remainder trust will not be considered an act of self-dealing under the following condition:

[IRC §4941(d)(2)(F)]

(a) any transaction between a private foundation and a corporation which is a disqualified person (as defined in section 4946(a)), pursuant to any liquidation, merger, recapitalization, or other corporate adjustment, organization, or reorganization, shall not be an act of self-dealing if all of the securities of the same class as that held by the foundation are subject to the same terms and such terms provide for receipt by the foundation of no less than fair market value.[emphasis added]

The phrase, subject to the same terms means the corporation makes a bona fide offer on a uniform basis to the foundation and every other person who holds such securities.11 Furthermore, the exception appears to require an all-cash transaction. Any loan (i.e., the extension of credit by a private foundation (trust) to a disqualified person (the corporation))would, in and of itself, arguably appear to constitute a separate act of self-dealing.

In Ltr. Rul. 9015055, a private foundation owned 100 percent of the issued and outstanding six percent cumulative preferred stock of a for-profit corporation. The foundation received the stock under the wills of a husband and wife, who formed the foundation, and who owned and controlled the corporation until their deaths. The founding couple's daughter and her husband currently manage the foundation and run the corporation. The husband holds 99.99 percent of the company's common stock for the benefit of his wife for life, with the remainder to the daughter's children. The corporation proposed to redeem all outstanding preferred stock at fair market value as determined by an independent appraisal and by a previous IRS appraisal (made for estate tax value purposes).

The Service ruled the corporation is a disqualified person with respect to the foundation and the proposed redemption of the corporation's preferred stock constitutes an act of self-dealing. However, the redemption will not be subject to the self-dealing excise tax because, under IRC §4941(d)(2)(F), all of the shares subject to the redemption will be treated alike.

Charitable ESOP

A charitable remainder trust can be a very effective tool in effectuating the sale of a privately-held business interest to employees via an Employee Stock Ownership Plan (ESOP). Under the rules of IRC §1042, a noncorporate shareholder can sell employer securities to an ESOP on a tax-free basis, provided (a) the individual held the securities for at least three years prior to the sale, (b) the individual purchases "qualified replacement property " (QRP) within 15 months of the date of sale, and (c) the ESOP meets percentage stock ownership tests and consents to being subject to certain excise taxes.12

Generally, a disposition of QRP will cause recapture of capital gain. Therefore, a seller who purchases QRP will be locked in if they wish to avoid recognition of gain. Enter the charitable remainder trust.

The Code provides several exceptions to the recapture provisions. Included within these exceptions is a gift of replacement securities.13 The term "gift" is not defined in IRC §1042 or the regulations, however. Furthermore, a transfer to a charitable remainder trust is a gift of only a remainder interest. Therefore, the transfer attributable to the retained income interest might not qualify.

The IRS has ruled privately that a taxpayer does not avoid recognition of capital gain upon the transfer of appreciated property to a charitable trust due to any specific non-recognition provision of the Code. Rather, it is because an irrevocable trust assumes the holding period and cost basis of assets transferred to it and, therefore, does not realize gain at all. The ruling concluded the transfer of QRP constitutes a disposition of property within the meaning of IRC §1042(e). However, no gain is realized by the trustors upon the transfer of QRP to a charitable remainder trust. Thus, no recapture of gain is triggered on the original sale by the trustor to ESOP.14

Regarding the financing of the purchase, prior to August 20, 1996, a bank, an insurance company, or other lending institution could exclude from gross income 50 percent of the interest received with respect to a securities acquisition loan. This provision, contained in former section 133 of the Internal Revenue Code of 1986, was repealed, for loans made after that date by Section 1602(a) of The Small Jobs Protection Act of 1996.

If the ESOP does finance the purchase, it can service the debt by receiving tax deductible contributions from the corporation (generally subject to a limit of 15 percent of participating employee payroll).15

As an alternative, if any portion of the sale cannot be paid for in cash, the shareholder can contribute this portion of the stock to the charitable remainder trust. The trust can then sell the contributed securities to the ESOP in exchange for a note. The trust permits financing, while the tax-free exchange rules of IRC §1042 do not.16 In all events, the planner should pay particular attention to valuation issues pertaining to both privately-held stock and promissory notes as discussed infra.

  • ESOP as Charitable Remainderman

    Can an ESOP be named as the remainderman of a charitable remainder trust? Apparently so.

    The IRS has ruled in technical advice that a charitable remainder trust was qualified because any distribution to an ESOP could be made only in the event the ESOP was a qualified charitable organization to which the remainder interest could be transferred. The trust also provided, in the event the ESOP did not qualify, that trust assets would be distributed to another qualified organization.17

  • ESOP as Disqualified Person

    Is an ESOP a disqualified person for purposes of the self-dealing rules. Rev. Rul. 81-76 holds that an ESOP described in IRC § 4975(e) is not treated as the owner of stock in a corporation where the stock is allocated to participating employees and thus is not a disqualified person.

C Corporation as Trustor

Can a C Corporation establish a charitable remainder trust? Yes. Like an S Corporation or a partnership, a C Corporation can create a charitable remainder trust provided the measuring term of the trust consists of a term of years not to exceed twenty. The IRS has ruled privately that in a case where the trust was funded with publicly traded stock and which named a private foundation as remainderman, the trust qualified. The corporation would be allowed a charitable income tax deduction based on the fair market value of the stock provided the amount contributed did not exceed 10 percent of the gift corporation's outstanding stock. If the amount contributed to a private foundation exceeded the 10 percent limit, the deduction on any excess would be based on the lesser of the stock's fair market value and its adjusted cost basis.18

Transfers of C Corporation Stock to Charitable Lead Trusts

Transfers of privately-held C stock to charitable lead trusts present both opportunities and challenges. Like charitable remainder trusts, charitable lead trusts are burdened with the payment of a unitrust or annuity amount. Unlike charitable remainder unitrusts, however, a net income option is unavailable to the CLT; therefore, when the transfer of stock in a privately-held C corporation to a CLT is contemplated, the source of future income payments is a critical issue.

Potential sources of the trust payments include dividends issued by the corporation, a sale of all or a portion of the company stock (including a redemption by the corporation itself), a sale of corporate assets followed by a partial or complete liquidation of the corporation, or an in-kind distribution of the stock itself. Unlike charitable remainder trusts, which are conditionally exempt from income tax, the trustor, corporation, and the CLT are non-exempt taxpayers. Depending on the type of CLT (i.e., grantor or non-grantor), the corporation, grantor, and trust must consider the tax consequences of the trust satisfying its payment obligations.

Unrelated Business Income Tax

If the trust is a non-grantor charitable lead trust (i.e. the donor is not treated as the owner of the trust for income tax purposes, then the trust is a taxable entity--unlike a charitable remainder trust). The trust itself, however, is entitled to a charitable deduction for amounts distributed to the charity.19 However, a deduction is not allowed for amounts allocable to unrelated business income realized by the trust during the taxable year.20 In contrast, the unrelated business income tax rules should have no application to a grantor charitable lead trust, because the grantor (a non-charity) will incur all taxable income of the trust.

If a C Corporation is engaged in an unrelated trade or business, gross income and deductions from such trade or business will not be included within the trust's computation of unrelated business taxable income. Ordinarily, a C Corporation's current distribution will constitute a dividend, which does not constitute unrelated business income.21 In addition, the gain on the sale of privately-held C Corporation stock will not constitute unrelated business income.22 Although unrelated business income will not ordinarily be a concern, if a charitable lead trust owns privately-held C Corporation stock, consideration must be given to the methodology and consequences of making the charitable lead payment.

For further reading, see Taxation of Charitable Lead Trusts.

Self-Dealing

If privately-held corporate stock is contributed to a qualified charitable lead trust, the self-dealing rules are implicated.23

Excess Business Holdings and Jeopardy Investments

When transferring stock of a privately-held C corporation to a charitable lead trust, the planner must be aware that the excess business holdings and jeopardy investment rules regarding private foundations apply when the value of the charitable lead interest at the creation of the trust exceeds 60% of the total value of the trust's assets or if a portion of the income interest is not paid to charity.24 These rules essentially prohibit the trust from owning more than 20% of the voting stock of a corporation for more than five years.25

Discount

The value of stock in a privately-held corporation may be discounted to reflect its lack of marketability. In addition, the value of non-voting interests and non-controlling voting interests may be entitled to discounts for lack of control or minority interests.

Giving discounted stock to a charitable lead trust may enable the donor to leverage his or her unified credit for estate or gift tax purposes, assuming with a lifetime gift that the donor does not retain the remainder interest in the trust or have any rights that cause the trust to be included in his or her estate. The discounts allow the donor to transfer the remainder interest in the charitable lead trust at a reduced gift or estate tax cost. Of course, the income, gift and estate tax charitable deductions for the lead interest will also be reduced. The corporation will be able to produce income for its shareholders with the full value of its underlying assets despite the discount applicable to the value of the stock for transfer tax purposes.

Specific Issues

Retained Vote

If the trustor retains voting rights in a non-fiduciary capacity (other than as trustee), the charitable remainder trust will be disqualified.26 Further, the transfer of stock with retained voting rights is considered a non-qualified gift of a partial interest.27

Stock in a Professional Corporation

Stock in professional corporations such as incorporated legal, accounting, medical, or dental practices may or may not be allowed for transfer to a charitable remainder or lead trust. Determination of suitability will depend on the licensing authority in the state of the corporation's situs. A transfer may be permissible if the trust is only a transitory holder, pending the sale or other disposition of the practice, or if the trustee holds a professional license compatible with the type of stock being contributed. However, state law may specifically permit a split-interest trust to own professional corporation stock. Under Indiana law for example, a charitable remainder trust is, under certain circumstances, specifically permitted to own stock in a professional corporation.28

Section 306 Stock

Preferred stock issued as a nontaxable stock dividend is considered "tainted" under IRC §306. Such stock is considered ordinary income property to the extent of the corporation's retained earnings. Therefore, the trustor's deduction is based on the lesser of fair market value and adjusted cost basis.29

Gift By Corporation of Option to Purchase Stock in Corporation

A corporation which pledges to sell shares of its common stock to a charitable organization is entitled to a charitable contribution deduction provided by IRC §170 in the taxable year in which the pledge is exercised. The amount of the contribution will be the excess of the fair market value of the shares on the date of the exercise over the exercise price.30

This transaction is distinguishable from the contribution by a shareholder of an assignable call option to purchase stock in a corporation. Such arrangements have been contemplated to facilitate the transfer to and sale of S Corporation stock by a charitable remainder trust. This arrangement, and the IRS' negative response to it, are discussed in detail in the next section.

Stock "Pregnant" with Dividend

Stock for which a dividend has been declared but not yet paid is commonly referred to as "pregnant" with a dividend. In such cases, the market value of the stock usually increases immediately after the dividend is declared to reflect the imminent payment. After the dividend is paid, the value (market fluctuations notwithstanding) returns to its pre-declaration level. When stock is sold during this period, the dividend is paid and taxed to the purchaser.

In the context of charitable gift planning, an opportunity may exist to convert an asset that will produce ordinary income to long-term capital gain for income tax charitable deduction purposes. Consider the following scenario:

On May 8, a closely-held C-corporation declared a $1.5 million dividend on its preferred non-voting stock. The dividend was payable to shareholders of record on May 15. On May 9, the majority shareholder contributed the shares to a qualified charitable organization and claimed an income tax charitable deduction for their full fair market value (which included the unpaid dividends). Eleven months later, the donor reacquired the shares from the charitable donee.

Although the IRS did not challenge the value of the claimed charitable deduction, it did attempt to tax the dividend to the donor arguing that, as majority shareholder, he manipulated the dates of the transactions to his benefit. The Circuit Court of Appeals disagreed commenting that although the shareholder did indeed control the timing of the gift, he did actually give away the golden egg along with the goose.31

Applying this result to a charitable remainder trust, the IRS might not be disappointed for too long. The dividend, although not taxed to the trustor, would fall into tier 1 for trust accounting purposes. Therefore, the first penny distributed to the trust's income recipients (and many pennies thereafter until the dividend was distributed in its entirety) would be characterized as ordinary income under the four-tier system. The IRS would ultimately receive its tax on the dividend, albeit over a period of years.


  1. Reg. §1.170A-13; IRC §542(a)(2)back

  2. IRC §512(b)(1)back

  3. IRC §512(b)(5)back

  4. Rev. Rul. 79-9, 1979-1 C.B. 125back

  5. See the exceptions for corporate reorganizations and redemptions in IRC §4941(d)(2)(F) and the Regulations thereunder.back

  6. IRC §512(b)(1)back

  7. IRC §512(b)(5)back

  8. IRC §4947(b)(3)(B)back

  9. IRC §4943(c)(6), (7)back

  10. Ltr. Rul. 9339018back

  11. Reg. §53.4941(d)-3(d)(1)back

  12. Temp. Reg. §1.1042-1Tback

  13. IRC §1042(e)(3)back

  14. Ltr. Ruls. 9234023; 9438012; 9515002; 9547022; 9547023back

  15. IRC §409back

  16. A loan from a private foundation to a disqualified person is a prohibited act of self-dealing.back

  17. TAM 9244001back

  18. Ltr. Rul. 9205031back

  19. IRC §642(c)back

  20. IRC §681back

  21. IRC §512(b)(1)back

  22. IRC §512(b)(5)back

  23. See the exceptions for corporate reorganizations and redemptions in IRC §4941(d)(2)(F) and the Regulations thereunder.back

  24. IRC §4947(b)(3)back

  25. IRC §§4943(c)(6) and 4943(c)(7)back

  26. Reg. §1.664-1(a)(4)back

  27. Rev. Rul. 81-282, 1981-2 C.B. 78back

  28. Indiana Code §23-1.5-3-1back

  29. IRC §306(a)(1)back

  30. Rev. Rul. 75-348, 1975-2 C.B. 75back

  31. Caruth v. U.S.back

S Corporations

Like a C corporation, an S corporation is an entity formed as a corporation under state law by the filing of appropriate articles of incorporation and paying any registration fees that may be required. It often has written by-laws governing its operation. The owners are referred to as shareholders and have stock certificates to evidence their ownership interests.

Subchapter S of the IRC governs the taxation of S corporations. The tax treatment of an S corporation differs from a C corporation in that most items of income, gain, loss and deduction of an S corporation flow through to the shareholders for income tax purposes and are not taxed at the corporate level. Only certain corporations qualify as S corporations. Specifically, an S corporation is a small business corporation, as defined in IRC §1361(b), which has made an election for Subchapter S treatment under IRC §1362(a). In order to qualify as a small business corporation, the entity must not, among other things, have more than 75 shareholders and the shareholders must fall into certain categories.

Charitable organizations described in Code Section 501(c)(3) or 401(a) and exempt from tax under Code Section 501(a) are qualified shareholders. A charitable remainder trust does not qualify as an S corporation shareholder. A charitable lead trust may qualify if it is a grantor trust for income tax purposes.

An S corporation may have only one class of stock, although it may have both voting and non-voting shares as long as voting rights are the only difference between the two types of shares. In many instances, the transfer of S corporation stock is restricted in some fashion, such as with a buy-sell agreement.

Outright Gifts

In 1996, Congress enacted The Small Business Job Protection Act, which permits a charitable organization to be an eligible shareholder of an S Corporation beginning January 1, 1998.1 The donor will be entitled to a charitable contribution deduction, which may be reduced under IRC §170(e)(1).

See Gift Planner's Digest - Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems

State corporate law and any stockholder agreement (commonly referred to as a buy-sell agreement) must permit the transfer of the corporate stock or permit the transfer with appropriate consent. In addition, a transfer of S Corporation stock to many different shareholders or to disqualified shareholders will terminate the S Corporation's tax status.2

Self-Dealing

If S Corporation stock is contributed to a private foundation, charitable remainder trust, or qualified charitable lead trust, the self-dealing rules are implicated. For further reading, see Application of Private Foundation Excise Taxes in Other Issues.

Intermediate Sanctions

If S Corporation stock is contributed to a public charity, the intermediate sanctions rules should be considered. These rules are discussed in detail in the "Other Issues" section of this text.

Unrelated Business Income Tax

If an IRC §501(c)(3) organization holds stock in an S Corporation, such interest is treated as an interest in an unrelated trade or business.3 Thus, the income generated from the business or the gain on the sale of the S Corporation stock will cause a taxable event to the charity.

Planned Gifts

S Corporation stock may, in limited circumstances, be a good candidate as a funding asset to a charitable remainder trust or a charitable lead trust.

Transfers of S Corporation Stock to Charitable Remainder Trusts

Can stock in an S Corporation be transferred to a charitable remainder trust? Yes, but not if the shareholder wishes to retain S Corporation status. A charitable remainder trust is not a qualified S Corporation trust. Thus, an S Corporation will, for tax purposes, convert into a C Corporation upon the receipt by the trust of such stock.

The Service has stated that IRC §§664 and 1361 contemplate two distinct systems of taxation and are mutually exclusive. It further noted that a beneficiary electing under IRC §1361(d) to be treated as the owner of the portion of the trust consisting of stock, agrees to be taxed on all items of income relating to that stock. Under IRC §664(b) it said, the recipient of an income interest in a charitable remainder unitrust is only taxable on the unitrust amount. Therefore, the transfer of even one share of stock to a charitable remainder trust will terminate S Corporation status.4 Rev. Rul. 92-48 cements the IRS's opinion. However, the corporation may qualify for relief under the inadvertent termination rules of IRC §1362(f).

Self-Dealing

If S Corporation stock is contributed to a charitable remainder trust, the corporation's S status will terminate. Nevertheless, the self-dealing rules are implicated.

Unrelated Business Income Tax

Since a charitable remainder trust can never own S Corporation stock, as the corporation will lose its tax status upon receipt by the trust of the stock, unrelated business income may not be a relevant consideration.

Using Assignable Call Options to Sell S-Corporation Stock Via a CRT

In 1992, the IRS published a letter ruling that offered a unique solution to a traditional problem; how to liquidate an incompatible asset via a charitable remainder trust. An incompatible asset is one that will either terminate the tax-exempt status of a charitable remainder trust or that will adversely affect qualification of the asset itself. Examples of incompatible assets include stock in an S-corporation, stock in a professional corporation, and real property that generates unrelated business income or that may contain toxic waste. The solution called for the creation and transfer to the trust of an assignable call option in place of the incompatible asset. The following case study illustrates how such a strategy operates:

The Facts

Mr. Smith owns unencumbered real property that he wants to sell to Mr. Jones for $2,000,000. Smith would like to sell the property via a charitable remainder unitrust and, in the process, avoid a $1,500,000 capital gain. The property is unencumbered; however, Smith has been advised that his property produces unrelated business income that will jeopardize the tax-exempt status of the trust.

An Exotic Solution - Creating a Charitable Option

Step 1. Smith creates an assignable three-year option that allows the holder to purchase the property for $100,000.

Step 2. Smith transfers option to a charitable remainder trust.

Step 3. Trustee sells option to Jones for $1,900,000 (the difference between market value and exercise price).

Step 4. Jones exercises the option to buy, paying Smith $100,000.

Result

Because the trust never owned the property, the unrelated business income produced by the property could not taint the trust. Smith will recognize capital gain allocable to the $100,000 received upon exercise of the option. Gain attributable to the remaining $1,900,000 will be recognized by the trust (unless it has unrelated business taxable income from other sources).

IRS Rules on Option with Unencumbered Property

In Ltr. Rul. 9240017, the IRS concluded that, under facts similar to those presented above, the trustee's contractual right to acquire a fee interest in the property for an amount below the fair market value of the property is an asset of the trust for purposes of meeting the requirements of IRC §664(d)(2). In addition, the trustee's contract right to acquire a fee interest in real property with substantial value ($2,000,000) for an amount substantially lower ($100,000) has substantial fair market value. This substantial fair market value must be included each year in determining the net fair market value of the trust's assets and the resulting unitrust amount payable to the income recipient.

Regarding the availability and sequencing of the trustor's charitable income tax deduction, the IRS's opinion was disappointing, but logical. Rev. Rul. 82-197 provides, an individual who grants an option on real property to charity is allowed a charitable deduction for the year in which the charitable organization exercises the option in an amount equal to the excess of fair market value of the property on the date the option is exercised over the exercise price.5 The IRS concluded that the trustor is not entitled to a deduction for the remainder interest, either when the purported option is granted or when the charitable remainder trust sells it. The trustor is, however, entitled to a deduction for the remainder interest only if and when he sells the property to the trust or to another charitable organization exercising the option. The deduction is based on the spread between the fair market value and the exercise price ($1,900,000).

IRS Rescinds Ltr. Rul. 9240017

One month after receiving a favorable ruling regarding the use of an option with unencumbered real property, the same taxpayer requested a new ruling on the use of the same technique with encumbered property. This triggered an unanticipated result. The Service responded by immediately issuing a ruling that rescinded the 1992 ruling stating only that it was reconsidering the issues raised in the original ruling.

IRS Rules on Use of Options for Unencumbered and Encumbered Assets

In September of 1994, the Service responded to the second ruling request. There were two questions at issue. First, was the trust a qualified charitable remainder trust? Second, would the taxpayer (trustor) be treated as the owner of the trust, thereby causing the gain realized by the trust on the sale of the option to be recognized by the taxpayer? With respect to the first issue, the Service first stated,

"To qualify as a charitable remainder trust within the meaning of section 664 of the Code and the regulations thereunder, a trust must be one with respect to which a deduction is allowable under one of the specified sections--section 170, 2055, 2106, or 2522. Further, the trust must be a charitable remainder trust in every respect and must meet the definition of and function exclusively as a charitable remainder trust from its creation. The requirements of being a charitable remainder trust in every respect and functioning exclusively as a charitable remainder trust from its creation cannot be met unless each transfer to the trust during its life qualifies for a charitable deduction under one of the applicable sections (IRC §§170, 2055, 2106, or 2522)."

This being an inter vivos trust, the Service then focused its attention on the qualification for income tax deduction under section 170 and qualification for gift tax deduction under section 2522. With respect to qualification for an income tax deduction, the IRS concluded,

"The transfer to a charitable organization of an option by the option writer is similar to the transfer of a note or pledge by the maker. In the noted situation there is a promise to pay money at a future date. In the pledge situation there is a promise to pay money or transfer other property, or to do both, at a future date. And in the option situation there is a promise to sell property at a future date. Although the promise may be enforceable, a promise to pay money or to sell property in the future is not itself a 'payment' for purposes of deducting a contribution under section 170 of the Code. Thus, the grant of the option to [the charitable organization] in this case is not a contribution for which a deduction is allowable under section 170.

With respect to the availability of the gift tax charitable deduction under section 2522, the IRS cited Rev. Rul. 80-186 in its primary argument, which concludes that the transfer of an option to purchase real property for a specified period is a completed gift under section 2511 of the Code on the date the option is transferred, if, under state law, the option is binding and enforceable on the date of the transfer. In the instant case, under local law, the purported option is not binding on a taxpayer when granted. Accordingly, the proposed transfer of the purported option to the trust would not be a completed gift on the date of transfer under section 25.2511-2(b), because the taxpayer would not have made a binding offer on that date.

With respect to the second issue (i.e., whether the grantor would be treated as the owner of the trust and, accordingly, be taxable on the gain from the sale of the option), the IRS's conclusion was obvious. If the trust is not a qualified charitable remainder trust, it must be a grantor trust, the income from which (including gain from the sale of trust assets) is taxable to the grantor.

Excess Business Holdings and Jeopardy Investments

A charitable remainder trust will not be subject to the excess business holdings or jeopardizing investment rules unless it includes as income recipient an IRC §170(c) organization.6 Specimen trusts published by the IRS include these two prohibitions (most likely in an effort to cover the possibility that charity will be an income recipient).

If applicable, the jeopardizing investment rules could come into play if the trustee decides to hold the one issue of stock for investment purposes (due to lack of diversification). Regarding excess business holdings, the trustee has five years to dispose of the stock (with a possible five-year extension).7 Accordingly, if the transfer is followed by a sale, these two problems should disappear. Ltr. Rul. 9210005 confirms that charitable remainder trusts are exempt from the excess business holdings and jeopardizing investment rules per IRC §4947(b)(3)(B).

S Corporation Without Built-in-Gains

Stock in an S Corporation that has no built-in gains (resulting from a conversion from a C Corporation), that would otherwise cause tax at the corporate level in the event of an asset sale/liquidation, may not be suitable for transfer to a charitable remainder trust if an asset sale/liquidation is anticipated.

An asset sale/liquidation outside the charitable remainder trust will result in a taxable event only at the shareholder level. By contrast, the transfer of stock in an S Corporation to a charitable remainder trust will terminate S Corporation status. Therefore, a subsequent asset sale (within the trust) will result in a taxable event at the C Corporation level. The subsequent liquidation will avoid tax at the shareholder (trust) level. However, the damage has already been done. Even though the corporation is owned by a tax-exempt entity, the tax will remain the obligation of the corporation. Accordingly, the net tax result of both alternatives may be roughly the same with the only difference caused by the marginal tax bracket applicable to the shareholder verses the corporation and the charitable contribution deduction generated to the trustor.

As an alternative, the S Corporation itself should consider becoming the trustor and income recipient.

S Corporation as Trustor

Can an S Corporation establish a charitable remainder trust? Yes. Like a C Corporation, an S Corporation will be the trustor and income recipient of the trust. Income distributions will pass through to shareholders according to their pro rata shareholdings. However, because an S Corporation is other than an individual or a qualified charitable organization, the trust term is limited to a term of years not to exceed twenty.8

Pass-Through of Charitable Deduction to Shareholders

Can an S Corporation that establishes a charitable remainder trust pass the charitable contribution deduction through to its shareholders? According to Ltr. Rul. 9340043, it can.

IRC §1366(a)(1)(A) provides that a shareholder in an S Corporation determines his liability by assuming his pro rata share of items of income, loss, deduction, or credit that if separately stated and given separate treatment would effect his individual income tax liability. Items of loss include charitable contributions.9

The amount of the shareholder's contribution deduction is the present value of the remainder interest in the gift reduced in accordance with the applicable provisions of IRC §170(e). Under that section, the amount of a contribution of property is reduced by the amount of gain that would not have been long-term capital gain (i.e., short-term capital gain or ordinary income) had the property been sold at its fair market value. Under IRC §170(e)(1)(B), however, the amount of the contribution is reduced by the amount of gain that would have been long-term capital gain if (a) the property is tangible personal property unrelated the exempt organization's purpose, or (b) the contribution is to or for the use of a private non-operating foundation.

Regarding the percentage limitation placed on the use of the deduction, the Service's position was favorable to the taxpayer, but at the same time perplexing. IRC §1366(d)(1) provides that the aggregate amount of losses and deductions assumed by any shareholder shall not exceed the sum of the adjusted basis of the shareholder's stock in the S Corporation and the shareholder's adjusted basis of any indebtedness.10 The Service, however, made no reference to that section in its ruling, stating simply, "The limitations applicable to individuals set forth in IRC §170(b) apply in determining the shareholder's allowable deduction for the charitable deduction." Finally, when the net charitable deduction is passed through to the shareholder, the shareholder's basis in his stock is decreased (but not below zero) by the amount of the deduction.11

Bargain Sale of Company Stock Followed by Redemption

In Ltr. Rul. 8213063, a company president proposed to sell company stock that he owned personally to a charitable organization at a discount; after which, the company could redeem the shares at their fair market value. The charity was not bound, however, to offer the shares for redemption and the company was not bound to redeem them.

The Service ruled the president would receive a charitable contribution income tax deduction for the difference between the selling price of the stock and its fair market value on the date of sale. Further, any subsequent redemption by the company would not result in dividend treatment to the president, nor would it cause the company to recognize gain or loss. Gain to the president was to be determined under the standard bargain sale rules.

Transfers of S Corporation Stock to Charitable Lead Trusts

S Corporation stock can be transferred to all forms of charitable lead trusts; however, the corporation will retain its S status only if the grantor is treated as the owner of the trust for income tax purposes 12, if the stock is transferred to the trust by will but only for two-years following the transfer 13, or if the trustee is able to make an electing small business trust election.14

Beginning in 1998, it appears that an electing small business trust election may be made for a non-grantor charitable lead trust assuming the charitable lead beneficiary is one of the eligible types (an organization described in Section 170(c)(2), (3), (4) or (5)) and the requirements are otherwise met.15

Unrelated Business Income Tax

If S Corporation stock is transferred to a grantor charitable lead trust, any unrelated business income should have no application because the grantor (non-charity) will incur all taxable income of the trust.

Conversely, when an S Corporation loses its S election due to a transfer of stock to a non-grantor charitable lead trust, unrelated business income tax will be implicated as explained above for C Corporation stock.

If the trust is a non-grantor charitable lead trust (i.e., the donor is not treated as the owner of the trust for income tax purposes), then the trust is a taxable entity. The trust itself, however, is entitled to a charitable deduction for amounts distributed to the charity.16 However, a deduction is not allowed for amounts allocable to unrelated business income realized by the trust during the taxable year.17

For further reading, see Charitable Lead Trusts - Taxation of Charitable Lead Trusts.

Self-Dealing

If S Corporation stock is contributed to a qualified charitable lead trust, the self-dealing rules are implicated.18 These rules are discussed in detail in the "Other Issues" section of this text.

Excess Business Holdings and Jeopardy Investments

When transferring S Corporation stock to a charitable lead trust, the planner must be aware that the excess business holdings and jeopardy investment rules regarding private foundations apply when the value of the charitable lead interest at the creation of the trust exceeds 60% of the total value of the trust's assets or if a portion of the income interest is not paid to charity.19 These rules essentially prohibit the trust from owning more than 20% of the voting stock of a corporation for more than five years.20

For further reading, see Application of Private Foundation Excise Taxes in Other Issues.

S Corporation Stock to "Super" Grantor Charitable Lead Trust

In Ltr. Rul. 199936031, the Service approved the income, gift, and estate tax status of a super-grantor charitable lead annuity trust funded with Subchapter S stock and with it recognized a new method to establish grantor trust status for income tax purposes, and yet not cause inclusion for estate tax purposes.


  1. Public Law 104-188; signed into law on August 20, 1996back

  2. IRC §1361(b)back

  3. IRC §512(e)(1)back

  4. Ltr. Rul. 8922014back

  5. Ltr. Ruls. 8714013; 8825069; 8826008back

  6. Ltr. Rul. 9501004back

  7. Rev. Rul. 92-48, I.R.B. 1992-26, 7 (June 29, 1992)back

  8. IRC §4947(b)(3)(B)back

  9. IRC §4943(c)(6),(7)back

  10. Ltr. Rul. 9340043back

  11. IRC §702(a)(4)back

  12. IRC §1361(c)(2)(A)(i)back

  13. IRC §1361(c)(2)(A)(iii)back

  14. IRC §1361(c)(2)(A)(v)back

  15. See IRC §1361(e) and Ltr. Rul. 199908002 (Nov. 5, 1998), where the IRS held that electing small business trust elections could be made for a grantor charitable lead annuity trust and grantor charitable lead unitrust after the grantor's death in years beginning after December 31, 1997. Presumably, this electing small business trust ruling was requested because the charitable lead trusts were to last for six years and, thus, could extend beyond the two-years-after-death qualifying period.back

  16. IRC §§1367(a)(2)(B) and 1366(a)(1)(A)back

  17. IRC §642(c)back

  18. IRC §681back

  19. IRC §512(c)back

  20. See exceptions in IRC §4941(d)(2)(F) and the Regulations thereunder.back

Limited Liability Companies

A limited liability company (LLC) is an entity formed under state law by filing articles of organization with the state and paying any required registration fees. It may or may not have a written operating agreement to govern its operations. Its owners are usually referred to as members and they have membership interests in the LLC. Management is generally by either majority vote of the members or a specified general manager. None of the members is personally liable for the LLC's debts. As with other closely-held entities, the transfer of interests in an LLC is often restricted.

All states allow LLCs to be formed with two or more members. Some states also allow an LLC to be formed with only one member. The check-the-box rules in the Regulations under IRC §7701 govern the classification of LLCs for federal tax purposes. A single-member LLC is either taxed as a corporation or is disregarded as a separate entity for tax purposes. An LLC with at least two members is generally taxed as a partnership unless it elects to be taxed as a corporation.

Outright and Planned Gifts

An LLC may be treated for tax purposes as a partnership or an association taxable as a corporation. If the LLC is treated as a partnership for tax purposes, a contribution of a member's interest in the LLC is likely to be treated the same as a gift of a partnership interest, as discussed earlier. If the LLC is treated as a corporation for tax purposes, a contribution of a member's interest in the LLC is likely to be treated the same as a C Corporation, also as discussed earlier. In no event should the LLC lose its state law status (i.e., to limit the liability of its members). However, unique issues and uses will arise because of the difference in treatment for state and tax law purposes. For instance, the single member LLC is currently being used by net income with makeup charitable remainder unitrusts as a vehicle to defer the receipt of fiduciary income. The Service, however, has declined to issue further rulings regarding such arrangements.1

For further reading, see Gift Planner's Digest -- Using Single Member LLCs in Net Income Charitable Remainder Unitrusts.


  1. Rev. Proc. 99-3back

Other Issues

Valuation of Charitable Gifts

The charitable contribution deduction is based on the contributed property's fair market value, which is defined as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts."1 The terms of the agreement and the nature of the assets owned by the privately held business will determine the value of the contributed property.

Unlisted Securities

In order to value unlisted securities, quotations may be obtained from brokers, or, evidence as to their sale can be obtained from the officers of the issuing companies. Copies of letters furnishing such quotations or evidence of sale should be attached to the return.2

Closely-Held Stock

The IRS has stated that when valuing the stock of closely-held corporations or the stock of corporations where market quotations are either lacking or too scarce to be recognized, all available financial data, as well as all relevant factors affecting the fair market value, should be considered. The following factors, although not all-inclusive, are considered fundamental and require careful analysis in each case: (a) the nature of the business and the history of the enterprise from its inception; (b) the economic outlook in general and the condition and outlook of the specific industry in particular; (c) the book value of the stock and the financial condition of the business; (d) the earning capacity of the company; (e) the dividend-paying capacity; (f) whether or not the enterprise has goodwill or other intangible value; (g) sales of the stock and the size of the block of stock to be valued; (h) the market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.3

Restricted Securities

The subsequent sale of stock in a publicly-traded company may be restricted. Such stock is referred to as Rule 144 stock and is defined as "securities acquired directly or indirectly from the issuer thereof, or from an affiliate of such issuer, in a transaction or chain of transactions not involving any public offering." Since the stock may not be readily marketable, the value of such stock may be subject to a discount. Rev. Rul. 77-287 discusses the facts and circumstances material to valuing restricted securities.

Partnership Interests

As with a corporation, the value of a partnership interest is the net amount which a willing purchaser would pay for the interest to a willing seller with neither being under any compulsion to buy or sell and with both having reasonable knowledge of the relevant facts.4 The Regulations underlying the IRC provisions governing the valuation of assets that are transferred during life or at death specify that many of the factors that apply in valuing corporate stock also apply in valuing other business interests, such as partnership interests.5

Limited Liability Company Interests

Similarly, the value of a membership interest in an LLC is the net amount which a willing purchaser would pay for the interest to a willing seller with neither being under any compulsion to buy or sell and with both having reasonable knowledge of the relevant facts. 6 The estate and gift tax Regulations indicate that many of the factors that apply in valuing corporate stock also apply in valuing other business interests. 7

New Charitable Remainder Trust Regulations

Regulation §1.664-1(a)(7) provides new rules for valuing unmarketable assets that are transferred to or held by a charitable remainder trust. The final Regulations specify that a charitable remainder trust holding unmarketable assets will be disqualified under IRC §664 (and no corresponding charitable deduction will be allowed) unless any required valuations of the unmarketable assets owned by the trust are (i) performed exclusively by an independent trustee or (ii) determined by a current qualified appraisal as defined under Regulation §1.170A-13(c)(3) by a qualified appraiser as defined under Regulation §1.170A-13(c)(5).8 The final Regulations also clarify the definition of "independent trustee" and "unmarketable assets" for purposes of these valuation rules.

  • An independent trustee is a person who is not a grantor or a noncharitable beneficiary of the charitable remainder trust and is not a related or subordinate party (within the meaning of IRC §672(c) and the applicable regulations) to a grantor, a grantor's spouse or a noncharitable beneficiary of the trust. The addition of the noncharitable beneficiary to this list is an expansion of the traditional definition of "related or subordinate person" found in the grantor trust rules.9
  • Unmarketable assets are assets that are not cash, cash equivalents or other assets that can be readily sold or exchanged for cash or cash equivalents. Unmarketable assets include real property, closely held stock and unregistered securities with no available exemption permitting public sale.10
  • Regulation §1.664-1(f)(4) states that these new valuation rules are applicable to charitable remainder trusts created on or after December 10, 1998. However, if a charitable remainder trust was created before December 10, 1998, and its governing instrument requires that an independent trustee value the unmarketable assets11, the Regulations allow the governing instrument to be amended or reformed to permit a valuation method that satisfies the requirements of the new valuation rules, effective for taxable years beginning on or after December 10, 1998.

Unrelated Business Income Tax

If a charity incurs unrelated business taxable income, the charity must pay income tax on the unrelated business taxable income.12 A charitable remainder trust that incurs unrelated business taxable income loses its tax-exempt status in that taxable year so unrelated business taxable income could be particularly devastating in a year when an appreciated asset is sold. A non-grantor charitable lead trust loses its charitable income tax deduction on a dollar-for-dollar basis for the amount of unrelated business income incurred by the trust.

Although a term of art, unrelated business taxable income generally means income earned from the active operation of a business enterprise. In general, passive income, such as interest, dividends, rents from real property under certain circumstances, certain royalties and gains from a capital asset do not constitute unrelated business taxable income, so long as debt is not incurred to acquire those assets. The incurrence of any debt by a charitable remainder or charitable lead trust generally is very dangerous. For instance, no investments should be acquired through the incurrence of "margin" debt and as a general rule, no asset subject to debt should be contributed to such a trust. In addition, the distributions from certain partnerships or LLCs treated as a partnership for tax purposes, which incur (or may incur) debt, may also constitute unrelated business taxable income.

A charitable remainder trust is exempt from all taxes unless it has unrelated business taxable income within the meaning of IRC §512. In any year in which a charitable remainder trust has one penny of UBTI, the trust is subject to tax as if it was a complex trust.

For a discussion of the application of unrelated business taxable income to charitable lead trusts, see Taxation of Charitable Lead Trusts - Unrelated Business Income

Application of Private Foundation Excise Taxes

IRC §4941 - Self-Dealing

In general, "self-dealing" consists of any direct or indirect transaction between a private foundation and a disqualified person13 involving the:

(i) sale, exchange, or leasing or property,
(ii) lending of money or other extension of credit,
(iii) furnishing of goods, services, or facilities, or
(iv) payment of compensation or payment/reimbursement of certain expenses.14

IRC §4946(a)(1) defines a "disqualified person" as a person who is a:

(i) substantial contributor to the private foundation15 ,
(ii) a foundation manager16,
(iii) an owner of more than 20 percent of

(a) the total combined voting power of a corporation,
(b) the profits interest of a partnership, or
(c) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation,
(iv) a member of the family 17 of any person described in (i), (ii), or (iii), and (v) corporations, partnerships, trusts or estates in which substantial contributors, foundation managers, grantors of trusts, persons described under (iii), or any members of their families, owning or holding more than 35 percent of the total combined voting power, profits interest, or beneficial interest.

Excise taxes are imposed on disqualified persons who participate in acts of self-dealing with a private foundation. The rate of tax is equal to 5 percent of the amount involved with respect to the act of self-dealing for each year (or part thereof) in the taxable period.18 The rate of tax will increase to 200 percent if the act is not corrected within the taxable period.19 The tax is to be paid by the disqualified person (other than a foundation manager acting only as such) who participates in the act.20

A participating foundation manager, however, is liable for a tax equal to 2-1/2 percent of the amount involved with respect to the act of self-dealing for each year (or part thereof) in the taxable period, unless the foundation manager's participation is not willful and is due to reasonable cause.21 The rate of tax will increase to 50 percent if the act was not corrected within the taxable year and the foundation manager refused to agree to part or all of the correction.22 The tax is to be paid by the foundation manager who participated in the act of self-dealing 23 or refused to agree to part or all of the correction.24 The maximum amount imposed on a participating foundation manager with respect to any one act of self-dealing is $10,000.25

The private foundation excise tax rules against self-dealing apply to all charitable remainder trusts. For additional discussion, see Charitable Remainder Trusts - Operating Considerations

In addition, the self-dealing rules apply to all qualified charitable lead trusts. For further reading, see Charitable Lead Trusts - Private Foundation Excise Tax Rules.

IRC §4943 - Excess Business Holdings

In order to discourage private foundations from holding investments in business enterprises, Congress enacted IRC §4943, which basically subjects a private foundation to a two-tier excise tax for its "excess business holdings." In enacting this Section, Congress was concerned that private foundation managers would focus their attention on the success of a business enterprise and away from the charitable purposes for which the private foundation was created. In addition, such enterprise, as owned by a tax-exempt entity, could unfairly compete with another similarly situated enterprise that was owned by a taxable entity.

The excise tax imposed under IRC §4943 is 5% of the highest value of the holdings in a business enterprise in excess of the "permitted holdings." A harsh second-tier excise tax equal to 200% of such excess business holdings may apply if (i) the 5% tax is imposed and (ii) the Trust still has excess business holdings at the close of the earlier to occur of (A) the date of mailing of a notice of deficiency by the IRS relating to such holdings or (B) the date on which the 5% tax is assessed by the IRS.26

"Permitted holdings" means, in an incorporated business enterprise, 20% of the voting stock, reduced by the percentage of voting stock owned by all disqualified persons (as defined in IRC §4946(a)) ("Disqualified Persons").27 However, in any case in which disqualified persons together do not own more than 20% of the voting stock of an incorporated business enterprise, nonvoting stock held by the private foundation shall also be treated as permitted holdings.

Once the permitted holdings have been determined, the permitted holdings are subtracted from the percentage of voting stock held by the foundation to determine the amount of "excess business holdings."28 The net effect of these formulas is to assure that the combined holdings of all disqualified persons and the private foundation in a business enterprise are not more than 20%. Any readjustment of the assets held by the Trust (e.g., a recapitalization, redemption, merger) may also impact the excess business holdings rules.29

The jeopardizing investment rules do not apply to charitable remainder trusts unless the trust includes a section 170(c) charitable organization as an income recipient.30

Although IRC §4943 deals with a private foundation and not a charitable lead trust, IRC §§4947(a)(2) and (b)(3) cause the excess business holdings tax to apply to a charitable lead trust where the aggregate value of the charitable lead interest exceeds 60% of the fair market value of the property contributed to such trust.

For a detailed discussion of the application of the excess business holdings rules to charitable lead trusts, see Charitable Lead Trusts - Private Foundation Excise Tax Rules.

Exceptions To Excess Business Holdings Tax

If the excess business holdings tax will apply, there are several methods by which the trust can limit the impact of, or altogether avoid, such tax.

Five-Year Period

The trust is given a five-year period beyond the date of the gift to dispose of the business holdings in excess of the combined 20% permitted holdings.31 The law treats the business holdings held by the trust in this instance as being held by disqualified persons to the trust for such five-year period. Thus, the trust is not deemed to own any business holdings for such period.

There are, however, exceptions to this favorable rule. These exceptions basically attempt to prohibit an end run around this rule (i.e., transfer from the trust to another commonly controlled or related private foundation, a purchase by an entity effectively controlled by a disqualified person or the trust or a disqualified person's plan to purchase during the five-year period additional holdings in the same business enterprise held by the trust).32

Effective Control Exception

Under certain circumstances, the permitted holdings may be increased from 20% to 35%.33 Such an increase is permitted if (i) persons other than the private foundation and disqualified persons have "effective control" of the company and (ii) the private foundation establishes to the satisfaction of the Commissioner that effective control is in one or more persons (other than the private foundation itself) who are not disqualified persons.

Effective control means the power to direct or cause the direction of the management and policies of a business enterprise, whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise. For example, the effective control test is met if individuals holding a minority interest, none of whom is a disqualified person, have historically elected a minority of the corporation's directors. The key is to prove that another person or group of persons do control the company, not that the disqualified persons don't control the company.34

Passive Source Exception

The third possible method of avoiding the IRC §4943 tax is the passive source exception. The definition of a "business enterprise" includes the active conduct of a trade or business, including any activity that is regularly carried on for the production of income from the sale of goods or the performance of services.35 If 95% or more of the gross income of a business enterprise is "passive," the entity will not be deemed to be a business enterprise.

The definition of what is passive is a term of art and basically includes dividends, interest, payments with respect to securities loans, annuities, royalties measured by production of income from the property, rents from real property (unless taxable as unrelated business income) and gains or losses on sales and exchanges of property (other than inventory and property held for the sale to customers).36 This concept is consistent with the Congressional intent in attempting to discourage foundation managers from spending too much time on the business enterprise.37 If the activity is passive, by definition, the managers would not be spending time on the business enterprise.

Extension of Initial Five-Year Period

The IRS has the statutory power to extend the initial five-year period, for unusually large gifts or bequests of diverse holdings or holdings with complex corporate structures, for up to an additional five years.38 The private foundation must prove to the Secretary of the Treasury that it has made diligent efforts to dispose of such holdings during the initial period, and a disposition of such holdings within the initial period has not been possible (except at a price substantially below fair market value) due to the size and complexity or diversity of such holdings. The private foundation must submit a plan with the Secretary and the state official having the authority over the foundation's affairs (usually the Attorney General's Office) for disposing of the excess during the extended period. This plan may be accepted by the Secretary if it can be reasonably expected to be carried out during the extension period.

De Minimis Rule

A de minimis rule is provided in which disqualified persons may retain any percentage of holdings, so long as the private foundation holds no more than 2% of the voting stock or 2% by value of all outstanding shares.39

90-day Grace Period

A private foundation will have at least 90 days from the date of the gift to dispose of the excess business holdings without incurring this excise tax.40 This 90-day period is extended to include the period during which a private foundation is prevented by federal or state securities laws from disposing of such excess business holdings.41

IRC §4944 - Jeopardy Investments

IRC §4944 subjects a private foundation and a manager of the private foundation (i.e., a trustee) to a two-tier excise tax for making investments in such a manner as to jeopardize the carrying out of the private foundation's exempt purposes.

If such a jeopardizing investment is made, IRC §4944(a)(1) imposes on the private foundation a tax of 5% of the amount of the investment for each year or part thereof in the "taxable period" (defined below), and IRC §4944(a)(2) imposes a similar 5% tax on any foundation manager who knowingly and willfully participated in making such investment. However, the tax on the foundation manager is limited to $5,000 per investment.

The second tier tax of 25% of the investment is imposed whenever (i) an initial tax is imposed pursuant to IRC §4944(a)(1) on the making of a jeopardy investment and (ii) the investment is not removed from jeopardy within the "taxable period", pursuant to IRC §4944(b)(1). The "taxable period" is the earlier to occur of (A) the date of mailing of the deficiency notice by the IRS, (B) the date on which the IRC §4944(a)(1) tax is imposed or (C) the date on which the amount so invested is removed from jeopardy, pursuant to IRC §4944(e)(1).

A foundation manager is liable for an additional tax equal to 5% of the amount invested, only if an additional tax has been imposed on the foundation and the manager has refused to agree to part or all of the removal from jeopardy of such investment. This second-tier tax on the foundation manager is likewise limited to $10,000 per investment.42

Gift of Speculative Property

The tax under IRC §4944(a)(1) is imposed on the private foundation if it "invests" any amount in such a manner as to jeopardize its tax-exempt purpose.43 Although neither the Code nor the legislative history address the application of this tax to contributed property, Regulation §53.4944-1(a)(2)(ii)(a) provides that IRC §4944 shall not apply to an investment made by any person which is later gratuitously transferred to a private foundation. This Regulation Section further provides that, if such foundation furnishes any consideration to such person upon the transfer, the foundation shall be treated as having made an "investment" in the amount of such consideration.

One commentator describes this Regulation Section as follows, "Property received as a gift or bequest is not a jeopardizing investment regardless of how imprudent it might be if purchased by the foundation."44

Thus, it appears clear that the receipt by way of gift of a speculative asset by a private foundation cannot be described as an "investment," causing the private foundation to be subject to the tax under IRC §4944. However, what is less clear is the ability of the foundation to retain such asset without incurring the jeopardy investment tax. In fact, another commentator has indicated that an implied duty to dispose of highly speculative property, even if acquired by gift, can arguably be read into IRC §4944.45

However, two private letter rulings that relate directly to charitable lead trusts indicate a contrary and favorable taxpayer result.46 In Ltr. Rul. 8125038, father transferred common stock in his for-profit corporation to two charitable lead annuity trusts, one for the ultimate benefit of his son and the other for his daughter (and their respective descendants). Father and mother are the trustees of the trusts.

Citing Regulation §53.4944-1(a)(2)(ii)(a), the IRS held that the receipt and retention of the corporation's stock will not be considered an investment that would jeopardize the exempt purpose of the trusts. However, this ruling was based on the condition that the Donor would not receive any consideration upon the transfer of the assets. Should any of the two trusts furnish any consideration to the Donor, the IRS found that such trust will be treated as having made an investment in the amount of the consideration within the meaning of IRC §4944.

"It appears under this ruling that the trustees may not have a duty under §4944 to dispose of the stock if it later appears to be an imprudent investment. Rather, the §4944 determination is apparently made once and for all at the time the trustee acquires the assets."47

Similarly, in Ltr. Rul. 8038180, a taxpayer proposed creating a charitable lead annuity trust and contributing approximately One Million Dollars in cash and\or common stock in a specified company to such trust. A bank and two private individuals (who were not "related or subordinate parties" within the meaning of IRC §672(c)) were the trustees of the trust. The remainder beneficiaries of the trust are descendants of the taxpayer.

Although deciding other issues, the IRS again held that the receipt and retention of the proposed assets will not be deemed to be an investment which would jeopardize the carrying out of the exempt purposes of the trust, so long as the taxpayer receives no consideration upon the transfer. The IRS specifically stated in the ruling that the taxpayer's investment and subsequent gratuitous transfer to the trust is removed from the scope of IRC §4944 applicability by the above-cited Treasury Regulation Section.48

Interestingly, in all of the above-cited rulings, the jeopardizing nature of the transferred assets (i.e., corporate stock, etc.) was not even at issue, as Regulation §53.4944-1(a)(2)(ii) apparently overrode any need for such an analysis.

In another favorable private letter ruling, the IRS again confirmed the inapplicability of IRC §4944 where a donor gratuitously transfers assets to a charitable lead annuity trust if no consideration is received by the donor.49 The IRS, however, adds the following qualification to that conclusion: The trust does not change the form or terms of such investment. Reg. §53.4944-1(a)(2)(iii) provides in effect that if a private foundation changes the form or terms of an investment (including property gratuitously transferred to a private foundation), the trust will be considered to have entered into a new investment which will be judged at the time of such change as to whether that investment carries out the organization's exempt purposes. Thus, a change in the form or terms of an investment triggers a reapplication of the jeopardy investment standard.

Application of Regulation §53.4944-1(a)

Such Regulation Section states the general trustee standard to be applied in determining when an investment is a "jeopardy investment" under IRC §4944, as follows: When the foundation managers, in making such investment, have failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investments, in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes.

This standard as established in the legislative history has been described as a "prudent trustee" approach.50

As provided in Regulation §53.4944-1(a), the managers may, in the exercise of the requisite standard of care and prudence, take into account the expected return (including both the income and appreciation of capital), the risks of rising and falling price levels, and the need for diversification within the investment portfolio (for example, with respect to type of security, type of industry, maturity of company, degree of risk and potential for return). In addition, the determination whether the investment of a particular amount jeopardizes the carrying out of the exempt purposes of the foundation shall be made on an investment by investment basis, in each case taking into account the foundation's portfolio as a whole.

Such Regulation Section also provides that no category of investments shall be treated as a per se violation of IRC §4944. However, this Regulation does cite certain investments that will be closely scrutinized. These include trading on margin, trading in commodity futures, investments in working interests in oil and gas wells, purchase of puts, calls and straddles, purchase of warrants, and selling short.

The determination whether the investment of any amount jeopardizes the carrying out of a foundation's exempt purposes is to be made as of the time that the foundation makes the investment and not subsequently on the basis of hindsight. Therefore, once it has been ascertained that an investment does not jeopardize the carrying out of such purposes, the investment shall never be considered to jeopardize the carrying out of such purposes, even though as a result of such investment, the foundation subsequently realizes a loss.51

Application of the Jeopardy Investment Standard

The "prudent trustee" standard has been applied in several IRS rulings. For instance, in GCM 39537, the IRS held that the foundation manager failed to meet the prudent trustee standard, where the foundation borrowed a large sum of money and invested 75% of its assets to purchase an interest in a corporation whose stock was publicly traded but not of blue chip quality.

In Ltr. Rul. 8711001, certain loans, which were made at below-market rates for a lengthy period of time and were inadequately secured, were found to be jeopardy investments. In TAM 9132005, the IRS held that the purchase of a bingo hall in order to raise funds for a private foundation's charitable purpose was not a jeopardizing investment. Although the effort to raise the funds was unsuccessful, there was no evidence that the organization failed to exercise business care and prudence in purchasing the hall.

In Ltr. Rul. 8718006, the investment by a private foundation in gold mining stocks did not constitute a jeopardy investment, nor did it jeopardize the carrying out of its exempt purposes, as such purchase was consistent with its policy of investing as a hedge against inflation. In Ltr. Rul. 9205001, a private foundation that exchanged its sole asset - common stock in a corporation - for preferred stock in another corporation made a jeopardy investment. The trustees did not exercise ordinary business care and prudence when they entered into the investment. The investment did not allow for diversification of the foundation's assets. Also, there was no reasonable expectation of return from the investment considering the risk involved in the particular industry in which the investment was made.

In Rev. Rul. 80-133, a whole life insurance policy was contributed to a foundation but was subject to a policy loan to the donor-insured. The foundation made annual premium payments but the life expectancy of the donor was 10 years and in 8 years the full value of the investment would be greater than the life insurance proceeds. The IRS held that each payment was a jeopardy investment. However, in Ltr. Rul. 8134114, the IRS held that a life insurance policy was not a jeopardy investment where there is no outstanding loan, the donor surrenders all incidents of ownership and the donor pays the premiums, since the policy was gratuitously transferred to the foundation.52

And finally, in Rev. Rul. 74-316, the IRS determined that the use of a proposed investment procedure by a foundation would not preclude the imposition of IRC §4944, because such an approach would preclude the analysis on an investment by investment basis and eviscerate the prudent trustee approach.

The jeopardizing investment rules do not apply to charitable remainder trusts unless the trust includes a section 170(c) charitable organization as an income recipient.53

For a detail discussion of the application of the jeopardizing investment rules to charitable lead trusts, see Charitable Lead Trusts - Private Foundation Excise Tax Rules.

Intermediate Sanctions

A transaction with a public charity may result in private inurement or private benefit if a donor or some other private person is deemed to receive some benefit from the transaction. Prior to the enactment of the intermediate sanctions, the only penalty that the Service could impose on a public charity in such cases was revocation of the charity's exemption from federal income taxation. IRC §4958 was added to the Code when President Clinton signed the Taxpayer Bill of Rights 2 into law in August of 1996. This new provision imposes penalty excise taxes as an intermediate sanction in cases where, among other things, a IRC §501(c)(3) public charity engages in an excess benefit transaction with a disqualified person. In simple terms, an excess benefit transaction is one where a disqualified person engages in a non fair-market-value transaction with a charity. A "disqualified person" means any individual who is in a position to exercise substantial influence over the affairs of the organization, whether by virtue of being an organization manager or otherwise. If an excess benefit transaction occurs, IRC §4958 imposes a two-tiered approach to punish disqualified persons: A 25% tax followed by a 200% tax if the excess benefit situation is not corrected. Organization managers of a charity who knowingly participate in an excess benefit transaction can be liable for a 10% tax.

Imputation of Gain

There are many cases and IRS rulings that involve the imputation of gain to the donor on the sale of an appreciated asset by a donee. However, there are several overriding principles and cases that must be discussed in this regard.

In Palmer 54, the court held that the gain on the sale of the stock of a closely-held company by a charity would not be imputed back to the donor on the corporate redemption of the stock. In Palmer, the donor controlled both the company and the charity. The court found that, in light of the presence of an actual, valid gift and because the foundation was not a sham, the gift of stock was not a gift of the proceeds of redemption.

The taxpayer in Palmer donated appreciated stock in a corporation to a charitable foundation. The taxpayer owned voting control of the corporation and exercised de facto control over the charitable foundation. One day after the gift, the corporation redeemed its stock that was owned by the charitable foundation.

The IRS argued the step transaction and the assignment of income doctrines, both well established in the tax law. The step transaction doctrine would disregard the gift and treat it as an intermediary step of a single, integrated transaction, which would cause a taxable gain to the shareholder on the corporate redemption. The IRS further contended that, if the gift was not disregarded, the taxpayer assigned the income from the redemption transaction to the charity, which would cause the taxpayer to recognize the income on the proceeds from the redemption.

The Tax Court cited from Humacid Co. , 42 T.C. 894, 913 (1964), that "The law with respect to gifts of appreciated property is well established. A gift of appreciated property does not result in income to the donor so long as he gives the property away absolutely and parts with title thereto before the property gives rise to income by way of a sale..."

The Tax Court found these doctrines inapplicable in this case. In citing the law relating to the assignment of income doctrine, the Court stated that, if the putative assignor performs services, retains the property or retains the control over the use and enjoyment of the income, the liability for the tax remains on his shoulders. "However, if the entire interest in the property is transferred and the assignor retains no incidence of either direct or indirect control, then the tax on the income rests on the assignee."

The Tax Court cited seven cases in which similar attacks were rejected by the courts where a gift of stock was followed by its redemption and concluded that the only question was whether he really made a gift, thereby transferring ownership of the stock prior to the redemption. The Tax Court found that "...the presence of an actual gift [to the charitable foundation] and the absence of an obligation to have the stock redeemed have been sufficient to give such gifts independent significance."

The IRS argued that the taxpayer's control of the foundation precluded the court from ignoring the interrelated nature of the gift/redemption. But the Tax Court noted that Iowa law required the taxpayer to exercise his control as an officer and director of the foundation in a fiduciary capacity. Further, the Tax Court stated that there was nothing in the record to indicate that the taxpayer exercised command over the use and enjoyment of the foundation property in violation of his fiduciary duty.

The IRS additionally argued that the redemption was anticipated. The Tax Court ended the matter and held that "expectation is not enough."55 At the time of the gift, "...the redemption had not proceeded far enough along for us to conclude that the foundation was powerless to reverse the plans of the petitioner [the taxpayer]. In light of the presence of an actual, valid gift and because the foundation was not a sham, we hold that the gift of stock was not in substance a gift of the proceeds of redemption."

The IRS acquiesced to the decision in Palmer and in Rev. Rul. 78-197 stated that the Tax Court was correct. In this ruling, the Service specifically acknowledged that the taxpayer in Palmer had voting control of both the corporation and a tax-exempt private foundation. Further, the Service stated that the gift, followed by the redemption, was "[p]ursuant to a single plan." Nonetheless, the ruling concluded:

"The Service will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donor only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption."

Subsequent to Palmer, the court in Blake 56 held that the mere prearrangement of the sale caused an imputation of gain to the donor. Many in the planned giving community believe that this case is a good example of the maxim, "bad facts make bad law." In Blake, the donor transferred $700,000 of marketable securities to a charity "to purchase the yacht AMERICA." The charity accepted the gift and sold the stock. The charity then purchased from the donor the yacht for $675,000, in a so-called "quid pro quo" transaction. However, the charity sold the yacht three to four months thereafter for only $200,000.

On the basis of the Tax Court's factual findings, the Second Circuit had little trouble concluding that Blake had expected the charity to purchase his vessel and that he had an enforceable cause of action under promissory estoppel theory, as a matter of law, if the charity refused.

The court treated the transaction as a "unitary one," where the appreciated stock was used for the purpose of purchasing another asset of the donor. Thus, the donor was taxable on the sale by the charity of the $700,000 of marketable securities.

Despite the apparent inconsistencies between Palmer, Rev. Rul. 78-197 and Blake, there are logical interpretations of these and other relevant cases and rulings. After an extensive review of the law in the area, these inconsistencies are more perceived than real. Blake dealt solely with a situation in which there was a gift of an appreciated asset to charity, so that the charity in turn could purchase an asset from the donor. In effect, there was a quid pro quo being required by the donor, in order for the donor to make such a substantial gift. Even the donor admitted this.

In fact, viewed in its entirety, Blake involved a taxpayer who got a charitable deduction of $675,000 for a boat which was really worth $200,000 to $250,000 as evidenced by the sales price three to four months later. If a situation does not involve a quid pro quo, or if it does not involve a scheme to obtain an inflated tax deduction, arguably the result would be the same as in Palmer and Rev. Rul. 78-197, namely that the obligation must be legally enforceable to tax the gain to the donor.

In the case of Greene 57, the taxpayer contributed futures contracts to an IRC §501(c)(3) private operating foundation which he founded in the early 1970s. In 1974, the taxpayer obtained a private letter ruling from the Service to the effect he would be entitled to a charitable income tax deduction equal to the fair market value of the contracts on the date of gift, and that no gain would be recognized to him when the charity sold the futures contracts.

In 1981, IRC §1256 was amended to provide that 60% of such gain on futures contracts would be long-term capital gain, and the balance would be treated as short-term capital gain. In 1982 Greene donated the 60% long-term capital gain portion to the charity, taking a full deduction.

In the lower court proceeding, the IRS contested the deduction, arguing that the 1974 ruling was inapplicable on its facts, since the law had changed. Accordingly, the Service contended (i) the gift of the 60% long-term capital gain portion was an assignment of income, and (ii) the step-transaction doctrine applied to collapse the transactions (a gift and then a sale) into one step.

As to the assignment of income doctrine, the lower court ignored Greene's relationship to the charity as a director and officer, commenting that this fact alone did not cause Greene to be taxed on the long-term capital gain portion. Further, the lower court felt the "[r]easonable probability of gains existing from a property's sale is not enough alone to make a gift an anticipatory assignment of income." In fact, the lower court stated the Service should have expected, when it issued its 1974 ruling, that donated futures contracts "would be sold almost immediately to insure that the value of such volatile securities would be realized and thus useful to the recipient [the charity]." Finally, from a factual standpoint, the court found that Greene retained no control over the timing of the sales of the futures contracts.

As to the step-transaction doctrine, Greene argued that the critical question was whether the futures contracts were donated with no strings attached or prearrangement made. The Service argued Blake, namely that:

"If, by means of restrictions on a gift to a charitable donee, either explicitly formulated or implied or understood, the donor so restricts the discretion of the donee that all that remains to be done is to carry out the donor's prearranged plan for disposition of the stock, the donor has effectively realized the gain inherent in the appreciated property." Blake v. Commissioner, supra.

On appeal in Greene, the Second Circuit explicitly enunciated two tests that the Service and the courts use to apply the step-transaction doctrine, and implicitly referenced a third test:

  1. The End Result Test - a series of separate transactions will be collapsed if they are really parts of a single transaction intended from the outset to achieve an ultimate result.58
  2. The Mutual Independence Test - a series of separate transactions will be collapsed if they are so interdependent that the legal relations created by one transaction would be fruitless without completion of the series.59
  3. The Binding Commitment Test - a series of separate transactions will be collapsed if there is a legal obligation, after the first step, for other steps to occur.

The Second Circuit held that the "end result" test did not apply, because there was no prearranged agreement to sell the property, although it was highly likely that such would occur. As to the mutual independence test, the Second Circuit likewise held this concept inapplicable:

"Moreover, this case is distinguishable from those in which the interdependence test has been met. For example, in Blake, a taxpayer donated appreciated stock to a charity with an understanding that the charity would liquidate the stock and purchase the taxpayer's yacht.60 We applied the step transaction doctrine to disregard the initial gift of the stock, and treated the transaction as a gift of the yacht.61 Here, in contrast, taxpayers made a substantial gift to the Institute and received nothing in return. They retained a right to a portion of the income from the contracts, but giving a partial gift is quite different from giving away something with an understanding that the donee will later buy something back from the donor with the proceeds of the donated gift. There was no understanding that the Institute would handle the contracts or the donated portion of the proceeds from sale in any way that would benefit the Greenes. In fact, they were not benefitted by the charity."

The last case which needs to be examined is Ferguson 62, in which three individuals donated appreciated stock to charitable organizations immediately before the corporation was sold to another corporation in a tender offer. The Tax Court had held that the taxpayers were taxable on the gain in the stock transferred under the anticipatory assignment of income doctrine.

Factually, the taxpayers and their children owned stock of American Health Companies Inc. ("AHC"). In July of 1988, AHC entered into a merger agreement with two acquiring corporations ("X"). Under the agreement, X was to purchase AHC's stock in a tender offer and then merge into AHC.

On August 3rd, AHC's board voted on the tender offer made by X. The taxpayers abstained from voting, as board members, on the tender offer; nonetheless, the offer was approved.

Between August 15th and 21st, the taxpayers executed "donation-in-kind" records stating their collective intention to donate 61,111 shares of AHC stock to charities. The taxpayers' stockbroker ("Broker") helped the taxpayers create separate accounts for ALL of their respective stockholdings. On August 26, the charitable foundations were formed.

As of August 30th, more than 50% of AHC's outstanding shares had been tendered or guaranteed. On September 8th, the Broker transferred the shares to the newly formed charities, at which time over 95% of the outstanding shares of AHC stock had been tendered or guaranteed. On September 9, 1988, the merger took place, with AHC stock being traded for X stock.

The IRS determined that the taxpayers were taxable on the gain attributable to the AHC shares that were donated to the charities. The Taxpayers argued, in part, that (i) the gifts had been made on August 15th and 21st, (ii) the charities were not legally obligated to tender their AHC stock, and (iii) the right to the tender offer's proceeds did not mature until October 12th when X's directors adopted a resolution stating the terms of the merger.

The Ninth Circuit stated that the key issue "is whether the Fergusons had completed their contributions of the appreciated AHC stock before it had ripened from an interest in a viable corporation into a fixed right to receive cash." The Ninth Circuit also stated that "to determine whether a right has "ripened" for tax purposes, a court must consider the realities and substance of events to determine whether the receipt of income was practically certain to occur" and that "while a finding of a mere anticipation or expectation of the receipt of income has been deemed insufficient to conclude that a fixed right to income existed, courts also have made it quite clear that the overall determination must not be based on a consideration of mere formalities and remote hypothetical possibilities."

The Ninth Circuit upheld the Tax Court's determination that on August 31, 1988, the first date by which over 50% of the AHC share had been tendered, "it was practically certain that the tender offer and the merger would be completed successfully and that all AHC stock, even untendered stock, either already had been converted into cash (via the tender offer) or imminently would be converted into cash (via the merger)." In addition, the Ninth Circuit stated that the Tax Court, in selecting August 31, 1988 as the relevant date for the ripening of the AHC stock, had considered whether, as of that date, "the surrounding circumstances were sufficient to indicate that the tender offer and the merger would proceed, as if both had to be completed as of or on that date." Accordingly, the Ninth Circuit upheld the Tax Court's decision and adopted the "anticipatory assignment of income" doctrine, which states that "once a right to receive income has "ripened" for tax purposes, the taxpayer who earned or otherwise created that right, will be taxed on any gain realized from it, notwithstanding the fact that the taxpayer has transferred the right before actually receiving the income."

Final Regulations Under Section 337 - Corporate Liquidation

The rules regarding the taxation of corporate liquidations were recently changed. The Regulations now generally provide that under either of two scenarios, a taxable event will be incurred at the corporate level: (a) a taxable corporation transfers all or substantially all of its assets to one or more tax-exempt entities, or (b) a taxable corporation changes its status to a tax-exempt entity.

See Planned Giving Online - Final Regs Under 337(d): More Taxation for Tax-Exempts


  1. Regs. §§25.2512-2(b)(1) and 20.2031-2(b)(1); IRC §2031(b)back

  2. Regs. §§25.2512-3(a) and 20.2031-3; Rev. Rul. 59-60, 1959-1 C.B. 237 modified by Rev. Rul. 65-193, 1965-2 C.B. 370 and amplified by Rev. Rul. 77-287, 1977-2 C.B. 319; Rev. Rul. 80-213, 1980-2 C.B. 101 and Rev. Rul. 83-120, 1983-2 C.B. 170back

  3. Rev. Rul. 77-287, 1977-2 C.B. 319back

  4. Reg. §§20.2031-3 and 25.2512-3(a)back

  5. Reg. §§20.2031-3(c) and 25.2512-3(a)(3)back

  6. Reg. §§20.2031-3 and 25.2512-3(a)back

  7. Reg. §§20.2031-3(c) and 25.2512-3(a)(3)back

  8. Reg. §1.664-1(a)(7)(i) (the qualified appraiser rules are the same as those in the substantiation rules that exist for charitable income tax deduction purposes).back

  9. Reg. §1.664-1(a)(7)(iii)back

  10. Reg. §1.664-1(a)(7)(ii)back

  11. The use of an independent trustee for such valuations was a requirement that many commentators had assumed existed based on the legislative history to IRC §664.back

  12. IRC §§511-514back

  13. IRC §§4943(b) and (d)(2)back

  14. IRC §§4943(a)(1) and (2)back

  15. Reg. §53.4943-3back

  16. Reg. §53.4943-7(d)back

  17. IRC §4943(c)(6)back

  18. Reg. §53.4943-6(c)back

  19. IRC §4943(c)(2)(B)back

  20. Rev. Rul. 81-111, 1981-1 C.B. 509back

  21. IRC §4943(d)(3)(B)back

  22. IRC §4943(d)(3)back

  23. Ltr. Rul. 9211067back

  24. IRC §4943(c)(7)back

  25. IRC §4943(c)(2)(C)back

  26. Reg. §53.4943-2(a)(1)(ii)back

  27. Reg. §53.4943-2(a)(1)(iii)back

  28. IRC §4947(b)(3)back

  29. Also See, IRC §6684 for a possible "third-tier" tax where the private foundation or manager had been liable for the IRC §4944 tax in a prior year and became liable for the same tax in a subsequent year or where the act or failure to act giving rise to the excise tax is both willful and flagrant; this tax would equally apply to a IRC §4943 tax.back

  30. Reg. §53.4944-1(a)back

  31. Bittker & Lokken, Federal Taxation of Income Estates and Gifts, Second Edition, 1993, 101.7.3, p.101-111back

  32. See, Chiechi and Maloy, 338-3rd T.M., Private Foundations - Section 4940 and Section 4944, p. A-17back

  33. Ibidback

  34. Ibidback

  35. See also Ltr. Rul. 9320052 in which the IRS again held the receipt and retention of oil and gas interests by a testamentary charitable lead annuity trust qualified for the exception in Reg. §53.4944-1(a)(2)(ii), and thus, a tax under IRC §4944 was not imposed.back

  36. Ltr. Rul. 8135040back

  37. See, S. Rep. No. 91-552, 91st Cong., 1st Sess. 46 (1969), 1969-3 C.B. 423, 453, and reaffirmed as such by the IRS in Rev. Rul. 74-316, 1974-2 C.B. 389.back

  38. Reg. §53.4944-1(a)(2)back

  39. Rev. Rul. 80-133, 1980-1 C.B. 19back

  40. IRC §4947(b)(3)back

  41. See also Ltr. Rul. 8909037back

  42. Rev. Rul. 74-316, 1974-2 C.B. 389back

  43. IRC §4946(a)(1)back

  44. IRC §4941(d)back

  45. Any person who (i) contributed or bequeathed an aggregate amount of more than $5,000 to the private foundation, if such amount is more than 2 percent of the total contributions and bequests received by the foundation during the taxable year, or (ii) in the case of a trust, the creator of the trust. IRC §507(d)(2)back

  46. An officer, director, or trustee of a private foundation (or an individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation). IRC §4946(b)back

  47. Includes spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. IRC §4946(d)back

  48. IRC §4941(a)(1)back

  49. IRC §4941(b)(1)back

  50. IRC §§4941(a)(1) and 4941(b)(1)back

  51. IRC §4941(a)(2)back

  52. IRC §4941(b)(2)back

  53. IRC §4941(a)(2)back

  54. IRC §4941(b)(2)back

  55. IRC §4941(c)(2)back

  56. Palmer v. Commissioner, 62 T.C. 684 (1974)back

  57. Hudspeth v. United States [73-1 USTC 9136], 471 F.2d 275 (8th Cir. 1972). See also, W. B. Rushing, 52 T.C. 888 (1969), aff'd [71-1 USTC 9339] 441 F.2d 593 (5th Cir. 1971)back

  58. Blake v. Commissioner, 697 F.2d 473 (2d Cir. 1982), aff'g 42 TCM 1336 (1981)back

  59. Greene v. United States, 13 F.3d 577 (1994), aff'g 806 F.Supp. 1165 (1992)back

  60. Penrod v. Commissioner, 88 T.C. 1415, 1429 (1987). See also, Stephen S. Bowen, "The End Result Test," TAXES, Dec., 1994 at p. 722back

  61. American Bantam Car Co. v. Commissioner, 11 T.C. 397, aff'd 177 F. 2d 513 (3d Cir. 1949, cert. denied 339 U.S. 920 (1950))back

  62. Ferguson v. Commissioner, U.S. Court of Appeals, 9th Circuit, 98-70095, 4/7/99, Affirming the Tax Court, 108 TC 24back

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