CGNA: Chapter 4 - Pass-through Entities, Advanced - Part 1 of 3

CGNA: Chapter 4 - Pass-through Entities, Advanced - Part 1 of 3

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

Below is an in-depth examination on gifts of pass-through entities. Pass-through entity topics are based on Dennis Walsh’s “Navigating the Charitable Transfer of a Partnership Interest: A Primer,” and Jane Wilton and Nicole Spooner’s “Considerations in Making Charitable Gifts of Interests in Pass- Through Entities.” For quick take-aways on gifts of pass-through entities, see Pass-Through Entities Quick Take-Aways. For a review based on the articles, see Pass-Through Entities Intermediate. For an in-depth examination adapted and excerpted from the articles, see Pass-Through Entities Advanced. For further details, see Pass-Through Entities Additional Resources.3

This section addresses the tax considerations for charitable contributions using closely held businesses or alternative investments structured as “pass-through entities.” For the most part, these are limited partnerships or limited liability companies (LLCs) that have not chosen to be taxed at the entity level as Subchapter C corporations, but instead “pass through” each partner or member’s allocable share of net income or gain.4

For an individual holding an interest in a business or investment entity taxed as a partnership, a charitable transfer can create an attractive planning opportunity while providing welcome support to a favored charity. A transfer may take the form of an outright gift, a sale followed by donation of the proceeds, or part gift, part sale as needed to satisfy the charitable, estate, and succession objectives of the donor.

In the case of an interest in an active business, the donors can usually optimize the tax benefit of a charitable donation at a time when the entity is performing at or near its historical high, especially if it is likely to be bought out. A fair market value deduction that captures enterprise value and untaxed appreciation of tangible assets can result in greater tax savings than the contribution of the proceeds of a sale of the business interest or from the liquidation of its underlying assets.

But the transfer of a pass-through interest poses special challenges for both a donor and recipient charity. The parties must exercise great care to avoid inadvertent consequences and attain the desired charitable benefits.

General Rules

The IRS considers gain from the sale or exchange of a pass-through interest to be gain from the sale of a capital asset.5 The contribution of property to a qualifying charity is deductible at fair market value, except for gain that would not be long-term capital gain if the owners sold the property at its fair market value on the date it was contributed.6 However, the IRS generally limits the deduction for long-term capital gain property contributed to a private foundation, other than an operating foundation, to the lesser of fair market value and cost or other basis of the property.

Subchapter K of the Internal Revenue Code (the “Code”)7 contains an extensive set of rules that govern partnership taxation (including entities taxed like partnerships such as LLCs). Under Code Section 702(b), the character of any item of income, gain, loss, deduction, or credit included in a distributive share from entity activities is determined as if such item were realized directly or incurred in the same manner as incurred by the entity.8

It should be noted that most charities will not accept a general partnership interest; the for-profit activity generally is inconsistent with a charitable mission, and may place charitable assets at risk for the liabilities of the partnership. Even the acceptance and disposition of a limited partnership of LLC interest may impose an undue burden on the charity and its staff.

Deduction Considerations

Generally, fair market value of an interest ordinarily will be the difference between the donor’s share of the fair market value of entity assets and his share of liabilities, whether recourse or nonrecourse. This section discusses the various factors affecting the value of the interest.

Undivided Interest—Under the partial interest rules, the IRS only allows a charitable deduction if the donor of a pass-through interest gives his or her entire interest in the property or an undivided portion of that entire interest to charity. A gift of an undivided portion of an interest must include a pro rata share of all attributes of the interest in the entity, such as capital, allocation of income and expense, and distributions.

Relief of Debt—If the transfer of an interest results in a donor being relieved of any debt, it is treated as an amount realized. While the relief of debt does not provide any immediate consideration to a donor, the elimination of a liability improves the donor’s economic position. In addition, if the debt was part of the donor’s at-risk amount, he or she has either received an equivalent tax benefit from past entity deductions or will receive an offsetting deduction of such remaining basis allocable to a sale.9

Recognition of Loss—Before application of the passive loss limits (discussed below), the IRS initially limits recognition of any item of loss or deduction to the donor’s adjusted basis and then to the amount at risk. These amounts may be different if the nature of the entity, nonrecourse debt (other than qualified nonrecourse debt), or a loss-limiting agreement act to limit personal liability.

Hot Assets—Another important consideration in evaluating a gift or sale is an exception to the Section 741 rule that gain recognized on a partnership or LLC interest is gain from the sale of a capital asset. The presence of Section 751 “hot assets” in the entity will affect the donor’s character of gain recognized from a sale as well as the allowable amount of a charitable contribution of the interest.

Hot assets include unrealized receivables, inventory items that have appreciated to a fair market value exceeding 120 percent of their inside basis, and Section 1245/Section 1250 property to the extent of depreciation recapture. Gain realized from a transfer of such property treated as a sale is ordinary income. The donor reduces the amount of a charitable contribution deduction by the amount of any ordinary income that he/she would realize if the property had been sold at fair market value on the date contributed.

Passive Losses—Donors who have not at all times materially participated in any trade or business activities of the entity should calculate unrecognized losses with respect to such activities as a result of the passive loss limitations of Section 469. If passive losses are present, the tax benefit will be forfeited to the extent allocable to a gift.10 Instead, the donee organization must add suspended losses allocable to a gift to its carryover basis.

Bargain Sale

Assuming that there is no receipt of cash or other consideration, and that there is not relief of any amount of partnership debt, the donor would not realize any amount from the donation. But when the donor receives consideration from the donee organization and the total amount realized is less than the fair market value of the interest, the IRS classifies the transfer as a bargain sale.

In such case, the transaction is a partial gift and a partial sale. The donor subtracts the total amount realized from the fair market value of the interest, and the difference is considered a gift.

However, regulations prohibit a sale between a private foundation and a “disqualified person,” as defined in Section 4946(a), as an act of self-dealing. Further, they provide that a sale of stock or other securities by a disqualified person to a private founda- tion in a bargain sale is treated as an act of self-dealing regardless of the foundation’s amount paid.111

The bargain sale provisions of Section 1011(b) limit the amount of basis allocated to the portion of the interest sold. The donor must prorate his or her basis in the pass- through interest, along with any suspended passive losses, between the gift and sale portions. The basis for calculating gain must bear the same ratio to the total basis that the amount realized from sale bears to the total fair market value of the interest. Donors may not recognize any loss if the amount realized is less than the basis allocated to the sale portion.12

The donor-seller must separately allocate ordinary income and capital gain realized on a bargain sale to the sale and gift portions as well. The amounts which a seller would realize on a fair market value sale of the entire interest are allocated between the sale and gift portions based on the ratio that the fair market value of the sale and gift portions each bear to the fair market value of the entire interest.13 Examples of the allocation of basis, calculation of recognized gain, and reduction of a charitable contribution as the result of a bargain sale or an ordinary income element are available in Treas. Reg. Section 1.1011-2(c).14

Timing of Charitable Contribution

The limited partnership agreement or, in the case of an LLC, the LLC operating agreement generally governs the admission of a new partner or member. Where the agreement is silent, state law will control. For example, the substitution of a new partner may require consent of both the new partner and the existing partners. Under a typical limited partnership agreement, the contribution of a partnership interest would not be effective until the charity accepts and the general partner consents.

  • 3. This chapter excerpts and adapts Walsh, D. (January 26, 2011), “Navigating the Charitable Transfer of a Partnership Interest: A Primer,” Planned Giving Design Center, http://www.pgdc.com/pgdc/navigating-charitable-transfer-partnership-inte..., and Wilton, J. and Spooner, N. (June 2010), “Considerations in Making Charitable Gifts of Interests in Pass-Through Entities,”The New York Community Trust Professional Notes, http://www.nycommunitytrust.org/ProfessionalAdvisors/ProfessionalTaxEsta...
  • 4. Owners of interests in LLCs are referred to as members.
  • 5. IRC § 741 (2002).
  • 6. IRC § 170(e)(1) (2015); Treas. Reg. § 1.170A-1(c)(1) (2008).
  • 7. All “Code” references are to the Internal Revenue code of 1986, as amended, and all “Treas. Reg. Section” references are to the regulations promulgated thereunder.
  • 8. IRC § 702(b) (2003).
  • 9. IRC § 752(d) (1954).
  • 10. IRC § 469(j) (2014).
  • 11. Treas. Reg. § 53.4941(d)-2(a)(1) (1995).
  • 12. Treas. Reg. § 1.1001-1(e)(1) (2007).
  • 13. Treas. Reg. § 1.170A-4(c)(3) (1994).
  • 14. Treas. Reg. § 1.1011-2(c) (1994).

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