Corporate Recapitalization Facilitates Charitable Lead Trusts

Corporate Recapitalization Facilitates Charitable Lead Trusts

Article posted in Charitable Lead Trust on 17 March 1999| comments
audience: National Publication | last updated: 18 May 2011

Intrafamily transfers of closely-held family corporations often present a significant challenge for estate planners. Nongrantor charitable lead trusts can mitigate wealth transfer tax costs; however, funding trusts of this type with stock in a closely-held corporation is often problematic because the stock does not produce sufficient dividend income to satisfy the payment obligation of the trust. Furthermore, it may be impractical or impossible for a corporation to increase the dividend for all shares of a particular class of stock in order to facilitate a charitable gift that may comprise only a portion of the total outstanding shares.

Private letter ruling 9819031 (cited in News Alerts on May 11, 1998) offers a creative solution to this challenge. The ruling approved the funding of charitable lead annuity trusts with a specially-issued, higher dividend paying, temporary class of stock in a closely held corporation and held that the issuance of the new class of stock for this purpose was not a taxable dividend.


The corporation in the Ruling was owned by two families. Family Y owned approximately 92% and Family X owned approximately 8% of the outstanding stock. Prior to the proposed transaction, the stock was divided into four classes of common stock, which were non-voting Class B and voting Classes C, D and E. The corporation had redeemed a number of Class B shares over the three years prior to the Ruling request, but the taxpayers represented that there had never been any intent to change the proportionate interests of the shareholders by such redemptions.

The corporation's charter provided that dividends could be paid on only the Class B shares. If dividends were paid on the other Classes, the charter provided that the other Classes were to participate equally. All Classes were to share equally in liquidating distributions. The Ruling notes that there were no dividend arrearages and that none of the stock had conversion rights.

Upon the death of a shareholder, stock purchase agreements provided that a shareholder's estate could require the corporation to purchase the number of shares of the deceased shareholder that could be redeemed under Internal Revenue Code Section 303. The Ruling indicates that the value of the corporation's stock had been increasing for many years and there was concern that the corporation could be required to purchase a large amount of stock at the death of a shareholder.

In addition, the Ruling notes that the corporation had been paying out significant amounts of income to charity and portions of these payments were not currently deductible under Code Section 170. Therefore, the corporation wanted to redirect its charitable giving more effectively via the payment of dividends on corporate stock owned by charitable lead trusts. However, the corporation was concerned about its ability to pay the necessary dividends for the lead trusts if it had to pay dividends on all the outstanding Class B shares.

To solve this problem, the corporation proposed to amend its charter to authorize a one-time issuance of 500,000 shares of a new Class F of non-voting common stock in exchange for shares of Class B stock. The exchange would be based on the respective market value of the shares determined by an independent appraisal firm. The Class F shares would be entitled to dividends at a cumulative fixed rate per year for 15 years and there would be no requirement for the other classes to participate in these dividends. The Class F shares would receive a share of any liquidating distributions as if such Class F shares had been converted into Class B shares.

Any Class F shares issued would have to be placed into a charitable lead trust created by the shareholder that held the exchanged Class B shares. Fifteen years after the initial issuance of the Class F stock, the Class F shares would automatically convert back into Class B shares under the same ratio as used for the original exchange.

Two members of Family Y indicated their plan to exchange Class B shares for Class F shares and to use the Class F shares to fund charitable lead annuity trusts with 15-year terms. The trust instruments would provide that the trustee would pay "a guaranteed annuity in an amount such that the gift tax value of the annuity interest will be less than 60% of the value of the trust assets." Upon termination of the lead interests, the assets remaining in the charitable lead trusts would be distributed to descendants of the trust donors. The trusts were to include a provision specifying that the trustees could not designate as recipients of the charitable lead interests organizations which the donors had interests as officers, directors or employees.

The Ruling noted that the trust instruments gave the donors the ability to appoint successor trustees if a trustee became unable to serve and no successor was otherwise designated. However, no trust donor, no spouse of a donor and no related or subservient party (as defined in Code Section 672(c)) to a donor could be appointed as a co-trustee or successor trustee.

The Ruling lists a number of representations made by the corporation, including (i) that the corporation and shareholders would each pay their own expenses in the transaction; (ii) that none of the shareholders had plans to sell or otherwise dispose of the Class F stock other than the gifts to be made to the charitable lead annuity trusts; (iii) that there would be no outstanding options, warrants, or convertible securities allowing someone to acquire stock in the corporation; (iv) that the transaction proposed in the Ruling was an isolated transaction and "not part of a plan to increase any shareholder's proportionate interest in the assets or earnings and profits" of the corporation; (v) that there was no plan for the corporation to redeem or otherwise acquire any of the Class F stock issued in the transaction; (vi) that the shareholders could not elect to receive cash or other assets or other stock in the transaction; and (vii) that the shareholders would not be able to require the redemption of the Class F stock at their option.

The Internal Revenue Service reviewed the law pertaining to grantor trusts, estate tax inclusion, and gift tax charitable deductions, including the provisions of Code Section 2522 and the regulations thereunder relating to charitable lead trusts and the definition of guaranteed annuity interests. The Service specifically declined to rule about the tax treatment of the transaction under Code Section 368(a)(1)(E), which pertains to recapitalizations, or Code Sections 2701 and 2703, which contain special valuation rules.


The Service reached five conclusions in the Ruling, noting its reliance on the corporation's representations. First, the Service held that the issuance of the Class F stock would not be treated as a taxable corporate distribution under Code Section 301 by the application of Code Sections 305(b) and 305(c) "provided the proposed exchange of Class B stock for Class F stock is not pursuant to a plan to periodically increase a shareholder's proportionate interest in the assets or earnings and profits of the corporation." Second, the Service ruled that the charitable interests under the trust instruments would be guaranteed annuity interests. Third, the Service held that the trusts would be split-interest trusts described in Code Section 4947(a)(2). Fourth, the Service concluded that the income of the trusts would not be taxable to the donors under the grantor trust rules, and finally, the Service held that no portion of the trusts would be includible in the donors' estates.


This Ruling highlights the implementation of sophisticated charitable gift planning in order to meet the needs of the particular taxpayers involved. For instance, the taxpayers were concerned about business succession issues, as well as charitable income tax deduction issues. Because the value of the corporate stock has been continually rising, the taxpayers were concerned that funding the death buy-out of a particular shareholder may damage the cash flow of the corporation. In addition, the corporation was making charitable contributions; however, it was not entitled to fully utilize the income tax deductions.

The corporate recapitalization (i.e., the creation of the Class F stock) was a necessary first step in the process. The corporation would not be able to pay dividends on all of the Class B stock. Therefore, those shareholders who desired to create a charitable lead trust could do so with a portion of their Class B stock, which is converted into the Class F stock. The Class F stock could then be contributed to the charitable lead trust with assurances that the payments (dividends from the corporation) would be available to meet the charitable annuity payment requirement.

Several aspects regarding the charitable lead trust are noteworthy. First, the present value of the charitable lead interest is less than 60% of the fair market value of the Class F stock contributed to the trust. Otherwise, the trust would be subject to excess business holdings rules, which may cause the imposition of an excise tax under Code Section 4944. Second, the donor desired to contribute the lead interest to a private foundation (i.e., no reference was made to charities described in Code Section 170(b)(1)(A)). The trust instrument indicated that the donors could not have an interest as an officer, director, or employee of the charity. This was included to guard against a possible inclusion issue under Code Section 2036. In addition, the donors were given the right to remove the trustee of the trust, so long as the donor, the spouse of the donor and no person related to the donor could be appointed as a trustee. Generally, care must be exercised whenever the donor is given the right to remove the trustee, as a person with the right to remove and replace a trustee is deemed to have all of the powers of the trustee.

It is also interesting to note the items that the IRS specifically declined to rule on. First, the IRS would not rule that the corporate recapitalization qualified as a tax-free reorganization under Code Section 368(a)(1)(E). Second, the IRS may not respect the buy-sell provisions in the stock purchase agreements under Code Section 2703 for purposes of valuing the stock. Third, the IRS would not state that the implications of Code Section 2701 on the transaction. Therefore, by not confirming the valuations of the Class F stock, the IRS would not rule on the exact gift tax implications of the transaction.

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