Many entrepreneurs and investors have accumulated substantial net worth through their business and investment holdings. For years, these individuals have focused their efforts and attention to building their business or accumulating wealth. Many times, however, they may have allowed the years to slip by without formulating a successful business exit plan. After taking a small initial investment and building that into something of considerable value, these entrepreneurs and investors tend to have a very low cost basis in their business interest. If it is sold, there will be undesirable tax consequences to the owner.
A business owner may find that adding a charitable component to his or her business exit plan will help achieve many goals. Accordingly, developing the appropriate exit strategy may depend on the type of assets the owner holds as well as the owner's personal objectives and goals for the future of the business. This article will discuss several commonly held business interests, how different charitable solutions could assist the business owner in his or her exit plan and potential pitfalls associated with each scenario.
Parts I and II of this series covered charitable solutions for shares of corporations. This third and final installment of the series will discuss charitable gifts from owners of partnership interests. In contrast to C corporations, partnerships are pass-through entities and, thus, do not pay tax at the entity level. Rather, each partner's share of the partnership's income will be included on the partner's personal income tax return. This is true regardless of whether the income is actually distributed. While businesses in the United States are often organized as C-corps or S-corps, there are many others that started as a simple joint venture between partners, without the formalities of the corporate form.
Charitable Solutions for Partnership Interests and Limited Liability Companies
Limited liability companies (LLCs) have grown in popularity over recent decades. As a relatively new form of business association, an LLC provides the pass-through taxation status of a partnership along with the liability protection afforded to C corporations. The owners of LLC interests, known as members, may elect at the outset whether the LLC will be taxed as a partnership or as a corporation using IRS Form 8832. All LLC discussions in this article will assume that partnership taxation was elected. Information on the tax consequences of charitable gifts of corporate business assets can be found in Parts I and II of this series.
The basic rule for charitable ownership of interests in pass-through entities is that any gain or loss on the sale of a partnership interest will be treated the same as if a capital asset were sold. Sec. 741. The partner or LLC member will be subject to capital gains taxation on the sale of partnership interest just as if he or she had sold appreciated stock or real estate. Under Sec. 751, however, any amount received from the transfer of unrealized receivables or inventory "shall be considered as an amount realized from the sale or exchange of property other than a capital asset." In other words, these so-called "hot assets" will be treated as ordinary income assets, thus the deduction for those assets will be limited to the donor's basis. In addition to Sec. 751 "hot assets," any ordinary income or short-term capital gain assets will reduce the donor's deduction.
An outright gift of a portion of a partnership interest will provide the donor with a charitable income tax deduction. The gift must be a percentage or fraction of the overall ownership interest and not a partial interest gift. In other words, the partner may not donate certain partnership rights but not others; he or she must donate all rights in the partnership attributable to the gifted interest.
As with other capital assets, if the value of the claimed deduction exceeds $5,000 the partner is required to obtain a qualified appraisal in order to substantiate the deduction. Gifts of closely held business interests may be subject to valuation discounts for minority interests and lack of marketability. These discounts have the potential to equal between 20% and 40% of the donated interest.
Alice and her younger sister Susan started a small-town produce stand nearly 50 years ago. At the time, they did not think much about corporate form, as they were young and eager to get their business idea started. Their small produce stand has grown into a mid-sized, locally-sourced grocery store in their town, with a committed customer base. Alice is now ready to retire and wants to sell her partnership interest. When she meets with her advisor, he tells her that selling her partnership interest will result in a hefty tax bill. The partnership interest is a capital asset and is appraised at $500,000. With a federal capital gains tax of 23.8%, Alice could end up with a $119,000 capital gains tax bill. Alice's state capital gains tax is 8%, resulting in an additional $40,000 in state taxes.
Her advisor suggests that she consider selling an undivided percentage of the partnership interest to a third party and make a charitable gift of the remaining portion of her partnership interest so that she can take an income tax deduction. The advisor cautions Alice, however, that there are two factors that may mitigate the benefit she will receive. First, she will not be allowed a charitable income tax deduction for the entire value of the gifted interest, since the store's inventory and unrealized receivables will be considered "hot assets." Second, because she is donating a portion of her partnership interest, the value of her deduction is going to be further diminished by a discount applied by the appraiser.
One option for an exiting partner is a bargain sale of the partnership interest. A bargain sale occurs when the owner of property sells the property to charity below fair market value. The donor will receive cash for the sale price and will also be entitled to a charitable income tax deduction based on the difference between the asset's fair market value and the sale price. It is important to note here that the donor's basis in the asset must be properly allocated between the sale and gift portions of the transaction. Sec. 1011(b). Without this rule, a partner could simply allocate all of his or her basis to the sale portion, bypassing capital gains altogether.
Carlos and Jose started making custom tee shirts for their friends as a side job in college. As they approached graduation, they realized they had a strong business model and decided to open up a shop in town. Now, 10 years later, Carlos is ready to move on to other ventures. After consulting with his attorney and accountant, he negotiates a bargain sale of his $250,000 interest to a charity that plans to quickly resell the partnership interest to Nolan, Jose's brother-in-law. Carlos receives $175,000 in cash from the charity, which represents nearly three-quarters of the value of his partnership interest, as well as a $75,000 charitable income tax deduction. Carlos must allocate 70% of his basis in the partnership to the sale portion. Through this gift, he is able to save taxes with a bypass of a portion of his capital gain along with a charitable income tax deduction.
Additionally, if a partner's transfer of a partnership interest to charity results in a relief of indebtedness to the partner, it is treated as a distribution to the partner. Sec. 752(d). Therefore, if the partner makes an outright charitable donation, and the partnership has any debt, the partner's share of the debt is treated as taxable income to the donor.
Unrelated Business Income
As noted above, income earned by partnerships and LLCs pass through to the entity's owners. If the entity operates an active trade or business, the income from the trade or business maintains its character as active trade or business income in the hands of the partners or LLC members. When a charitable organization has an ownership interest in a partnership or LLC with active trade or business income, that income will be taxable unrelated business income (UBI) to the charity. If a charitable remainder trust (CRT) is a partner or LLC member, an excise tax will apply on all UBI. The tax will be equal to 100% of the UBI. Sec. 664(c)(2)(A).
While UBI rules make the partnership or LLC interests quite undesirable for charities in many circumstances, it may be a feasible gift under the right conditions. If the charity is able to sell the business interest before muchor anyUBI accumulates, the gift may make sense for all parties involved.
Aaron and Bryan own a successful car wash in the Southwest. They never incorporated, instead operating for decades as a partnership. Bryan is now looking to retire and sell his ownership interest in the car wash. He is, however, concerned over the hefty capital gains tax bill he will have to pay if he sells his interest outright. He meets with his attorney, Bob, to discuss the possibility of donating his interest to a charitable remainder trust for the benefit of a local university foundation. Bob advises Bryan that the trustee would only be willing to accept the gift if there is a buyer waiting in the wings. Bryan has informal discussions with Vince, who indicates that he would like to get into the car wash business, but they do not sign a sales contract.
Bryan and Aaron close the car wash for repairs over a holiday weekend. During this time, Bryan places his ownership interest in a CRT. On the following Monday, Vince purchases the partnership interest from the CRT. Because the car wash was closed during the entire time the CRT held the partnership interest, there is probably no UBI for the CRT and thus no excise tax due.
As noted in the previous installment in this series, it is important that a binding obligation to sell the ownership interest does not exist prior to the transfer to charity or the CRT. If there is a binding obligation prior to the charitable transfer, then the donor will not be able to bypass capital gains on the sale of the partnership interest. This can often be accomplished by having a buyer waiting in the wings without any binding obligation in place.
Another creative solution for avoiding UBI when funding a charitable remainder trust with an ownership interest in a pass-through entity is to consider leasing the entity's assets to a third party prior to making a charitable contribution of the ownership interest. With a fixed rent lease in place prior to the charitable gift, all income received by the entity is passive rather than active. Sec. 512(c). This will allow the donor to place the interest in a CRT and avoid UBI.
The business owner must be cautious when finding someone to lease the business' assets. Section 4941 prohibits a CRT from engaging in any self-dealing, whether direct or indirect. This prohibition on self-dealing means that the CRT may not receive lease payments from a disqualified person, as defined under Sec. 4946. This includes any substantial contributor to the CRT, anyone who owns more than 20% of the business, a trustee of the CRT and family members of disqualified persons. The best option is to lease the business interest to an employee who does not fall within the classification of disqualified persons.
Heather and her sister Maria own a small shop selling novelty items. The sisters organized the shop as an LLC 15 years ago. Although the shop has enjoyed great success, they are now ready to move on to other ventures. Heather decides to meet with her advisor, John, to come up with a creative and cost effective way to sell the business and also generate a future stream of income. John recommends that Heather and Maria lease the shop's assets to their valued employee, Michael, and then transfer their LLC membership interests into separate CRTs. Michael is willing and eager to take on the lease of the LLC assets over the short term. Heather and Maria are able to successfully transfer their LLC interests to their own CRTs, generating income for their lives and also avoiding the 100% excise tax on the shop's income. The CRTs then sell the LLC interest to a new buyer.
Regardless of the type of business interest the owner holds, his or her attorney should take the time to examine its articles of incorporation, operating agreement, partnership agreement or other foundational documents. These documents mayunbeknownst to the ownerimpose restrictions on the transfer of an ownership interest. Often, such restrictions may be removed prior to the charitable transfer, but usually require additional legal legwork before the gift can be made.
Business owners preparing to exit their businesses may have any number of reasons for doing so. It is imperative that the professional advisor work with the owner to determine the owner's goals and how best to meet those goals. There are many circumstances in which a charitable gift may be the best way to serve the owner's interest. However, the potential for missteps along the way requires business owners to work with advisors who can guide them to the most effective solution for their circumstances.