AMERICAN RED CROSS
CINCINNATI AREA CHAPTER
STRATEGY SEMINAR
FOR
PROFESSIONAL ADVISORS
PART I
Cincinnati, Ohio
PHILIP T. TEMPLE, ESQ.
McCarthy
Fingar LLP
White
Plains, New York
1. Changes in Estate
and Gift Taxes.
A. Estate Tax
Applicable Exclusion Amount -- Really a Credit.
(1) The
Economic Growth and Tax Relief Reconciliation Act of 2001 (“2001 Act”) resulted
in major changes in the estate tax laws.
These changes are effective from January 1, 2002 through December 31,
2010, after which the estate tax law reverts back to existing law without
regard to the 2001 Act.
(2) Under the
2001 Act, the estate tax applicable exclusion amount will increase as follows:
$1,000,000 in 2002
$1,500,000 in 2004
$2,000,000 in 2006
$3,500,000 in 2009
(3) The exemption is really a
credit equal to the tax on the applicable exemption amount.
(4) The estate tax is repealed for
persons dying in 2010 and current estate tax law is reinstated for persons
dying in year 2011 and thereafter.
(5) Under the 2001 Act the top
estate tax rate is 50% and is reduced by 1% each year until 2007 when it will
remain at 45% until 2010.
B. Annual Gift
Tax Exclusion.
(1) Gift tax
annual exclusion is now $11,000 per donee (as of 2002), but only for gifts of
present, not future, interest. Indexed
for inflation; rounded down to nearest $1,000.
With gift-splitting, spouses can transfer total of $22,000 (and more)
per donee per year without gift tax (regardless of which spouse’s property is
used to make gift).
(2) Any amounts
paid on behalf of any individual (a) as tuition to educational organization or
(b) as payment for individual's medical care will not be considered a
gift. Exclusion for medical expenses
and tuition in addition to $11,000 annual gift tax exclusion and is permitted
without regard to relationship between donor and donee.
C. Taxable Gifts.
(1)
2001
Act does NOT repeal the gift tax.
(2) The gift
tax applicable exclusion amount increased to $1,000,000 on January 1, 2002 and
is frozen at that level.
(3) Top
gift tax rate decreases with estate tax rate, but in 2010 is reduced to 35%.
(4) Gifts
in trust after 2009 will be treated as completed gifts unless the trust is
treated as wholly owned by the Donor or the Donor's spouse.
AMERICAN RED CROSS
CINCINNATI AREA CHAPTER
PART II
CHARITABLE GIFTS
OF
UNIQUE ASSETS
I. Gifts of Closely Held Corporate
Stock
1. Background
on Corporate Income Taxation.
A. Generally, corporate income is
subject to double taxation. First, the
corporation pays corporate income tax on its net income. Then, the corporate shareholders pay income
tax on receipt of dividends or on distributions of corporate assets when the
corporation terminates. There is some
relief from double taxation for S corporations, as discussed below.
B. Example: Jane Donor created a corporation some years
ago and made a capital contribution of $10,000.00. The closely held corporation has assets worth $200,000 with a tax
basis of only $40,000. Jane believes
that her stock is worth $200,000 - - the value of the corporate assets. However, if the corporation sold those
assets and liquidated, the IRS would collect approximately $81,520 of income
tax and Jane would be left approximately $108,500.
Corporation: Sells
assets worth $200,000
Tax basis 40,000
Taxable gain $160,000
Corporate tax (assuming 34%
tax bracket) 54,400
Proceeds left for shareholder
(Sales proceeds of $200,000 less
$54,400 tax) = $145,600
Shareholder: Liquidating
distribution of net
proceeds $145,600
Less: Jane’s cost basis 10,000
Long-term capital gain $135,600
Capital gains tax (20%) 27,120
Net proceeds to Jane $108,480
C. The result would be the same if the corporation merely distributed its assets to the shareholder because the law requires the corporation to pay income tax as if it had sold its assets and the shareholder is treated as if she had sold her stock.
The tax burden would be even worse
if the distribution of assets were treated as a dividend to the shareholder
because then the corporation still pays income tax as if it had sold the assets
but the shareholder pays ordinary income tax on the value of the assets
received rather than the more beneficial long-term capital gain rate.
D. Clear Conclusion: Keep appreciated assets, such as real
estate, out of a C corporation. The problem
is that the gift planner must deal with that fact because the shareholder/donor
has already placed assets inside the corporation.
E. The corporation itself can
contribute assets to a charity or a charitable remainder trust and avoid the
tax on the assets’ growth if sold by the charity or the trust but, if a trust
is established, the income stream would be paid to the corporation, taxed to
the corporation at its rates and then, when distributed to the shareholders,
would generate regular income tax as a dividend.
2. Gifts of Closely Held Stock.
A. Gift of appreciated publicly traded
stock to charity - - whether a public charity or a private foundation - - will
still generate a double tax benefit: A
charitable contribution deduction based on the fair market value of the stock
with no realization of capital gain income.
B. However, the benefits obtained on a
gift of closely held corporate stock will depend upon the charitable donee:
(1) If the gift is to a public charity, the deduction is still at fair market value with no realization of capital gain income;
(2) If the gift is to a private foundation, the deduction is
for cost basis only;
(3) There are also higher ceiling limitations for gifts to a
public charity than to a private foundation, as follows:
Cash or Long Term
Kind of Charity Ord.
Inc. Prop. Cap. Gain Prop.
Public
Charity 50%
of AGI 30% of
AGI
Private
Non-Operating
Foundation 30% of AGI 20% of AGI
Private
Operating Foundation 50% of AGI 30% of AGI
A five
year carryover for any “excess” contribution is allowed in each case.
C. Qualified appraisal required. See below for discussion of valuation and substantiation rules.
3. Life Income Arrangements.
A. If publicly traded securities are transferred to, for example, a charitable remainder trust, the results are clear and there are ordinarily no problems with a deduction for the remainder value calculated on the full fair market with no imputing of the gain to the donor and generating an income stream which will generally increase the donor’s income.
B. Using closely held C corporation stock. Example: John and Jane Donor, both age 65, are about to sell their corporate business for $10,000,000 that they started many years ago and which has basically a zero cost basis. Before the sale is a binding obligation, they transfer $1,000,000 of that stock to a charitable remainder unitrust at 7% retaining the income stream jointly and for the survivor of them. The below chart shows that, by avoiding capital gains tax, they receive an income stream of $70,000 rather than $56,000, an increase of 25%. And, they have generated an income tax charitable contribution deduction of approximately 25% of the value of their gift or $250,000 which is money in their pockets and which can be used for themselves or their heirs.
Sell the Stock Transfer Stock to
Personally CRUT Which Sells
Sales Price $1,000,000 $1,000,000
Cost Basis
0 0
Capital Gain $1,000,000 $1,000,000
Tax (20%) 200,000 0
Net Proceeds $ 800,000 $1,000,000
Invest at 7%
Annual Income $ 56,000 $ 70,000
A wealth replacement life insurance policy coupled, where appropriate, with an irrevocable life insurance trust will even more significantly increase the ultimate benefit to their heirs.
C. Often, a gift followed by a redemption by the corporation will achieve
the same results. And, in corporations
that have concern regarding the accumulated earnings tax, a charitable gift of
stock in that corporation followed by a redemption can result in the
corporation having less undistributed cash; therefore, it is less likely
subject to the accumulated earnings tax and, of course, there are the other tax
benefits already discussed.
D. Be careful in arranging the
corporate redemption.
(1) Avoid imposition of the self-dealing rules; generally, it would appear that the
corporation is itself a disqualified person that would not be able to purchase
the stock from the trust. However, Code
Section 4941(d)(2)(f) provides an exception to the self-dealing rules where the
corporation makes an offer on the same terms to all shareholders of the same
class and the terms of the offer provide for receipt of no less than fair
market value. Must be all cash deal.
E. Beware of the pre-arranged sale.
(1) The threshold case:
Palmer v. Commissioner, 62 T.C.684(1974), Aff’d on another issue,
523 F.2d 1308(8 Cir. 1975).
(a) Donor had voting control of both a closely held corporation and a tax-exempt private foundation. Pursuant to what appeared to be a single plan, donor contributed shares of corporation’s stock to foundation and then caused the corporation to redeem the stock from the foundation.
(b) IRS
wanted to impute gain to Palmer.
(c) Tax Court, affirmed by the Appeals Court, held that
transfer of stock to foundation was valid gift and gain not taxed to Palmer on
the following grounds:
(i) Foundation was not bound to go through with redemption at
the time it received title to the shares, and
(ii) Corporation’s right to redeem is based upon a purchase at
fair market value.
(d) IRS has acquiesced in Palmer. Rev. Rul., 78-197, 1978-1 CB 83. Redemption proceeds of stock under facts
similar to those of Palmer will impute gain to the donor only if the donee is
legally bound or can be compelled by the corporation to surrender the shares
for redemption.
(2) However, see Blake v. Commissioner, 697, F2d. 473
(2d Cir. 1982). A “chutzpah” case.
II. S Corporation Stock
1. Background:
Generally, S corporation does not pay income tax. It is a pass through entity (like a
partnership) and corporation’s income is taxed directly to shareholders. This avoids double taxation of income that
often occurs with C corporations.
2. Charity can now be eligible S corporation
shareholder. Code Section 1361(c)(6),
effective January 1, 1998.
A. Charitable deduction is often less
than full fair market value of stock because of reduction rule of Code Section
170(e), which requires that the income tax
deduction for a gift of appreciated long-term
capital gain property is generally reduced by the amount of “ordinary income”
that the donor would have realized had he sold the property. With an S corporation, often Code Section
751 rules regarding certain assets such as (1) “unrealized receivables,” (2)
“inventory,” (3) “depreciation recapture,” may have impact on deductible
amount.
B. Watch out for phantom income.
C. Charity will be subject to unrelated business income tax
(UBIT) on its portion of S corporation’s accounting income. Also, unlike almost every other capital gain
asset, the gain from the sale of S corporation stock by the charity will also
be subject to UBIT. Code Section
512(e)(1)(B)(ii).
3. But, the above rule does not apply to a transfer that is
not an outright transfer to charity, such as a transfer to a charitable
remainder trust. Such a transfer will
still automatically terminate the S corporation election. Often, that can have adverse tax
implications to the donor who contributes such stock.
4. A way out: S
corporation creates the charitable remainder trust.
A. S
corporation transfers appreciated assets to the CRT; corporation gets
the income tax charitable deduction; passes
deduction through to its shareholders; problem - - deduction that can be
claimed by the shareholder is limited to his or her basis in the S corporation
stock which is generally minimal.
B. But
the charitable remainder trust can sell and invest the appreciated assets
without capital gains tax and reinvest the full sales proceeds to generate the
income stream.
C. Trust term can only be for term of years - - not to
exceed 20.
D. Potential
problems where there are multiple shareholders of the S corporation with
different agendas.
III. Family Limited Partnerships - - The Charitable FLP
1. Background:
Family limited partnership generally used in estate planning to manage
the family wealth and create discounts for marketable securities and
other assets where discounts are not generally allowable.
A. Husband and wife, for example, create limited partnership; retain general partnership interests so that they maintain control, as well as limited partnership interests.
B. Make gifts to, say, children of limited partnership
interest; take deep discounts for lack of marketability and minority interest.
C. Internal Revenue Service getting more aggressive in
fighting deep discounts of, say, 50%; but the planning still works if taxpayer
is not too greedy.
D. Discounts
can also apply for estate tax purposes reducing the value of the estate. But, be aware, IRS using Code Section 2036
to keep value of stock in
estate.
2. Charitable FLP: too good to be true? IRS has taken hard look. See Wall Street Journal article of July 13, 1999; Chronicle of Philanthropy article of July 15, 1999.
A. The mechanics.
(1) John Donor creates family limited partnership comprised of general partnership interest and one or more levels of limited partnership interests.
(2) He puts business and other appreciated assets and cash
into FLP.
(3) As general partner, donor retains a management fee for
operating the partnership. The fee
generally ranges from 3% to 10% of partnership income. This enables donor to keep all or almost all
of the firm’s cash flow or, perhaps, trickle out token amount to limited
partners at discretion of donor as general partner. General partner also retains the right to borrow partnership
assets for personal needs at competitive interest rates.
(4) Donor makes gift of, say, 97% of limited partnership interest to charity. This generates large income tax charitable deduction.
(a) Even when majority of all the limited partnership interests are conveyed to charity, those interests carry limited, if any, control and, often, no marketability, and must, therefore, be discounted considerably for valuation of the charitable deduction.
(b) Charitable gift is made, but subject to a “put” enabling
the charity to force a buyback of the limited partnership interests - -
typically, at significant discount from their value when received by charity.
(5) Donor makes a simultaneous gift of remaining 3% of limited partnership units to children and/or grandchildren. Gift tax valuation of those interests also takes into account lack of control and marketability and so a relatively large valuation discount for gift tax purposes is also taken.
(6) As part of transaction, partnership purchases life
insurance on donor’s life to fund the later buyout. The partnership itself splits the premium dollars with an
irrevocable trust representing the interests of its beneficiaries, the limited
partners of the 3% interest. Therefore,
indirectly, since charity holds 97% of the limited partnership interests,
charity is paying most of the insurance premiums. In one variation on this theme, charity, through its “put,” can
sell its interest to the irrevocable life insurance trust. Thus, charity’s dollars have been helping to
fund life insurance that will be used to buyout its interest - - at a
substantial discount - - and the trust then receives the partnership interests
with a stepped up basis benefiting the family members.
Further, if there is sale of partnership assets during donor’s life and before charity exercises its right to demand a purchase of its interest, approximately 97% of the gain on sale is attributable to the charitable partner. Thus, donor’s family pays tax on only the 3% balance, a small fraction of the gain.
(7) At the specified “put” date, charity exercises its option
to force the purchase - - at pennies on the dollar - - of the limited
partnership interest charity holds. It
receives cash in return for the interest, which has been sold back, either to
the partnership itself or to the 3% owners or to the irrevocable life insurance
trust. Thus, the family business and
other holdings of the limited partnership (together with any appreciation on
the relatively untaxed capital gains sheltered by the charity’s exempt status)
comes back into the family’s control.
B. So, where’s the gift? Donor and his advisors try to convince charity that it will make some money on the transaction in return for allowing the donor and his family to receive tremendous benefits from the transaction. They receive a disproportionate benefit and facilitate their personal estate planning objectives. Remember Blake? This may be another classic example of using charity to serve a private rather than public purpose.
C. The IRS’ likely position.
(1) The agreement of the parties from the beginning was based
on an unwritten - - but very real - - understanding between the donor and
charity that, after a relatively short period of time, charity will sell its
interest back to the partnership or the other partners and receive only a small
portion of what the underlying assets and, therefore, the charity’s limited
partnership interest, is worth.
(a) IRS could argue that what charity received at the time of contribution was only the sum of the future right to receive the “put” price and the present value of minimal income distributions for, say, five years.
(b) More likely, IRS will argue that there is no allowable income or gift tax deduction because the reality is that what the donor gave was a possible but uncertain stream of dollars over a period of years.
(2) The donor and his advisors would likely argue that the “put” is merely an option and that there was never a legal obligation on the charity to sell. Therefore, the contribution of the 97% interest in the limited partnership must be respected. However, in the more egregious and aggressive cases, would the transaction ever have been entered into had the parties not “known” from the beginning that the charity would have no practical choice but to exercise its “put.”
D. Does it ever work? Yes, if there is donative intent, the family limited partnership is entered into to achieve other family planning objectives and there is not the overreaching present in the type of “charitable” family partnership described above.
IV. Stock Options; Restricted Stock
1. Stock Options - - Definition: A contractual right given by a corporation
to an employee (and sometimes, to an independent contractor) to purchase stock
in the corporation at a stated price per share for a stated period of time. There are two basic types of options.
A. Nonstatutory (“Nonqualified”) Options (IRC §83).
(1) Generally, this type of option is not taxable to an employee when granted, unless the option has a readily ascertainable value (i.e., it is actually
traded on an established securities market), at the time of grant.
(2) Compensation is realized when the option is exercised or “otherwise disposed of.” Compensation is equal to the difference between the fair market value of the stock at the time of exercise and the exercise price.
(3) An employee may choose to recognize compensation income
on grant by making an IRC '83(b) election.
Seldom done because of difficulty in ascertaining value of options. No income will then be realized on
subsequent exercise.
B. Statutory
Options
(1) Includes incentive stock options (“ISOs”), employee stock
purchase plans, qualified stock options and restricted stock options.
(2) General
Tax Treatment:
(a) The employee does not recognize
taxable compensation income at the time the option is granted or at the time
the option is exercised. For AMT
purposes, the difference between the fair market value and the exercise price
will be considered part of AMT income
(unless exercised more than three months after leaving employment). The
price for such avoidance is that the employee must not dispose of the stock
until two years from the date the option was granted and one year from the date
the employee received the shares upon exercise. Code Section 422(a)(1). A disposition includes a sale, exchange
or gift.
(b) If the employee disposes of the stock before the holding
period is up, he must recognize as compensation income the difference between
the option exercise price and the fair market value of the stock at the time of
the option exercise. In addition, he
will recognize income equal to the difference between his basis in the stock
(the exercise price increased by the amount included in gross income as
compensation) and the amount he receives in the disposition.
(c) If the employee waits to dispose of the stock until after
the holding period, there will be no compensation income, but there will be
capital gain, if any (short or long-term, depending on how long the stock is
held). The capital gain would be the
difference between the amount received in the disposition over the basis in the
stock (i.e., the amount the employee paid when exercising the option).
(3) Alternative Minimum Tax (“AMT”) for ISOs: While the exercise of an ISO does not result in current taxable income, there are implications with regard to the AMT. When calculating income for AMT purposes, the difference between the fair market value and the exercise price will be considered part of AMT income.
(4) Where
does cash for exercise come from?
(a) Other
assets;
(b) Brokerage
loan and sale;
(c) Sale
in same year.
C. Disposition of Option Stock
(1) Definition: Generally, a disposition is any sale, exchange, gift or transfer of legal title of the stock. IRC §424(c) provides certain exceptions.
(a) Transfer from a decedent who held ISO stock to an estate, or a transfer by bequest or inheritance.
(b) Exchange of ISO stock in certain nonrecognition
transactions (e.g., reorganization).
(c) Pledge or hypothecation is not a disposition, but
transfer pursuant to pledge or hypothecation is a disposition.
(d) Between spouses incident to a divorce.
(e) Acquisition in joint ownership with right of
survivorship. Change in joint ownership
is disposition.
(f) Taxpayer in bankruptcy.
(2) IRS
rulings:
(a) Purchase of a put on option stock is not a disposition
(Rev. Rul. 59-242, 1959-2 C. B. 125).
(b) Short sale on option stock is a disposition (Rev. Rul.
73-92, 1973-1 C.B. 208).
D. Charitable Alternatives
(1) Outright
Gift of Stock to Charity
(2) Charitable
Remainder Trust
(3) Charitable Lead Trust:
Employee establishes charitable lead trust with cash proceeds of sale or
with other assets to offset gain in connection with exercise of option.
(4) Charitable Gift Annuity:
Employee “sells” stock to charity in exchange for an annuity.
2. Rule 144 Stock
A. Regardless of whether they are publicly traded or not, securities are subject to certain Securities and Exchange Commission rules regarding their sale if they are acquired, directly or indirectly, in a transaction or chain of transactions not involving a public offering (in which case they are “restricted securities”) from (1) the company issuing them or (2) an individual or company affiliated with the issuing company (generally including officers and directors of the company, in which case they are “control securities”). SEC Rule 144 provides a safe harbor for the sale of these securities if all the conditions of the rule are met.
B. Generally, Rule 144 requires that a charity and its donor together must hold restricted securities for a minimum of one year before their sale in accordance with the rule. It also imposes a value limitation on the amount of securities that can be sold by affiliates of the company during any three-month period and may require aggregation of the charity’s sales with the donor’s. Adequate current information on the issuing corporation must be on file with the SEC. The SEC, as well as the principal national exchange on which the securities are listed, must be notified of the sale.
C. Securities laws do not generally prohibit gift, but donor’s restrictions on sale apply to donee (including charity).
D. Rule 144 stock not considered “qualified appreciated stock.”
3. ESOPS and CHESOPS
A. ESOP is tax qualified, defined contribution employee benefit plan whereby, in return for meeting certain rules which protect the interests of plan participants, the ESOP sponsors receive various tax benefits.
B. Ordinarily,
to set up an ESOP, the company creates a trust fund for employees and funds it
by one, or a combination of, the following tax deductible methods:
(1) Contributing
shares of the company.
(2) Contributing
cash to buy company shares; or
(3) Having
the plan borrow money to buy shares with the company then making payments to an
ESOP trust to repay the loan.
C. Tax Advantages:
(1) Employer can deduct (within limits) contributions to an ESOP, including both principal and interest on loan proceeds the ESOP uses to buy company stock.
(2) Employer
can generally deduct reasonable cash dividends, if paid to an ESOP and used to
repay the ESOP loan or passed through to participants on ESOP held stock.
(3) The
shareholders of a close corporation can defer taxation on the gain resulting
from their sale of company stock to an ESOP, provided the ESOP owns 30% or more
of a company’s shares after the sale, by reinvesting sale proceeds in qualified
replacement property (“QRP”) consisting of stock or bonds in operating
companies in the United States.
D. A CHESOP is a combination of an ESOP with a gift to charity.
(1) The
simplest way is to have the shareholder donate his privately-held stock to a
nonprofit institution, which then sells the stock back to an ESOP established
by the company. Donor gets charitable
deduction for full fair market value and avoids capital gain on the
appreciation; or
(2) The
owner of the shares can use the proceeds of the sale to an ESOP to purchase QRP
and then gift the QRP to a qualified charity.
Individual owns QRP with same holding period and basis as the stock sold
to the ESOP, but avoids capital gain and gets full fair market value deduction
by giving QRP to charity or, perhaps, to a qualified charitable remainder trust
retaining an income stream.
V. Gifts of Real Estate
1. Real estate represents approximately 50% of total individual wealth; important that charities tap potential of real estate gifts.
2. Many
kinds of real estate interests; know the names and rules, for example: whole
fee interests; partial interests (undivided interests, life estate and
remainder; joint tenancy; tenancy in common).
3. Income tax charitable contribution deduction.
A. Limit on charitable deduction for appreciated real estate gifts is 30% of adjusted gross income with five year carryover for any “excess” contribution - - up to 30% of adjusted gross income in each carryover year until exhausted.
B. If you can’t use entire gift, consider contributing
partial or undivided interest over a period of years or making the election to
reduce the amount of the gift by the appreciation so that the ceiling increases
to 50% of adjusted gross income.
4. Transfer
of Encumbered Property to Remainder Trusts and as Outright Gift.
A. Mere transfer of mortgaged property is deemed bargain
sale. Reg. Section 1.1011-2(a)(3).
(1) IRS has said Reg. Section 1.1011-2(a)(3) applies to
CRT. Rev. Rul. 81-163, 1981-1
C.B. 433.
(2) Gain is for difference between amount of debt and allocated adjusted basis; not limited by property's fair market value.
B. LTR 9015049.
CRT disqualified if funded with mortgaged property.
(1) Facts. D planned to fund charitable remainder unitrust with income-producing real estate. Trustee would make regularly scheduled payments on mortgage, but D would remain personally liable for the debt.
(2) IRS rules. Trust won't qualify. Charitable remainder trust must function exclusively as one from its creation. It isn't charitable remainder trust - indeed, it isn't even deemed "created" - as long as donor treated as owner of entire trust under the grantor-trust rules. Reg. Section 1.677(a)-1(d) provides that donor is treated as owner of trust whose income is or may be applied in discharge of donor's legal obligation. Because D would be treated as owner of entire trust, it wouldn't be de