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Wednesday November 22, 2017

Article of the Month

Charitable Giving Strategies for Business Ownership Interests — Part I


Many entrepreneurs and investors have accumulated substantial net worth related to their business and investment holdings. For years, these individuals have focused their efforts and attention to building their businesses 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 of his or her 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 is the first in a three-part series. Part I will cover gifts of C-Corp stock, Part II will discuss giving options for S-Corp owners and Part III will cover partnership interests.


Nearly 90% of all businesses in America are organized as closely held businesses. Oftentimes, the majority owner of the business is the founder of what has become a family business. Corporations may be organized under either Subchapter C or Subchapter S of the U.S. tax code. So-called C corporations (C-corps) and S corporations (S-corps) each have their own benefits and drawbacks for shareholders.

When a business is organized as a C-corp, the corporation files its own tax return and pays corporate taxes. Income of the C-corp is taxed at the corporate level and distributions to shareholders are also taxed at the shareholder level. When the owner is ready to sell his or her stock, he or she often learns that a sale will lead to a potentially large capital gains tax liability. Thus, it is prudent for the owner's advisor to suggest strategies that will help lessen the tax impact of the sale.

The first charitable gift option for the owner of C-corp stock is an outright gift of a portion of stock to charity. This gift will entitle the donor to a charitable income tax deduction based on the stock's fair market value. While publicly traded stock is exempt from the Internal Revenue Service ("the Service") qualified appraisal requirement, closely held stock is not. For gifts of closely held stock valued at $10,000 or more, the donor must have a qualified appraisal in order to substantiate the value of the gift. Reg. 1.170A-13(c).

Depending on the donor's deduction limits, he or she may be able to use the tax savings from the charitable deduction to offset gain on the sale of the remaining portion of his or her stock. For cash donations to a public charity, a donor's deduction is limited to 50% of his or her adjusted gross income (AGI) in the tax year. For a gift of appreciated property, the donor's deduction limit is equal to 30% of AGI. Any amounts in excess of these limits may be carried forward for up to an additional five years. Sec. 170(b).

If the charity receives the stock as a gift, the charity is able to sell the newly-acquired stock tax-free. Unlike publicly traded stock, however, there is usually not a ready market for closely held C-corp stock. Thus, it usually cannot be easily sold. Often, the business is family owned and operated. The founder's children have taken an interest in the business and wish to continue running the business for decades to come. The owner is likely looking for a way to transfer the business to family without incurring tax consequences.

Due to the nature of closely held corporate stock, one potential purchaser of the stock is the corporation itself. Corporate redemption allows the exiting shareholder to take a charitable income tax deduction while the remaining shareholders retain control of the corporation. The owner should be careful to make the charitable gift with no binding agreement for the sale of the stock. As this article will explore in more detail below, if a binding agreement for sale is reached prior to the transfer, the sale will be treated as if it were between the donor and the purchaser, thus burdening the donor with taxable capital gain.

Example 1
Twenty-nine years ago, Tommy started a family business manufacturing baseball bats. The company has come a long way from its humble beginnings. The company is now one of the industry leaders, selling bats to little leagues across the country and to up-and-comers in the minor leagues as well as some of the biggest names in the major leagues. Despite its success, the company has never gone public. Instead, Tommy chose to keep his company as a closely held C-corp so he could focus on making quality products rather than having to answer to investors. Tommy is now considering his retirement options. He is ready to liquidate his stock, but has two major concerns. First, the value of his stake in the company has appreciated astronomically compared to his cost basis. Second, he wants to leave the company to his two sons, Kirk and Justin, who are minority shareholders, but he understands they do not have the liquidity to buy him out.

Tommy meets with his attorney for advice on the most efficient way to leave the business in good hands. His attorney explains that he might want to consider donating a portion of his shares to his favorite charity and selling the remainder of his shares to the corporation itself. The attorney goes on to explain that once the donation and sale have both closed, it is likely that the corporation will be able to purchase the charity's shares. Tommy gives a portion of his shares to charity and sells his remaining shares to the corporation. Within a few months after the charitable gift is complete, the charity and corporation negotiate a corporate redemption. Tommy is satisfied because his income tax deduction offset a significant amount of the gain on the sale of his stock. Kirk and Justin are satisfied because they are able to remain in control of the family business.
C-Corp Charitable Bailout

Owners of closely held C-corp stock concerned with family succession may also benefit from transferring the stock to a charitable remainder trust (CRT). Similar to outright gifts, CRTs provide the donor with a charitable income tax deduction and the ability to bypass gain. A CRT has the added benefit of providing income to the donor or selected beneficiaries for their lives or a term of up to 20 years. So long as the stock has been held for more than one year and the trust remainder is designated only for public charities, the donor will receive a deduction based on the full fair market value of the donated stock. Because this is a split-interest gift, the deduction is equal to the present value of the trust's remainder interest. The transfer of the stock to the CRT also has capital gains tax benefits for the donor. The portion of the capital gains allocated to the present value of the remainder interest in the CRT will be bypassed.

Charitable remainder trusts are subject to the private foundation self-dealing rules under Sec. 4941. Generally, a charitable remainder trust may not engage in any transaction, including a sale, with a disqualified person as defined by Sec. 4946. The grantor of the CRT is a disqualified person, along with his or her ancestors, lineal descendants and their spouses. In addition, any corporations of which a donor or his or her family members own more than 20% of the total voting power are also disqualified persons.

There is an exception to the self-dealing rules that would allow an ordinarily disqualified corporation to redeem stock from a CRT, so long as certain rules are followed. Sec. 4941(d)(2)(F). First, the repurchase must be at fair market value. Second, the company must offer to repurchase all of its stock "subject to the same terms" so that every shareholder has an opportunity to sell shares back to the corporation under the same price and terms. As a practical matter, if the stock is held exclusively by family members who understand the goal of the corporate redemption, these provisions do not usually create a major obstacle.

Example 2
Ernie has spent most of his adult life operating his eponymous, family-owned pizza parlor. Established as a closely held C-corp, it didn't take long for Ernie's Pizza to go from serving the best deep dish on the north side of town to having locations across the state. Ernie is now advancing in age and is ready to hand off the business to his sons, Joe, Tony and Kris.

When he meets with his attorney to discuss his possibilities, Ernie mentions that, while he is ready to back away from the business, he is concerned that he will not have a steady stream of income. Ernie's attorney lays out a plan whereby Ernie can establish a charitable remainder unitrust to benefit a local charity. With this plan, Ernie is able to take a charitable income tax deduction, bypass capital gains and also receive unitrust income for the remainder of his life. Following the establishment of the trust, Ernie gives 10,000 shares to the unitrust. After four weeks, Ernie's Pizza offers a stock redemption plan to all of its shareholders for the appraised value of the company. While Joe, Tony and Kris are content with their stake, the CRT is willing to liquidate the stock and reinvest the proceeds. Ernie's Pizza and the CRT readily agree to the corporate redemption for fair market value.
C-Corp Sale of Stock

In contrast to the examples above, there will be times when the founder of a C-corp does not have family members who possess the skill or desire to carry on the business. In this circumstance, the founder will need to find an outside party to buy the company.

Whether the stock is sold to the corporation or an independent third party, the owner must be careful to avoid entering into a binding agreement to sell the stock prior to making a transfer to charity. The sale of a corporation usually includes several steps, including initial discussion, a letter of intent, negotiating the sale agreement and votes by the corporation's directors and shareholders. The question that commonly arises is this: when exactly does the donor's interest ripen into a right to receive income from the sale of the stock?

The risk of a sale being deemed "prearranged" (and thus an assignment of income) will vary from one situation to the next. However, the risk is generally low in situations where there is merely a buyer "waiting in the wings" to purchase the stock once the charitable transfer is complete. Beyond that point, the risk of a prearranged sale increases. Business owners and their counsel should examine the facts and circumstances in light of the current state of the law regarding prearranged sales.

In Rev. Rul. 78-197, the Service adopted the ruling of the tax court in Palmer v. Commissioner, 62 T.C. 684 (1974), stating, "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 shares for redemption." In other words, there is no prearranged sale—and thus no anticipatory assignment of income—unless there is a legally binding agreement to sell the asset.

In Ferguson v. Commissioner of Internal Revenue, 921 F.2d 588, the 9th Circuit Court of Appeals affirmed a Tax Court decision that the taxpayers' stock had ripened into a right to receive income prior to completion of a transfer of the stock to several charities. The Fergusons founded Diet Center, Inc. and then transferred the entity to American Health Companies, Inc. (AHC). A prospective purchaser, CDI Holding, Inc. (CDI), subsequently approached AHC. The companies reached a merger agreement on July 28, 1988. An offer to all AHC shareholders to tender their shares was sent on August 3, 1988. The tender was initially to be completed by August 31, but was extended to September 9.

The Fergusons opened a brokerage account on August 23 and placed 341,466 shares of AHC in the account. They also announced their intent to give 57,778 shares to charity. The transfer of the shares required legal approval, causing the actual transfer to charity to be delayed until September 8. The tender offer expired on September 9 and actual acceptance by the buyer was on September 12.

On August 31, 52.2% of the shares had been tendered, on September 8, 57% of the shares had been tendered and on September 9, 95.2% of the outstanding shares had been tendered. While the sale was contingent upon tender of 85% of the shares, the Court noted that the buyer had the option of waiving the 85% requirement. Under state law, tendering of more than 50% of the shares enabled the buyer to complete the sale.

The Court determined that the stock had ripened because the receipt of cash related to the transaction was "practically certain to occur" as of August 31, the date that over 50% of the shares had been tendered. Because over 50% of the shareholders had voted in favor of the sale, the buyer had a legally enforceable right to compel performance. Therefore, the Fergusons were unable to bypass the capital gain on the shares donated to charity.

However, in Rauenhorst v. Commissioner, 119 T.C. No. 9, the Tax Court required the IRS to follow Rev. Rul. 78-197. The Rauenhorsts owned warrants that allowed them to acquire 772.14 shares of stock in NMG, Inc (NMG). On September 28, 1993, the directors of World Color Press, Inc. (WCP) signed a letter of intent describing a prospective purchase of NMG. This letter of intent was not a legally binding contract for sale. On November 8, the Rauenhorsts donated the warrants for 770 shares to four charities. The gift was reflected on NMG's warrant ledger on November 12. The donors, the four charities and all other shareholders agreed to the sale on November 19.

The Service argued that the binding obligation standard from Rev. Rul. 78-197 was not binding on the Tax Court or the IRS and that the Ferguson practical certainty standard should apply. The Tax Court disagreed, applying the "binding obligation" test instead. Because the stock gain had not ripened when the stock was transferred, the donors were able to bypass capital gain on the shares donated to the charities.


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 may—unbeknownst to the owner—impose 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 upfront 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 try to best 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.

Published November 1, 2017
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Previous Articles

Charitable Strategies for Hedge Fund Managers Facing Repatriation of Offshore Fees

Blended Gifts - Part V

Blended Gifts - Part IV

Blended Gifts - Part III

Blended Gifts — Part II


Shelby Harder, 2018
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Milwaukee-Downer Scholarships and Professorships

Some of the many recipients of Milwaukee-Downer scholarships gather for a photo with Carolyn King Stephens M-D'62 and Marlene Crupi-Widen M-D'55 in January 2014 at the annual scholarship luncheon.

Rosamund Victoria Bille Adler Scholarship
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Memorial Scholarship Fund - Milwaukee-Downer
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Kaitlin Yorde, 2017
Maurine Campbell Endowed Scholarship

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