Sam Storeowner and the Tax-Free Buyout

Case:

Sam Storeowner was having coffee at Small Town Café when his friend Bob Banker walked into the café. Bob motioned Sam to a booth in the back and said that he wanted to talk to Sam. It turns out that Bob and several friends were in the process of obtaining a charter for a new bank. They were contacting a number of business owners in town and offering them the opportunity to invest. Sam had known Bob for a number of years and decided to go forward with an investment in the bank. He invested $100,000 and acquired 10% of the bank stock.

Over the years, the bank gradually built up assets and continued to make loans in the small community. Eventually, a large bank that was purchasing all of the smaller banks in its section of the state contacted the bank board. The large bank made an offer for the stock of the smaller bank. After discussing the offer, the board of directors, who owned 29% of the total stock in the bank, decided to accept the offer. They set a date six weeks later for the shareholders to meet and vote on whether or not to accept the purchase offer.

Sam initially was hesitant to sell his stock. But as he talked to the other shareholders, it became apparent that many of them were going to vote in favor of the sale. So Sam was going to be forced to sell his stock. The good news is that his $100,000 investment was now worth $800,000. Sam went to his attorney and asked if there was any way to save the capital gains tax on the sale of his stock.

Question:

Could Sam still avoid the tax? Does it matter that the board of directors had voted to accept the offer?

Solution:

Fortunately, Sam's attorney understood how to use a charitable trust to sell stock tax-free. Since the small bank is a C corporation, Sam's stock may be transferred to a charitable remainder trust. Sam and his wife will benefit from a bypass of capital gain and will receive a charitable tax deduction of almost $300,000.

But does it matter that the board of directors had voted to sell? Well, it is not permissible to transfer stock into a unitrust and expect to bypass capital gain if there is a binding agreement to sell. However, in the Ferguson and Rauenhorst cases, the Tax Court affirmed the principle that a sale is not binding until 51% of the shareholders have voted in favor of the sale. Since the board of directors owned only 29% of the stock, this directors' vote is not yet a binding vote.

Provided that the transfer of stock to the unitrust is made before 51% of the shareholders have voted in favor of the sale, the stock will bypass the capital gain. Since the vote by the shareholders is still over a month away, Sam can transfer the stock into the charitable remainder unitrust and bypass the gain.

Of course, this stock will need to be appraised by a qualified independent appraiser. However, since the bank had already obtained an appraisal to determine what the appropriate selling price would be, the outside appraisal firm will be able to provide a valuation of Sam's stock at modest additional cost. Sam and his wife will transfer their stock into the charitable remainder trust and benefit from bypassing the capital gain. They also will receive a large charitable deduction and will receive about $1 million of income from their 6% unitrust over their two lives.

Sam Storeowner and the Tax-Free Buyout

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