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Thursday, May 2, 2024
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Case Studies |
Priorities of a Proprietorship Sale
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Case:
Thomas and Beatrice Davis, ages 65 and 60 respectively, own a security alarm business that they have operated as a proprietorship for tax purposes. Over the years they have built the business into a thriving enterprise employing over 25 workers. A number of the key employees have expressed an interest in purchasing the business, which has recently been appraised by a business valuation expert at a value of $1.5 million. While there have been discussions regarding a sale, there is no formal written or oral contract between the Davises and the employees.
Thomas and his wife have been considering the possibility of retirement and would like to sell the business, but in recent meetings with their financial advisors, they have been told that substantial capital gain taxes would be due if the sale was consummated. They began the business on a shoestring over 20 years ago and therefore have very little basis in the business.
Question:
They have been actively involved with a number of charities over the years and would like to consider setting up a charitable remainder unitrust (CRUT) with a portion of or all of the business. However, according to their advisors, a problem exists in funding a CRUT with the business. Under the principles set forth in Sec. 512 of the Internal Revenue Code, there is unrelated business income (UBI) for a charity or charitable trust that operates an active business. While there are exclusions under Sec. 512(b) for dividends, interest, royalties and rents, there clearly would not be an exclusion for a business that actively markets and rents equipment. The short-term nature of the rentals and the general level of activity to market and provide service and maintenance for the equipment would clearly constitute a business "regularly carried on," and this business could thus expose the trust to UBI under Sec. 512.
With assets from an active trade or business in the charitable remainder trust, there will be tax on the UBI. The trust will be subject to 100% excise tax on the unrelated business income. Sec. 664(c)(2)(A). Since a unitrust with unrelated business taxable income does not lose exempt status, an active business asset may still be transferred to the trust and sold fairly quickly. If the asset is sold quickly, a donor may receive the capital gains bypass benefit with a modest cost for the 100% excise tax on trust unrelated business income. However, Thomas and Beatrice may not want to pay even a modest amount of excise tax on UBI.
Solution:
One possible solution to investigate is the creation of a lease. If the business is leased to key employees for a period of several months, then all of the income from the business can be converted into a fixed rental payment that comes within the express exception of Sec. 512(b).
There is one caution with respect to the lease. Under Sec. 512(b)(3)(B)(i), the income from rent must not be more than 50% from personal property. With an alarm business, the majority of the rental payment can be structured to come from the value of the plant and goodwill of the business, rather than merely the use of the personal property in the business. However, this limit should be carefully reviewed.
In addition, it is essential to avoid the trap of Sec. 512(b)(3)(B)(ii), which occurs if the rental payment is based on "income or profits derived by any person from the property leased." If there is any net profits interest, then the lease will generate UBI. The lease must necessarily be created to avoid the use of profits as a measuring yardstick, but rather must be a fixed payment so that this amount will clearly not generate UBI. Since the duration of the lease is relatively short, it should be possible to create a fair payment of a fixed amount that will enable the key employees who lease the business to pay the lease and yet be confident of a reasonable profit during that time for their efforts.
As a result of potential UBI problems, Thomas and Beatrice decide to create a six-month lease with key employees and then fund the charitable trust with the alarm business. Based on the creation of a 7% CRUT with a value of $1.5 million, they will receive an income tax deduction of $315,300 and bypass the substantial capital gains on the sale. More important, they will be able to fulfill their priority objective of benefiting the charities they have supported over the years.
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