Facilitating a Lead Trust Through a Corporate Recapitalization

Case:

Timothy and Molly Armstrong own 90% of the outstanding stock in a manufacturing company, and the other 10% is owned by another family. The stock is divided into four classes of common stock, which are non-voting Class B and voting Classes C, D and E. The corporation had redeemed a number of Class B shares over the past three years, but there has never been any intent to change the proportionate interests of the shareholders by such redemptions. The corporation's charter provides that dividends can be paid only on the Class B shares. If dividends were to be paid on the other classes, the charter provides that those classes must participate equally in the dividends. All classes are to share equally in any liquidating distributions.

Timothy and Molly are very charitable and through their corporation have been paying out significant amounts of corporate income to charity. However, because of the 10% limitation on corporate contributions, significant portions of these charitable contributions are not deductible by the corporation. Therefore, Timothy and Molly desire a method whereby they can make contributions through their corporation more effectively. Also, they are very concerned about business succession issues in regard to the corporation, which is currently valued at $10 million. Their two children are actively involved in the corporation as executive vice presidents, and Timothy and Molly desire to eventually pass control of the corporation to the children.

Question:

In a recent meeting with their CPA and attorney, Timothy and Molly discussed these two underlying issues regarding charitable giving by the corporation and the business succession problem. The CPA and attorney were well versed in charitable estate planning concepts, including charitable remainder trusts, and charitable lead trusts, and had recommended these techniques to a number of their high-net-worth clients. A lengthy discussion ensued regarding the ability of the corporation to redirect its charitable giving more effectively by paying dividends on corporate stock owned by a charitable lead trust. Even though this seemed like a valid technique, Timothy and Molly were concerned about the corporation's ability to pay the necessary dividends for the lead trusts if it had to pay dividends on all the outstanding Class B shares.

Solution:

To solve this problem, the attorney stated that the corporation could amend its charter to authorize a one-time issuance of 100,000 shares of a new Class F non-voting common stock in exchange for shares of Class B stock. The exchange would be based upon the respective value of the shares determined by an independent appraisal firm. The Class F shares would be entitled to dividends at a cumulative fixed rate per year for 15 years, and there would be no requirement for the other classes to participate in the dividends. The Class F shares would receive a share of any liquidating distributions as if such Class F shares had been converted into Class B shares.

Timothy and Molly decide to use this plan to exchange their Class B shares for Class F shares and then use the Class F shares to fund a $2,000,000 charitable lead annuity trust for a term of 15 years. The trust instrument will provide that the trustee pay "a guaranteed annuity in an amount such that the gift tax value of the annuity trust will be less than 60% of the value of the trust assets." This provision is included so that the trust will not be subject to excess business holdings rules, which may cause the imposition of tax under Code Sec. 4944. Therefore, the chosen trust payout percentage to charity will be 6.3%, which will generate a charitable gift tax deduction of $1,177,200 (59% of the value of the trust assets). The taxable transfer to the children for gift tax purposes is $822,800 and, therefore, Timothy and Molly will be required to file a gift tax return and use a portion of their lifetime exemptions.

Timothy and Molly are primarily interested in three public charities, so the trust income of $126,000 will be divided equally and distributed to those three named charities annually. Upon termination, the assets remaining in the charitable lead trust will be distributed to the children. Assuming that the stock grows by 4% a year, the trust value will increase to $3.6 million at the end of 15 years. The $1.6 million accumulation in value will not be subject to any further gift or estate taxation.

This plan meets Timothy and Molly's needs and objectives. They were concerned about business succession issues as well as charitable income tax deduction issues. This particular plan addresses both of these concerns. The corporate recapitalization (i.e., creation of Class F stock) was a necessary first step in the process. After conversion from Class B to Class F stock, the Class F stock could be contributed to the lead trust with assurance that the payments (dividends from the corporation) would be available to meet the charitable annuity payment requirement.

For further information on this recapitalization technique, see PLR 9819031.

Facilitating a Lead Trust Through a Corporate Recapitalization

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