Thursday, April 25, 2024
GiftLaw Pro
GiftLaw Note: The IRS, in this ruling, stated that a corporate recapitalization did not constitute a taxable dividend distribution and the "new stock" could be used to fund a charitable lead annuity trust.
This is in reply to your letter dated March 27, 1997, requesting rulings as to the federal income tax consequences of a proposed transaction. Additional information was received on August 28, 1997 and February 2, 1998.

The information provided states that Company is a closely held corporation organized under the laws of State A. More than 92% of the Company stock is held by members of the Y Family. The remaining 8% is owned by members of a family unrelated to the Y Family and a charitable organization.

Company is an accrual basis taxpayer with a 52-53 week fiscal year ending on the Saturday nearest to July 1. Company is in the X Business.

Company's authorized and outstanding stock consists only of common stock. The common stock is divided into four classes, which are designated as Class B, C, D, and E. Class B, which has the largest number of shares outstanding, is nonvoting stock. Classes C, D, and E have voting rights (collectively referred to as the Voting stock).

During the three preceding fiscal years, Company has redeemed a number of its Class B shares from various shareholders. Company has represented that there has never been any plan to increase the proportionate interests of any shareholders and that such redemptions were isolated events.

Pursuant to Company's charter, dividends may be paid to the holders of Class B stock to the exclusion of the other classes of stock. To the extent dividends are paid to the holders of any class of stock besides Class B, the holders of all classes of stock participate equally in such dividend distribution. In the event of liquidation, the corporate assets remaining in the Company after the payment of liabilities will be shared ratably by all shareholders. There are no dividend arrearages. No shares of Company's stock have any type of conversion rights.

Both the Class B stock and the Voting stock are subject to Stock Restriction Agreements (the "Agreements"). Under the Agreements, on the death of a shareholder, that shareholder's estate can require the Company and the other shareholders to purchase stock. If the executor of a deceased shareholder's estate offers stock to Company, Company is required to purchase that number of shares which could be redeemed under section 303 of the Internal Revenue Code.

A substantial portion of Company's stock is owned by Family Y. Based upon the current appraised value of Company's stock, the estates of members of Family Y would each be substantially in excess of $a. Under the Agreements discussed above, upon the death of a Family Y member, Company could be required to purchase a substantial portion of that family member's Class B stock. Other shareholders also own significant amounts of Company stock, and they also have large estates. Under the Agreements discussed above, upon the death of any shareholder, Company can be required to expend substantial amounts to purchase stock from the shareholder's estate.

Based on the current value of its stock (which has been increasing annually for many years), Company is faced with the prospect of having to expend increasingly larger amounts to meet its obligations under the Agreements. In addition, Company currently pays out significant amounts of its income for charitable purposes. Portions of these payments are not currently deductible under the limitations set forth under section 170. The Board of Directors believes Company's charitable giving could be redirected in a more effective manner by reducing direct charitable contributions and increasing dividend payments on Company's stock owned by split interest charitable income (or lead) trusts which qualify for the charitable gift tax deduction under section 2522.

An increase in dividends would facilitate the use of stock to fund charitable lead trusts. However, given the large number of outstanding shares of Class B stock, it is not practical to raise dividends on all of those shares sufficiently to facilitate effective use of the lead trust.

To accomplish its objectives, Company will amend its charter to authorize the issuance of 500,000 shares of a new class of nonvoting stock, to be denominated Class F stock. The holders of Class F Stock will be entitled to dividends at a cumulative fixed rate per annum to be determined by the board of directors at the time the Class F shares are issued. The fixed rate dividend may be paid to the holders of Class F common stock without a dividend being paid to the holders of any other class of stock. The aggregate amount of fixed rate dividends paid to the holders of Class F common stock in any year will not exceed $b. The fixed rate dividend will terminate on the date which is fifteen (15) years after the initial issuance of the Class F common stock. The holders of Class F common stock will participate equally, share for share, in all distributions in liquidation of Company's assets as if each share of Class F common stock had been converted to Class B common stock using the same conversion ratio established for the initial exchange of shares, discussed below.

Under the terms of the Articles of Amendment to the Charter of Company, Class F shares will be issued only once (the "Initial Issue"). Any shares not issued with the Initial Issue will be cancelled and will not be issued by Company. Shares of Class F stock may only be obtained in exchange for Class B common stock (the "proposed transaction"). The exchange of Class B stock for shares of Class F stock will be based on the respective fair market values of the shares on the date of exchange. The fair market value of the respective shares will be determined by an independent valuation firm.

The number of shares of Class F stock that a holder of Class B stock will receive will equal the number of shares of Class B stock the holder elects to exchange multiplied by a fraction, the numerator of which will be the fair market value of a share of Class B stock and the denominator of which will be the fair market value of a share of Class F stock. The shares of Class F stock which are issued in exchange for shares of Class B stock must be placed in a charitable lead trust created by the holder of the shares of the Class B stock making the exchange. On the date which is fifteen (15) years after the initial issuance of Class F stock, the shares of Class F stock will be automatically converted into shares of Class B stock using the same ratio established for the initial exchange of shares.

Upon approval of the Plan of Exchange by the Board of Directors and the issuance of the new Class F stock, Z and Z-1, members of the Y Family, intend to exchange their Class B stock for Class F stock and establish charitable lead annuity trusts in substantially the same form as the instrument submitted.

The proposed trust instrument provides, in Paragraph 2(a), that in each taxable year of the trust, the trustee is to pay to the specified charitable organization(s) a guaranteed annuity in an amount such that the gift tax value of the annuity interest will be less than 60% of the value of the trust assets. The guaranteed annuity amount is to be paid at the end of each year in one annual installment from the net income of the trust and, to the extent income is not sufficient, from principal. Any income of the trust for any taxable year not distributed in payment of the guaranteed annuity is to be added to principal. Paragraph 2(b) provides that no amount may be paid during the term of the trust to or for the use of any person other than an organization described in sections 170(c), 2055(a) and 2522(a) of the Code.

Paragraph 2(c) of the proposed trust provides that if the annuitant is not an organization described in sections 170(c), 2055(a) and 2522(a) of the Code at the time any payment is to be made to it, the trustee is to distribute such payment to one or more other organizations then described in those sections. It is represented that the proposed trusts will be amended to provide that the trustee may not designate as a charitable beneficiary any organization in which Z or Z-1 has an interest as a director, officer, or employee.

Paragraph 3 provides that the taxable year of the trust is to be the calendar year. The amount of the guaranteed annuity for any short taxable year is to be the guaranteed annuity amount specified in Paragraph 2(a) multiplied by a fraction, the numerator of which is the number of days in that short taxable year, and the denominator of which is the number of days in the calendar year which includes such short taxable year.

Paragraph 4 provides that the trust is to terminate 15 years from the date the trust agreement is signed. Upon termination of the trust and after the final guaranteed annuity payment is made, the trustee is to distribute the then remaining assets of the trust in equal shares to the living children of the grantor and to the estates of any then deceased children.

Paragraph 5 provides that to the extent required by section 4947, the trustee shall not (a) engage in any act of self-dealing as defined in section 4941(d), (b) acquire or retain any excess business holdings as defined in section 4943(c), if such retention would subject the trust to tax under section 4943, (c) make any investment in such a manner as to give rise to a tax under section 4944, or (d) make any taxable expenditure as defined in section 4945(d).

Paragraph 7(j) authorizes the trustee to do all acts, take all proceedings and exercise all rights and privileges, although not specifically mentioned in the trust agreement, regarding any trust asset as if the trustee was the absolute owner thereof and to execute any instrument and to enter into any agreements binding the trust, provided that the trustee shall take no action that would cause the trust to be treated as a grantor trust under sections 671 through 677.

Paragraph 9 provides that the trust is irrevocable and may not be changed or modified by the trustor. The trustee has the power to amend the trust agreement in any manner for the sole purpose of ensuring that the annuity paid to the annuitants continues to qualify as a guaranteed annuity within the meaning of section 2522(c)(2).

Paragraph 10(b) provides that any trustee may resign by giving written notice specifying the resignation's effective date to the designated successor trustee, if there is one. If not, notice must be delivered to the grantor. If no successor trustee has been named, the successor trustee shall be named by the grantor. However, neither the grantor nor his spouse may serve as trustee. In addition, no person related or subservient (as defined in section 672(c)) to the grantor shall be appointed as a co-trustee or successor trustee.

Paragraph 12 states that, notwithstanding any other provisions of the trust instrument, the grantor intends that the trust be treated as a separate taxable entity for federal income tax purposes and that all provisions of the instrument be construed consistent with this intent. Furthermore, none of the powers granted to the trustee may be construed to enable the grantor, the trustee, or any entity in which the grantor or the trustee has a substantial interest to borrow the principal of the trust without adequate interest or security. No one but the trustee may vote or direct the voting of any corporate shares or other securities of the trust, control the trust's investments or reinvestments by direction or veto, and no one may compel the trustee to exchange trust property by substituting property of equal value. The income and principal of the trust shall not be used for the benefit of the grantor or his spouse or to pay premiums on policies of insurance on the lives of the grantor or his spouse.

Section 671 of the Code provides that where the grantor is treated as the owner of any portion of a trust, there shall be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust that are attributable to that portion of the trust to the extent that such items would be taken into account under chapter 1 of the Internal Revenue Code in computing taxable income or credits against the tax of an individual.

Sections 673 through 677 of the Code specify the circumstances under which the grantor will be regarded as the owner of a portion of a trust. Under section 673, the grantor is treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of the trust, the value of such interest exceeds five percent of the value of such portion.

Section 674 of the Code provides that the grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.

Under section 675 of the Code and the applicable regulations, the grantor of a trust is treated as the owner of any portion of the trust if under the terms of the trust agreement or circumstances attendant on its operation, administrative control is exercised primarily for the benefit of the grantor rather than the beneficiaries of the trust. Section 676 of the Code treats the grantor as the owner of any portion of a trust, whether or not he is treated as the owner under any other provision, where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a nonadverse party, or both.

Under section 677 of the Code, the grantor is treated as the owner of any portion of a trust, whether or not he is treated as the owner under section 674, whose income without the approval or consent of an adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be: 1) distributed to the grantor or the grantor's spouse; 2) held or accumulated for future distribution to the grantor or the grantor's spouse; or, 3) applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse.

Section 2001(a) of the Code imposes a tax on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States.

Section 2033 of the Code provides for the inclusion in the gross estate of any property in which the decedent had an interest at the time of his death.

Sections 2036, 2037, and 2038 of the Code provide for the inclusion in the gross estate of property transferred by the decedent with respect to which the decedent has retained, until death, certain powers or interests described in those sections.

Section 2501 of the Code imposes a tax for each calendar year on the transfer of property by gift during such calendar year by any individual, resident or nonresident. Section 2511(a) of the Code provides that the tax imposed by section 2501 applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.

Section 2522(a) of the Code provides that, for purposes of the Federal gift tax, in computing taxable gifts for the calendar year, there shall be allowed as a deduction in the case of a citizen or resident the amount of all gifts made during the calendar year to or for the use of certain governmental entities, certain corporations organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, and certain other fraternal and veterans organizations.

Section 2522(c)(2) of the Code provides that, where a donor transfers an interest in property (other than an interest described in section 170(f)(3)(B)) to a person, or for a use, described in section 2522(a) or (b), and an interest in the same property is retained by the donor, or is transferred or has been transferred (for less than an adequate and full consideration in money or money's worth) from the donor to a person, or for a use, not described section 2522(a) or (b), no deduction is allowed for the interest which is, or has been transferred to the person, or for the use described in section 2522(a) or (b) unless, in the case of interests other than charitable remainder interests described in section 664 or pooled income funds described in section 642(c)(5), such interest is in the form of a guaranteed annuity or is a fixed percentage distributed yearly of the fair market value of the property (to be determined yearly).

Section 25.2522(c)-3(c)(2)(vi)(a) of the regulations provides that a charitable interest is a guaranteed annuity interest, whether or not such interest is in trust. The term "guaranteed annuity interest" means an irrevocable right pursuant to the instrument of transfer to receive a guaranteed annuity. A guaranteed annuity is an arrangement under which a determinable amount is paid periodically, but not less frequently than annually, for a specified term or for the life or lives of a named individual or individuals, each of whom must be living at the date of the gift and can be ascertained at such date. For example, the annuity may be paid for the life of A plus a term of years. An amount is determinable if the exact amount which must be paid under the conditions specified in the instrument of transfer can be ascertained as of the date of the gift. For example, the amount to be paid may be a stated sum for a term, or for the life of an individual, at the expiration of which it may be changed by a specified amount, but it may not be redetermined by reference to a fluctuating index such as the cost of living index.

Under section 25.2522(c)-3(c)(2)(vi)(e) of the regulations where a charitable interest in the form of a guaranteed annuity is in trust and the present value on the date of gift of all income interests for a charitable purpose exceeds 60 percent of the aggregate fair market value of all amounts in the trust (after the payment of liabilities), the charitable interest will not be considered a guaranteed annuity interest unless the governing instrument of the trust prohibits both the acquisition and the retention of assets which would give rise to a tax under section 4944 if the trustee had acquired such assets.

The following representations have been made by Company in connection with the proposed distribution.
  1. Company and its shareholders will each pay their own expenses, if any, incurred in connection with the proposed transaction.
  2. To the best of Company's knowledge, none of the shareholders has any plan to sell or otherwise dispose of any of the Class F nonvoting common stock to be distributed in the proposed transaction, except for gifts of such stock to charitable lead trusts to be established by those shareholders.
  3. At the time of the proposed transaction, there will not be outstanding any warrants, options or convertible securities, or any type of right under which any person could acquire any stock in Company.
  4. The proposed transaction is an isolated transaction and is not part of plan to periodically increase any shareholder's proportionate interest in the assets or earnings and profits of the Company.
  5. Company has no present plan or intention to redeem or otherwise acquire any of the Class F nonvoting common stock to be issued in the proposed transaction.
  6. Shareholders of Company do not have an election to receive cash or other stock or property in the proposed transaction.
  7. The Class F nonvoting common stock to be distributed will not redeemable at the option of any shareholder.
Based solely on the information received and the representations made, we hold as follows:
  1. Provided that the proposed exchange of Class B stock for Class F stock is not pursuant to a plan to periodically increase a shareholder's proportionate interest in the assets or earnings and profits of the corporation, the proposed issuance of Class F nonvoting common stock will not be treated as a distribution to the Company's shareholders to which section 301 of the Code applies by reason of section 305(b) and section 305(c).
  2. The charitable interest under the proposed trust instrument is a guaranteed annuity interest within the meaning of section 2522(c)(2)(B) and section 25.2522(c)-3(c)(2)(vi)(a).
  3. A gift tax charitable deduction under section 2522(a) will be allowed in an amount equal to the present value of the guaranteed annuity interest determined as of the date of the funding of the charitable lead trust. The amount of the charitable deduction will be determined under section 25.2522(c)-3(d)(2)(iv).
  4. The established charitable lead trusts will be split interest trusts described in section 4947(a)(2).
  5. Neither a shareholder-grantor nor a shareholder-grantor's spouse of a trust operated in accordance with the proposed trust agreement will be treated as the owner of any portion of the trust for federal income tax purposes.
  6. No portion of the proposed charitable lead trust will be includible in the gross estates of Z and Z-1 for federal estate tax purposes.
No opinion is expressed about the tax treatment of the transaction under other provisions of the Code (including sections 368(a)(1)(E), 1036, 2701 and 2703) and regulations or about the tax treatment of any conditions existing at the time of, or effects resulting from, the transaction (including effects under the cited provisions) that are not specifically covered by the above rulings. In addition, this letter does not purport to rule on the effect of any future distributions on these rulings.

A copy of this letter should be attached to the Federal income tax returns of the taxpayers involved for the taxable year in which the transaction covered by this ruling letter is consummated.

Sincerely yours,
Assistant Chief Counsel (Corporate)
By ____
Richard L. Osborne
Senior Technician Reviewer

Related Topics On Corporate Recapitalization Funds Lead Trust

3.5.1  Family, or Non-Grantor, Lead Trusts:    There are two basic types of living charitable lead trusts. These are the grantor lead trust and the non-grantor, or family, lead trust.


3.5.4  Lead Annuity Trust:    A charitable lead annuity trust must pay a guaranteed annuity amount to qualified charities at least annually. Reg. 20.2055-2(e). Reg. 25.2522(c)-3(c). The annuity must be paid in all events. It is not permissible to create a lead trust in which the payment to charity is determined by the income earned by the trust.



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