Saturday April 20, 2024
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4.10.2 Lease and Debt Solutions
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Lease and Debt Solutions
Active Businesses Transferred to Unitrusts: A common challenge for business owners who would like to use a charitable trust is that the business is an ongoing activity that may not be held in a charitable trust.
Short-Term Lease: The practical aspects of creating a lease vary according to the type of proprietorship.
Debt on Property: If property subject to debt is transferred to a charity, and the use of that property is unrelated to the charity's exempt purpose, then it is considered "debt-financed property."
Four Debt Relief Strategies: First, the debt could be paid off.
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Active Businesses Transferred to Unitrusts
A common challenge for business owners who would like to use a charitable trust is that the business is an ongoing activity that is not allowed to be held in a charitable trust. Charitable trusts are exempt from tax under Sec. 501(a) and Sec. 508(e). They also are subject to the private foundation rules on self-dealing, excess business holdings and taxable expenditures. Sec. 4947(a)(2).
Charities and charitable trusts are normally tax exempt. However, if they are regularly conducting a trade or business that is not substantially related to the exercise of their exempt purpose, they are subject to unrelated business income (UBI) tax. Sec. 513(a).
Since a charitable trust will never be able to claim that an active trade or business is related to its exempt purpose, the transfer of an operating business to a charitable remainder trust results in UBI. See Newhall v. Commissioner.
However, there are exceptions to the unrelated business rules. Among the various exceptions are the receipt of rent from real property and the payment of royalties and lease returns. These exceptions require the payouts to be fixed. If the payments are dependent upon earnings and profits, the trust is in effect a partner and will be subject to UBI. Sec. 512(c).
If an active trade or business is involved, transfer of these assets to a CRT could subject the unitrust to a 100% excise tax on the UBI. Sec. 664(c)(2)(A). While the tax may not be large if the asset is sold quickly, many grantors may prefer to avoid the tax on UBI.
To avoid UBI, a donor who plans to contribute active business assets to a CRT may lease those assets to a third party prior to making the contribution. If this lease is in place before the assets are contributed to a CRT, the only income the CRT will ever receive from the assets is fixed rent from the lease. Rents are passive income and not taxable UBI. Note: rent payments derived from personal property leases will not be excluded from UBIT. Sec. 512(b)(3). If personal property is leased with real property and the rent attributable to the personal property is an incidental amount to the total rents received the rent may be excluded from UBIT. Sec. 512(b)(3)(ii).
Therefore, there are two possible solutions for active businesses. First, if there is a buyer "waiting in the wings," then the business interest may be transferred into a charitable trust and sold in an expeditious manner to the buyer waiting in the wings. While it will be essential to avoid a prearranged sale, the time that the business is held in the trust may be just a few days. As a result, there may be a very modest amount of unrelated business income subject to the 100% excise tax.
The "near zero" tax of a unitrust for the sale of an operating business will provide over 99% of the unitrust benefits to business owners. There still will be the bypass of capital gain and a charitable income tax deduction, plus the favorable tax benefits of an operating unitrust. With the possible cost of very modest excise tax when the trust is created, nearly all business properties may now be sold with a "near zero tax" unitrust.
Alternatively, the grantor may prefer to lease the assets to a third party and completely avoid the UBI excise tax.
Short-Term Lease
The practical aspects of creating a lease vary according to the type of proprietorship. However, many small operating businesses such as retail stores or small sales or manufacturing companies could be leased to key employees. The leases would probably be three months in duration, with options for renewal.
The two key aspects of the lease strategy are to find the proper lessee and to determine the proper amount of fixed payments. Quite often, the lessee could be an employee or a group of employees from the company. Alternatively, the lessee might be a friendly business owner who is willing to manage the business until it is sold. The term of the lease is quite short because there frequently is a buyer waiting in the wings during this process. With a reasonably short term to the lease, the buyer may purchase the business and have full ownership within a short period of time.
The lessee usually will receive a portion of the profits. The lease must have fixed payments, but the payments will frequently be set at 60% - 75% of the anticipated profits for that period of time. Thus, the lessee will have a sufficient level of profits to justify his or her efforts in running the business for the short period of time.
Example 4.10.2 Lease and Sale
John and Mary Smith own a small manufacturing business as a sole proprietorship. The value in the business is comprised primarily of the business operations plant and goodwill. The business is valued at $2 million and a larger company is interested in purchasing the business assets.
John and Mary lease the business, including their equipment, the building and the goodwill to key employee Ron Reliable. Ron Reliable will operate the business on a three-month lease with potential renewal options. The lease will make fixed payments to John and Mary. The payments are set at approximately two-thirds of the estimated profits for the three-month period.
After the lease is in place, John and Mary transfer the entire business to a charitable remainder unitrust. Two weeks later, the trustee negotiates with new buyer and agrees to sell the entire business for $2 million, subject to the remaining two months on the lease. New buyer pays for the business in cash. At the termination of the three-month lease, new buyer owns the entire business and may operate it. Since the unitrust was not operating the business and was receiving only fixed payments from the lease, there is no UBI.
Debt on Property
If property subject to debt is transferred to a charity, and the use of that property is unrelated to the charity's exempt purpose, it is considered "debt-financed property." The sale of this property will produce UBI. Sec. 514(a)(2).
However, if the organization acquires the property through a bequest, or if property is given to the organization and the debt is more than five years old and the property has been owned for over five years, the charity will not have acquisition indebtedness and UBI, so long as it sells the property within the succeeding 10-year period. Sec. 514(c)(2)(B).
For a charitable remainder unitrust, the rules are more stringent. If property is transferred to a unitrust that is subject to a recourse debt, the Service position is that the unitrust will be disqualified as a grantor trust, since it is making payment on a debt obligation of the grantor. PLR 9015049. While some commentators have suggested that a Tax Court might not follow the IRS position, there are several strategies that can be used to avoid transfer of debt-encumbered property into a unitrust. The only exception to these strategies is for property on which there is a non-recourse debt that is more than five years old and the property has been owned for over five years. It appears that this property may be transferable into a unitrust and sold without triggering UBI.
Four Debt Relief Strategies
First, the debt could be paid off. If the debt is small and the donor has resources, the simplest solution is for the donor to pay off the debt. Once the debt is paid off, all or part of the property can be given to charity or a charitable remainder trust (CRT).
Second, it may be possible to obtain a release. If the debt-encumbered property is divisible, the property can be legally subdivided. The debt can then be transferred entirely to one of the subdivisions and released with respect to the remaining subdivisions. The debt-free subdivisions can then be transferred to charity or a CRT.
For example, assume that a potential donor owns apartment buildings alpha, beta and gamma. These buildings are mortgaged and the debt is about 10% of total value and evenly spread among the three buildings. The owner approaches the lender and obtains a release on buildings beta and gamma and the entire debt is transferred to alpha. The owner then transfers beta and gamma to a charitable remainder unitrust (CRUT). After alpha is sold, the debt is repaid and the balance of the sale proceeds is distributed to the owner. Meanwhile, the CRUT sells beta and gamma and receives cash proceeds.
The third option is a bridge loan. With the apartment buildings alpha, beta and gamma, the owner could borrow on his fourth building, delta. Owner then uses the borrowed funds to pay off the debt on alpha, beta and gamma. Beta and gamma are transferred to the CRUT and sold tax-free. With the cash proceeds from alpha, owner then repays the bridge loan.
The fourth strategy is a partial sale to charity. The owner sells apartment building alpha to the charity for cash, then uses the cash proceeds to pay off the debt on all three buildings. This leaves buildings beta and gamma free and clear to be transferred into a CRT. Charity then sells building alpha to recoup the money it paid owner to purchase alpha.
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Case Studies on Lease and Debt Solutions
Grizzly Gordon and the Ranch LLC, Part II:
Grizzly Gordon grew up in the Big Sky country. He loved the mountain and plain vistas of this beautiful ranching country. During his youth, Grizzly acquired his nickname by discovering a grizzly bear that had gotten too near his cattle. Grizzly felled the bear with one well-aimed shot and all his neighbors called him Grizzly after that experience.
Grizzly Gordon and the Ranch LLC, Part III:
Grizzly Gordon grew up in the Big Sky country. He loves the mountain and plain vistas of this beautiful ranching country. During his youth, Grizzly acquired his nickname by discovering a grizzly bear that had gotten too near his cattle. Grizzly felled the bear with one well-aimed shot and all his neighbors called him Grizzly after that experience.
Swenson "Early" Retirement, Part 2:
Bill and Clara Swenson consider themselves very fortunate. Bill was born in Norway. When he was seven years old, his parents immigrated to America. He attended high school and State College in northern Minnesota.
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