Friday April 19, 2024
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4.10.4 Sale and Unitrust
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Sale and Unitrust
Liquidity Objectives: A sole proprietor is typically interested in one principal goal.
Unitrust Design: The preferred unitrust method is a FLIP charitable remainder unitrust (CRUT).
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Liquidity Objectives
A sole proprietor is typically interested in one principal goal. First, he or she may need or desire cash liquidity. Many business owners have placed most of their assets into the business. Upon retirement, a portion of the business assets will be sold for cash.
The optimum method for achieving this goal is to sell part of the business for cash and place part in a charitable remainder trust (CRT). The easiest solution is to give real property or other capital gain assets to a CRT. Other equipment, inventory and operational assets may be sold for cash.
Unitrust Design
The preferred unitrust method is a FLIP charitable remainder unitrust (CRUT). A FLIP unitrust may be funded with real property or other illiquid assets. It normally functions as a net income plus makeup unitrust (NIMCRUT) until a specified "trigger" event.
The trigger event may be the sale of a non-marketable asset or even the sale of a certain percentage of non-marketable assets. For example, if the trust is funded with real property, the trigger event could be the sale of the real property or the sale of a percentage of the real property.
The FLIP trust has both a trigger event and a change or "flip" date. The trigger event occurs in one year and the trust changes or flips to a standard or Type I trust on the following January 1. Following the FLIP, the trust will function as a standard CRUT.
A FLIP trust provides a donor with the flexibility of a NIMCRUT and later the three major advantages of a standard CRUT. First, a standard CRUT is easy for a donor to understand. A 6% trust with $300,000 in funding will pay $18,000.
Second, a standard CRUT is easier to administer. The calculation of the trust payout is usually completed every January 1 and the trustee can quite easily pay that amount out at the designated frequency, typically quarterly, monthly or annually.
Third, the CRUT can in most cases pay out capital gain returns. Retired business owners are very interested in minimizing their annual income tax. The CRUT will usually be invested 35% - 40% in bonds and the balance in equities. The trust payouts under the four-tier accounting structure of Sec. 664 will be first ordinary income taxable at ordinary rates, then long-term capital gain taxable at capital gains rates.
Example 4.10.4A FLIP Trust for Land
Bill and Alice Kenton own a small manufacturing business. They have a buyer who is interested in acquiring the business. Among the assets that would be acquired are the plant and the surrounding land.
The plant and land are worth $600,000 ($280,000 for the plant and $320,000 for the land), with a depreciated basis of $40,000. Since Bill and Alice took straight-line depreciation, the whole $560,000 of gain represents a potential long-term capital gain.
Bill and Alice transfer one-half of the value of the real property into a charitable remainder unitrust (CRUT) with their financial advisor as initial trustee. They and the financial advisor as trustee then jointly sell the property to a new buyer for $600,000. Bill and Alice receive $300,000 cash for their portion, and the financial advisor receives $300,000 for the trust sale of the other half.
On the $300,000 of cash, Bill and Alice do recognize capital gain in the amount of $280,000.
With the unitrust, there is a charitable deduction of $102,582. Transferring half of the property to the charitable trust enables Bill and Alice to reduce their tax bill by over $100,000.
Example 4.10.4B Equipment Unitrust
Bill and Alice also have machinery that has a fair market value of $500,000 and has been depreciated to $200,000. If the machinery were sold, the $300,000 of the sale price would be recaptured as ordinary income.
Therefore, Bill and Alice transfer the $500,000 in machinery into a second FLIP CRUT. Once again, the trigger event is the sale of the non-marketable asset. The trust is a net income unitrust (NICRUT) the first year and the machinery is sold promptly after the trust is funded. Since it is not permitted to use the machinery for an active business purpose while in the trust, the machinery is transferred into the trust on a Friday and then sold to new buyer on a Monday morning.
Because the 5% unitrust has been funded with an asset that includes potential ordinary income, the charitable deduction is based not on $500,000 in value but upon $200,000 in value. The charitable deduction is $188,826. However, the avoidance of tax on the $300,000 at ordinary income rates could save a large amount in potential income taxes at the time of sale. Therefore, even though there is a smaller tax deduction, Bill and Alice are very pleased to avoid recognizing the ordinary income upon sale.
With advice of counsel, Bill and Alice decided to use a second CRUT for the equipment rather than adding this gift to the first CRUT. While the first CRUT was funded with capital gain assets and thus can distribute capital gain, upon sale of the equipment this CRUT has $300,000 ordinary income in tier one. With this substantial amount in the ordinary income tier, all payouts from this trust for the lives of the Kentons are likely to be tier one ordinary income. For this reason, Bill and Alice select a 5% unitrust and hope to achieve greater growth in the trust. If the CRUT grows to nearly $1 million before they pass away, their income will nearly double by trust maturity. If Alice should live well past the estimated maturity when she is age 90 (she has an aunt who lived to be 97), there will be even greater income in those later years.
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Case Studies on Sale and Unitrust
The Dirtiest CRT Ever Created, Part 1 of 2:
Sam Morello, 50, has been in the mining business for some 30 years. His company, Hard Hat Drillers, a sole proprietorship, owns and operates several mines in the northeast part of the country. The company's sole source of revenue is from its mining efforts. However, a national landscaping company has made Sam an offer to buy his entire surplus of dirt for $100,000. There has not yet been any contract or other formal agreement between the two parties. In total, Sam estimates that he has about 12,000 tons of dirt.
The Dirtiest CRT Ever Created, Part 2 of 2:
Sam Morello, 50, has been in the mining business for many years and his company, Hard Hat Drillers, a sole proprietorship, owns and operates several mines in the northeast part of the country. The company's sole source of revenue is from its mining efforts. However, a national landscaping company has recently expressed an interest in purchasing the rights to extract dirt from Hard Hat Drillers' Pennsylvania mine. It is estimated that 12,000 tons of dirt could be extracted from the site. There has not yet been any contract or other formal agreement between the two parties.
Swenson "Early" Retirement, Part 3:
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. After he received a business degree, Bill moved back home and started a snowmobile and boating dealership. He and Clara worked very hard and now own two other dealerships. All are proprietorships. They also bought a small hotel and four commercial properties in town.
Priorities of a Proprietorship Sale:
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.
The Ultimate Donor Advised Fund:
Juan and Maria Hernandez, ages 65 and 60 respectively, are successful produce farmers and own 200 acres of prime land on the outskirts of their local community. The land is currently being farmed and produces primarily a variety of fruits and vegetables.
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