Thursday March 28, 2024

4.12.2 Family Business Stock

Family Business Stock

Major Planned and Endowment Gifts:  During the past decades, millions of new jobs have been created.

Succession or Sale:  A fundamental decision by the business owner who is of retirement age is whether to sell the business or to pass it on to family members.

Sale of Family Business:  If the decision is made to sell the business, there are usually two objectives.

Gift and Sale:  The first method is a gift and sale.

Charitable Bailout:  A charitable bailout involves a transfer of the corporation to the children or other persons.

Gift and Corporate Repurchase:  A fourth method is use of a gift and subsequent stock repurchase.

Unitrust Bailout:  Another option is the unitrust bailout.

Gift Annuity Bailout:  A third bailout strategy involves a charitable gift annuity.

Major Planned and Endowment Gifts


During the past decades, millions of new jobs have been created. Few of these jobs were created by the largest companies in America: most large companies actually reduced employment during this time. The millions of new jobs were created in small and medium-sized family businesses.

Many owners of family businesses serve as members of a charity's board of directors or are major donors to charity. Most of the largest gifts and many substantial endowment gifts come from family business owners.

Family corporations are either C corporations or Subchapter S corporations. The C corporation files its own tax return and pays corporate-level taxes. Most closely held C corporations do not pay dividends, but distribute salaries to family members. These salaries are deductible to the corporation as compensation.

Gifts of closely held C corporate stock to charities have both favorable and unfavorable features. The favorable feature is that the stock may be sold tax-free by the charity. The challenge is that the stock is not publicly traded and there may be no one other than the family and the closely held corporation willing to purchase it.

Subchapter S corporation owners also may make major gifts. The Sub S gifts could be shares of stock, but are more likely to be gifts of actual assets. Since a charity now is a permissible holder of Sub S stock, the owner could transfer shares directly to the charity. However, the stock held by a charity produces unrelated business taxable income. Sec. 512(e)(1)(A). Therefore, most charities are reluctant to hold Sub S stock.

With the Sub S corporation, a donor may prefer instead to make gifts of assets. With a gift of Sub S assets to charities, the charitable deduction will flow through, but the deduction limit will be the outside cost basis of the owner in the Sub S shares of stock. Sec. 1366(a). For more information on gifts of S corporation stock, see GiftLaw Pro 4.14.

Succession or Sale


A fundamental decision by the business owner of retirement age is whether to sell the business or to pass it on to family members or employees.

The majority of businesses are sold rather than passed to family members or employees. There are several reasons why a business might be sold. First, the owners' children or other relatives may not have the desire or skills necessary to run the business. Second, the business may be in a field, such as technology or manufacturing, in which size is essential to success. The successful continued operation of the business may require it to become part of a larger organization.

However, if there are family members or employees who are competent to manage the business, then a family succession plan may be implemented. With a family succession plan, there are a number of considerations. Some of these relate to gift or estate taxes. Perhaps the more important considerations are practical. How will the next generation fare in operating the company? Do they have the requisite skills and knowledge? Will they surpass the founder and take the company to a completely new level of success? Are there other children or heirs not in the business who should also receive a fair inheritance through other means?

All of these questions can be answered successfully, but require careful planning by both the business owners and their advisors. If the business owners have charitable receptivity, there are some excellent means for business transfer that can both benefit charities and potentially increase the probability of success for the children who operate the business.

Sale of Family Business


If the decision is made to sell the business, there are usually two objectives. First, the business owners want to minimize loss in value due to capital gains taxation. Typically, the business has been built over a period of 25 to 40 years and parents would like to maintain the value it has reached when they are ready to retire.

There are several methods individuals in this situation use to minimize tax, particularly if they are charitably oriented. These methods are most effective if the family business is a C corporation that is sold to a larger C corporation.

Gift and Sale


The first method is a gift and sale. The business owners transfer a portion of their stock outright to a charity. There is no prearranged sale when the stock is transferred to the charity, since the charity is not under a binding obligation to sell. See Rev. Rul. 78-197, 1978-1 CB 83. See also Ferguson v. Commissioner.

The charity and the owner then jointly sell the shares of stock to the new buyer. On the gifted shares, the donors bypass capital gain and receive a charitable deduction. The charitable deduction then offsets part or all of the tax on the portion that is sold.

Example 4.12.2A Gift and Sale

Harry and Wilma Nelson started their company 32 years ago. They now are in their late 60s and have an offer from a larger corporation to purchase their stock. Their cost basis is $1,000 and the C corporate stock is worth $1 million. They do have a letter of intent, but it is not legally binding. Therefore they can still transfer a portion of their shares to charity.

Harry and Wilma decide to give one-tenth, or $100,000 in value, to their favorite charity. After the stock has been transferred to the charity, they and the charity jointly sell all shares to the large corporation. The $100,000 block of stock given to the charity enables them to bypass the capital gain on $99,900 and to receive a charitable deduction of $100,000.

On the $900,000 sale portion, there is capital gain tax due. They are able to make a gift to charity of $100,000 and net cash after tax. This was the best opportunity in their entire lifetimes to make such a major gift to charity at moderate cost.

Charitable Bailout


A charitable bailout involves a transfer of the corporation to the children or other persons. The charitable bailout has three basic features.

First, there is an outright or leveraged gift to children. The easiest option is to transfer the stock using their annual exclusions. With two parents and three or more children, significant value may be transferred, particularly since the stock shares may have a discount of 20-40% of fair market value for gift tax purposes.

There are various other methods for leveraged transfers. These include a charitable lead trust for five years or less; a grantor retained annuity trust normally for two or three years; a family limited partnership or even a combination plan termed an FLP-lead trust. These transfers of larger value will also frequently make use of the gift exemption of the business owners.

Second, there is typically a transfer to a charity outright or through a charitable remainder trust or a gift annuity. This method facilitates sale of assets with bypass of capital gain, and may provide a secure retirement income for the parents.

Third, life insurance trusts are frequently included in planning. A life insurance trust may provide needed liquidity for the estate. It also is very helpful in facilitating an inheritance for family members who are not participating in the business.

Gift and Corporate Repurchase


A fourth method is use of a gift and subsequent stock repurchase. This method involves a gift of part of the C corporation stock to children and a gift of the balance to charity. At some point after these transfers, the corporation redeems the charity's stock, leaving the charity with liquid assets and the children as the sole corporate shareholders. So long as the charity is a public charity, this repurchase may be achieved with either cash or a note. If cash is used, distributions of cash to the charity will reduce the corporation's excess accumulated earnings.

When the gift and corporate repurchase plan is used, it is important that at the time of the gift to charity, no prearranged agreement exists between the corporation and charity to redeem the stock. Specifically, on the date of the gift neither party may be bound to effect a repurchase. See Palmer v. Commissioner, 62 T.C. 684 (1974), aff'd 523 F.2d 1308 (8th Cir. 1975). See also Rev. Rul. 78-197, 1978-1 CB 83.

A redemption that follows a gift to charity should be sufficiently separate from the gift that the risk of prearranged sale is removed and it is clear the repurchase is a separate transaction from the gift. The period of time that should separate the gift and repurchase varies by situation. In some cases, more than a year separates the gift and repurchase. In others, a period of two to six weeks is sufficient.

Since the value of the shares given to charity is very likely to be over $10,000, an appraisal will be necessary to substantiate the gift to charity and the donor will need to file Form 8283. An independent appraisal will consider the nature of the business, the book value of the stocks, the company's earning capacity, the dividend paying capacity, company goodwill, other tangible value, any other sales of stock and the value of comparable companies. Rev. Rul. 80-213, 1980-2 CB 101, Rev. Rul. 83-120, 1983-2 CB 170.

One of the benefits of the gift and repurchase strategy is that the corporate bailout can be accomplished over a period of years. If the transfer takes place towards the end of each year for a number of years, the appraisal costs may be reduced, since the appraiser will merely need to update the appraisal each year.

Example 4.12.2C Gift and Corporate Redemption

Mary Business Owner owns 8,000 shares of non-voting stock and 2,000 shares of voting stock in her C corporation. Over the years, using gift exclusions and her available gift exemption, she has given most of the non-voting shares to her four children. She intends to keep the 1,000 voting shares and transfer the remaining 1,000 voting shares to children or to charity.

Mary Business Owner begins this process by transferring 50 voting shares to charity. The appraised fair market value of these shares is $50,000. There is no binding agreement that the corporation will repurchase these shares from the charity, but when the charity offers to sell its shares to the corporation six weeks after the gift, the corporation agrees to the repurchase and pays charity $50,000 for the stock. Following the repurchase, the charity has $50,000 cash and the corporation holds the shares as treasury stock. Mary has received a personal income tax deduction of $50,000 for her gift.

Through this transaction, Mary reduced the number of shares that will eventually need to be transferred to her family or other charities. This saves income, gift and future estate taxes.

Unitrust Bailout


Another option is the unitrust bailout. Once again, there is a gift of stock to children. At the same time, shares of stock may be transferred to a charitable remainder unitrust. There is no binding obligation for the unitrust to sell. After a period of two to eight weeks, the unitrust trustee (usually an independent party) offers to sell the shares to the corporation. Using the self-dealing exception of Sec. 4941(d)(2)(F), the corporation then repurchases the shares.

Example 4.12.2D Unitrust Bailout

John and Mary Jones are age 70 and 68 and ready to retire. They own a business worth $1.5 million. John and Mary give $1 million worth of stock to the children. They then transfer $300,000 in stock to a charitable remainder unitrust. John and Mary also sell the remaining $200,000 of stock to the corporation for cash.

The sale and unitrust enable John and Mary to bypass gain on the sale of the $300,000 of stock. They also receive an income tax charitable deduction of $121,722. This tax deduction and resulting tax savings offsets the tax paid on the receipt of $200,000 of cash.

John and Mary Jones now have $210,000 in their securities account and $300,000 in the unitrust. The unitrust pays 5% for two lives. If the trust earns 8% and pays 5% it grows by 3% for the estimated 22.7 years of their expectancy.

Gift Annuity Bailout


A third bailout strategy involves a charitable gift annuity. The business owners again transfer part of the stock to children through a gift or leveraged gift strategy. The balance of the stock is transferred to a charity in exchange for fixed payments through a charitable gift annuity. The charity is legally obligated to make payments on the gift annuity, and after a reasonable period of time, offers to sell the stock to the corporation. The corporation then redeems the shares of stock. In some circumstances, the corporation may choose to repurchase the stock for a note, usually with corporate real estate securing the debt.

Since the charity is running some risk in issuing a gift annuity for closely held stock, the parents also make a gift of $100,000 worth of stock outright to the charity. The charity also sells this $100,000 of stock back to the family business. Since the charity is obligated on the gift annuity, but has received approximately double the value of the gift annuity in total gifts, there is minimal financial risk to the charity. With this plan, the charity receives both a current and a future gift.

Example 4.12.2E Gift Annuity Bailout

John and Mary Stock have a business valued at $1.5 million. They make a leveraged gift to family of the majority of the stock. They also make a gift to charity of stock. In addition, they transfer $200,000 of appreciated stock to the charity for a charitable gift annuity.

Based upon their ages, they receive a 6.3% annuity, or $12,600. Part of the value is a charitable deduction of $83,671. In addition, they bypass the part of the gain attributable to the charitable tax deduction. The balance of the gain is allocated to the contract value. Each year the $12,600 payout is $3,440 of ordinary income, $7,328 of capital gain and $1,832 of tax-free payouts. After their life expectancy, the payouts will thereafter be ordinary income.

John and Mary have transferred the business to family members and enjoy a secure income supplement to their Social Security and other pension income. In addition, they have enabled their children to have opportunity to purchase from the charity a portion of the value of the business. This buyout opportunity is very helpful in encouraging the children to learn the skills necessary to run the business successfully.

Case Studies on Family Business Stock

Greenco Unitrust Bailout:   Bill and Clara Green consider themselves very fortunate. Bill was born in Estonia. When he was an infant his parents immigrated to America. He attended high school and State College on the East Coast. After he received an engineering degree, Bill worked for two different companies on the East Coast. He met Clara, married and they have two children, Susan and Harry.

Greenco Gift Annuity Bailout:   Bill and Clara Green consider themselves very fortunate. Bill was born in Estonia. While he was an infant his parents immigrated to America. He attended high school and State College on the East Coast. After he received an engineering degree, Bill worked for two different companies on the East Coast. He met Clara, married and they have two children, Susan and Harry.


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