Friday April 26, 2024
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4.2.5 Charitable Unitrust Bailout
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The majority of family businesses are sold when the founders retire. However, perhaps one third of the time, children or other heirs will be capable of taking over the business. Normally, one or more children will show the aptitude and skills necessary to acquire and operate the business successfully.
In this circumstance, the parents typically have three goals. First, they desire to have a secure source of retirement income. As business owners, they understand that there is risk. Technologies and businesses and markets do change and the children may or may not be successful operating the business. Therefore, it would be desirable if there is a source of income other than just the business to secure their retirement.
Second, there is the desire to transfer the business to children. However, in most circumstances, some children will operate the business and other children will pursue independent lives and careers. For most small businesses, the children operating the business will need to have both control and ownership to assure the long-term success of that business. Thus, goal number two is to achieve transfer of the business to children, generally with zero gift or estate taxation.
Third, there often are other children who will not be involved in the business. Since children view an inheritance from the parents as a representation of the love of the parents, it is desirable for there to be at least general equivalence to the overall inheritance. Therefore, the third goal is to acquire resources appropriate to provide a substantial inheritance for children who are not involved in the business.
Avoiding Conflict Among the Children
If parents transfer either non-voting stock or minority interest in stock to non-business-owner children, there is a high probability of future conflict. The children who are involved in the business will frequently receive moderate to large salaries. Since most small businesses do not pay dividends, the children who are not involved in the business may receive nothing. This is a clear prescription for major family conflict.
Therefore, it is nearly always preferable to provide an inheritance from other sources for children who are not going to operate the business. This method will certainly facilitate family harmony and may also be very important in the successful operation of the business.
Retirement Income - Two Life Unitrust
The first part of the plan is to create a secure base for retirement income. The business founders create a 5% or 6% unitrust with a duration of two lives. They then transfer stock each year into the charitable remainder trust and obtain a qualified appraisal. Since there is no income from the stock, the preferred payout method is a FLIP unitrust.
After transfer of shares of stock into the charitable remainder trust, there is still no income. However, the corporation generally has liquid assets and generates additional after-tax cash each year. Thus, the corporation could redeem shares from the charitable trust.
However, the self-dealing rules normally prohibit any transfer between a trust funded by a disqualified party and the family business. Sec. 4941(d)(1)(A) and Sec. 4946(a)(1). Under the statutes, the donors are disqualified persons due to their transfer to the trust. In addition, their ownership of the family business, with the attribution of stock interests of children, also makes them disqualified persons.
Fortunately, an exception permits redemption of stock from the unitrust at fair market value. Sec. 4941(d)(2)(F). At the time the stock is transferred to the trust, there is no binding agreement for the corporation to purchase the stock. Rev. Rul. 78-197,1978-1 C.B.83. After a reasonable time, the trustee offers to sell the stock to the corporation. The corporation must be willing to purchase the stock from all shareholders and must be willing to pay fair market value. Since it was necessary to obtain an appraisal to qualify for the charitable income tax deduction, there is a clear determination of fair market value for the stock. Finally, with all stock held by family members, no one except the trust is willing to sell at the fair market value and the corporation may then purchase the shares of stock from the trust.
This gift and redemption process will occur on an annual basis. The cost of the appraisal is minimized if the same appraiser updates the company valuation each year. If the time between the gift and redemption is approximately 4-6 weeks, normally the same valuation will be used for both charitable deduction purposes and redemption.
Over a period of time, a significant proportion of the parent's stock (perhaps one-third or more) is transferred into the charitable remainder unitrust and redeemed by the corporation. The unitrust now acquires securities with the cash transferred and is able to produce a secure retirement income for the parents.
Transfer to Children
The second part of the plan is to transfer a block of stock to the children. In some circumstances, the parents desire to retain voting control. One option is to conduct a Sec. 368(a)(1)(E) recapitalization from all voting stock into both voting and nonvoting common stock. The parents may retain a majority of the voting stock and transfer the nonvoting stock to the children. There also will be an additional discount in the valuation of the nonvoting stock for lack of control.
The nonvoting stock may be transferred to children through several means. In some circumstances, use of the annual gift exclusion may be quite helpful. However, it is probable that the parents will also use their exemption equivalents for this transfer.
It is possible to leverage the transfer. A family limited partnership can reduce the value transferred by approximately 30%-40% or more. The FLP may be combined with a grantor retained annuity trust or a charitable lead annuity trust. Through a combination of various methods, $2 million to $25 million in stock may be moved through to children with no gift or estate tax.
Inheritance for Remaining Children
If there are several children, the probability is that one or two will be involved in the business and the others will pursue other occupations and activities. Fortunately, the charitable trust also facilitates another option. The parents may use a portion of the income from the charitable trust to create an irrevocable insurance trust. The irrevocable insurance trust typically uses a "Crummey" power. Since the parents also have annual gift exclusions for the remaining children, these exclusions are used to cover the transfers of funds into the trust each year. The remaining children are given a right for 30 days to withdraw the funds from the insurance trust. If they do not exercise that power, when the power lapses, the funds may then be used to purchase the insurance. See Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968,) Rev. Rul. 81-7, 1981-1 C.B.474.
Example 4.2.5A Clarke Company Charitable Bailout
Steve and Jody Clarke started the Clarke Children's Clothing Company 30 years ago. They now are both age 65 and are interested in retiring. Two of the four Clarke children are currently involved in the business. Their daughter Susan is company President and son Michael is Vice President and Director of Marketing.
The Clarke Clothing Company is now valued at approximately $5 million. By specializing in children's clothing and opening several stores in suburbs with young families, they have gradually expanded. The company is producing a substantial profit each year and holds approximately $800,000 in reserves. Since these reserves are well in excess of the $250,000 permitted amount for accumulated earnings tax purposes, it is necessary each year to justify the retention of the larger sum.
In order to facilitate their retirement plan, Steve and Jody recapitalized the company into 1,000 voting shares and 20,000 non-voting shares of common stock. They then created a two-life charitable remainder trust. This trust will pay 6% to them for their lifetimes. Steve and Jody transferred non-voting shares valued at approximately $500,000 to the charitable trust. They anticipate transferring similar amounts each year for the next four years to the trust.
The $800,000 in liquid assets plus accumulated profits over the next five years will be sufficient to cover the anticipated $2.5 million. Each year, there will be an appraisal to determine the number of shares that equal the $500,000. This appraisal is necessary to complete Form 8283 and support the charitable deduction. It also will substantiate the redemption under the Sec. 4941(d)(2)(F) exception for self-dealing.
Over five years, $2.5 million plus growth is accumulated in the unitrust. This is invested to produce a substantial retirement income for Steve and Jody.
At the same time, Steve and Jody transfer approximately one-half of their stock into a family limited partnership. Over the five years, they use their annual exclusions and their exemption equivalent to transfer FLP units to Susan and Michael. By the end of five years, the full amount of the value in the family limited partnership has been transferred. With the redemption of the stock from the unitrust and the transfer of the balance of the non-voting stock, Susan and Michael now own all of the non-voting stock. However, Steve and Jody continue to own 1,000 voting shares until year six. In year six, they transfer the 1,000 voting shares to Susan and Michael. Steve and Jody are now completely retired from both the business and stock ownership.
With the increase in the exemption equivalent, Steve and Jody still have available exemption and so will be able to provide substantial additional assets with no gift or estate tax. They are very pleased with the plan. They saved substantial capital gains and income taxes, have a generous retirement payout from the unitrust and moved Clarke Clothing Company through to Susan and Michael with no gift or estate tax.
The Clarke Insurance Trust
Steve and Jody create an irrevocable life insurance trust. The trust purchases a second-to-die survivorship variable universal life plan. They fund the plan with approximately $75,000 per year. Since the unitrust income when the trust is fully funded will be approximately $150,000 or more per year, they think the annual cost of the life insurance is acceptable. This funding will support a policy of approximately $3 million.
The goal is to have general equivalence to the inheritance plan. Business owners Susan and Michael received stock valued at approximately $3 million, while Steve and Jody's other two children will receive their $3 million from the life insurance trust. Of course, if the business prospers and does well, the shares of Susan and Michael could increase in value, but that will be largely as the result of their diligence and personal efforts. Steve and Jody Clarke believe that this is a fair and appropriate plan for everyone.
They have achieved a secure retirement income, transferred the business to Susan and Michael and provided a substantial inheritance for their other two children. With this plan, they have saved large income and capital gain taxes and completed their entire transfer plan with zero gift and estate tax.
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Case Studies on Charitable Unitrust Bailout
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.
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Private Letter Rulings
PLR
200230004 Redemption of Stock from CRT by Donor's Corporation Approved:
Donor A is President and sole shareholder of X, a C corporation. X has one class of stock and 500 shares outstanding. Donors A and B want to fund a net income plus makeup charitable remainder unitrust (NIMCRUT) with 495 shares of X, which has a fair market value of $594,000 and a basis of only $495. Donor A will continue to own the remaining five shares of X. Upon the termination of the trust, the remainder will be distributed to a foundation.
PLR
201228012 Stock Gift and Redemption Plan:
Father is president of a business (Corporation) and owns 100% of the voting stock. Child 1 and Child 2 are directors of Corporation.
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