Thursday April 18, 2024

4.8.2 Lease Option

Lease Option

Active Businesses Transferred to Unitrusts:  Most limited liability companies (LLCs) operate an active trade or business.

Who Can Lease LLC Assets?  A CRT is prohibited from engaging in any direct or indirect transaction with a disqualified person.

Lease Term:  If the LLC plans to sell its assets following their contribution to a CRT, the term of the net lease can be relatively short.

Active Businesses Transferred to Unitrusts
Most limited liability companies (LLCs) operate an active trade or business. If a charitable remainder trust (CRT) owns a membership interest in such an LLC, it may become subject to tax on unrelated business taxable income when the LLC's income is passed through to it or when the LLC's assets are sold.

Because an active trade or business is involved, any transfer of LLC assets to a CRT could subject the unitrust to a 100% excise tax on the unrelated business income (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. If, however, the income produced by the LLC assets is passive income, then LLC assets can be transferred into a CRT without the trust being subject to the 100% excise tax.

To avoid UBI, a donor who plans to contribute LLC assets used as part of an active trade or business to a CRT may have the LLC 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 rent from the lease. Fixed rent payments are passive income and not taxable UBI. Sec. 512(c). 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.

Who Can Lease LLC Assets?
A CRT is prohibited from engaging in any direct or indirect transaction with a disqualified person. Sec. 4941. This means that a CRT cannot receive lease payments from a disqualified person. It is therefore important for an LLC to select a non-disqualified person to lease its assets if it plans to employ the lease UBI strategy.

Whether someone is a disqualified person with respect to a CRT is determined by facts and circumstances, but generally, disqualified persons include the LLC itself, anyone who owns more than 20% of the LLC, a trustee of the CRT or a family member of any disqualified person (not including his or her brothers and sisters). Sec. 4946.

A common choice of person to lease assets from an LLC is a key employee (but not an owner of the LLC). Legal counsel should be consulted to ensure that the person who leases assets is not a disqualified person. The person who leases the asset will actually make a net profit on the lease.

Lease Term
If the LLC plans to sell its assets following their contribution to a CRT, the term of the net lease can be relatively short. For safety, the short-term lease should include additional renewal periods.

Case Studies on Lease Option

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.

Related Topics on Lease Option

4.10.2  Lease and Debt Solutions:    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.

4.14.7  Lease UBI Solution:    As discussed in GiftLaw Pro 4.14.5, it is common for an S corporation to make a direct gift of one or more assets to charity or to a term of twenty years charitable remainder trust (CRT). When this occurs, it is important to consider whether the gifted asset is used in an active trade or business. If it is, both the income from that asset and any gain or loss from the sale of that asset are subject to unrelated business income (UBI) tax.

4.14.8  Self-Dealing Issues:    A CRT is prohibited from engaging in any direct or indirect transaction with a disqualified person. Sec. 4941.

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