The purpose of the excess business holding rules is to discourage business owners from attempting to operate businesses in a manner that avoids taxation. If it were possible to operate a business in a charitable lead trust for a long period of time, some owners might attempt to transfer the business to the lead trust and run the business through the lead trust. So long as the profits from the business were approximately equal to the charitable distributions under the lead trust, the business could effectively run with minimal taxation. Under the incidental exception to the Sec. 4941 self-dealing rules, the owners could even pay themselves and family members' salaries for services rendered, provided that the salaries were reasonable.
To minimize the potential for business owners to attempt to operate a business long-term in a charitable lead trust, there is another application of the excess business holding rules. Under Sec. 4947(b)(3), if the charitable deduction for the value of the income interest transferred to charity with the lead trust is over 60%, then the excess business holding rules apply.
Planning Options
This still allows two different planning options for the business owner. First, it is possible to create a lead trust with a charitable deduction of 59.9%. The business could be transferred to the charitable trust and then owned by the trust, provided the deduction is limited to that amount. If the owner still has his or her full lifetime gift exemption, it may be possible to transfer a fairly substantial business to a charitable lead trust and operate it. However, the option would require that the business be a C corporation. If the business were operated as a partnership or LLC, then the unrelated business income would trigger Sec. 681 and only 50% of the income paid to charity each year would be deductible.
While a lead trust is a taxable entity and files IRS Form 1041, the lead trust normally is permitted, under Sec. 642(c), to qualify for a 100% charitable income tax deduction for all amounts paid to a qualified charity. Therefore, all lead trust income may be deductible, if distributed under the appropriate unitrust or annuity trust formula to charity.
The second option is to transfer a family C corporation to a lead trust and set the duration of the lead trust at five years or less. If a lead trust were created for 4.999 years, the family business stock could be transferred to the lead trust. Since the duration of the lead trust is reasonably short, the payout may need to be fairly high to receive a large charitable gift tax deduction. This could in some cases require distribution of stock. However, it may also be possible to reduce the taxable transfer through a combination of a family limited partnership and a charitable lead trust.
Example 5.3.3A Business Lead Trust
George and Martha started Family Corporation many years ago. They now wish to move Family Corporation through to their two children. They have already made gifts of some shares of stock to the children. Since all stock is held by George and Martha White or their children, the family members are disqualified parties and the excess business holding rules could apply.
George and Martha transfer $2,000,000 of corporate stock to a lead trust. It pays 6% to Favorite Charity for a term of 14 years. The total charitable payments are $1,680,000. After that period of time, the stock will be transferred to their two children who are currently in their 40's.
The advantage of this plan is that the charitable deduction of $1,172,796 is less than 60% of the total value. Since they are able to use their gift exemptions to cover the remaining taxable gift, there is no gift tax payable now. George and Martha can continue to operate the business. They plan to pay dividends to the charitable lead trust to make the distributions to Favorite Charity. At the end of 14 years, the stock in Family Corporation will flow to their two children.
Example 5.3.3B
George and Martha White operate a family business that is a C corporation. They are interested in making a transfer to their children, but the children are now in their 50's. Therefore, George and Martha would like to make the transfer as quickly as possible.
The stock has a fair market value of $2,000,000. George and Martha transfer the stock into a family limited partnership. They follow all of the appropriate partnership business practices and have retained substantial assets outside the family partnership to provide for all of their personal support and needs. The family limited partnership units are then transferred into a charitable lead trust for a term of 4.999 years. With the 33% discount for the FLP, the limited partnership assets are valued at $1,340,000. The lead trust annuity of $120,064 is nearly 9% of the trust assets. As a result of the double discount, the taxable gift is reduced by the FLP from $2,000,000 to $1,340,000, and then with the charitable deduction reduced a second time to $823,136. This amount is then covered by the gift exemptions of Martha and George.
Over five years, the double discount lead trust pays $600,200 to Favorite Charity. On the five year anniversary, the full value of the stock is transferred to the children. Because the stock was transferred by a gift, George and Martha's cost basis flows through to the children. However, the children plan to hold the stock, so this is not a problem. If the children at some point decided to sell the highly appreciated stock to a new buyer, they could always use a sale and unitrust strategy for a zero capital gain sale.
