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Wednesday June 12, 2024

Article of the Month

Charitable Giving with LLCs, Part 2

Introduction

Individuals who want to start a business have several options for structuring their enterprise. As individuals explore the various possibilities, they often weigh factors like tax implications, liability protection and potential for business growth. One option is a limited liability company (LLC), which combines the pass-through taxation status of a partnership along with the liability protection afforded to C corporations. This limited liability protection helps shield personal assets from business debts and obligations, which provides some financial security.

LLCs have grown in popularity over recent decades. The owners of LLC interests, known as members, may elect at the outset whether the LLC will be taxed as a partnership or as a corporation using IRS Form 8832. All LLC discussions in this article will assume that partnership taxation was elected. In this two-part series, we will provide options to consider for charitably-minded LLC members. The first installment discussed the basics of LLC taxation, outright gifts, gifts to donor advised funds and bargain sales. The current installment will explore the benefits of using a charitable remainder trust (CRT) with LLCs, unrelated business taxable income, prearranged sales and disqualified person rules.

Charitable Remainder Unitrusts

A charitable remainder trust is an irrevocable tax-exempt trust that can be funded with LLC interests or LLC assets. The donor funds the trust with the asset, and the donor or named beneficiaries receive income for the duration of the CRT. Upon the termination of the trust, the nonprofit receives the remainder interest. When a charitable remainder trust is funded, the donor will receive an income tax deduction equal to the present value of the charitable remainder interest. The present value is calculated using the factors published by the IRS and the applicable federal rate (AFR) for the current month or one of the two prior months.

There are two types of charitable remainder trusts, charitable remainder annuity trusts (CRAT) and charitable remainder unitrusts (CRUT). Both CRATs and CRUTs can be created for a life, lives, a term up to 20 years or a life or lives plus a term of years. The trust creates a vested remainder interest in one or more qualified charities. The major difference between the two is that a CRAT pays a fixed percentage of the trust's initial funding amount, while a CRUT pays a fixed percentage of the trust principal as revalued each year. For example, a CRAT with a 5% payment funded with $100,000 will pay out $5,000 each year; a CRUT with the same funding value and payment percentage will pay out $5,000 the first year and then 5% of the trust's value, as revalued each year thereafter. When funding a trust with LLC assets, CRUTs are favored due to the ability to create more flexible payment structures. Because the LLC is not a "life" and cannot be a measuring life for a charitable remainder trust, the trust should be structured as a term of years trust if the LLC is the donor.

Charitable remainder unitrusts and annuity trusts have many similarities, but also possess distinct differences. Both types of CRTs are subject to the 10% minimum deduction interest test to qualify as a CRT. Under this test, the charitable remainder interest must be at least 10% of the initial value of the trust. The trusts must also make payments of at least 5% but no more than 50% to qualify as a charitable remainder trust.

While CRTs are tax-exempt trusts, the payments to beneficiaries are subject to the four-tier accounting rules from Sec. 664. Under this structure, the first tier is ordinary income, then capital gain, then tax-free income and, lastly, trust principal. Ordinary income must be paid out in its entirety before moving to the next tier with more favorable tax treatment and so on for each tier. The taxation of payments from charitable remainder trusts can be complex and donors should consult with a financial advisor or tax professional.

The trust payments in CRUTs can be structured in four different ways: (1) standard unitrust, which pays the unitrust percentage stated in the trust document; (2) net income unitrust (NICRUT), which pays the lesser of net income or the stated unitrust percentage; (3) net income plus makeup unitrust (NIMCRUT), which operates in a similar way as a NICRUT but includes an additional provision allowing the trustee to distribute make up payments when the trust earns more than the stated unitrust percentage if there were deficits in previous years due to the net income limitation on payments; and (4) FLIP Unitrust, which first operates as a NIMCRUT, then later flips to a standard unitrust on the following January 1 after a trigger event or date. When drafting a charitable remainder trust, the donor's attorney should be knowledgeable about the similarities and differences of each type. The donor's attorney will be best suited to guide the donor to the correct trust type based on the facts and circumstances of the LLC interest.

Unrelated Business Income

Income earned by LLCs passes through to the entity's owners. If the entity operates an active trade or business, the income from the trade or business maintains its character as active trade or business income in the hands of the LLC members. When a charitable organization has an ownership interest in an LLC with active trade or business income, the income will be unrelated business income (UBI) that is taxable to the nonprofit. Sec 512(c). If a CRT is an LLC member, an excise tax will apply on all UBI. Newhall v. Commissioner; No. 95-70501 (9th Cir. 1997). The tax will be equal to 100% of the UBI. Sec. 664(c)(2)(A).

While these UBI rules make LLC interests quite undesirable for charities in many circumstances, it may be a viable gift under the right conditions. If the nonprofit can sell the business interest before accumulating UBI, the gift may make sense for all parties involved. The nonprofit or CRT trustee will want to have an exit plan for disposing of the LLC interest soon after acquiring it and to avoid holding the LLC interest for an extended period. The nonprofit should be mindful that there may be a limited market for resale of a closely held LLC interest.

Example 1

Alana would like to retire and sell her ownership interest in a multi-member LLC. The LLC generates income from installing garage doors. She is concerned about paying capital gains tax if she sells the interest outright. She meets with an attorney, Brad, to discuss the possibility of donating her LLC interest to a charitable remainder trust for the benefit of a local university foundation. Brad advises Alana that it is advisable to have a buyer waiting in the wings since the LLC is generating income from an active business that will be taxable. Alana has informal discussions with another member of the LLC, Hattie, who indicates that she would be willing to acquire her interest in the LLC, but they do not sign a sale contract or negotiate terms.

Alana funds her CRT with her attorney, Brad, acting as trustee after the close of business on the Friday before a long holiday weekend. Alana knows that installations are halted on holiday weekends, thus the LLC does not generate any income. Over the holiday weekend, the independent trustee works with Hattie to negotiate the terms of sale of the LLC interest. On the following Monday, Hattie purchases the LLC interest from the CRT. Because the business was closed during the entire time the CRT held the LLC interest, there is likely no UBI for the CRT and thus no excise tax due. Any UBI would be minimal due to the short duration. Alana's attorney was comfortable with the short negotiation time and felt that no prearranged sale was present.

Prearranged Sale

As mentioned in the example, it is important for the nonprofit and trustees to avoid a binding obligation to sell the ownership interest before the transfer to a nonprofit or CRT. If there is a binding obligation prior to the charitable transfer, then the donor will not be able to bypass capital gains on the sale of the LLC interest. In most scenarios, having a buyer waiting in the wings without any binding obligation in place will not be considered a prearranged sale.

Donors can choose to self-trustee a CRT, but it is not advisable when funding with LLCs. The risk of a transaction being deemed a prearranged sale increases with this structure. The best practice is to have an independent trustee negotiate the sale of the interest. The donor can be designated as the successor trustee after the sale concludes.

Another creative solution for avoiding UBI when funding a CRT with an LLC interest is to consider leasing the entity's assets to a third party prior to making a charitable contribution of the ownership interest. With fixed lease payments in place prior to the charitable gift, all income received by the entity is deemed as passive income rather than active. Sec. 512(c). This will allow the donor to place their interest in a CRT and avoid UBI.

Disqualified Persons

The nonprofit must be mindful to prevent private inurement. This entails the nonprofit ensuring that no part of the net earnings of the nonprofit benefit any private shareholder or individual. This rule underscores the overall mission and operation of the nonprofit to provide a public benefit to a class of beneficiaries.

When a donor is contributing to a CRT, the disqualified person rules apply to prevent self-dealing between the CRT and certain related parties. Section 4941 prohibits a CRT from engaging in any self-dealing, whether direct or indirect. Some examples of disqualified transactions involving LLCs are the sale, exchange or leasing of property with disqualified persons. This prohibition on self-dealing means that the CRT may not lease to a disqualified person, as defined under Sec. 4946. This includes any substantial contributor to the CRT, anyone who owns more than 20% of the business, the trustee of the CRT and lineal descendants, including children, grandchildren and spouses of disqualified persons. The best option is to lease the business interest to an employee who does not fall within the classification of disqualified persons. The excise taxes imposed can be severe and donors and trustees should consult with an attorney when administering the trust.

Donor advised funds (DAF) are subject to excess benefit transaction rules, requiring caution when the DAF engages in transactions with related parties. Sec. 4958. If the value of the economic benefit, provided directly or indirectly, to any disqualified person exceeds the value of the consideration, then an excess benefit will have occurred. There is a 25% excise tax that is applicable on the excess portion of the benefit. If the transaction is uncorrected, then an additional tax of up to 200% of the excess benefit can be imposed on the disqualified person. DAFs are also subject to excess business holding rules under Sec. 4943, which limits ownership in a business enterprise to 20%, when combined with holdings by the donor and disqualified persons. If a DAF exceeds this limit, it must reduce its holdings within five years to avoid excise taxes.

Example 2

Corbin and his sister, Chloe, have owned a retail store organized as an LLC for the past 15 years. Although the shop has enjoyed great success, they are now ready to move on to other ventures. Corbin meets with his advisor, Henry, to come up with a creative and cost-effective way to sell the business while also generating a future income stream. Henry recommends that Corbin and Chloe lease the shop's assets to one of their valued employees, Dakota, and then transfer their LLC membership interests into separate CRTs. Dakota is not a disqualified person and is willing to take on a short-term lease of the LLC assets. Corbin and Chloe successfully transfer their LLC interests to their own CRTs, generating income for their lives and avoiding the 100% excise tax on the shop's income. By structuring a fixed passive lease prior to the transfer of the LLC interest, the UBI within the CRT is eliminated. The trustees of the two CRTs then sell the LLC interest to a new buyer. The new buyer does not renew the short-term lease and assumes control of the retail store.

Conclusion

There are several charitable strategies that can be used when selling a business or transferring a business to the next generation. Using charitable gifts, LLC members can align their objectives for exiting their business with their philanthropic efforts, while realizing tax savings. By understanding the tax implications that come with the pass-through taxation of LLCs and the tax advantages offered by charitable gift strategies, professional advisors will be well-equipped to guide and support business owners through their wind-down process.


Published June 1, 2024

Previous Articles

Charitable Giving with LLCs, Part 1

C Corporations and Charitable Giving

Employee Stock Ownership Plans and Charitable Giving

Charitable Gifts and Life Insurance Policies

Secure Act 2.0: New Year, New Rules

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