Coordinating Charitable Trusts and Private Foundations for the Business Owner: Complying With UBIT and Self-Dealing Rules

Editor: Mindy Tyson Weber, CPA, M.Tax.

Estates, Trusts & Gifts

For many closely held business owners, the bulk of their wealth is tied to the business to which they have devoted the better part of their life growing. With such a concentration of assets, and the illiquidity that generally goes along with it, charitable planning using charitable trusts and private foundations can be more difficult. This item details some charitable giving options for owners of closely held businesses, the applicable unrelated business income and self-dealing rules, and best practices for taxpayers who have these charitable desires and restrictions.

Charitable Trust and Private Foundation Basics

Through the use of charitable trusts, donors can achieve their goals of providing meaningful gifts to their favorite charity, with the added benefits of passing wealth to the next generation and obtaining favorable tax treatment. From a tax perspective, charitable remainder trusts (CRTs) and charitable lead trusts (CLTs) can offer three main benefits. First, the donor may take an income tax deduction for the remainder interest or lead interest that is calculated as going to charity (Sec. 170(b)(1)(A)), reduced by the amount that would be taxed as ordinary income if sold by the donor, though a CLT must be a grantor trust to qualify.

When computing the charitable deduction for transfers of long-term capital gain property, no reduction for the allocable built-in gain is necessary, although special rules apply to transfers of tangible personal property unrelated to the charity’s exempt purpose (Sec. 170(e)(1)(A) and Regs. Sec. 1.170A-4(a)). Second, the portion of the trust given to charity will be removed from the donor’s estate and thus avoid the 40% estate tax (for persons with estates over $5.34 million, the 2014 unified estate and gift tax exemption amount). Lastly, creating a charitable trust and transferring appreciated property allows the donor to avoid the capital gains tax that would have been due if the property were sold by the donor individually. Because CLTs are required to be grantor trusts to receive the income tax deduction upon creation, there will be no double income tax benefit if appreciated property is transferred to the trust and later sold, as any future sale by the trust will be recognized by the grantor.

Charitable remainder trusts: Just as its name implies, a CRT pays an annuity or percentage amount (known as a unitrust, if the trust agreement calls for a percentage payout) to a designated beneficiary for a term of years (not to exceed 20) or the life of the beneficiary, with the remainder passing to a charity selected by the trust’s settlor. The trust agreement needs to meet a number of specific requirements for the trust to qualify as a CRT and obtain the favorable treatment outlined above (see Sec. 664(d) and Regs. Secs. 1.664-1(a) and -3(a)). To make the drafting of charitable trusts more of a science than an art, the IRS published “safe-harbor” draft trust agreements with alternate provisions and annotations, giving examples of trusts that would satisfy all the requirements of a qualified CRT (see Rev. Procs. 2005-52 through 2005-59).

CRTs are the best alternative when settlors would like to provide a current benefit to themselves, or their descendants, for life or a term of years, with the remainder passing to a charity of their choice. These trusts can provide a stable, annual cash flow stream for the settlor or the settlor’s loved ones, bringing peace of mind. The optimal time for creating a charitable remainder trust is during a tax year when the settlor expects to recognize greater-than-average taxable income.

Charitable lead trusts: A CLT is essentially the reverse of a CRT. The grantor establishes a trust that makes an annual payment to charity for a stated number of years or for a period measured by one or more related persons’ lives, with the remainder passing to the donor or a person selected by the donor in the trust agreement (Regs. Sec. 20.2055-2(e)(2)(vi)(a)). As discussed above, a CLT must be set up as a grantor trust, with all the trust’s income reported on the grantor’s individual return, in order to qualify for an income tax charitable deduction. In addition, if the grantor dies during the term of the CLT and is thus no longer responsible for income taxes on the income earned by the trust, the grantor is required to recapture the income tax charitable deduction on his or her final income tax return (Sec. 170(f)(2)(B) and Regs. Sec. 1.170A-6(c)(4)). These detriments mean that a CLT is not always considered a valuable tool for income tax planning. The “safe-harbor” sample trusts, alternate provisions, and annotations published by the IRS for charitable lead annuity trusts and unitrusts can be found in Rev. Procs. 2007-45 and 2007-46 and Rev. Procs. 2008-45 and 2008-46, respectively.

The creation of a CLT is ideal for a high-net-worth individual looking to benefit a charity immediately for a specified amount of time, move some of his or her wealth out of the estate, and provide a benefit to heirs when the grantor may no longer be around. Through the creation of a charitable lead annuity trust, the donor’s favorite charity can count on a specific dollar amount coming into the charity for a term of years, allowing the charity to do large capital projects or establish an ongoing program supported directly by the annuity payment.

Planning in a low-interest-rate environment: The current low interest rates may influence the choice of trust type. Any annual increase in a CLT’s value over the Sec. 7520 rate (2.4% for February 2014) increases the remainder amount passing to the grantor or his or her descendants, making these trusts more attractive. Conversely, charitable remainder trusts that are unitrusts, which pay out a predetermined percentage of the net fair market value (FMV) of the trust each year, are not as attractive for individuals in this low-interest-rate environment because the remainder interest passing to the beneficiaries is calculated using the unitrust percentage (at least 5%), rather than the Sec. 7520 rate. One benefit of the unitrust over the annuity structure is that each year only the predetermined percentage of assets will be distributed to charity. Therefore, if the trust assets’ FMV decreases sharply, the unitrust payment will not deplete the trust as a result of a predefined dollar payout.

NIMCRUTs and FLIPCRUTs–Ideal for low-income-producing assets or income planning: Similar to a CRT, a net income makeup charitable remainder unitrust (NIMCRUT) has a current noncharitable beneficiary receiving an annual payment of a percentage of trust assets (at least 5%) for a term of years (no more than 20) or the life of one or more persons, with the remainder passing to charity (the net income payout structure is not available to CLTs). However, a NIMCRUT differs from a CRT in that it needs only to pay out the lesser of the current-year trust income or the percentage specified in the trust agreement. Any “underpayment” for years when income is less than the amount calculated under the stated unitrust percentage is deferred and paid out in future years when there is net income available for payment.

The net income of a NIMCRUT is not determined under income tax or financial accounting principles, but rather is calculated under the terms of the trust agreement and applicable local law. Most states have now adopted some form of the Uniform Principal and Income Act, which determines the income required to be distributed annually by the NIMCRUT unless the trust agreement says otherwise. This affords the trust drafter considerable latitude in planning for what cash flow items should be considered “income” for purposes of annual distributions, as well as what should be included as part of principal.

The real benefit of the NIMCRUT to closely held business owners is that in years when trust accounting income (TAI) is less than the amount computed under the stated unitrust percentage, the trust principal remains in the trust, allowing the assets to continue to appreciate in value over the trust term. Funding a NIMCRUT with a partnership interest is ideal for TAI planning purposes. Under the Uniform Principal and Income Act, TAI includes only partnership distributions, not the actual items reflected on the partnership Schedule K-1 the trust received. This allows for trust principal to accumulate unless the partnership makes an actual distribution to the trust.

As if the acronyms are not plentiful enough, the “flip” charitable remainder unitrust (FLIPCRUT) is yet another planning option. FLIPCRUTs allow for a NIMCRUT to “flip” back to a non-net income makeup structure and act simply as a CRUT. This planning flexibility can be great for a married couple using a NIMCRUT as part of their retirement planning. Initially, a NIMCRUT would be structured to allow for unitrust payments, but funded with assets that lend themselves to easy income timing based on the grantor’s needs. The intent would be to recognize minimal income until the occurrence of an event (e.g., death of one spouse or retirement). Adding language to the NIMCRUT to allow it to flip to a regular CRUT allows for increased payments upon the triggering of the event, when the money is needed, but leaves the assets to continue growing before the event. In theory, this results in a larger remainder amount and the potential for more income, due to a higher principal value prior to the triggering event.

Private foundation option–Larger charitable purpose and increased cost: For a closely held business owner who desires to create an ongoing entity with the sole purpose of benefiting one or more qualified charities, a private foundation can accomplish those goals. However, a foundation carries higher administrative costs than a charitable trust. The foundation will need to apply for exempt status under Sec. 501(c)(3), file an annual Form 990-PF, Return of Private Foundation, with the IRS to maintain its exempt status, and pay employee salaries. With these higher operating costs, the foundation should be established with substantial funds (usually more than $1 million) to ensure the foundation can still provide large charitable grants annually without depleting the original contribution.

Furthermore, a closely held business owner whose major asset is closely held stock or a partnership interest should carefully evaluate the extent to which the business stock or partnership interest should be used to establish a private foundation. Funding the private foundation with business stock or a partnership interest may result in unrelated business taxable income (UBTI) subject to tax and raise self-dealing issues.

Self-Dealing Rules and Common Danger Zones

When establishing a charitable trust or private foundation, the donor needs to be aware of the self-dealing rules and how they apply to someone who is considered a “disqualified person” under Sec. 7701(a)(1). Charitable trusts are considered Sec. 4947(a) split-interest trusts and, thus, treated as private foundations subject to the self-dealing rules under Sec. 4941. A tax is imposed for each act of self-dealing that occurs between a foundation and a disqualified person, defined under Sec. 4946(a) as any of the following:

1. A substantial contributor: Any person who contributed or bequeathed more than $5,000 to the private foundation if the amount represents more than 2% of the total contributions and bequests received by the foundation in the tax year the gift is received.
2. A foundation manager: Any officer, director, or trustee of a foundation, or an individual who has similar powers.
3. The owner of more than 20% of the total combined voting power in a corporation, the profits interest in a partnership, or the beneficial interest in a trust or unincorporated enterprise that is a substantial contributor.
4. The spouse, ancestors, descendants, or spouse of descendants of any of the persons listed in items 1 through 3, above.
5. A corporation, partnership, trust, or estate in which any person listed in items 1 through 4, above, owns more than a 35% interest.
6. For purposes of the tax on excess business holdings (Sec. 4943), a controlled or related private foundation that is effectively controlled by the same person or persons, or that received substantially all of its contributions from the persons listed in items 1, 2, or 3 (or their families), who also made substantially all of the contributions to the foundation.
7. A government official as defined under Sec. 4946(c).

As the founder of a private foundation, a business owner is considered a substantial contributor and disqualified person under 1, above. Under Sec. 4941(d), acts of self-dealing include:

• Selling, exchanging, or leasing property;
• Lending money or extending credit;
• Furnishing goods, services, or facilities;
• Paying compensation to or reimbursing expenses of a disqualified person;
• Transferring to or using the income or assets of a private foundation by a disqualified person;
• A private foundation agreeing to pay money or other property to a government official.

The excise tax imposed on an act of self-dealing committed by a disqualified person contains, potentially, two components. A first-tier tax of 10% is imposed on the disqualified person on the greater of the money and FMV of property given, or the money and FMV of property received, determined as of the date of the act of self-dealing (Secs. 4941(a) and (e)(2)). Next, an additional second-tier 200% tax is imposed on the amount involved if the prohibited transaction is not corrected within the tax period (Sec. 4941(b)).

LLC and partnership joint investment: The creation of a partnership or a limited liability company (LLC) by a private foundation and disqualified persons is not automatically deemed a prohibited sale or exchange of property (Letter Ruling 200420029). However, the normal operations of the partnership or the disposition of the foundation’s interest in the business may cause self-dealing issues to arise. Therefore, if a business owner decides to transfer closely held stock to a private foundation or enter into a partnership with a private foundation as a partner, care should be taken in reviewing the self-dealing rules to ensure prohibited transactions and associated excise taxes are avoided.

Leases, goods, services, and use of facilities: When a disqualified person enters into a lease or provides goods, services, or facilities to a private foundation, or vice versa, this may be considered an act of self-dealing. If a disqualified person owns several pieces of real estate and the foundation needs office space for foundation operations, the foundation should not use the property unless it is given without charge (Regs. Sec. 53.4941(d)-2(d)(3)). Certain exceptions do apply to foundation managers and employees, including for items on the following nonexhaustive list: office space, cars, auditoriums, secretarial help, meals, libraries, publications, laboratories, or parking lots (Regs. Secs. 53.4941(d)-2(d)(1) and (2)).

Loans: Another problematic self-dealing area for the unwary is the extension of credit between the foundation and a disqualified person, or vice versa. A disqualified person might “help out” the foundation by lending it money at a below-market interest rate. However, this constitutes an act of self-dealing subject to the excise taxes outlined above (Sec. 4941(d)(1)(B)). In theory, foundation managers will be sophisticated enough to identify and avoid self-dealing, but this is an area that can be counterintuitive for the primary substantial contributor to the foundation. It should be noted that if a loan is interest-free and without any other charges and the proceeds are used exclusively for the foundation’s exempt purposes, the loan is not considered an act of self-dealing (Sec. 4941(d)(2)(B)).

Unrelated Business Income Tax

As another area of concern outside of self-dealing, funding a private foundation or charitable trust with a closely held business interest can subject the income of the foundation or trust to a tax on UBTI. An activity of a foundation or charitable trust will be considered an unrelated trade or business if the three following conditions are met:

1. The organization is conducting a trade or business for the production of income from selling goods or performing services (Regs. Sec. 1.513-1(b));
2. The organization regularly carries on the trade or business (Regs. Sec. 1.513-1(c)); and
3. The activity is “not substantially related” to the carrying out of the organization’s exempt purpose (Regs. Sec. 1.513-1(d)).

A charitable trust or foundation is generally subject to tax on income from a business if a controlling interest in the business is transferred to the trust or foundation (Sec. 512(b)(13)). If greater than 50% of a company’s stock (by vote or value) or a partnership’s profit or capital interest is transferred, the trust or private foundation will be considered to have control.

Unrelated business income tax (UBIT) exceptions: Even if all the criteria above are met, certain exceptions apply that are statutorily defined under Sec. 513. Common exceptions to unrelated business income treatment include activities substantially related to the organization’s exempt purpose (Sec. 513(a)), activities staffed with volunteer labor (Sec. 513(a)(1)), activities carried on for members’ convenience (Sec. 513(a)(2)), activities related to selling donated merchandise (Sec. 513(a)(3)), qualified public entertainment and convention and trade show activities (Sec. 513(d)), activities not regularly carried on (Sec. 512(a)(1)), and activities involving distributions of low-cost articles without obligation to purchase and exchanges and rentals of member lists (Sec. 513(h)(1)).

Donor-Advised Funds

With the high annual operating and administration costs of split-interest trusts and private foundations, a donor may be looking for an easier planning technique that stops short of handing a check directly to charity. Donor-advised funds are an excellent vehicle for donors looking for simplicity, low cost, and flexibility in directing gifts, while avoiding the self-dealing rules. Sec. 4966(d)(2) defines a donor-advised fund as a fund or account that is separately identified by reference to contributions of a donor or donors, that is owned and controlled by a sponsoring organization, and for which the donor or donor adviser has, or reasonably expects to have, advisory privileges in the distribution or investment of amounts held in the donor-advised fund or account by reason of the donor’s status as a donor.

The main benefits of donor-advised funds come through the donor’s ability to (1) gift anonymously; (2) get a current income tax deduction (in most cases) for the contribution to the donor-advised fund without necessarily knowing which charity the donor would like to benefit at the time of contribution; and (3) have professional investment management, if necessary. As mentioned above, the self-dealing rules do not apply to transfers to donor-advised funds; however, there are special rules relating to transfers with “more than incidental benefit” to certain persons (Sec. 4967(a)). Providing certain persons with prohibited benefits from the donor-advised fund will result in an excise tax, which should be kept in mind by those donating through such a fund.

Conclusion

Charitable planning through split-interest trusts, private foundations, and donor-advised funds provides a great deal of flexibility for the closely held business owner wishing to benefit a charity now or in the future. Through these vehicles, the donor can also achieve multiple tax and estate-planning goals through estate reduction and providing a current or future wealth transfer to descendants. While these options exist to benefit taxpayers and charities alike, it is important to keep in mind that the tax on acts of self-dealing and excise tax on UBTI can upend the planning and must be carefully considered when donating a business interest to charity.

EditorNotes

Mindy Tyson Weber is a senior director, Washington National Tax, for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.