Privately-Held Business Interests

Published on May 2, 2003 - 12:00am

Privately-held business forms include sole proprietorships, general and limited partnerships, C-corporations,

S-corporations, and recently created limited liability companies. In the context of charitable gift planning, the

diversity of business forms and the rules that apply to each regarding taxation, ownership, transferability,

liquidity, marketability, and income producing capability place them, as a category, at the pinnacle of

complexity. This memorandum focuses on outright transfers of privately-held business interests to public

charities and private foundations, as well as transfers to charitable remainder trusts and charitable lead trusts.

Privately-held business forms include sole proprietorships, general and limited partnerships, C-corporations, S-corporations,

and recently created limited liability companies. In the context of charitable gift planning, the diversity of business forms and

the rules that apply to each regarding taxation, ownership, transferability, liquidity, marketability, and income producing

capability place them, as a category, at the pinnacle of complexity.

This section focuses on outright transfers of privately-held business interests to public charities and private foundations, as

well as transfers to charitable remainder trusts and charitable lead trusts.

1. Sole Proprietorships

2. Partnerships - General and Limited

3. C Corporations

4. S Corporations

5. Limited Liability Companies

6. Other Issues

Sole Proprietorships

Sole proprietorships are the simplest business form. They require no formal documentation or registration other than,perhaps, securing a business license and filing or publishing a fictitious name statement. Although sole proprietors avoid thecomplexities inherent in other business forms, such simplicity comes at the cost of the proprietor remaining personally liablefor all debts and other legal liabilities of the enterprise.

A sole proprietorship can be owned by an individual or by a husband and wife. A sole proprietorship cannot be owned by acharitable organization or charitable trust. Therefore, the transfer of a sole proprietorship to such an entity consists of atransfer of the assets of the proprietorship.

Sole proprietorships are comprised of capital, tangible, and intangible assets. These assets may include real property, plantand equipment, inventory, receivables, and goodwill. For tax purposes, the assets of the business and the owner areconsidered one and the same. Therefore, all items of income and expense, gain and loss, are considered those of the owner.

Outright Gifts

In general, net taxable income produced by a sole proprietorship is considered unrelated business income.

The term "unrelated business taxable income" is defined as the gross income derived by any organization from any unrelatedtrade or business (as defined in IRC §513) regularly carried on by it, less the deductions allowed which are directly connectedwith the carrying on of such trade or business, both computed with certain modifications.1

For this reason, transferring the assets of an operating sole proprietorship to a public charity or private foundation may beinappropriate because the continuation of the business may produce taxable income to the recipient. The effect on theorganization can range from benign to catastrophic. In general, the receipt of unrelated business taxable income (UBTI) by an

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IRC §170(c) organization will not cause the recipient to lose its tax-exempt status, thereby exposing all its income to tax;rather, it will pay income tax on amounts attributable only to its UBTI. However, if the organization exploits its tax-exemptstatus with a disproportionate share of UBTI to its overall income, it may place its tax-exempt status at risk.Transfersof Sole Proprietorship Assets to Charitable Remainder Trusts

As stated earlier, a charitable organization or trust cannot own a sole proprietorship. Therefore, a transfer will consist of theunderlying assets of the business. The continued operation of the business by a charitable remainder trust is not generallyrecommended because the trust loses its tax-exempt status for any year in which it generates unrelated business taxableincome (UBTI). In such years, the trust is taxed as a complex trust paying tax on ALL its net income (including non-UBI andgains from the sale of trust assets). In addition, the transfer of debt-encumbered property may cause the trust to have"unrelated debt-financed income" under IRC §514 and otherwise cause it to be treated as a grantor trust.2

Finally, the continued use of trust assets for the benefit of a disqualified person (e.g., the trust/former business owner) mayconstitute a prohibited act of self-dealing under IRC §4941.Transfers of Sole Proprietorship Assetsto Charitable Lead Trusts

The transfers of assets of an operating sole proprietorship to a grantor or nongrantor charitable lead trust may not be soonerous. All income attributable to a grantor CLT is taxable to the grantor regardless of its characterization as unrelatedbusiness income. On the other hand, nongrantor CLTs are taxed as complex trusts. Under normal circumstances, the trustreceives a charitable deduction against its taxable income for amounts distributed to charity in satisfaction of its annuity orunitrust amount. However, the deduction is unavailable for unrelated business taxable income. In essence, the trust may payincome tax on amounts distributed to charity.Planning Alternatives

As an alternative to transferring an operating sole proprietorship, it may be more appropriate to discontinue businessoperations and/or contribute selected assets of the business that do not produce unrelated business taxable income (e.g.,certain rents from unencumbered real property).

These issues are discussed in greater detail in the following section on Partnerships -- General and Limited.

1.

IRC §512(a)(1)back 2.

Ltr. Rul. 9015049back

Partnerships - General and Limited

A partnership is a joint undertaking by two or more individuals or entities whereby they pool their money, labor, skills or otheritems in a business and they share in the profits and losses that result. The partnership may own virtually any type of asset.The partners may or may not enter into a written partnership agreement.

In general, a business entity with two or more members may be classified as either a partnership or a corporation for taxpurposes.1 The "check-the-box" rules under the Regulations to IRC §7701 now determine whether an entity with two or moremembers is to be classified as a partnership for federal tax purposes.2 A partnership is subject to special tax treatment underSubchapter K of the Internal Revenue Code. Most partnership items of income, gain, loss, deduction and credit simply passthrough to the partners on some agreed basis, such as on a pro rata basis, and the partners report these items on their owntax returns. The partnership itself does not pay tax but it files informational returns reporting the items that have passedthrough to the partners. Certain elections must be made at the partnership level.

Because of the nature of the partnership entity, the partners may agree to place various restrictions on the transfer ofinterests in the entity.General Partnership

General partnerships may be established without any formal documentation or registration, although it may be necessary toobtain business licenses and/or secure the right to use fictitious names. In a general partnership, each partner is personallyliable for the debts of the partnership.Limited Partnership

As distinguished from general partnerships, limited partnerships are creatures of state law and formal registration isnecessary to create a limited partnership. Although the specific requirements may vary from state to state, in most cases a

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certificate of limited partnership is filed with the appropriate state agency and registration fees are paid. Note that a familylimited partnership is simply a limited partnership where most or all of the interests are held by family members.

A limited partnership has at least one partner, known as a general partner, who is personally liable for the debts of thepartnership and at least one partner, known as a limited partner, who is not personally liable for the debts of the partnership.In other words, a limited partner is only liable for the partnership's debts to the extent of the assets he or she has contributedto the partnership. The general partners usually have more rights to manage the partnership business than do the limitedpartners. State law often determines to what extent a limited partner may participate in management without being treatedas a general partner.Outright Gifts

In order for the transfer to be valid, the partnership agreement must contain language that permits the transfer of apartnership interest to a charity or permits a transfer with appropriate consent.Self-Dealing

If a partnership interest is contributed to a private foundation, the self-dealing rules are implicated. Since a partnership for taxpurposes is generally viewed as a pass-through or conduit entity, any business activity conducted by the partnership must beanalyzed in this regard (i.e., leases, loans, and debt of the partnership). For further reading, see Application of PrivateFoundation Excise Taxes in Other Issues.Intermediate Sanctions

If a partnership interest is contributed to a public charity, the intermediate sanctions rules should be considered.ExcessBusiness Holdings and Jeopardy Investments

If a partnership interest is contributed to a private foundation, the excess business holdings and jeopardy investment rules ofIRC §§4943 and 4944 are implicated. For further reading, see Application of Private Foundation Excise Taxes in Other Issues.

Unrelated Business Income Tax

As with a sole proprietorship, if the partnership is engaged in an unrelated trade or business, gross income and deductionsfrom such trade or business will be included within a private foundation's or public charity's computation of unrelatedbusiness taxable income.3Bargain Sale of Limited Partnership Interest

If a limited partner contributes his entire limited partnership interest to a charitable organization, a charitable contributiondeduction is allowed under IRC §170 if the value of his share of the partnership assets exceeds his share of partnershipliabilities at the time of the transfer. However, pursuant to IRC §§752(d) and 1011(b), the value of the donor's share ofpartnership liabilities at the time of the transfer constitutes an amount realized by the donor. Therefore, the donor mustrecognize gain on the transfer equal to the excess of the amount realized by the donor over that portion of the adjusted basisof his partnership interest, at the time of the transfer, allocable to the sale under IRC §1011(b).4

See Gift Vehicle Review -- Bargain SalesTransfer Taxes

State and county transfer taxes may apply to a transfer of real estate. Some jurisdictions also require the payment of transfertaxes when a partnership interest in a partnership that owns real estate is transferred.

Planned Gifts

As with the assets of a sole proprietorship, partnership interests may prove to be poor candidates for transfer to a charitableremainder or lead trust because the underlying enterprise may conduct activities that could adversely impact both donor andtrust. The contribution of a partnership interest is only appropriate after a full consideration of all potential issues.

Transfers of Partnership Interests to Charitable Remainder Trusts

As a pass-through entity, the major concern regarding the transfer of a partnership interest to a charitable remainder trustinvolves the character of the income earned by the trust. A charitable remainder trust loses its tax-exempt status in anytaxable year in which it incurs unrelated business taxable income (as described in §IRC 513). Unrelated business income canbe produced by 1) a trade or business that is regularly carried on by the partnership which is unrelated to the tax-exemptpurpose of the trust (presumably any trade or business would be unrelated), or 2) ownership by the partnership of propertythat causes debt-financed income (as described in IRC §514).

The loss by the trust of its tax-exempt status could be particularly devastating in a year in which an appreciated asset is sold(such as contributed property).5Self-Dealing

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Charitable remainder trusts are subject to private foundation excise taxes imposed on acts of self-dealing between the trusteeand a disqualified person.6Excess Business Holdings and Jeopardy Investments

A charitable remainder trust will not be subject to the excess business holdings or jeopardizing investment rules unless itincludes as an income recipient an IRC §170(c) organization.7 Specimen trusts published by the IRS include these twoprohibitions (most likely in an effort to cover the possibility that charity will be an income recipient).

If applicable, the jeopardizing investment rules could come into play if the trustee decides to hold the one issue of stock forinvestment purposes (due to lack of diversification). Regarding excess business holdings, the trustee has five years to disposeof the stock (with a possible five-year extension).8 Accordingly, if the transfer is followed by a sale, these two problems shoulddisappear. Ltr. Rul. 9210005 confirms that charitable remainder trusts are exempt from the excess business holdings andjeopardizing investment rules per IRC §4947(b)(3)(B).Limited Partnership as a Trustor

In Ltr. Rul. 9419021, a taxpayer asked (a) if a limited partnership is a permissible grantor of a charitable remainder trust, (b)if the partnership is a permissible recipient of the unitrust payments, and (c) whether the trust is a qualified charitableremainder unitrust under IRC §664(d).

The trust will pay the unitrust amount to the donor for a term not to exceed 20 years. It has also been represented theunitrust amount will be greater than five percent of the net fair market value of the assets to be determined annually andthat an independent trustee will be appointed.

The Service ruled there is nothing in IRC §664 or the underlying regulations that would prohibit a partnership from being apermissible donor to an otherwise qualified charitable remainder unitrust as long as all the partners are permissible donors. Inaddition, the Service noted that IRC §7701(a)(1) defines a "person" to include an individual, trust, estate, association,company, corporation, and partnership.

In the present situation, the proposed trust will provide that the unitrust amount is payable to the donor, a partnership, for aterm not to exceed 20 years. Because the term of the trust is for a term of years, the recipient of the unitrust amount may beany person or persons, including a partnership, so long as at least one such person is not a charitable organization. Thepartners are not charitable organizations. Thus, both the partnership and the partners are permissible recipients, and thedonor is a permissible recipient of the unitrust amount.Planning Opportunity: Distribution Followed by Transfer

The potential problems created by transferring a partnership interest to a charitable remainder trust can be mitigated oreliminated by partial or complete distribution of partnership assets to the partner. A distributee partner realizes gain only tothe extent that distributed money exceeds the partner's basis in his or her interest.9 No gain is recognized to a distributeepartner, with respect to a distribution of property other than money, until he sells or otherwise disposes of such property,except as otherwise provided by IRC §736 (relating to payments of a retiring partner or a deceased partner's successor ininterest) and IRC §751 (relating to unrealized receivables and inventory items).10 Therefore, under certain circumstances, apartner might be able to receive a distribution of property from a partnership followed by the transfer of compatible propertyfrom such distribution to a charitable remainder trust without recognition of gain. However, it should be noted that thedefinition of money also includes marketable securities.11Publicly Traded (Master Limited) Partnerships

Whether a publicly traded or master limited partnership is suitable for transfer to or investment in a charitable remaindertrust depends on whether the partnership produces unrelated business taxable income under IRC §512(c). The OmnibusBudget Reconciliation Act of 1987 amended §512(c) by adding §512(c)(2). It provided that any organization's share (whetherdistributed or not distributed) of the gross income of a publicly traded partnership (as defined in IRC §469(k)(2)) acquiredafter December 17, 1987 is treated as income derived from an unrelated trade or business. The section further provided thatan organization's share of partnership deductions are allowed in computing unrelated business taxable income.12

IRC §512(c)(2) was short-lived, however. The Omnibus Budget Reconciliation Act of 1993 repealed it for partnership yearsbeginning on or after December 17, 1994. While the repeal removed the automatic classification of publicly tradedpartnership income as UBTI, a determination must still be made as to whether the partnership income represents UBTI on thebasis of IRC §512(c) itself.Installment Obligations Owned by Partnership

The transfer to a charitable remainder trust of a partnership interest that owns an installment obligation may accelerate anygain attributable to the installment obligation to the donor.13 The amount recognized is the partner's share of the fair marketvalue of the obligation over his or her share of the partnership's basis in the obligation. Like other transfers of installmentobligations, the donor's deduction is based on the fair market value of the obligation.Debt-Encumbered Property Ownedby Partnership

Debt on partnership assets is treated as a liability of the owner of the property.14 Accordingly, the transfer of a partner'sinterest to a charitable remainder trust is considered a relief of such indebtedness to the partner. Such transfers expose thedonor and trust to all of the issues of debt-encumbered property including self-dealing, grantor trust and unrelated business

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income tax issues.15

Transfers of Partnership Interests to Charitable Lead Trusts

Certain types of partnership interest (e.g., a family limited partnership) interests may be ideal funding assets for certain formsof charitable lead trusts -- specifically, the nongrantor/nonreversionary CLT, which is used to transfer the remainder interest toheirs at reduced gift and estate tax cost.Discounts

From a gift and estate tax valuation standpoint, the sum of the parts of certain types of partnerships do not always make awhole. A number of value discounts may be available. These include: - Minority interests; - Marketability and liquidity; - Business risks; and/or - Key personUnrelated Business Income Tax

If the trust is a non-grantor charitable lead trust, i.e. the donor is not treated as the owner of the trust for income taxpurposes, then the trust is a taxable entity (unlike a charitable remainder trust). The trust itself, however, is entitled to acharitable deduction for amounts distributed to the charity.16 However, a deduction is not allowed for amounts allocable tounrelated business income realized by the trust during the taxable year.17 Since the partnership's activities determinewhether unrelated business income tax will be incurred18, great care must be given prior to the contribution of a partnershipinterest to a non-grantor charitable lead trust. In contrast, the unrelated business income tax rules should have no applicationto a grantor charitable lead trust, because the grantor (a non-charity) will incur all taxable income of the trust.

See Charitable Lead Trusts -- Taxation of Charitable Lead TrustsSelf-Dealing

Charitable lead trusts are subject to private foundation excise taxes imposed on acts of self-dealing between the trust and adisqualified person.Excess Business Holdings and Jeopardy Investments

The excess business holdings and jeopardy investment rules regarding private foundations apply when the value of thecharitable lead interest at the creation of the trust exceeds 60% of the total value of the trust's assets or if a portion of theincome interest is not paid to charity.19

1.

Reg. §301.7701-2(a)back 2.

Prior to the check-the-box rules, the Regulations provided complex rules which determined an entity's classificationdepending upon how many corporate characteristics the entity possessed.back 3.

IRC §512(c)back 4.

Rev. Rul. 75-194, 1975-1, C.B. 80back 5.

IRC §664(c). See also Ltr. Ruls. 7943062 and 9633007, and Leila G. Newhall Unitrust v. Commissioner, 104 T.C. 236back 6.

IRC §4947back 7.

IRC §4947(b)(3)(B)back 8.

IRC §4943(c)(6), (7)back 9.

IRC §731(a)(1)back 10.

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Reg. §1.731-1(a)(1)back 11.

IRC §731(c)back 12.

§10213(a) of the Omnibus Budget Reconciliation Act of 1987, Pub. L. 100-203, 101 Stat. 1330-406back 13.

IRC §453Bback 14.

IRC §752back 15.

Ltr. Rul. 9533014back 16.

IRC §642(c)back 17.

IRC §681back 18.

IRC §512(c)back 19.

IRC §4947(b)(3)back

C Corporations

A corporation is a separate entity for tax and non-tax purposes. Corporations are creatures of state law and are generallyestablished by filing articles of incorporation with an appropriate state agency and paying the necessary registration fees.Corporations often have written by-laws that govern their operation. Owners of corporations are usually referred to asshareholders and they usually receive stock certificates to evidence their ownership interests. Each shareholder's liability fordebts of the corporation is limited to his, her or its investment in the corporation. The transfer of stock in a privately-heldcorporation (i.e., one that is not traded publicly on an established securities market) is often restricted by means of a buy-sellagreement.

A C corporation means a corporation that is governed by Subchapter C of the Internal Revenue Code. The income of thecorporation is taxed at the corporate level and most distributions are taxed again at the shareholder level.

Privately-held corporations are commonly referred to as "closely-held." Technically, a closely-held corporation is defined asany corporation other than an S-corporation of which at least 50% of the total outstanding stock is owned by or for less thanfive shareholders.1 Thus, although all corporations that are not publicly traded can be described as "privately-held," onlycertain C corporations can technically be called "closely-held." For purposes of this discussion, we will refer to C corporationsas privately-held with the understanding they may be closely-held as well.Outright Gifts

State corporate law and any stockholder agreement (commonly referred to as a buy-sell agreement) must permit the transferof the corporate stock or permit the transfer with appropriate consent.Self-Dealing

If privately-held C stock is contributed to a private foundation, the self-dealing rules are implicated. For further reading, seeApplication of Private Foundation Excise Taxes in Other Issues.Intermediate Sanctions

If privately-held corporate stock is contributed to a public charity, the intermediate sanctions rules regarding excess benefittransactions should be considered.Unrelated Business Income Tax

If a C Corporation is engaged in an unrelated trade or business, gross income and deductions from such trade or business willnot be included within a private foundation's or public charity's computation of unrelated business taxable income. Ordinarily,a C Corporation's current distribution will constitute a dividend which does not constitute unrelated business income.2 Inaddition, the gain on the sale of privately-held C Corporation stock should not constitute unrelated business income.3

Dividend Treatment

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The IRS will treat a charitable contribution by a closely-held corporation as a taxable distribution to its shareholders only if theshareholders or their families receive property or economic benefit as a result of the corporate contribution.4

Planned Gifts

With careful consideration of all issues, privately-held C Corporation stock may be a worthwhile consideration as a fundingasset to a charitable remainder trust or a charitable lead trust. As a general rule, most charitable organization that issuecharitable gift annuities or that maintain pooled income funds will, as a matter of policy and/or local law, not acceptnon-publicly traded business interests in connection with such gift vehicles.Transfers of C Corporation Stock toCharitable Remainder Trusts

Stock in a C Corporation presents several unique planning opportunities and challenges in connection with charitableremainder trusts.Unrelated Business Income Tax

If a C Corporation is engaged in an unrelated trade or business, gross income and deductions from such trade or business willnot be included within a trust's computation of unrelated business taxable income. Ordinarily, a C Corporation's currentdistribution will constitute a dividend which does not constitute unrelated business income.5 In addition, the gain on the saleof privately-held C Corporation stock should not constitute unrelated business income.6Self-Dealing

If privately-held corporate stock is contributed to a private foundation, the self-dealing rules are implicated.7 For furtherreading, see Application of Private Foundation Excise Taxes in Other Issues.Excess Business Holdings and JeopardyInvestments

A charitable remainder trust will not be subject to the excess business holdings or jeopardizing investment rules unless itincludes as an income recipient an IRC §170(c) organization. 8 Specimen trusts published by the IRS include these twoprohibitions (most likely in an effort to cover the possibility that charity will be an income recipient).

If applicable, the jeopardizing investment rules could come into play if the trustee decides to hold the one issue of stock forinvestment purposes (due to lack of diversification). Regarding excess business holdings, the trustee has five years to disposeof the stock (with a possible five-year extension).9 Accordingly, if the transfer is followed by a sale, these two problems shoulddisappear. Ltr. Rul. 9210005 confirms that charitable remainder trusts are exempt from the excess business holdings andjeopardizing investment rules per IRC §4947(b)(3)(B).Stock Sale by Charitable Remainder Trust

The TRA '86 repeal of the General Utilities Doctrine makes the sale of corporate assets a two-edged sword resulting inpotential taxation of sale proceeds at both corporate and shareholder levels. Can these taxes be mitigated or avoided? Thetransfer of stock to a charitable remainder trust followed by a sale of such stock can result in complete avoidance of capitalgain at both stockholder and corporate levels. However, this is achieved at the expense of the buyer losing a stepped-upbasis on the corporate assets and bearing potential liability for prior business operations.Asset Sale Followed byLiquidation

In the event stock is transferred to a charitable remainder trust followed by an asset sale and a subsequent corporateliquidation, the corporation will pay a tax on the sale of corporate assets even though the stock is owned by the trust.However, the capital gains tax will be avoided upon liquidation and distribution of the net proceeds to the shareholder/trust(because the trust is a tax-exempt trust).

Even though tax might not be avoided at the corporate level, the impact of the tax can be mitigated by the tax savingscreated by the charitable contribution deduction received by the trustor outside the trust.Case Study - Selling aClosely-Held Corporation Using a CRT

The tax and cash flow economics of selling a privately-held C corporation via a charitable remainder unitrust are compared inGift Design Blueprints - Selling a Closely-Held Corporation Using a Charitable Remainder UnitrustCharitable StockRedemption

One of the more creative uses of a charitable remainder trust involves the transfer of stock in a C Corporation followed by aredemption by the corporation of the shares held by the trust. The transaction can be likened to a partial redemption on apartially deductible basis and may be an excellent method of transferring excess retained earnings from the corporation.

The Service has ruled privately that a provision that grants an independent trustee with the power to accept any offer for theredemption of shares of the company stock and to value said stock will not disqualify the trust.10Self-Dealing and CorporateStock Redemptions

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Normally, a transfer of stock to a charitable remainder trust by an owner of more than 35 percent of the voting stock of thecorporation followed by a corporate redemption is a prohibited act of self-dealing. However, a special exception applies. Aredemption of stock from a charitable remainder trust will not be considered an act of self-dealing under the followingcondition: [IRC §4941(d)(2)(F)]

(a) any transaction between a private foundation and a corporation which is a disqualified person (as defined in section4946(a)), pursuant to any liquidation, merger, recapitalization, or other corporate adjustment, organization, orreorganization, shall not be an act of self-dealing if all of the securities of the same class as that held by the foundation aresubject to the same terms and such terms provide for receipt by the foundation of no less than fair market value.[emphasisadded]

The phrase, subject to the same terms means the corporation makes a bona fide offer on a uniform basis to the foundationand every other person who holds such securities.11 Furthermore, the exception appears to require an all-cash transaction.Any loan (i.e., the extension of credit by a private foundation (trust) to a disqualified person (the corporation))would, in and ofitself, arguably appear to constitute a separate act of self-dealing.

In Ltr. Rul. 9015055, a private foundation owned 100 percent of the issued and outstanding six percent cumulative preferredstock of a for-profit corporation. The foundation received the stock under the wills of a husband and wife, who formed thefoundation, and who owned and controlled the corporation until their deaths. The founding couple's daughter and herhusband currently manage the foundation and run the corporation. The husband holds 99.99 percent of the company'scommon stock for the benefit of his wife for life, with the remainder to the daughter's children. The corporation proposed toredeem all outstanding preferred stock at fair market value as determined by an independent appraisal and by a previous IRSappraisal (made for estate tax value purposes).

The Service ruled the corporation is a disqualified person with respect to the foundation and the proposed redemption of thecorporation's preferred stock constitutes an act of self-dealing. However, the redemption will not be subject to the self-dealingexcise tax because, under IRC §4941(d)(2)(F), all of the shares subject to the redemption will be treated alike.Charitable ESOP

A charitable remainder trust can be a very effective tool in effectuating the sale of a privately-held business interest toemployees via an Employee Stock Ownership Plan (ESOP). Under the rules of IRC §1042, a noncorporate shareholder can sellemployer securities to an ESOP on a tax-free basis, provided (a) the individual held the securities for at least three years priorto the sale, (b) the individual purchases "qualified replacement property " (QRP) within 15 months of the date of sale, and (c)the ESOP meets percentage stock ownership tests and consents to being subject to certain excise taxes.12

Generally, a disposition of QRP will cause recapture of capital gain. Therefore, a seller who purchases QRP will be locked in ifthey wish to avoid recognition of gain. Enter the charitable remainder trust.

The Code provides several exceptions to the recapture provisions. Included within these exceptions is a gift of replacementsecurities.13 The term "gift" is not defined in IRC §1042 or the regulations, however. Furthermore, a transfer to a charitableremainder trust is a gift of only a remainder interest. Therefore, the transfer attributable to the retained income interestmight not qualify.

The IRS has ruled privately that a taxpayer does not avoid recognition of capital gain upon the transfer of appreciatedproperty to a charitable trust due to any specific non-recognition provision of the Code. Rather, it is because an irrevocabletrust assumes the holding period and cost basis of assets transferred to it and, therefore, does not realize gain at all. Theruling concluded the transfer of QRP constitutes a disposition of property within the meaning of IRC §1042(e). However, nogain is realized by the trustors upon the transfer of QRP to a charitable remainder trust. Thus, no recapture of gain istriggered on the original sale by the trustor to ESOP.14

Regarding the financing of the purchase, prior to August 20, 1996, a bank, an insurance company, or other lending institutioncould exclude from gross income 50 percent of the interest received with respect to a securities acquisition loan. Thisprovision, contained in former section 133 of the Internal Revenue Code of 1986, was repealed, for loans made after that dateby Section 1602(a) of The Small Jobs Protection Act of 1996.

If the ESOP does finance the purchase, it can service the debt by receiving tax deductible contributions from the corporation(generally subject to a limit of 15 percent of participating employee payroll).15

As an alternative, if any portion of the sale cannot be paid for in cash, the shareholder can contribute this portion of the stockto the charitable remainder trust. The trust can then sell the contributed securities to the ESOP in exchange for a note. Thetrust permits financing, while the tax-free exchange rules of IRC §1042 do not.16 In all events, the planner should payparticular attention to valuation issues pertaining to both privately-held stock and promissory notes as discussed infra. - ESOP as Charitable Remainderman

Can an ESOP be named as the remainderman of a charitable remainder trust? Apparently so.

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The IRS has ruled in technical advice that a charitable remainder trust was qualified because any distribution to an ESOPcould be made only in the event the ESOP was a qualified charitable organization to which the remainder interest could betransferred. The trust also provided, in the event the ESOP did not qualify, that trust assets would be distributed to anotherqualified organization.17 - ESOP as Disqualified Person

Is an ESOP a disqualified person for purposes of the self-dealing rules. Rev. Rul. 81-76 holds that an ESOP described in IRC §4975(e) is not treated as the owner of stock in a corporation where the stock is allocated to participating employees and thusis not a disqualified person.

C Corporation as Trustor

Can a C Corporation establish a charitable remainder trust? Yes. Like an S Corporation or a partnership, a C Corporation cancreate a charitable remainder trust provided the measuring term of the trust consists of a term of years not to exceedtwenty. The IRS has ruled privately that in a case where the trust was funded with publicly traded stock and which named aprivate foundation as remainderman, the trust qualified. The corporation would be allowed a charitable income tax deductionbased on the fair market value of the stock provided the amount contributed did not exceed 10 percent of the giftcorporation's outstanding stock. If the amount contributed to a private foundation exceeded the 10 percent limit, thededuction on any excess would be based on the lesser of the stock's fair market value and its adjusted cost basis.18

Transfers of C Corporation Stock to Charitable Lead Trusts

Transfers of privately-held C stock to charitable lead trusts present both opportunities and challenges. Like charitableremainder trusts, charitable lead trusts are burdened with the payment of a unitrust or annuity amount. Unlike charitableremainder unitrusts, however, a net income option is unavailable to the CLT; therefore, when the transfer of stock in aprivately-held C corporation to a CLT is contemplated, the source of future income payments is a critical issue.

Potential sources of the trust payments include dividends issued by the corporation, a sale of all or a portion of the companystock (including a redemption by the corporation itself), a sale of corporate assets followed by a partial or complete liquidationof the corporation, or an in-kind distribution of the stock itself. Unlike charitable remainder trusts, which are conditionallyexempt from income tax, the trustor, corporation, and the CLT are non-exempt taxpayers. Depending on the type of CLT (i.e.,grantor or non-grantor), the corporation, grantor, and trust must consider the tax consequences of the trust satisfying itspayment obligations.Unrelated Business Income Tax

If the trust is a non-grantor charitable lead trust (i.e. the donor is not treated as the owner of the trust for income taxpurposes, then the trust is a taxable entity--unlike a charitable remainder trust). The trust itself, however, is entitled to acharitable deduction for amounts distributed to the charity.19 However, a deduction is not allowed for amounts allocable tounrelated business income realized by the trust during the taxable year.20 In contrast, the unrelated business income taxrules should have no application to a grantor charitable lead trust, because the grantor (a non-charity) will incur all taxableincome of the trust.

If a C Corporation is engaged in an unrelated trade or business, gross income and deductions from such trade or business willnot be included within the trust's computation of unrelated business taxable income. Ordinarily, a C Corporation's currentdistribution will constitute a dividend, which does not constitute unrelated business income.21 In addition, the gain on the saleof privately-held C Corporation stock will not constitute unrelated business income.22 Although unrelated business income willnot ordinarily be a concern, if a charitable lead trust owns privately-held C Corporation stock, consideration must be given tothe methodology and consequences of making the charitable lead payment.

For further reading, see Taxation of Charitable Lead Trusts.Self-Dealing

If privately-held corporate stock is contributed to a qualified charitable lead trust, the self-dealing rules are implicated.23

Excess Business Holdings and Jeopardy Investments

When transferring stock of a privately-held C corporation to a charitable lead trust, the planner must be aware that the excessbusiness holdings and jeopardy investment rules regarding private foundations apply when the value of the charitable leadinterest at the creation of the trust exceeds 60% of the total value of the trust's assets or if a portion of the income interest isnot paid to charity.24 These rules essentially prohibit the trust from owning more than 20% of the voting stock of a corporationfor more than five years.25Discount

The value of stock in a privately-held corporation may be discounted to reflect its lack of marketability. In addition, the valueof non-voting interests and non-controlling voting interests may be entitled to discounts for lack of control or minority

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interests.

Giving discounted stock to a charitable lead trust may enable the donor to leverage his or her unified credit for estate or gifttax purposes, assuming with a lifetime gift that the donor does not retain the remainder interest in the trust or have anyrights that cause the trust to be included in his or her estate. The discounts allow the donor to transfer the remainder interestin the charitable lead trust at a reduced gift or estate tax cost. Of course, the income, gift and estate tax charitabledeductions for the lead interest will also be reduced. The corporation will be able to produce income for its shareholders withthe full value of its underlying assets despite the discount applicable to the value of the stock for transfer tax purposes.

Specific IssuesRetained Vote

If the trustor retains voting rights in a non-fiduciary capacity (other than as trustee), the charitable remainder trust will bedisqualified.26 Further, the transfer of stock with retained voting rights is considered a non-qualified gift of a partial interest.27

Stock in a Professional Corporation

Stock in professional corporations such as incorporated legal, accounting, medical, or dental practices may or may not beallowed for transfer to a charitable remainder or lead trust. Determination of suitability will depend on the licensing authorityin the state of the corporation's situs. A transfer may be permissible if the trust is only a transitory holder, pending the sale orother disposition of the practice, or if the trustee holds a professional license compatible with the type of stock beingcontributed. However, state law may specifically permit a split-interest trust to own professional corporation stock. UnderIndiana law for example, a charitable remainder trust is, under certain circumstances, specifically permitted to own stock in aprofessional corporation.28Section 306 Stock

Preferred stock issued as a nontaxable stock dividend is considered "tainted" under IRC §306. Such stock is consideredordinary income property to the extent of the corporation's retained earnings. Therefore, the trustor's deduction is based onthe lesser of fair market value and adjusted cost basis.29Gift By Corporation of Option to Purchase Stock inCorporation

A corporation which pledges to sell shares of its common stock to a charitable organization is entitled to a charitablecontribution deduction provided by IRC §170 in the taxable year in which the pledge is exercised. The amount of thecontribution will be the excess of the fair market value of the shares on the date of the exercise over the exercise price.30

This transaction is distinguishable from the contribution by a shareholder of an assignable call option to purchase stock in acorporation. Such arrangements have been contemplated to facilitate the transfer to and sale of S Corporation stock by acharitable remainder trust. This arrangement, and the IRS' negative response to it, are discussed in detail in the next section.Stock "Pregnant" with Dividend

Stock for which a dividend has been declared but not yet paid is commonly referred to as "pregnant" with a dividend. In suchcases, the market value of the stock usually increases immediately after the dividend is declared to reflect the imminentpayment. After the dividend is paid, the value (market fluctuations notwithstanding) returns to its pre-declaration level. Whenstock is sold during this period, the dividend is paid and taxed to the purchaser.

In the context of charitable gift planning, an opportunity may exist to convert an asset that will produce ordinary income tolong-term capital gain for income tax charitable deduction purposes. Consider the following scenario:

On May 8, a closely-held C-corporation declared a $1.5 million dividend on its preferred non-voting stock. The dividend waspayable to shareholders of record on May 15. On May 9, the majority shareholder contributed the shares to a qualifiedcharitable organization and claimed an income tax charitable deduction for their full fair market value (which included theunpaid dividends). Eleven months later, the donor reacquired the shares from the charitable donee.

Although the IRS did not challenge the value of the claimed charitable deduction, it did attempt to tax the dividend to thedonor arguing that, as majority shareholder, he manipulated the dates of the transactions to his benefit. The Circuit Court ofAppeals disagreed commenting that although the shareholder did indeed control the timing of the gift, he did actually giveaway the golden egg along with the goose.31

Applying this result to a charitable remainder trust, the IRS might not be disappointed for too long. The dividend, althoughnot taxed to the trustor, would fall into tier 1 for trust accounting purposes. Therefore, the first penny distributed to the trust'sincome recipients (and many pennies thereafter until the dividend was distributed in its entirety) would be characterized asordinary income under the four-tier system. The IRS would ultimately receive its tax on the dividend, albeit over a period ofyears.

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1.

Reg. §1.170A-13; IRC §542(a)(2)back 2.

IRC §512(b)(1)back 3.

IRC §512(b)(5)back 4.

Rev. Rul. 79-9, 1979-1 C.B. 125back 5.

See the exceptions for corporate reorganizations and redemptions in IRC §4941(d)(2)(F) and the Regulations thereunder.back 6.

IRC §512(b)(1)back 7.

IRC §512(b)(5)back 8.

IRC §4947(b)(3)(B)back 9.

IRC §4943(c)(6), (7)back 10.

Ltr. Rul. 9339018back 11.

Reg. §53.4941(d)-3(d)(1)back 12.

Temp. Reg. §1.1042-1Tback 13.

IRC §1042(e)(3)back 14.

Ltr. Ruls. 9234023; 9438012; 9515002; 9547022; 9547023back 15.

IRC §409back 16.

A loan from a private foundation to a disqualified person is a prohibited act of self-dealing.back 17.

TAM 9244001back 18.

Ltr. Rul. 9205031back 19.

IRC §642(c)back 20.

IRC §681back 21.

IRC §512(b)(1)back 22.

IRC §512(b)(5)back 23.

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See the exceptions for corporate reorganizations and redemptions in IRC §4941(d)(2)(F) and the Regulations thereunder.back 24.

IRC §4947(b)(3)back 25.

IRC §§4943(c)(6) and 4943(c)(7)back 26.

Reg. §1.664-1(a)(4)back 27.

Rev. Rul. 81-282, 1981-2 C.B. 78back 28.

Indiana Code §23-1.5-3-1back 29.

IRC §306(a)(1)back 30.

Rev. Rul. 75-348, 1975-2 C.B. 75back 31.

Caruth v. U.S.back

S Corporations

Like a C corporation, an S corporation is an entity formed as a corporation under state law by the filing of appropriate articlesof incorporation and paying any registration fees that may be required. It often has written by-laws governing its operation.The owners are referred to as shareholders and have stock certificates to evidence their ownership interests.

Subchapter S of the IRC governs the taxation of S corporations. The tax treatment of an S corporation differs from a Ccorporation in that most items of income, gain, loss and deduction of an S corporation flow through to the shareholders forincome tax purposes and are not taxed at the corporate level. Only certain corporations qualify as S corporations.Specifically, an S corporation is a small business corporation, as defined in IRC §1361(b), which has made an election forSubchapter S treatment under IRC §1362(a). In order to qualify as a small business corporation, the entity must not, amongother things, have more than 75 shareholders and the shareholders must fall into certain categories.

Charitable organizations described in Code Section 501(c)(3) or 401(a) and exempt from tax under Code Section 501(a) arequalified shareholders. A charitable remainder trust does not qualify as an S corporation shareholder. A charitable lead trustmay qualify if it is a grantor trust for income tax purposes.

An S corporation may have only one class of stock, although it may have both voting and non-voting shares as long as votingrights are the only difference between the two types of shares. In many instances, the transfer of S corporation stock isrestricted in some fashion, such as with a buy-sell agreement.Outright Gifts

In 1996, Congress enacted The Small Business Job Protection Act, which permits a charitable organization to be an eligibleshareholder of an S Corporation beginning January 1, 1998.1 The donor will be entitled to a charitable contribution deduction,which may be reduced under IRC §170(e)(1).

See Gift Planner's Digest - Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems

State corporate law and any stockholder agreement (commonly referred to as a buy-sell agreement) must permit the transferof the corporate stock or permit the transfer with appropriate consent. In addition, a transfer of S Corporation stock to manydifferent shareholders or to disqualified shareholders will terminate the S Corporation's tax status.2Self-Dealing

If S Corporation stock is contributed to a private foundation, charitable remainder trust, or qualified charitable lead trust, theself-dealing rules are implicated. For further reading, see Application of Private Foundation Excise Taxes in Other Issues.

Intermediate Sanctions

If S Corporation stock is contributed to a public charity, the intermediate sanctions rules should be considered. These rules arediscussed in detail in the "Other Issues" section of this text.Unrelated Business Income Tax

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If an IRC §501(c)(3) organization holds stock in an S Corporation, such interest is treated as an interest in an unrelated tradeor business.3 Thus, the income generated from the business or the gain on the sale of the S Corporation stock will cause ataxable event to the charity.

Planned Gifts

S Corporation stock may, in limited circumstances, be a good candidate as a funding asset to a charitable remainder trust or acharitable lead trust.Transfers of S Corporation Stock to Charitable Remainder Trusts

Can stock in an S Corporation be transferred to a charitable remainder trust? Yes, but not if the shareholder wishes to retain SCorporation status. A charitable remainder trust is not a qualified S Corporation trust. Thus, an S Corporation will, for taxpurposes, convert into a C Corporation upon the receipt by the trust of such stock.

The Service has stated that IRC §§664 and 1361 contemplate two distinct systems of taxation and are mutually exclusive. Itfurther noted that a beneficiary electing under IRC §1361(d) to be treated as the owner of the portion of the trust consistingof stock, agrees to be taxed on all items of income relating to that stock. Under IRC §664(b) it said, the recipient of an incomeinterest in a charitable remainder unitrust is only taxable on the unitrust amount. Therefore, the transfer of even one share ofstock to a charitable remainder trust will terminate S Corporation status.4 Rev. Rul. 92-48 cements the IRS's opinion.However, the corporation may qualify for relief under the inadvertent termination rules of IRC §1362(f).Self-Dealing

If S Corporation stock is contributed to a charitable remainder trust, the corporation's S status will terminate. Nevertheless,the self-dealing rules are implicated.Unrelated Business Income Tax

Since a charitable remainder trust can never own S Corporation stock, as the corporation will lose its tax status upon receiptby the trust of the stock, unrelated business income may not be a relevant consideration.Using Assignable Call Options toSell S-Corporation Stock Via a CRT

In 1992, the IRS published a letter ruling that offered a unique solution to a traditional problem; how to liquidate anincompatible asset via a charitable remainder trust. An incompatible asset is one that will either terminate the tax-exemptstatus of a charitable remainder trust or that will adversely affect qualification of the asset itself. Examples of incompatibleassets include stock in an S-corporation, stock in a professional corporation, and real property that generates unrelatedbusiness income or that may contain toxic waste. The solution called for the creation and transfer to the trust of an assignablecall option in place of the incompatible asset. The following case study illustrates how such a strategy operates:The Facts

Mr. Smith owns unencumbered real property that he wants to sell to Mr. Jones for $2,000,000. Smith would like to sell theproperty via a charitable remainder unitrust and, in the process, avoid a $1,500,000 capital gain. The property isunencumbered; however, Smith has been advised that his property produces unrelated business income that will jeopardizethe tax-exempt status of the trust.An Exotic Solution - Creating a Charitable Option

Step 1. Smith creates an assignable three-year option that allows the holder to purchase the property for $100,000.

Step 2. Smith transfers option to a charitable remainder trust.

Step 3. Trustee sells option to Jones for $1,900,000 (the difference between market value and exercise price).

Step 4. Jones exercises the option to buy, paying Smith $100,000.

Result

Because the trust never owned the property, the unrelated business income produced by the property could not taint thetrust. Smith will recognize capital gain allocable to the $100,000 received upon exercise of the option. Gain attributable to theremaining $1,900,000 will be recognized by the trust (unless it has unrelated business taxable income from other sources).IRSRules on Option with Unencumbered Property

In Ltr. Rul. 9240017, the IRS concluded that, under facts similar to those presented above, the trustee's contractual right toacquire a fee interest in the property for an amount below the fair market value of the property is an asset of the trust forpurposes of meeting the requirements of IRC §664(d)(2). In addition, the trustee's contract right to acquire a fee interest inreal property with substantial value ($2,000,000) for an amount substantially lower ($100,000) has substantial fair marketvalue. This substantial fair market value must be included each year in determining the net fair market value of the trust'sassets and the resulting unitrust amount payable to the income recipient.

Regarding the availability and sequencing of the trustor's charitable income tax deduction, the IRS's opinion wasdisappointing, but logical. Rev. Rul. 82-197 provides, an individual who grants an option on real property to charity is alloweda charitable deduction for the year in which the charitable organization exercises the option in an amount equal to the excess

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of fair market value of the property on the date the option is exercised over the exercise price.5 The IRS concluded that thetrustor is not entitled to a deduction for the remainder interest, either when the purported option is granted or when thecharitable remainder trust sells it. The trustor is, however, entitled to a deduction for the remainder interest only if and whenhe sells the property to the trust or to another charitable organization exercising the option. The deduction is based on thespread between the fair market value and the exercise price ($1,900,000).IRS Rescinds Ltr. Rul. 9240017

One month after receiving a favorable ruling regarding the use of an option with unencumbered real property, the sametaxpayer requested a new ruling on the use of the same technique with encumbered property. This triggered an unanticipatedresult. The Service responded by immediately issuing a ruling that rescinded the 1992 ruling stating only that it wasreconsidering the issues raised in the original ruling.IRS Rules on Use of Options for Unencumbered and Encumbered Assets

In September of 1994, the Service responded to the second ruling request. There were two questions at issue. First, was thetrust a qualified charitable remainder trust? Second, would the taxpayer (trustor) be treated as the owner of the trust, therebycausing the gain realized by the trust on the sale of the option to be recognized by the taxpayer? With respect to the firstissue, the Service first stated,

"To qualify as a charitable remainder trust within the meaning of section 664 of the Code and the regulations thereunder, atrust must be one with respect to which a deduction is allowable under one of the specified sections--section 170, 2055,2106, or 2522. Further, the trust must be a charitable remainder trust in every respect and must meet the definition of andfunction exclusively as a charitable remainder trust from its creation. The requirements of being a charitable remainder trustin every respect and functioning exclusively as a charitable remainder trust from its creation cannot be met unless eachtransfer to the trust during its life qualifies for a charitable deduction under one of the applicable sections (IRC §§170, 2055,2106, or 2522)."

This being an inter vivos trust, the Service then focused its attention on the qualification for income tax deduction undersection 170 and qualification for gift tax deduction under section 2522. With respect to qualification for an income taxdeduction, the IRS concluded,

"The transfer to a charitable organization of an option by the option writer is similar to the transfer of a note or pledge by themaker. In the noted situation there is a promise to pay money at a future date. In the pledge situation there is a promise topay money or transfer other property, or to do both, at a future date. And in the option situation there is a promise to sellproperty at a future date. Although the promise may be enforceable, a promise to pay money or to sell property in the futureis not itself a 'payment' for purposes of deducting a contribution under section 170 of the Code. Thus, the grant of the optionto [the charitable organization] in this case is not a contribution for which a deduction is allowable under section 170.

With respect to the availability of the gift tax charitable deduction under section 2522, the IRS cited Rev. Rul. 80-186 in itsprimary argument, which concludes that the transfer of an option to purchase real property for a specified period is acompleted gift under section 2511 of the Code on the date the option is transferred, if, under state law, the option is bindingand enforceable on the date of the transfer. In the instant case, under local law, the purported option is not binding on ataxpayer when granted. Accordingly, the proposed transfer of the purported option to the trust would not be a completed gifton the date of transfer under section 25.2511-2(b), because the taxpayer would not have made a binding offer on that date.

With respect to the second issue (i.e., whether the grantor would be treated as the owner of the trust and, accordingly, betaxable on the gain from the sale of the option), the IRS's conclusion was obvious. If the trust is not a qualified charitableremainder trust, it must be a grantor trust, the income from which (including gain from the sale of trust assets) is taxable tothe grantor.Excess Business Holdings and Jeopardy Investments

A charitable remainder trust will not be subject to the excess business holdings or jeopardizing investment rules unless itincludes as income recipient an IRC §170(c) organization.6 Specimen trusts published by the IRS include these twoprohibitions (most likely in an effort to cover the possibility that charity will be an income recipient).

If applicable, the jeopardizing investment rules could come into play if the trustee decides to hold the one issue of stock forinvestment purposes (due to lack of diversification). Regarding excess business holdings, the trustee has five years to disposeof the stock (with a possible five-year extension).7 Accordingly, if the transfer is followed by a sale, these two problems shoulddisappear. Ltr. Rul. 9210005 confirms that charitable remainder trusts are exempt from the excess business holdings andjeopardizing investment rules per IRC §4947(b)(3)(B).S Corporation Without Built-in-Gains

Stock in an S Corporation that has no built-in gains (resulting from a conversion from a C Corporation), that would otherwisecause tax at the corporate level in the event of an asset sale/liquidation, may not be suitable for transfer to a charitableremainder trust if an asset sale/liquidation is anticipated.

An asset sale/liquidation outside the charitable remainder trust will result in a taxable event only at the shareholder level. Bycontrast, the transfer of stock in an S Corporation to a charitable remainder trust will terminate S Corporation status.Therefore, a subsequent asset sale (within the trust) will result in a taxable event at the C Corporation level. The subsequent

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liquidation will avoid tax at the shareholder (trust) level. However, the damage has already been done. Even though thecorporation is owned by a tax-exempt entity, the tax will remain the obligation of the corporation. Accordingly, the net taxresult of both alternatives may be roughly the same with the only difference caused by the marginal tax bracket applicable tothe shareholder verses the corporation and the charitable contribution deduction generated to the trustor.

As an alternative, the S Corporation itself should consider becoming the trustor and income recipient.

S Corporation as Trustor

Can an S Corporation establish a charitable remainder trust? Yes. Like a C Corporation, an S Corporation will be the trustorand income recipient of the trust. Income distributions will pass through to shareholders according to their pro ratashareholdings. However, because an S Corporation is other than an individual or a qualified charitable organization, the trustterm is limited to a term of years not to exceed twenty.8Pass-Through of Charitable Deduction to Shareholders

Can an S Corporation that establishes a charitable remainder trust pass the charitable contribution deduction through to itsshareholders? According to Ltr. Rul. 9340043, it can.

IRC §1366(a)(1)(A) provides that a shareholder in an S Corporation determines his liability by assuming his pro rata share ofitems of income, loss, deduction, or credit that if separately stated and given separate treatment would effect his individualincome tax liability. Items of loss include charitable contributions.9

The amount of the shareholder's contribution deduction is the present value of the remainder interest in the gift reduced inaccordance with the applicable provisions of IRC §170(e). Under that section, the amount of a contribution of property isreduced by the amount of gain that would not have been long-term capital gain (i.e., short-term capital gain or ordinaryincome) had the property been sold at its fair market value. Under IRC §170(e)(1)(B), however, the amount of the contributionis reduced by the amount of gain that would have been long-term capital gain if (a) the property is tangible personal propertyunrelated the exempt organization's purpose, or (b) the contribution is to or for the use of a private non-operatingfoundation.

Regarding the percentage limitation placed on the use of the deduction, the Service's position was favorable to the taxpayer,but at the same time perplexing. IRC §1366(d)(1) provides that the aggregate amount of losses and deductions assumed byany shareholder shall not exceed the sum of the adjusted basis of the shareholder's stock in the S Corporation and theshareholder's adjusted basis of any indebtedness.10 The Service, however, made no reference to that section in its ruling,stating simply, "The limitations applicable to individuals set forth in IRC §170(b) apply in determining the shareholder'sallowable deduction for the charitable deduction." Finally, when the net charitable deduction is passed through to theshareholder, the shareholder's basis in his stock is decreased (but not below zero) by the amount of the deduction.11

Bargain Sale of Company Stock Followed by Redemption

In Ltr. Rul. 8213063, a company president proposed to sell company stock that he owned personally to a charitableorganization at a discount; after which, the company could redeem the shares at their fair market value. The charity was notbound, however, to offer the shares for redemption and the company was not bound to redeem them.

The Service ruled the president would receive a charitable contribution income tax deduction for the difference between theselling price of the stock and its fair market value on the date of sale. Further, any subsequent redemption by the companywould not result in dividend treatment to the president, nor would it cause the company to recognize gain or loss. Gain to thepresident was to be determined under the standard bargain sale rules.Transfers of S Corporation Stock toCharitable Lead Trusts

S Corporation stock can be transferred to all forms of charitable lead trusts; however, the corporation will retain its S statusonly if the grantor is treated as the owner of the trust for income tax purposes 12, if the stock is transferred to the trust by willbut only for two-years following the transfer 13, or if the trustee is able to make an electing small business trust election.14

Beginning in 1998, it appears that an electing small business trust election may be made for a non-grantor charitable leadtrust assuming the charitable lead beneficiary is one of the eligible types (an organization described in Section 170(c)(2), (3),(4) or (5)) and the requirements are otherwise met.15Unrelated Business Income Tax

If S Corporation stock is transferred to a grantor charitable lead trust, any unrelated business income should have noapplication because the grantor (non-charity) will incur all taxable income of the trust.

Conversely, when an S Corporation loses its S election due to a transfer of stock to a non-grantor charitable lead trust,unrelated business income tax will be implicated as explained above for C Corporation stock.

If the trust is a non-grantor charitable lead trust (i.e., the donor is not treated as the owner of the trust for income taxpurposes), then the trust is a taxable entity. The trust itself, however, is entitled to a charitable deduction for amounts

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distributed to the charity.16 However, a deduction is not allowed for amounts allocable to unrelated business income realizedby the trust during the taxable year.17

For further reading, see Charitable Lead Trusts - Taxation of Charitable Lead Trusts.Self-Dealing

If S Corporation stock is contributed to a qualified charitable lead trust, the self-dealing rules are implicated.18 These rules arediscussed in detail in the "Other Issues" section of this text.Excess Business Holdings and JeopardyInvestments

When transferring S Corporation stock to a charitable lead trust, the planner must be aware that the excess business holdingsand jeopardy investment rules regarding private foundations apply when the value of the charitable lead interest at thecreation of the trust exceeds 60% of the total value of the trust's assets or if a portion of the income interest is not paid tocharity.19 These rules essentially prohibit the trust from owning more than 20% of the voting stock of a corporation for morethan five years.20

For further reading, see Application of Private Foundation Excise Taxes in Other Issues.S Corporation Stock to "Super"Grantor Charitable Lead Trust

In Ltr. Rul. 199936031, the Service approved the income, gift, and estate tax status of a super-grantor charitable lead annuitytrust funded with Subchapter S stock and with it recognized a new method to establish grantor trust status for income taxpurposes, and yet not cause inclusion for estate tax purposes.

1.

Public Law 104-188; signed into law on August 20, 1996back 2.

IRC §1361(b)back 3.

IRC §512(e)(1)back 4.

Ltr. Rul. 8922014back 5.

Ltr. Ruls. 8714013; 8825069; 8826008back 6.

Ltr. Rul. 9501004back 7.

Rev. Rul. 92-48, I.R.B. 1992-26, 7 (June 29, 1992)back 8.

IRC §4947(b)(3)(B)back 9.

IRC §4943(c)(6),(7)back 10.

Ltr. Rul. 9340043back 11.

IRC §702(a)(4)back 12.

IRC §1361(c)(2)(A)(i)back 13.

IRC §1361(c)(2)(A)(iii)back 14.

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IRC §1361(c)(2)(A)(v)back 15.

See IRC §1361(e) and Ltr. Rul. 199908002 (Nov. 5, 1998), where the IRS held that electing small business trust elections couldbe made for a grantor charitable lead annuity trust and grantor charitable lead unitrust after the grantor's death in yearsbeginning after December 31, 1997. Presumably, this electing small business trust ruling was requested because thecharitable lead trusts were to last for six years and, thus, could extend beyond the two-years-after-death qualifying period.back

16.

IRC §§1367(a)(2)(B) and 1366(a)(1)(A)back 17.

IRC §642(c)back 18.

IRC §681back 19.

IRC §512(c)back 20.

See exceptions in IRC §4941(d)(2)(F) and the Regulations thereunder.back

Limited Liability Companies

A limited liability company (LLC) is an entity formed under state law by filing articles of organization with the state and payingany required registration fees. It may or may not have a written operating agreement to govern its operations. Its owners areusually referred to as members and they have membership interests in the LLC. Management is generally by either majorityvote of the members or a specified general manager. None of the members is personally liable for the LLC's debts. As withother closely-held entities, the transfer of interests in an LLC is often restricted.

All states allow LLCs to be formed with two or more members. Some states also allow an LLC to be formed with only onemember. The check-the-box rules in the Regulations under IRC §7701 govern the classification of LLCs for federal taxpurposes. A single-member LLC is either taxed as a corporation or is disregarded as a separate entity for tax purposes. An LLCwith at least two members is generally taxed as a partnership unless it elects to be taxed as a corporation.Outright andPlanned Gifts

An LLC may be treated for tax purposes as a partnership or an association taxable as a corporation. If the LLC is treated as apartnership for tax purposes, a contribution of a member's interest in the LLC is likely to be treated the same as a gift of apartnership interest, as discussed earlier. If the LLC is treated as a corporation for tax purposes, a contribution of a member'sinterest in the LLC is likely to be treated the same as a C Corporation, also as discussed earlier. In no event should the LLClose its state law status (i.e., to limit the liability of its members). However, unique issues and uses will arise because of thedifference in treatment for state and tax law purposes. For instance, the single member LLC is currently being used by netincome with makeup charitable remainder unitrusts as a vehicle to defer the receipt of fiduciary income. The Service,however, has declined to issue further rulings regarding such arrangements.1

For further reading, see Gift Planner's Digest -- Using Single Member LLCs in Net Income Charitable Remainder Unitrusts.

1.

Rev. Proc. 99-3back

Other IssuesValuation of Charitable Gifts

The charitable contribution deduction is based on the contributed property's fair market value, which is defined as "the priceat which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion tobuy or sell and both having reasonable knowledge of relevant facts."1 The terms of the agreement and the nature of theassets owned by the privately held business will determine the value of the contributed property.Unlisted Securities

In order to value unlisted securities, quotations may be obtained from brokers, or, evidence as to their sale can be obtainedfrom the officers of the issuing companies. Copies of letters furnishing such quotations or evidence of sale should be attached

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to the return.2Closely-Held Stock

The IRS has stated that when valuing the stock of closely-held corporations or the stock of corporations where marketquotations are either lacking or too scarce to be recognized, all available financial data, as well as all relevant factorsaffecting the fair market value, should be considered. The following factors, although not all-inclusive, are consideredfundamental and require careful analysis in each case: (a) the nature of the business and the history of the enterprise from itsinception; (b) the economic outlook in general and the condition and outlook of the specific industry in particular; (c) the bookvalue of the stock and the financial condition of the business; (d) the earning capacity of the company; (e) thedividend-paying capacity; (f) whether or not the enterprise has goodwill or other intangible value; (g) sales of the stock andthe size of the block of stock to be valued; (h) the market price of stocks of corporations engaged in the same or a similar lineof business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.3

Restricted Securities

The subsequent sale of stock in a publicly-traded company may be restricted. Such stock is referred to as Rule 144 stock andis defined as "securities acquired directly or indirectly from the issuer thereof, or from an affiliate of such issuer, in atransaction or chain of transactions not involving any public offering." Since the stock may not be readily marketable, thevalue of such stock may be subject to a discount. Rev. Rul. 77-287 discusses the facts and circumstances material to valuingrestricted securities.Partnership Interests

As with a corporation, the value of a partnership interest is the net amount which a willing purchaser would pay for theinterest to a willing seller with neither being under any compulsion to buy or sell and with both having reasonable knowledgeof the relevant facts.4 The Regulations underlying the IRC provisions governing the valuation of assets that are transferredduring life or at death specify that many of the factors that apply in valuing corporate stock also apply in valuing otherbusiness interests, such as partnership interests.5Limited Liability Company Interests

Similarly, the value of a membership interest in an LLC is the net amount which a willing purchaser would pay for the interestto a willing seller with neither being under any compulsion to buy or sell and with both having reasonable knowledge of therelevant facts. 6 The estate and gift tax Regulations indicate that many of the factors that apply in valuing corporate stockalso apply in valuing other business interests. 7New Charitable Remainder Trust Regulations

Regulation §1.664-1(a)(7) provides new rules for valuing unmarketable assets that are transferred to or held by a charitableremainder trust. The final Regulations specify that a charitable remainder trust holding unmarketable assets will bedisqualified under IRC §664 (and no corresponding charitable deduction will be allowed) unless any required valuations of theunmarketable assets owned by the trust are (i) performed exclusively by an independent trustee or (ii) determined by acurrent qualified appraisal as defined under Regulation §1.170A-13(c)(3) by a qualified appraiser as defined under Regulation§1.170A-13(c)(5).8 The final Regulations also clarify the definition of "independent trustee" and "unmarketable assets" forpurposes of these valuation rules. - An independent trustee is a person who is not a grantor or a noncharitable beneficiary of the charitable remainder trustand is not a related or subordinate party (within the meaning of IRC §672(c) and the applicable regulations) to a grantor, agrantor's spouse or a noncharitable beneficiary of the trust. The addition of the noncharitable beneficiary to this list is anexpansion of the traditional definition of "related or subordinate person" found in the grantor trust rules.9 - Unmarketable assets are assets that are not cash, cash equivalents or other assets that can be readily sold or exchangedfor cash or cash equivalents. Unmarketable assets include real property, closely held stock and unregistered securities withno available exemption permitting public sale.10 - Regulation §1.664-1(f)(4) states that these new valuation rules are applicable to charitable remainder trusts created onor after December 10, 1998. However, if a charitable remainder trust was created before December 10, 1998, and itsgoverning instrument requires that an independent trustee value the unmarketable assets11, the Regulations allow thegoverning instrument to be amended or reformed to permit a valuation method that satisfies the requirements of the newvaluation rules, effective for taxable years beginning on or after December 10, 1998.

Unrelated Business Income Tax

If a charity incurs unrelated business taxable income, the charity must pay income tax on the unrelated business taxableincome.12 A charitable remainder trust that incurs unrelated business taxable income loses its tax-exempt status in thattaxable year so unrelated business taxable income could be particularly devastating in a year when an appreciated asset issold. A non-grantor charitable lead trust loses its charitable income tax deduction on a dollar-for-dollar basis for the amountof unrelated business income incurred by the trust.

Although a term of art, unrelated business taxable income generally means income earned from the active operation of abusiness enterprise. In general, passive income, such as interest, dividends, rents from real property under certaincircumstances, certain royalties and gains from a capital asset do not constitute unrelated business taxable income, so long

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as debt is not incurred to acquire those assets. The incurrence of any debt by a charitable remainder or charitable lead trustgenerally is very dangerous. For instance, no investments should be acquired through the incurrence of "margin" debt and asa general rule, no asset subject to debt should be contributed to such a trust. In addition, the distributions from certainpartnerships or LLCs treated as a partnership for tax purposes, which incur (or may incur) debt, may also constitute unrelatedbusiness taxable income.

A charitable remainder trust is exempt from all taxes unless it has unrelated business taxable income within the meaning ofIRC §512. In any year in which a charitable remainder trust has one penny of UBTI, the trust is subject to tax as if it was acomplex trust.

For a discussion of the application of unrelated business taxable income to charitable lead trusts, see Taxation of CharitableLead Trusts - Unrelated Business IncomeApplication of Private Foundation Excise TaxesIRC §4941 - Self-Dealing

In general, "self-dealing" consists of any direct or indirect transaction between a private foundation and a disqualified person13 involving the:

(i) sale, exchange, or leasing or property,(ii) lending of money or other extension of credit,(iii) furnishing of goods, services, or facilities, or(iv) payment of compensation or payment/reimbursement of certain expenses.14

IRC §4946(a)(1) defines a "disqualified person" as a person who is a:

(i) substantial contributor to the private foundation15 ,(ii) a foundation manager16,(iii) an owner of more than 20 percent of(a) the total combined voting power of a corporation,(b) the profits interest of a partnership, or(c) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation,(iv) a member of the family 17 of any person described in (i), (ii), or (iii), and (v) corporations, partnerships, trusts or estates inwhich substantial contributors, foundation managers, grantors of trusts, persons described under (iii), or any members oftheir families, owning or holding more than 35 percent of the total combined voting power, profits interest, or beneficialinterest.

Excise taxes are imposed on disqualified persons who participate in acts of self-dealing with a private foundation. The rate oftax is equal to 5 percent of the amount involved with respect to the act of self-dealing for each year (or part thereof) in thetaxable period.18 The rate of tax will increase to 200 percent if the act is not corrected within the taxable period.19 The tax isto be paid by the disqualified person (other than a foundation manager acting only as such) who participates in the act.20

A participating foundation manager, however, is liable for a tax equal to 2-1/2 percent of the amount involved with respect tothe act of self-dealing for each year (or part thereof) in the taxable period, unless the foundation manager's participation isnot willful and is due to reasonable cause.21 The rate of tax will increase to 50 percent if the act was not corrected within thetaxable year and the foundation manager refused to agree to part or all of the correction.22 The tax is to be paid by thefoundation manager who participated in the act of self-dealing 23 or refused to agree to part or all of the correction.24 Themaximum amount imposed on a participating foundation manager with respect to any one act of self-dealing is $10,000.25

The private foundation excise tax rules against self-dealing apply to all charitable remainder trusts. For additional discussion,see Charitable Remainder Trusts - Operating Considerations

In addition, the self-dealing rules apply to all qualified charitable lead trusts. For further reading, see Charitable Lead Trusts -Private Foundation Excise Tax Rules.IRC §4943 - Excess Business Holdings

In order to discourage private foundations from holding investments in business enterprises, Congress enacted IRC §4943,which basically subjects a private foundation to a two-tier excise tax for its "excess business holdings." In enacting thisSection, Congress was concerned that private foundation managers would focus their attention on the success of a businessenterprise and away from the charitable purposes for which the private foundation was created. In addition, such enterprise,as owned by a tax-exempt entity, could unfairly compete with another similarly situated enterprise that was owned by ataxable entity.

The excise tax imposed under IRC §4943 is 5% of the highest value of the holdings in a business enterprise in excess of the"permitted holdings." A harsh second-tier excise tax equal to 200% of such excess business holdings may apply if (i) the 5%tax is imposed and (ii) the Trust still has excess business holdings at the close of the earlier to occur of (A) the date of mailingof a notice of deficiency by the IRS relating to such holdings or (B) the date on which the 5% tax is assessed by the IRS.26

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"Permitted holdings" means, in an incorporated business enterprise, 20% of the voting stock, reduced by the percentage ofvoting stock owned by all disqualified persons (as defined in IRC §4946(a)) ("Disqualified Persons").27 However, in any case inwhich disqualified persons together do not own more than 20% of the voting stock of an incorporated business enterprise,nonvoting stock held by the private foundation shall also be treated as permitted holdings.

Once the permitted holdings have been determined, the permitted holdings are subtracted from the percentage of votingstock held by the foundation to determine the amount of "excess business holdings."28 The net effect of these formulas is toassure that the combined holdings of all disqualified persons and the private foundation in a business enterprise are not morethan 20%. Any readjustment of the assets held by the Trust (e.g., a recapitalization, redemption, merger) may also impact theexcess business holdings rules.29

The jeopardizing investment rules do not apply to charitable remainder trusts unless the trust includes a section 170(c)charitable organization as an income recipient.30

Although IRC §4943 deals with a private foundation and not a charitable lead trust, IRC §§4947(a)(2) and (b)(3) cause theexcess business holdings tax to apply to a charitable lead trust where the aggregate value of the charitable lead interestexceeds 60% of the fair market value of the property contributed to such trust.

For a detailed discussion of the application of the excess business holdings rules to charitable lead trusts, see Charitable LeadTrusts - Private Foundation Excise Tax Rules.Exceptions To Excess Business Holdings Tax

If the excess business holdings tax will apply, there are several methods by which the trust can limit the impact of, oraltogether avoid, such tax.Five-Year Period

The trust is given a five-year period beyond the date of the gift to dispose of the business holdings in excess of the combined20% permitted holdings.31 The law treats the business holdings held by the trust in this instance as being held by disqualifiedpersons to the trust for such five-year period. Thus, the trust is not deemed to own any business holdings for such period.

There are, however, exceptions to this favorable rule. These exceptions basically attempt to prohibit an end run around thisrule (i.e., transfer from the trust to another commonly controlled or related private foundation, a purchase by an entityeffectively controlled by a disqualified person or the trust or a disqualified person's plan to purchase during the five-yearperiod additional holdings in the same business enterprise held by the trust).32Effective Control Exception

Under certain circumstances, the permitted holdings may be increased from 20% to 35%.33 Such an increase is permitted if(i) persons other than the private foundation and disqualified persons have "effective control" of the company and (ii) theprivate foundation establishes to the satisfaction of the Commissioner that effective control is in one or more persons (otherthan the private foundation itself) who are not disqualified persons.

Effective control means the power to direct or cause the direction of the management and policies of a business enterprise,whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise. Forexample, the effective control test is met if individuals holding a minority interest, none of whom is a disqualified person,have historically elected a minority of the corporation's directors. The key is to prove that another person or group of personsdo control the company, not that the disqualified persons don't control the company.34Passive Source Exception

The third possible method of avoiding the IRC §4943 tax is the passive source exception. The definition of a "businessenterprise" includes the active conduct of a trade or business, including any activity that is regularly carried on for theproduction of income from the sale of goods or the performance of services.35 If 95% or more of the gross income of abusiness enterprise is "passive," the entity will not be deemed to be a business enterprise.

The definition of what is passive is a term of art and basically includes dividends, interest, payments with respect to securitiesloans, annuities, royalties measured by production of income from the property, rents from real property (unless taxable asunrelated business income) and gains or losses on sales and exchanges of property (other than inventory and property heldfor the sale to customers).36 This concept is consistent with the Congressional intent in attempting to discourage foundationmanagers from spending too much time on the business enterprise.37 If the activity is passive, by definition, the managerswould not be spending time on the business enterprise.Extension of Initial Five-Year Period

The IRS has the statutory power to extend the initial five-year period, for unusually large gifts or bequests of diverse holdingsor holdings with complex corporate structures, for up to an additional five years.38 The private foundation must prove to theSecretary of the Treasury that it has made diligent efforts to dispose of such holdings during the initial period, and adisposition of such holdings within the initial period has not been possible (except at a price substantially below fair marketvalue) due to the size and complexity or diversity of such holdings. The private foundation must submit a plan with theSecretary and the state official having the authority over the foundation's affairs (usually the Attorney General's Office) fordisposing of the excess during the extended period. This plan may be accepted by the Secretary if it can be reasonablyexpected to be carried out during the extension period.De Minimis Rule

A de minimis rule is provided in which disqualified persons may retain any percentage of holdings, so long as the privatefoundation holds no more than 2% of the voting stock or 2% by value of all outstanding shares.3990-day Grace Period

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A private foundation will have at least 90 days from the date of the gift to dispose of the excess business holdings withoutincurring this excise tax.40 This 90-day period is extended to include the period during which a private foundation is preventedby federal or state securities laws from disposing of such excess business holdings.41

IRC §4944 - Jeopardy Investments

IRC §4944 subjects a private foundation and a manager of the private foundation (i.e., a trustee) to a two-tier excise tax formaking investments in such a manner as to jeopardize the carrying out of the private foundation's exempt purposes.

If such a jeopardizing investment is made, IRC §4944(a)(1) imposes on the private foundation a tax of 5% of the amount ofthe investment for each year or part thereof in the "taxable period" (defined below), and IRC §4944(a)(2) imposes a similar 5%tax on any foundation manager who knowingly and willfully participated in making such investment. However, the tax on thefoundation manager is limited to $5,000 per investment.

The second tier tax of 25% of the investment is imposed whenever (i) an initial tax is imposed pursuant to IRC §4944(a)(1) onthe making of a jeopardy investment and (ii) the investment is not removed from jeopardy within the "taxable period",pursuant to IRC §4944(b)(1). The "taxable period" is the earlier to occur of (A) the date of mailing of the deficiency notice bythe IRS, (B) the date on which the IRC §4944(a)(1) tax is imposed or (C) the date on which the amount so invested is removedfrom jeopardy, pursuant to IRC §4944(e)(1).

A foundation manager is liable for an additional tax equal to 5% of the amount invested, only if an additional tax has beenimposed on the foundation and the manager has refused to agree to part or all of the removal from jeopardy of suchinvestment. This second-tier tax on the foundation manager is likewise limited to $10,000 per investment.42Gift of SpeculativeProperty

The tax under IRC §4944(a)(1) is imposed on the private foundation if it "invests" any amount in such a manner as tojeopardize its tax-exempt purpose.43 Although neither the Code nor the legislative history address the application of this taxto contributed property, Regulation §53.4944-1(a)(2)(ii)(a) provides that IRC §4944 shall not apply to an investment made byany person which is later gratuitously transferred to a private foundation. This Regulation Section further provides that, if suchfoundation furnishes any consideration to such person upon the transfer, the foundation shall be treated as having made an"investment" in the amount of such consideration.

One commentator describes this Regulation Section as follows, "Property received as a gift or bequest is not a jeopardizinginvestment regardless of how imprudent it might be if purchased by the foundation."44

Thus, it appears clear that the receipt by way of gift of a speculative asset by a private foundation cannot be described as an"investment," causing the private foundation to be subject to the tax under IRC §4944. However, what is less clear is theability of the foundation to retain such asset without incurring the jeopardy investment tax. In fact, another commentator hasindicated that an implied duty to dispose of highly speculative property, even if acquired by gift, can arguably be read into IRC§4944.45

However, two private letter rulings that relate directly to charitable lead trusts indicate a contrary and favorable taxpayerresult.46 In Ltr. Rul. 8125038, father transferred common stock in his for-profit corporation to two charitable lead annuitytrusts, one for the ultimate benefit of his son and the other for his daughter (and their respective descendants). Father andmother are the trustees of the trusts.

Citing Regulation §53.4944-1(a)(2)(ii)(a), the IRS held that the receipt and retention of the corporation's stock will not beconsidered an investment that would jeopardize the exempt purpose of the trusts. However, this ruling was based on thecondition that the Donor would not receive any consideration upon the transfer of the assets. Should any of the two trustsfurnish any consideration to the Donor, the IRS found that such trust will be treated as having made an investment in theamount of the consideration within the meaning of IRC §4944.

"It appears under this ruling that the trustees may not have a duty under §4944 to dispose of the stock if it later appears to bean imprudent investment. Rather, the §4944 determination is apparently made once and for all at the time the trusteeacquires the assets."47

Similarly, in Ltr. Rul. 8038180, a taxpayer proposed creating a charitable lead annuity trust and contributing approximatelyOne Million Dollars in cash andor common stock in a specified company to such trust. A bank and two private individuals (whowere not "related or subordinate parties" within the meaning of IRC §672(c)) were the trustees of the trust. The remainderbeneficiaries of the trust are descendants of the taxpayer.

Although deciding other issues, the IRS again held that the receipt and retention of the proposed assets will not be deemed tobe an investment which would jeopardize the carrying out of the exempt purposes of the trust, so long as the taxpayerreceives no consideration upon the transfer. The IRS specifically stated in the ruling that the taxpayer's investment andsubsequent gratuitous transfer to the trust is removed from the scope of IRC §4944 applicability by the above-cited TreasuryRegulation Section.48

Interestingly, in all of the above-cited rulings, the jeopardizing nature of the transferred assets (i.e., corporate stock, etc.) was

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not even at issue, as Regulation §53.4944-1(a)(2)(ii) apparently overrode any need for such an analysis.

In another favorable private letter ruling, the IRS again confirmed the inapplicability of IRC §4944 where a donor gratuitouslytransfers assets to a charitable lead annuity trust if no consideration is received by the donor.49 The IRS, however, adds thefollowing qualification to that conclusion: The trust does not change the form or terms of such investment. Reg.§53.4944-1(a)(2)(iii) provides in effect that if a private foundation changes the form or terms of an investment (includingproperty gratuitously transferred to a private foundation), the trust will be considered to have entered into a new investmentwhich will be judged at the time of such change as to whether that investment carries out the organization's exemptpurposes. Thus, a change in the form or terms of an investment triggers a reapplication of the jeopardy investment standard.Application of Regulation §53.4944-1(a)

Such Regulation Section states the general trustee standard to be applied in determining when an investment is a "jeopardyinvestment" under IRC §4944, as follows: When the foundation managers, in making such investment, have failed to exerciseordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investments, inproviding for the long- and short-term financial needs of the foundation to carry out its exempt purposes.

This standard as established in the legislative history has been described as a "prudent trustee" approach.50

As provided in Regulation §53.4944-1(a), the managers may, in the exercise of the requisite standard of care and prudence,take into account the expected return (including both the income and appreciation of capital), the risks of rising and fallingprice levels, and the need for diversification within the investment portfolio (for example, with respect to type of security,type of industry, maturity of company, degree of risk and potential for return). In addition, the determination whether theinvestment of a particular amount jeopardizes the carrying out of the exempt purposes of the foundation shall be made on aninvestment by investment basis, in each case taking into account the foundation's portfolio as a whole.

Such Regulation Section also provides that no category of investments shall be treated as a per se violation of IRC §4944.However, this Regulation does cite certain investments that will be closely scrutinized. These include trading on margin,trading in commodity futures, investments in working interests in oil and gas wells, purchase of puts, calls and straddles,purchase of warrants, and selling short.

The determination whether the investment of any amount jeopardizes the carrying out of a foundation's exempt purposes isto be made as of the time that the foundation makes the investment and not subsequently on the basis of hindsight.Therefore, once it has been ascertained that an investment does not jeopardize the carrying out of such purposes, theinvestment shall never be considered to jeopardize the carrying out of such purposes, even though as a result of suchinvestment, the foundation subsequently realizes a loss.51Application of the Jeopardy Investment Standard

The "prudent trustee" standard has been applied in several IRS rulings. For instance, in GCM 39537, the IRS held that thefoundation manager failed to meet the prudent trustee standard, where the foundation borrowed a large sum of money andinvested 75% of its assets to purchase an interest in a corporation whose stock was publicly traded but not of blue chipquality.

In Ltr. Rul. 8711001, certain loans, which were made at below-market rates for a lengthy period of time and wereinadequately secured, were found to be jeopardy investments. In TAM 9132005, the IRS held that the purchase of a bingohall in order to raise funds for a private foundation's charitable purpose was not a jeopardizing investment. Although theeffort to raise the funds was unsuccessful, there was no evidence that the organization failed to exercise business care andprudence in purchasing the hall.

In Ltr. Rul. 8718006, the investment by a private foundation in gold mining stocks did not constitute a jeopardy investment,nor did it jeopardize the carrying out of its exempt purposes, as such purchase was consistent with its policy of investing as ahedge against inflation. In Ltr. Rul. 9205001, a private foundation that exchanged its sole asset - common stock in acorporation - for preferred stock in another corporation made a jeopardy investment. The trustees did not exercise ordinarybusiness care and prudence when they entered into the investment. The investment did not allow for diversification of thefoundation's assets. Also, there was no reasonable expectation of return from the investment considering the risk involved inthe particular industry in which the investment was made.

In Rev. Rul. 80-133, a whole life insurance policy was contributed to a foundation but was subject to a policy loan to thedonor-insured. The foundation made annual premium payments but the life expectancy of the donor was 10 years and in 8years the full value of the investment would be greater than the life insurance proceeds. The IRS held that each payment wasa jeopardy investment. However, in Ltr. Rul. 8134114, the IRS held that a life insurance policy was not a jeopardy investmentwhere there is no outstanding loan, the donor surrenders all incidents of ownership and the donor pays the premiums, sincethe policy was gratuitously transferred to the foundation.52

And finally, in Rev. Rul. 74-316, the IRS determined that the use of a proposed investment procedure by a foundation wouldnot preclude the imposition of IRC §4944, because such an approach would preclude the analysis on an investment byinvestment basis and eviscerate the prudent trustee approach.

The jeopardizing investment rules do not apply to charitable remainder trusts unless the trust includes a section 170(c)charitable organization as an income recipient.53

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For a detail discussion of the application of the jeopardizing investment rules to charitable lead trusts, see Charitable LeadTrusts - Private Foundation Excise Tax Rules.

Intermediate Sanctions

A transaction with a public charity may result in private inurement or private benefit if a donor or some other private personis deemed to receive some benefit from the transaction. Prior to the enactment of the intermediate sanctions, the onlypenalty that the Service could impose on a public charity in such cases was revocation of the charity's exemption fromfederal income taxation. IRC §4958 was added to the Code when President Clinton signed the Taxpayer Bill of Rights 2 into lawin August of 1996. This new provision imposes penalty excise taxes as an intermediate sanction in cases where, among otherthings, a IRC §501(c)(3) public charity engages in an excess benefit transaction with a disqualified person. In simple terms, anexcess benefit transaction is one where a disqualified person engages in a non fair-market-value transaction with a charity. A"disqualified person" means any individual who is in a position to exercise substantial influence over the affairs of theorganization, whether by virtue of being an organization manager or otherwise. If an excess benefit transaction occurs, IRC§4958 imposes a two-tiered approach to punish disqualified persons: A 25% tax followed by a 200% tax if the excess benefitsituation is not corrected. Organization managers of a charity who knowingly participate in an excess benefit transaction canbe liable for a 10% tax.Imputation of Gain

There are many cases and IRS rulings that involve the imputation of gain to the donor on the sale of an appreciated asset bya donee. However, there are several overriding principles and cases that must be discussed in this regard.

In Palmer 54, the court held that the gain on the sale of the stock of a closely-held company by a charity would not be imputedback to the donor on the corporate redemption of the stock. In Palmer, the donor controlled both the company and thecharity. The court found that, in light of the presence of an actual, valid gift and because the foundation was not a sham, thegift of stock was not a gift of the proceeds of redemption.

The taxpayer in Palmer donated appreciated stock in a corporation to a charitable foundation. The taxpayer owned votingcontrol of the corporation and exercised de facto control over the charitable foundation. One day after the gift, thecorporation redeemed its stock that was owned by the charitable foundation.

The IRS argued the step transaction and the assignment of income doctrines, both well established in the tax law. The steptransaction doctrine would disregard the gift and treat it as an intermediary step of a single, integrated transaction, whichwould cause a taxable gain to the shareholder on the corporate redemption. The IRS further contended that, if the gift wasnot disregarded, the taxpayer assigned the income from the redemption transaction to the charity, which would cause thetaxpayer to recognize the income on the proceeds from the redemption.

The Tax Court cited from Humacid Co. , 42 T.C. 894, 913 (1964), that "The law with respect to gifts of appreciated property iswell established. A gift of appreciated property does not result in income to the donor so long as he gives the property awayabsolutely and parts with title thereto before the property gives rise to income by way of a sale..."

The Tax Court found these doctrines inapplicable in this case. In citing the law relating to the assignment of income doctrine,the Court stated that, if the putative assignor performs services, retains the property or retains the control over the use andenjoyment of the income, the liability for the tax remains on his shoulders. "However, if the entire interest in the property istransferred and the assignor retains no incidence of either direct or indirect control, then the tax on the income rests on theassignee."

The Tax Court cited seven cases in which similar attacks were rejected by the courts where a gift of stock was followed by itsredemption and concluded that the only question was whether he really made a gift, thereby transferring ownership of thestock prior to the redemption. The Tax Court found that "...the presence of an actual gift [to the charitable foundation] andthe absence of an obligation to have the stock redeemed have been sufficient to give such gifts independent significance."

The IRS argued that the taxpayer's control of the foundation precluded the court from ignoring the interrelated nature of thegift/redemption. But the Tax Court noted that Iowa law required the taxpayer to exercise his control as an officer and directorof the foundation in a fiduciary capacity. Further, the Tax Court stated that there was nothing in the record to indicate thatthe taxpayer exercised command over the use and enjoyment of the foundation property in violation of his fiduciary duty.

The IRS additionally argued that the redemption was anticipated. The Tax Court ended the matter and held that "expectationis not enough."55 At the time of the gift, "...the redemption had not proceeded far enough along for us to conclude that thefoundation was powerless to reverse the plans of the petitioner [the taxpayer]. In light of the presence of an actual, valid giftand because the foundation was not a sham, we hold that the gift of stock was not in substance a gift of the proceeds ofredemption."

The IRS acquiesced to the decision in Palmer and in Rev. Rul. 78-197 stated that the Tax Court was correct. In this ruling, theService specifically acknowledged that the taxpayer in Palmer had voting control of both the corporation and a tax-exemptprivate foundation. Further, the Service stated that the gift, followed by the redemption, was "[p]ursuant to a single plan."Nonetheless, the ruling concluded:

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"The Service will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donoronly if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption."

Subsequent to Palmer, the court in Blake 56 held that the mere prearrangement of the sale caused an imputation of gain tothe donor. Many in the planned giving community believe that this case is a good example of the maxim, "bad facts make badlaw." In Blake, the donor transferred $700,000 of marketable securities to a charity "to purchase the yacht AMERICA." Thecharity accepted the gift and sold the stock. The charity then purchased from the donor the yacht for $675,000, in a so-called"quid pro quo" transaction. However, the charity sold the yacht three to four months thereafter for only $200,000.

On the basis of the Tax Court's factual findings, the Second Circuit had little trouble concluding that Blake had expected thecharity to purchase his vessel and that he had an enforceable cause of action under promissory estoppel theory, as a matterof law, if the charity refused.

The court treated the transaction as a "unitary one," where the appreciated stock was used for the purpose of purchasinganother asset of the donor. Thus, the donor was taxable on the sale by the charity of the $700,000 of marketable securities.

Despite the apparent inconsistencies between Palmer, Rev. Rul. 78-197 and Blake, there are logical interpretations of theseand other relevant cases and rulings. After an extensive review of the law in the area, these inconsistencies are moreperceived than real. Blake dealt solely with a situation in which there was a gift of an appreciated asset to charity, so that thecharity in turn could purchase an asset from the donor. In effect, there was a quid pro quo being required by the donor, inorder for the donor to make such a substantial gift. Even the donor admitted this.

In fact, viewed in its entirety, Blake involved a taxpayer who got a charitable deduction of $675,000 for a boat which wasreally worth $200,000 to $250,000 as evidenced by the sales price three to four months later. If a situation does not involve aquid pro quo, or if it does not involve a scheme to obtain an inflated tax deduction, arguably the result would be the same asin Palmer and Rev. Rul. 78-197, namely that the obligation must be legally enforceable to tax the gain to the donor.

In the case of Greene 57, the taxpayer contributed futures contracts to an IRC §501(c)(3) private operating foundation whichhe founded in the early 1970s. In 1974, the taxpayer obtained a private letter ruling from the Service to the effect he wouldbe entitled to a charitable income tax deduction equal to the fair market value of the contracts on the date of gift, and that nogain would be recognized to him when the charity sold the futures contracts.

In 1981, IRC §1256 was amended to provide that 60% of such gain on futures contracts would be long-term capital gain, andthe balance would be treated as short-term capital gain. In 1982 Greene donated the 60% long-term capital gain portion tothe charity, taking a full deduction.

In the lower court proceeding, the IRS contested the deduction, arguing that the 1974 ruling was inapplicable on its facts,since the law had changed. Accordingly, the Service contended (i) the gift of the 60% long-term capital gain portion was anassignment of income, and (ii) the step-transaction doctrine applied to collapse the transactions (a gift and then a sale) intoone step.

As to the assignment of income doctrine, the lower court ignored Greene's relationship to the charity as a director andofficer, commenting that this fact alone did not cause Greene to be taxed on the long-term capital gain portion. Further, thelower court felt the "[r]easonable probability of gains existing from a property's sale is not enough alone to make a gift ananticipatory assignment of income." In fact, the lower court stated the Service should have expected, when it issued its 1974ruling, that donated futures contracts "would be sold almost immediately to insure that the value of such volatile securitieswould be realized and thus useful to the recipient [the charity]." Finally, from a factual standpoint, the court found thatGreene retained no control over the timing of the sales of the futures contracts.

As to the step-transaction doctrine, Greene argued that the critical question was whether the futures contracts were donatedwith no strings attached or prearrangement made. The Service argued Blake, namely that:

"If, by means of restrictions on a gift to a charitable donee, either explicitly formulated or implied or understood, the donor sorestricts the discretion of the donee that all that remains to be done is to carry out the donor's prearranged plan fordisposition of the stock, the donor has effectively realized the gain inherent in the appreciated property." Blake v.Commissioner, supra.

On appeal in Greene, the Second Circuit explicitly enunciated two tests that the Service and the courts use to apply thestep-transaction doctrine, and implicitly referenced a third test: 1. The End Result Test - a series of separate transactions will be collapsed if they are really parts of a single transactionintended from the outset to achieve an ultimate result.58 2. The Mutual Independence Test - a series of separate transactions will be collapsed if they are so interdependent thatthe legal relations created by one transaction would be fruitless without completion of the series.59 3. The Binding Commitment Test - a series of separate transactions will be collapsed if there is a legal obligation, afterthe first step, for other steps to occur.

 

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The Second Circuit held that the "end result" test did not apply, because there was no prearranged agreement to sell theproperty, although it was highly likely that such would occur. As to the mutual independence test, the Second Circuit likewiseheld this concept inapplicable:

"Moreover, this case is distinguishable from those in which the interdependence test has been met. For example, in Blake, ataxpayer donated appreciated stock to a charity with an understanding that the charity would liquidate the stock andpurchase the taxpayer's yacht.60 We applied the step transaction doctrine to disregard the initial gift of the stock, and treatedthe transaction as a gift of the yacht.61 Here, in contrast, taxpayers made a substantial gift to the Institute and receivednothing in return. They retained a right to a portion of the income from the contracts, but giving a partial gift is quite differentfrom giving away something with an understanding that the donee will later buy something back from the donor with theproceeds of the donated gift. There was no understanding that the Institute would handle the contracts or the donated portionof the proceeds from sale in any way that would benefit the Greenes. In fact, they were not benefitted by the charity."

The last case which needs to be examined is Ferguson 62, in which three individuals donated appreciated stock to charitableorganizations immediately before the corporation was sold to another corporation in a tender offer. The Tax Court had heldthat the taxpayers were taxable on the gain in the stock transferred under the anticipatory assignment of income doctrine.

Factually, the taxpayers and their children owned stock of American Health Companies Inc. ("AHC"). In July of 1988, AHCentered into a merger agreement with two acquiring corporations ("X"). Under the agreement, X was to purchase AHC's stockin a tender offer and then merge into AHC.

On August 3rd, AHC's board voted on the tender offer made by X. The taxpayers abstained from voting, as board members,on the tender offer; nonetheless, the offer was approved.

Between August 15th and 21st, the taxpayers executed "donation-in-kind" records stating their collective intention to donate61,111 shares of AHC stock to charities. The taxpayers' stockbroker ("Broker") helped the taxpayers create separate accountsfor ALL of their respective stockholdings. On August 26, the charitable foundations were formed.

As of August 30th, more than 50% of AHC's outstanding shares had been tendered or guaranteed. On September 8th, theBroker transferred the shares to the newly formed charities, at which time over 95% of the outstanding shares of AHC stockhad been tendered or guaranteed. On September 9, 1988, the merger took place, with AHC stock being traded for X stock.

The IRS determined that the taxpayers were taxable on the gain attributable to the AHC shares that were donated to thecharities. The Taxpayers argued, in part, that (i) the gifts had been made on August 15th and 21st, (ii) the charities were notlegally obligated to tender their AHC stock, and (iii) the right to the tender offer's proceeds did not mature until October 12thwhen X's directors adopted a resolution stating the terms of the merger.

The Ninth Circuit stated that the key issue "is whether the Fergusons had completed their contributions of the appreciatedAHC stock before it had ripened from an interest in a viable corporation into a fixed right to receive cash." The Ninth Circuitalso stated that "to determine whether a right has "ripened" for tax purposes, a court must consider the realities andsubstance of events to determine whether the receipt of income was practically certain to occur" and that "while a finding of amere anticipation or expectation of the receipt of income has been deemed insufficient to conclude that a fixed right toincome existed, courts also have made it quite clear that the overall determination must not be based on a consideration ofmere formalities and remote hypothetical possibilities."

The Ninth Circuit upheld the Tax Court's determination that on August 31, 1988, the first date by which over 50% of the AHCshare had been tendered, "it was practically certain that the tender offer and the merger would be completed successfullyand that all AHC stock, even untendered stock, either already had been converted into cash (via the tender offer) orimminently would be converted into cash (via the merger)." In addition, the Ninth Circuit stated that the Tax Court, inselecting August 31, 1988 as the relevant date for the ripening of the AHC stock, had considered whether, as of that date,"the surrounding circumstances were sufficient to indicate that the tender offer and the merger would proceed, as if both hadto be completed as of or on that date." Accordingly, the Ninth Circuit upheld the Tax Court's decision and adopted the"anticipatory assignment of income" doctrine, which states that "once a right to receive income has "ripened" for taxpurposes, the taxpayer who earned or otherwise created that right, will be taxed on any gain realized from it, notwithstandingthe fact that the taxpayer has transferred the right before actually receiving the income."Final RegulationsUnder Section 337 - Corporate Liquidation

The rules regarding the taxation of corporate liquidations were recently changed. The Regulations now generally provide thatunder either of two scenarios, a taxable event will be incurred at the corporate level: (a) a taxable corporation transfers all orsubstantially all of its assets to one or more tax-exempt entities, or (b) a taxable corporation changes its status to atax-exempt entity.

See Planned Giving Online - Final Regs Under 337(d): More Taxation for Tax-Exempts

1.

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Regs. §§25.2512-2(b)(1) and 20.2031-2(b)(1); IRC §2031(b)back 2.

Regs. §§25.2512-3(a) and 20.2031-3; Rev. Rul. 59-60, 1959-1 C.B. 237 modified by Rev. Rul. 65-193, 1965-2 C.B. 370 andamplified by Rev. Rul. 77-287, 1977-2 C.B. 319; Rev. Rul. 80-213, 1980-2 C.B. 101 and Rev. Rul. 83-120, 1983-2 C.B. 170back 3.

Rev. Rul. 77-287, 1977-2 C.B. 319back 4.

Reg. §§20.2031-3 and 25.2512-3(a)back 5.

Reg. §§20.2031-3(c) and 25.2512-3(a)(3)back 6.

Reg. §§20.2031-3 and 25.2512-3(a)back 7.

Reg. §§20.2031-3(c) and 25.2512-3(a)(3)back 8.

Reg. §1.664-1(a)(7)(i) (the qualified appraiser rules are the same as those in the substantiation rules that exist for charitableincome tax deduction purposes).back 9.

Reg. §1.664-1(a)(7)(iii)back 10.

Reg. §1.664-1(a)(7)(ii)back 11.

The use of an independent trustee for such valuations was a requirement that many commentators had assumed existedbased on the legislative history to IRC §664.back 12.

IRC §§511-514back 13.

IRC §§4943(b) and (d)(2)back 14.

IRC §§4943(a)(1) and (2)back 15.

Reg. §53.4943-3back 16.

Reg. §53.4943-7(d)back 17.

IRC §4943(c)(6)back 18.

Reg. §53.4943-6(c)back 19.

IRC §4943(c)(2)(B)back 20.

Rev. Rul. 81-111, 1981-1 C.B. 509back 21.

IRC §4943(d)(3)(B)back 22.

IRC §4943(d)(3)back 23.

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Ltr. Rul. 9211067back 24.

IRC §4943(c)(7)back 25.

IRC §4943(c)(2)(C)back 26.

Reg. §53.4943-2(a)(1)(ii)back 27.

Reg. §53.4943-2(a)(1)(iii)back 28.

IRC §4947(b)(3)back 29.

Also See, IRC §6684 for a possible "third-tier" tax where the private foundation or manager had been liable for the IRC §4944tax in a prior year and became liable for the same tax in a subsequent year or where the act or failure to act giving rise to theexcise tax is both willful and flagrant; this tax would equally apply to a IRC §4943 tax.back 30.

Reg. §53.4944-1(a)back 31.

Bittker & Lokken, Federal Taxation of Income Estates and Gifts, Second Edition, 1993, 101.7.3, p.101-111back 32.

See, Chiechi and Maloy, 338-3rd T.M., Private Foundations - Section 4940 and Section 4944, p. A-17back 33.

Ibidback 34.

Ibidback 35.

See also Ltr. Rul. 9320052 in which the IRS again held the receipt and retention of oil and gas interests by a testamentarycharitable lead annuity trust qualified for the exception in Reg. §53.4944-1(a)(2)(ii), and thus, a tax under IRC §4944 was notimposed.back 36.

Ltr. Rul. 8135040back 37.

See, S. Rep. No. 91-552, 91st Cong., 1st Sess. 46 (1969), 1969-3 C.B. 423, 453, and reaffirmed as such by the IRS in Rev. Rul.74-316, 1974-2 C.B. 389.back 38.

Reg. §53.4944-1(a)(2)back 39.

Rev. Rul. 80-133, 1980-1 C.B. 19back 40.

IRC §4947(b)(3)back 41.

See also Ltr. Rul. 8909037back 42.

Rev. Rul. 74-316, 1974-2 C.B. 389back 43.

IRC §4946(a)(1)back 44.

IRC §4941(d)back

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45.

Any person who (i) contributed or bequeathed an aggregate amount of more than $5,000 to the private foundation, if suchamount is more than 2 percent of the total contributions and bequests received by the foundation during the taxable year, or(ii) in the case of a trust, the creator of the trust. IRC §507(d)(2)back 46.

An officer, director, or trustee of a private foundation (or an individual having powers or responsibilities similar to those ofofficers, directors, or trustees of the foundation). IRC §4946(b)back 47.

Includes spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, andgreat grandchildren. IRC §4946(d)back 48.

IRC §4941(a)(1)back 49.

IRC §4941(b)(1)back 50.

IRC §§4941(a)(1) and 4941(b)(1)back 51.

IRC §4941(a)(2)back 52.

IRC §4941(b)(2)back 53.

IRC §4941(a)(2)back 54.

IRC §4941(b)(2)back 55.

IRC §4941(c)(2)back 56.

Palmer v. Commissioner, 62 T.C. 684 (1974)back 57.

Hudspeth v. United States [73-1 USTC 9136], 471 F.2d 275 (8th Cir. 1972). See also, W. B. Rushing, 52 T.C. 888 (1969), aff'd[71-1 USTC 9339] 441 F.2d 593 (5th Cir. 1971)back 58.

Blake v. Commissioner, 697 F.2d 473 (2d Cir. 1982), aff'g 42 TCM 1336 (1981)back 59.

Greene v. United States, 13 F.3d 577 (1994), aff'g 806 F.Supp. 1165 (1992)back 60.

Penrod v. Commissioner, 88 T.C. 1415, 1429 (1987). See also, Stephen S. Bowen, "The End Result Test," TAXES, Dec., 1994 atp. 722back 61.

American Bantam Car Co. v. Commissioner, 11 T.C. 397, aff'd 177 F. 2d 513 (3d Cir. 1949, cert. denied 339 U.S. 920 (1950))back 62.

Ferguson v. Commissioner, U.S. Court of Appeals, 9th Circuit, 98-70095, 4/7/99, Affirming the Tax Court, 108 TC 24back

 

Tony Macklin

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Articles, Articles

tonymacklin1@gmail.com

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