Double Taxation

There are various forms under which an individual or group of people can choose to establish a business. One such form is a corporation. There are two different types of corporations a C corporation and an S corporation. Unlike other business structures, a C corporation is a taxable entity that is separate from the individual or individuals who own it. A C corporation is frequently created to shield the shareholders from liability.

It is quite possible to form a C corporation without taxable consequences to the shareholders. Under Internal Revenue Code (IRC) Sec. 351(a), it is permissible to transfer assets to corporations without the realization of tax. Thus, if a person owns a piece of highly appreciated real estate that he wishes to transfer to a C corporation, under Sec. 351 he or she may do so without having to recognize the gain on the transfer of the real estate.

Because a C corporation is its own taxable entity, the corporation files Form 1120 and pays tax at corporate rates, which may be as high as 35%. Further, a corporation does not have the lower, favorable capital gains rate of an individual taxpayer. In addition to federal taxes, most corporations also pay state income taxes.

After payment of tax, the corporation may distribute dividends to shareholders. These dividends are often subject to a second tax at the shareholder level. Whether or not the dividend is taxable depends on the corporation's accumulated earnings and profits. For any profitable corporation, distributions of dividends will almost always be taxable to the shareholder at ordinary income rates. Currently, there is a favorable 15% tax rate on qualified dividends of domestic corporations. That rate may increase to 20% in 2011.

While it is easy to establish a C corporation without recognition of gain, it is not as easy to transfer assets out of the corporation without tax. When a corporation distributes assets to its shareholders, the corporation must pay taxes on the gain in the assets. The shareholder in almost all cases will then pay taxes on the distribution.

Bypassing Gain

A charitable remainder unitrust or "CRUT" is one method that can be used to bypass capital gain. Because a CRUT is tax-exempt, it can sell assets or stock without having to recognize any gain. There are two ways in which a CRUT can be established using a C corporation. The first is by the shareholder transferring stock to a CRUT and the second occurs if the C corporation transfers some of its assets to the CRUT.

The Stock CRUT

The stock CRUT, rather than the asset CRUT, is the more commonly preferred trust and often provides better tax advantages. In the stock CRUT, the shareholders, usually of a closely held corporation, transfer all or part of their C corporation stock to the trustee of the CRUT. The CRUT is generally established for the lives of the shareholders, but it can also be created for a term of 20 years or less.

When the stock is transferred to the CRUT, the CRUT becomes the owner or a shareholder of the C corporation. The transfer of stock does not affect the taxation of the C corporation because the C corporation is its own taxable entity.

Once the CRUT is funded, the trustee will attempt to locate a buyer for the stock. Because the CRUT is a tax-exempt trust, there will not be capital gains tax when the stock is sold to the new buyer. Therefore, the donor will not recognize capital gain when the stock is sold by the CRUT because of the CRUT's tax-exempt status. Again, the transfer of stock will have no effect on the corporation's tax status.

However, the buyer may wish to purchase the assets from the corporation rather than the stock of the corporation. Often a buyer prefers an asset purchase over a stock purchase for two reasons. First, the buyer does not want to assume any potential liabilities of the corporation it is acquiring and second, when it purchases the assets it gets a cost basis in the asset equal to the purchase price. This allows the purchasing corporation to take larger depreciation deductions.

If the buyer purchases the assets rather than the stock, it is the corporation who is selling rather than the shareholder. Therefore, the corporation will recognize gain on the sale of its assets. If the stock is purchased instead, the seller (i.e. the CRUT) recognizes no gain because it is tax-exempt. Thus, it is more advantageous to the shareholders for the stock to be sold rather than the corporate assets.

The Asset CRUT

Another method is for the corporation itself to establish the CRUT. The corporation owns assets and, therefore, could transfer assets to the CRUT. In this scenario, because the corporation is establishing the CRUT, the length of the CRUT can only be for a term of 20 years or less. This is because a C corporation does not have a life expectancy and, therefore, cannot have a lifetime CRUT.

Is it possible for the C corporation to fund the CRUT with its assets, but have the income paid to the shareholders for their lives? While this might be possible, it is usually not tax advantageous. If the corporation were to contribute assets to the CRUT and then have it pay to the shareholders, this action would be treated as a distribution to the shareholders and thus, the shareholders would be taxed on the present value of the income stream of the trust. That amount is the difference between the fair market value of the assets transferred to the CRUT minus the charitable deduction. Further, the tax benefits for establishing the CRUT would belong to the corporation and that is generally not helpful as described below.

When the C corporation establishes the CRUT, it is the corporation that is entitled to the charitable deduction. Unfortunately, a C corporation is more restricted than an individual in the amount of the charitable deduction that it can use each year. A C corporation can only use a charitable deduction for up to 10% of its taxable income. This is unlike an individual who can use a deduction for gifts of appreciated property for up to 30% of his or her adjusted gross income.

Potential Reg. 1-337(d)-4 Gain Recognition

When a corporation is liquidated, there is potential tax payable at the corporate level. If it were permissible for a corporation to distribute all of its assets to charity or to a charitable trust, then this tax could be avoided. In order to limit this type of transaction, Reg. 1.337(d)-4 requires recognition of gain at the corporate level if "substantially all" the assets are given to charity or to a charitable remainder trust.

The phrase "substantially all" is not defined in Sec. 337(b)(2) or in Reg. 1.337(d)-4. However, there are several other places in the Code in which the phrase "substantially all" is interpreted to mean 85%. Reg. 1.514(b)-1(b)(1)(ii). Reg. 53.4942(b)-1(c). Reg. 53.4946-1(b)(2). Reg. 1.401(k)-1(d)(1)(ii). While these regulations cover a variety of tax issues, it is significant that they uniformly interpret the phrase "substantially all" to mean 85%.

Since the exception under Sec. 337 refers to "an 80%" subsidiary, some counsel have also expressed the belief that "substantially all" could be interpreted to be 80%. Regardless, it is apparent that a transfer of perhaps 65% of assets to charity or to a charitable trust would be permissible under Sec. 337(b)(2). Cautious counsel would be prudent in remaining at or below that level with transfers to charity.

Planning Strategies

Using a CRUT to sell a C corporation can have great tax benefits for those who are charitably inclined. For example, Bob and Ann Edwards established a C corporation 50 years ago. The corporation has done well over the years, but Bob and Ann are now ready to retire. Bob and Ann have two children, but they both have their own successful careers and therefore, have no interest in taking over the business. Another corporation that wishes to acquire their business has approached Bob and Ann. The price offered was higher than they had expected and thus, they are carefully considering the offer.

Because Bob and Ann started the corporation with very little capital, they have a very low cost basis in their stock. If they were to sell, Bob and Ann would realize a very large capital gains tax. Throughout the years, Bob and Ann have worked in their community supporting numerous local charities. They would like to continue their support of the various charities when they sell the corporation.

Also, now that Bob and Ann are retiring, Bob has dreams of purchasing a motor home and traveling across the country with Ann. Bob would like to use some of the sale proceeds to purchase the RV that he has always dreamed of having. Is there a way for Bob and Ann to achieve their goal? Bob and Ann could transfer some of their stock to a charitable remainder unitrust. They would continue to own the balance of the stock.

While it is permissible for Bob and Ann to serve as trustees, because they have chosen to do a "unitrust and sale," they felt it would be better to have another party serve as trustee. Bob and Ann have chosen their local bank to be the trustee of the CRUT. Further, Bob and Ann have created a revocable trust with the bank also as trustee. Bob and Ann have placed the balance of their shares into the revocable trust. This two trust plan allows the trustee to negotiate the sale more easily, since there is only one legal owner of the stock, the trustee.

Once the desired amount of stock is placed into the CRUT, the trustee will negotiate the sale and sell all stock to the new buyer. The CRUT will then receive its share of cash from the sale. The revocable trust that Bob and Ann established will also receive its share of the proceeds. Because the CRUT is tax-exempt, it will not have to pay any capital gains tax on the sale of its stock. Bob and Ann's revocable trust is not tax-exempt, however, and thus, Bob and Ann will have to pay capital gains taxes on the sale of that stock.

However, an excellent benefit is that even though Bob and Ann will have a capital gains tax on the stock sold by the revocable trust, they also will receive a large charitable deduction for establishing the CRUT. The charitable deduction will be taken at their highest income tax bracket while the capital gains tax will be paid at a favorable 15% tax rate. This tax arbitrage allows Bob and Ann to use their charitable deduction to offset the capital gains tax owed. Therefore, Bob and Ann will receive enough cash to purchase their RV, benefit from an income stream for their two lives from the CRUT and enjoy the ability to benefit favorite charities with the CRUT remainder.

Conclusion

There are a number of charitable strategies that can be used when selling a business. Bob and Ann could have transferred all of their stock to the CRT. They also could have used a charitable gift annuity. The charitable gift annuity is especially beneficial when the children wish to continue to operate the business.

This article is the first in a series that will explore the options of using businesses and business assets to fund charitable gifts. Throughout this series, planning options with S corporations, partnerships, LLCs and sole proprietorships will be discussed.