The Tip of the Iceberg: Selling a Business in a CRT

by Temo Arjani and Reynolds T. Cafferata

To best illustrate the issues and complexities of selling a business in a charitable remainder trust (CRT), we have chosen a case study to help guide you through the decision-making process. Case studies are useful to illustrate the wide range of uses that will arise in a complicated business sale transaction involving shareholder charitable remainder trusts so that a planning team can anticipate those issues and perform the appropriate analysis.

The clients we have chosen for this case study are not risk averse. Accordingly, the decisions below are not presented as the "right answers," but represent one client's decisions based on facts and circumstances, and his assessment of the risks and rewards of the various alternatives. Individuals in different positions, with different risk tolerances, and different activities may reach different results.

Basic Facts

Cheston and Sunshine are newlyweds. Cheston is 67 and Sunshine is 27. Cheston owns, as his separate property, a business that he built up with his previous wife who is now deceased. The business, Body Barrels, Inc., is a redwood barrel hot tub manufacturing business based in Northern California. Body Barrels is an S Corporation. Several parties have expressed an interest in buying Body Barrels for approximately $100 million.

Creation Of Charitable Remainder Trusts

Sale of business: Cheston had determined that he wanted to sell Body Barrels. Cheston consulted his large accounting firm for tax strategies to reduce the taxes on the sale of the business. The accounting firm recommended a charitable remainder trust.

S Corporation: Body Barrels was an S Corporation and may not have a charitable remainder trust as a shareholder. Cheston's options were to have the S Corporation fund the charitable remainder trust or to transfer the stock of the corporation to the charitable remainder trust and terminate the S election. Since the S Corporation is not a natural person, any trust funded by it would be limited to a 20 year term. For reasons discussed below, this is not an acceptable arrangement for Cheston and Sunshine. Cheston wanted the advantages a CRT could provide and elected to terminate the S election of the corporation. Cheston terminated the S election well before he had a firm commitment that Body Barrels would be purchased.

CRT Structure Issues

Cheston wanted to provide an income for Sunshine and himself. He also wanted to obtain a tax deduction in order to offset income that he would receive under a covenant not to compete and the sale of shares he would sell outside of the CRT. Because of Sunshine's age, if she were included as a beneficiary of the CRT, the deduction would be quite small. If she was not included, the deduction would be significantly larger, but she would not have any income after Cheston's death. Ultimately, Cheston decided to create two charitable remainder trusts. One trust (60% of the stock of Body Barrels) would be for his benefit only and would generate a larger charitable deduction. The other trust (30% of the stock) would be for the benefit of both Sunshine and himself, generating almost no deduction at all. Cheston retained the remaining 10% of the stock.

Spigot Trusts

The accounting firm had initially proposed creating net income with makeup charitable remainder unitrusts (NIMCRUT) in which capital gains, including pre-contribution capital gains, would be allocated to income. A limited partnership would be created to hold the investments of the CRTs to act as a spigot to control trust distributions. Based on recent IRS rulings regarding spigot trusts, the plan was revised so that only post-contribution capital gains would be allocated to income.

In the middle of the process of planning the two charitable remainder trusts, the IRS issued the proposed regulations under Section 664 permitting flip trusts under limited circumstances, and issued Revenue Procedure 97-23 announcing a study of net income unitrusts in which a limited partnership or annuity was used to control the flow of distributions from the trust. In response to those pronouncements, the trust for Cheston only was revised to be a flip trust. The trust for both Cheston and Sunshine was drafted as a net income unitrust with all the other language necessary to accommodate a spigot, but the spigot in the form of a partnership would not be immediately implemented.

Shortly after the charitable remainder trusts were completed, the 1997 Tax Act-10% Remainder Interest legislation was proposed. Had this legislation been enacted prior to completion of the charitable remainder trust for both Cheston and Sunshine, Sunshine's charitable remainder trust would not have qualified.

Sale Of The Company

During the time that the structure of the trust was being developed, Cheston was having informal negotiations with potential buyers. A nonbinding letter of intent was prepared, initially drafted only for Cheston's signature. This was revised to reflect that the trusts also would be sellers of the company. The trusts were funded before the letter of intent was signed. A major issue in negotiating the letter of intent was whether the purchasers would buy stock or buy assets. Purchasers typically prefer to purchase assets for reasons of liability and increased tax basis in those assets. In order for Cheston's tax planning to work, however, the sale needed to be of stock. Ultimately, the parties agreed to a price on the basis of a stock sale. Purchasers also agreed to pay Cheston for a covenant not to compete. The covenant was a payment personal to Cheston and left open an issue of whether the payment was for the stock or was for him personally. If it was a payment for the stock, it was an act of self-dealing. Because the appraisers determined that the purchase price equaled the value of the corporation, the covenant not to compete was not an act of self-dealing.

The letter of intent called for a 90-day period of due diligence, and drafting and negotiation of the sale documents. Cheston was a tough negotiator. He objected to several terms and conditions requested by the buyers, including some that were relatively routine provisions for these types of transactions.

On two or three occasions, negotiations broke down completely, and it looked as if the sale would not be completed. If this happened, Cheston would be left with a corporation with the terminated S election inside of the charitable remainder trusts.

One of the most difficult negotiating points was the creation of an escrow account to hold back part of the purchase proceeds to make adjustments based on discoveries after the completion of the sale of the company. Although common in business sales, Cheston took great exception to this provision. Finally, however, he agreed to a $1.5 million escrow account.

Issues After The Sale

Appraisal issues. While the stock of Body Barrels was sold for $100 million ($60 million going to husband's trust, $30 million to wife's trust, and $10 million to husband personally), only six months after the CRTs were funded, the stock had to be appraised by a qualified appraiser before the return was filed. In the initial year, both the trusts were "net income" trusts, with the trust instruments including capital gains in the definition of trust accounting income. If the appraisal came at the same figures as the sale price, no trust accounting income would arise from the sale of the stock. The appraiser was, however, able to attribute lower values to both the CRTs for lack of marketability and for minority interest (in the case of wife's CRT) thereby producing some post-contribution gain that could be distributed in satisfaction of the unitrust amount.¹

Who should pay for the appraiser's fees? Should Cheston because his charitable contribution deduction requires an appraisal and completion of Form 8283? Should the CRTs because the trusts have to calculate the amount of the payout? All the three entities? Equally or 60:30:10? There is no clear-cut answer; an appraisal is required for the individual's personal income tax return. Therefore, Cheston should pay for, at least, a portion of the appraisal costs. An equal allocation of costs to the three entities appears to be a fair allocation.²

Are appraisal fees incurred in connection with a charitable contribution deductible as charitable contributions? Such appraisal fees are not considered charitable contributions. However, the donor could deduct them as a "miscellaneous itemized deduction" since it is incurred "in connection with the determination, collection, or refund of any tax." Miscellaneous itemized deductions can only be deducted if they exceed 2% of adjusted gross income. Also itemized deductions generally must be reduced by 3% of adjusted gross income in excess of $124,500 (for 1998) for a married individual filing a joint return.³

Escrow account problems. The escrow account raised self-dealing issues because it resulted in a pooling of investments between the trusts and disqualified persons. Cheston directed the escrow agent to make all deductions and additions to the account in proportion to the shares sold by each shareholder. Effectively, this created three separate escrows so no self-dealing occurred.

Other Concerns

UBTI is unrelated business taxable income and it arises in an "unrelated trade or business" or if it is "debt-financed income." The latter is a more common trap for a CRT. UBTI is defined as unrelated trade or business regularly carried on; and not substantially related to the organization's tax-exempt purpose.⁴

Debt-financed income. If there were "acquisition indebtedness" the income would be "debt-financed."⁵ Is a little bit of UBTI ominous? Even a dollar of UBTI results in a CRT being taxable on all its income for that year. Generally, in the first year when the contributed corpus is sold, it would be devastating to have any UBTI as all of the capital gain on the sale of the contributed assets would be taxed.⁶

Foreign funds: UBTI-qualified electing fund. Cheston desired to make significant foreign investments. When an individual invests in a foreign corporation, he or she often faces adverse tax consequences unless he or she makes a Qualified Electing Fund Election ("QEF Election") to treat the foreign corporation as a pass-through entity. Tax exempt entities need not make the QEF Election and CRTs should not make the election.⁷ If the CRT has not made a QEF Election, the distributed income from the fund is dividend income that is not UBTI.

Venture capital opportunity. Cheston learned of a hot new Internet company in a Wall Street Journal article, Tiforpon.com. Tiforpon.com is selling reformulated polyester leisure suits on the Internet. Tiforpon.com's founder has developed a new formula for polyester that is fire proof. Tiforpon.com is structured as a limited partnership that in turn holds a C Corporation that conducts the business. The limited partnership owns the polyester formula and licenses it to the business operations corporation.

Prudent investor concentrated risk. Before the Uniform Prudent Investor Act was promulgated in 1994, trustees had to "make such investments as a prudent man would make of his own property having in view the preservation of the estate and the amount and regularity of the income to be derived." An investment in Tiforpon.com would not have been permissible under the old rules since it would be considered a risky investment.

However, under the new act, the standard of prudence is applied to the entire portfolio taken as a whole (part of an overall investment strategy), rather than to each individual investment in isolation. The new rule is also called the "Prudent Investor Rule."

While the investment in Tiforpon.com was risky, the size of the investment in relation to the whole portfolio (15%) and the expectation of high return was such that the trade-off was justified.⁸

Self-dealing splitting investment. Cheston wanted to have both charitable remainder trusts and himself invest in Tiforpon.com. The IRS has ruled in private letter rulings that co-investments of foundations and disqualified persons are permissible where the foundation investment is not facilitating the investment of the disqualified person. Such co-investment is impermissible in circumstances where the foundation's investment facilitates the disqualified person's investment such as where the foundation's contribution is necessary to allow the individual to make the required minimum investment for the investment being acquired. Tiforpon.com was an unclear case because Cheston personally could have bought a piece of the investments, leaving the rest of the investment for others. Thus, there was no minimum investment required. The investments of the charitable remainder trusts, however, allowed him to acquire the entire interest being offered to give him a much more significant measure of control over the company. The documentation of the transaction required reworking because it was initially drafted only in the name of Cheston. A simple option had been signed by Cheston alone to acquire the interest in Tiforpon.com. Since Cheston simply had the right to buy Tiforpon.com, but faced no legal detriment, it was concluded that the option could be assigned to the Trusts without engaging in an act of self-dealing.

Structure of interest: UBTI. The CRT needed money to invest in Tiforpon.com. XYZ Securities, Inc. held one of the investments of the CRT. The broker suggested that he margin the securities and generate cash for investment in Tiforpon.com. A margin account, however, represents debt of the CRT. The income would be debt-financed income and part of UBTI.⁹ As an alternative, investments were sold by the trust to raise cash for the Tiforpon.com investment.

Controlling trust income in NIMCRUT. The trust for Cheston and Sunshine was set up to be a spigot trust. A recently released Technical Advice Memorandum (TAM) from the IRS suggests that spigot trusts are not problematic. Rather than using a variable annuity as was outlined in the TAM, a single member LLC will be used to control the flow of trust accounting income to the trust. Under the new check-the-box regulations for entity classification, a single member limited liability company (LLC) is a disregarded entity. All of its income will flow through to the charitable remainder trust itself in its tax-exempt environment. Trust accounting income, however, will occur only when the single member LLC makes a distribution to the trust.

The single member LLC appears to be superior to other deferral vehicles because it does not impose any restrictions on investment choices, or timings of sales and acquisitions of investments. The tax character of the income for the single member LLC will take advantage of capital gains rates. The single member LLC does not introduce the complication of finding another entity, as does a partnership. There are currently no rulings specifically addressing a single member LLC in a CRT, but that will not deter Cheston.

Final Regulations

An independent trustee or a qualified appraiser should be used to value unmarketable assets of a CRT if the donor, beneficiary, donor's spouse, or related or subordinate party of any of them is a trustee of the CRT. Generally, a related subordinate party of a person is a family member, controlled business entity, or an employee. The appraisal must comply with the appraisal requirements to substantiate a charitable deduction. However, a trustee who is not permitted to value assets may appoint an independent trustee who is not a related or subordinate party to perform the appraisal without obtaining a qualified appraisal.¹⁰

Cheston was contemplating appointment of an independent trustee who had no business background. Cheston would give information to such independent trustee and give necessary guidance. While an independent trustee does not need to have special qualifications, Cheston was advised that the IRS might take the position that, in substance, Cheston was doing the valuation. Accordingly, an independent trustee with business experience was appointed to value the trusts.

Conclusion

Cheston's gift is not typical of the type of gift that would necessarily be sought out by a charitable organization. The initial design of the gift came from professionals whose primary focus was maximizing tax benefits for a client. Obviously if a charity were designing the gift, the payout rates of the trust would be significantly lower. This study, however, is useful with respect to the many issues that arose independent of the trust payout rates. Even in the case of a trust with a 7% payout rate selling a business, many of the issues discussed in this case study would need to be addressed. Accordingly, even planners designing trusts with significantly larger charitable remainders, will need to anticipate the complexity of selling a business that has been contributed to charitable remainder trusts. To insure a successful gift, the charitable planners need to be involved and familiar with the negotiations and structure of the sale and also must monitor the activities of the trust after the sale of the business. With that coordination, the sale of the business can provide significant benefits to the donor and the charity.

1. See Rev. Rul. 59-60, 77-287, and 83-120-valuation of closely-held stock; IRS Publication 516-valuation, record keeping, and appraisals.^back

2. Treas. Reg. § 1.170A-13(c)(3)(I)-(ii).^back

3. IRC § 212(3); IRC § 67(a); IRC § 68(a).^back

4. IRC § 513.^back

5. IRC § 5.^back

6. IRC § 664(c); Treas. Reg. § 1.664-1(c); Leila G. Newhall Unitrust v. Commissioner, 104 T.C. 236 (1995), affd, 105 F. 3d 482 (9th Cir. 1997).^back

7. Temporary Treas. Reg. § 1.1291-1(e).^back

8. Promulgated in 1994 by the National Conference of Commissions on Uniform State Laws; see e.g., California Probate Code §§ 16002(a), 16003, and 16045-54.^back

9. Rev. Rule 74-197, 1974-1 C.B. 143.^back

10. Treas. Reg. § 1.664-1(a)(7).^back