When people hear about a family business dispute, what most often comes to mind are sibling rivalries and disagreements, or a falling out between a parent and a child, with each side seeking to go its own way.  In fact, these are the usual scenarios.  There is a set of circumstances, however, that arises with surprising frequency, and that requires an awareness for potential tax consequences that are often not appreciated:  the testamentary division of a decedent’s interest in a closely-held business between his or her family and a private foundation created by the decedent.

Assume Father started a business (Business) long ago.  It has done very well and, over the years, Father has made significant gifts of interests in Business to his children, Daughter and Son, of interests in Business. In the aggregate, however, their interests still represent less than 50% of Business’s equity and voting power. Daughter and Son have become the key employees in Business; they operate and manage Business.

Father has also established, and partially funded, a grant-making private organization (Foundation) through which he has pursued his charitable endeavors.  Foundation is exempt from income tax under Section 501(c)(3) of the Code.  It is treated as a private foundation (as opposed to a public charity), and Father and Mom serve as its directors.

When Father passes away, Business (which is very valuable) represents his estate’s (Estate) principal asset. His Will creates a credit shelter trust and a marital trust (Trust), which is funded with Father’s remaining assets, including his majority interest in Business.  On termination of his Estate, Father’s equity in Business will pass to Trust, along with the voting rights inherent in such equity.  Mom acts as executor of his Will and, with Mom’s brother (Uncle), as co-trustee of Trust.  The Trust provides for the entire net income of the Trust to be paid to Mom, at least annually, during her lifetime; on her death, the corpus of the Trust is to be distributed outright to the Foundation.

At the end of the day, Business will be owned by Son, Daughter, and Trust (with Mom and Uncle as trustees).  During the administration of Father’s Estate, however, the co-ownership of Business leads to friction between Daughter and Son, on the one hand, and Mom, on the other.  The former want to direct the operation of the business without interference from the Estate, and they also want to reinvest profits in Business, including for the expansion thereof and in satisfaction of Business’s debts.  As key employees, they are drawing down sizable, though reasonable, salaries.  The latter wants to see Business make more distributions, which would translate into more sizable distributions to Mom.

At the same time, Mom is concerned about the Foundation’s future exposure to the excess business holdings excise tax , which imposes a tax on a foundation that, together with disqualified persons, owns at least twenty percent of the voting stock in any corporation conducting a business.

After many negotiations, Daughter, Son and Mom, as executor of  the Estate, reach a settlement.  Under the terms of the settlement, Daughter and Son will purchase from the Estate, in exchange for cash and an interest-bearing note, the Mom’s interests in Business, thereby completely dissolving the co-ownership between the Estate/Trust and Son and Daughter, and leaving Son and Daughter with 100% of Business.  The parties engage independent, qualified appraisers to value Business and Estate’s interests therein, and agree to rely thereon in the disposition of those interests.

At this point, it may appear that the parties have resolved their differences as to the ownership of the business, and all that remains to effect their separation is the closing of the sale.  Unfortunately, that is not the case.

Pursuant to IRC Section 4941, an excise tax is imposed on each act of self-dealing between a so-called “disqualified person” and a private foundation.  The tax is imposed on an annual basis until the act of self-dealing is corrected.  The term “self-dealing” includes certain direct or indirect transactions, including the sale or exchange of property between a private foundation and a disqualified person –regardless of whether the foundation is the seller or purchaser, and regardless of whether the purchase price reflects fair market value.

Disqualified persons include “substantial contributors” to the foundation and “members of the family” of such substantial contributors.  Here, the proposed purchasers of the equity in the business (Daughter and Son) are disqualified persons as to the Foundation because they are the children of Father, who was a substantial (in fact, the sole) contributor to the Foundation.  Disqualified persons also include foundation managers, such as the Foundation’s directors.

Moreover, the sale or exchange of property to a disqualified person by an estate or trust in which a foundation has an interest or expectancy is an act of indirect self-dealing, particularly if a foundation is destined to be funded with such property, as is the case under Father’s Will and the terms of the Trust.

However, the transaction at hand may be salvageable:  Treasury Regulation Section 53.4941(d)-1(b)(3) creates an exception to the self-dealing rules, applicable to a transaction regarding a private foundation’s interest or expectancy in property held by an estate.  Such a transaction will not constitute self-dealing if, among other things:

  1. the estate executor either possesses a power of sale with respect to the property, has the power to reallocate the property to another beneficiary, or is required to sell the property under the terms of an option subject to which the property was acquired by the estate;
  2. the transaction is approved by the probate court having jurisdiction over the estate;
  3. the transaction occurs before the estate is considered terminated for federal income tax purposes pursuant to Treasury Regulation Section 1.641(b)-3(a);
  4. the estate receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction; and
  5. the transaction either

i.  results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up;

ii. results in the foundation receiving an asset related to the carrying out of its exempt purposes; or

iii. is required under the terms of an option which is binding on the estate.

Here, as to the safe harbor’s first requirement, the particular powers conferred upon the executor of Father’s Will include the power to sell property.

As to the third requirement, Father’s Estate has not yet been terminated, and the proposed sale will take place before Estate is considered terminated for Federal income taxes under Treasury Regulation Section 1.641(b)-3(a).

As to the fourth requirement, the purchase price of the Business interests held by Trust has been determined by an independent, professional appraiser and set forth in writing.

As to the fifth requirement, the proposed sale will result in the Foundation’s expectancy interest being more liquid since the interest in Business – which represents an interest in a non-marketable, closely held corporation – will be exchanged for cash.

This leaves the second requirement:  the approval of the probate court.  In order to secure the benefit of the above exception to the self-dealing rules, Estate will have to petition the Surrogate’s Court for approval of the sale of Estate’s interest in Business to Daughter and Son.  Assuming the court approves the sale, then the parties may consummate the transaction without fear of the excise tax on self-dealing.

The foregoing highlights the importance of identifying potential private foundation excise tax issues during the administration of a decedent’s estate where the foundation is to be funded with equity interests in a closely held business. Indeed, it behooves the owners of the business to consider these issues while the older generation is still alive. In many cases, it may be difficult to avoid them completely; the only way to reduce the expected estate tax liability on the owner’s death may be to fund a family foundation. That being said, the relevant parties should consider adopting a course of action that is to be implemented after the decedent’s passing. In this way, they may be able to avoid the personal, familial, and business disputes that may otherwise arise.