Home for the Holidays?

Our last post considered the division of a business between family members as a means of preempting the adverse consequences that will often follow disagreements within the family as to the management or direction of the business. https://www.taxlawforchb.com/2018/12/business-purpose-and-dividing-the-family-corporation-think-before-you-let-it-rip/.

This week, as family members return to work – after having come together to celebrate the holidays and renew their commitment to one another – we turn to a recent IRS ruling that considered a situation that presents the proverbial “trap for the unwary,” and that arises more often than one might think in the context of a business that is plagued by family discord. https://www.irs.gov/pub/irs-wd/201850012.pdf.

Another Family Mess

Corp was formed by Dad, who elected to treat it as an S corporation for federal tax purposes.[i] Immediately prior to the events described in the ruling, Dad owned more than 50% of Corp’s non-voting shares, but less than 50% of Corp’s voting shares. Mom and Daughter owned the balance of Corp’s issued and outstanding shares.

Following Mom’s death, Daughter – who was also the CEO of the business – received a testamentary transfer of all of Mom’s voting shares, resulting in Daughter’s owning a majority of Corp’s voting shares.

For reasons not set forth in the ruling, Daughter subsequently terminated Dad’s employment with Corp. In response, Dad filed a lawsuit against Corp and Daughter (the “Litigation”) in which he alleged shareholder oppression and breach of fiduciary duties. Dad asked the court to enter an order requiring Daughter and/or Corp to buy Dad’s shares in Corp (“Dad’s Shares”), or an order requiring Dad to purchase Daughter’s shares.[ii]

Within three months after Dad initiated the Litigation, Corp and Daughter filed a notice under the Litigation (the “Election”) for Corp to purchase Dad’s Shares (the “Proposed Transaction”). Dad filed a motion to nullify the Election.[iii] The court denied Dad’s nullification motion, and ruled that the Election was valid.

Proposed Buyout

Dad died before the Litigation could be resolved and his shares in Corp purchased. His revocable trust (the “Trust”) – which became irrevocable upon his death – provided that Dad’s Shares would pass to Foundation, a tax-exempt charitable organization that was created and funded by Mom and Dad, and that was treated as a private foundation under the Code. [iv]

Pursuant to the terms of the Trust, the trustee had the power and authority to sell any stock held by or passing to the Trust, including Dad’s Shares.[v] However, because of the Litigation, Foundation did not receive Dad’s Shares from the Trust; nor could the Trust sell Dad’s Shares to anyone other than Corp during the Litigation.[vi]

The court in the Litigation was required by state law to determine the “fair value” of Dad’s Shares as of the date the Litigation was initiated, or such other date the court deemed appropriate. The Foundation represented to the IRS that the Litigation court could determine the fair value of Dad’s Shares to be less than their fair market value after marketability and control discounts were applied.[vii]

The administration of the Trust was overseen by a probate court, not the court in which the Litigation was ongoing. The probate court had the responsibility to ensure that Foundation received the full value of Dad’s Shares, and was required to approve the valuation of Dad’s Shares and the Proposed Transaction. According to the Foundation, if the probate court approved the Proposed Transaction, the Litigation court would honor the probate court’s decision.


The foregoing may seem innocuous to most persons – just a buyout of a decedent’s shares in a corporation. Fortunately, Foundation recognized that Corp’s redemption of Dad’s Shares could be treated as an act of “self-dealing” under the Code, which could in turn result in the imposition of certain penalties (i.e., excise taxes) on the “self-dealer” and on the “foundation managers.”

The Code imposes a tax on acts of self-dealing between a “disqualified person”[viii] and a private foundation.[ix] The tax with respect to any act of self-dealing is equal to 10% of the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received in the transaction.[x] In general, the tax imposed is paid by any disqualified person who participated in the act of self-dealing.

The term “self-dealing” includes any direct or indirect sale or exchange of property between a private foundation and a disqualified person. For purposes of this rule, it is immaterial whether the transaction results in a benefit or a detriment to the private foundation; the act itself is prohibited.

An “indirect sale” may include the sale by a decedent’s estate (or revocable trust),[xi] to a disqualified person, of property that would otherwise have passed from the estate to the private foundation pursuant to the terms of the decedent’s will; in other words, property in which the foundation had an expectancy.

However, the term “indirect self-dealing” does not include a transaction with respect to a private foundation’s interest or expectancy in property held by a revocable trust, including a trust which became irrevocable on a grantor’s death, and regardless of when title to the property vested under local law, provided the following conditions are satisfied:

(i) The trustee of the revocable trust has the power to sell the property;

(ii) The transaction is approved by a court having jurisdiction over the trust or over the private foundation;

(iii) The transaction occurs, in the case of a revocable trust, before the trust is considered a “non-exempt charitable trust”;[xii]

(iv) The trust receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in the property at the time of the transaction; and

(v) The transaction results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up.[xiii]

The IRS Ruling

Foundation conceded that Dad was a disqualified person (a “substantial contributor”) as to Foundation while he was alive, having funded Foundation with Mom.[xiv] Daughter was a disqualified person as to Foundation because her father (a “member of her family”) was a substantial contributor to Foundation. Corp was also a disqualified person as to Foundation because Daughter owned more than 35% of Corp’s voting shares.[xv]

Because Corp was a disqualified person as to Foundation, and because of Foundation’s expectancy interest in receiving Dad’s Shares from the Trust, the proposed sale of Dad’s Shares by the Trust to Corp pursuant to the Litigation court’s order (the Proposed Transaction) could be an act of indirect self-dealing.

Foundation requested a ruling from the IRS that Corp’s purchase (i.e., redemption) of Dad’s Shares – which were held by the Trust – would satisfy the indirect self-dealing exception, described above, and would not be treated as an act of self-dealing for which a penalty could be imposed.

The IRS reviewed each of the requirements for the application of the exception.

First, a trustee must have the power to sell the trust’s property. Pursuant to the trust agreement that created Trust, Trust’s trustee had the power to sell any Trust assets, including Dad’s Shares. Thus, the Proposed Transaction met the first requirement.

Second, a court with jurisdiction over the trust must approve the transaction. Foundation sought, and was waiting to obtain, the approval of the Proposed Transaction from the probate court that had jurisdiction over, and was overseeing administration of, the Trust. Thus, the Proposed Transaction would meet the second requirement upon the Trust’s receipt of the probate court’s approval of the proposed sale.

Third, the Proposed Transaction must occur before the Trust became a non-exempt charitable trust. Foundation represented that because of the active and on-going status of the Litigation, the Trust’s trustees were, and would continue to be, unable to complete the ordinary duties of administration necessary for the settlement of Trust prior to the date of the sale of Dad’s Shares. Thus, the Trust would not be considered a non-exempt charitable trust prior to the date of the sale of Dad’s Shares; until then, the trustee would still be performing the ordinary duties of administration necessary for the settlement of the Trust.

In addition, before the sale of Dad’s Shares, the Trust will have made those other distributions required to be made from the Trust to any beneficiary other than Foundation, which would then be the sole remaining beneficiary.

Thus, if the Trust were not considered terminated for Federal income tax purposes prior to the Proposed Transaction, the Proposed Transaction would meet the third requirement.

Fourth, the Trust must receive an amount that equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction. The Litigation court was tasked with valuing Dad’s Shares. Foundation would endeavor to ensure that the Litigation court ordered the sale of Dad’s Shares to Corp at a price that was not less than the fair market value at the time of the Proposed Transaction. Thus, the Proposed Transaction would meet the fourth requirement if Dad’s Shares were sold to Corp at no less than their fair market value at the time of the transaction.

Fifth, the sale of Foundation’s interest or expectancy must result in its receiving an interest as liquid as the one that was given up. Pursuant to the trust agreement, Foundation had the expectancy of receiving Dad’s Shares, which were illiquid. Upon the completion of the Proposed Transaction, Foundation would receive the money that Corp paid Trust for Dad’s Shares. Thus, the Proposed Transaction would meet the fifth requirement if Foundation received the money proceeds from the Proposed Transaction.

Based on the foregoing, the IRS ruled that Corp’s purchase of Dad’s Shares held by the Trust would satisfy the “probate exception” from indirect self-dealing provided the following contingencies occurred:

  1. The probate court approved the Proposed Transaction;
  2. The Trust did not become a non-exempt charitable trust prior to the date of the sale of Dad’s Shares by the Trust; and
  3. The Trust received from the sale of Dad’s Shares to Corp an amount of cash or its equivalent that equaled or exceeded the fair market value of Corp’s Shares at the time of the transaction.

Trap for the Unwary?

Some of you may be thinking that the issue presented in the ruling discussed above, although somewhat interesting, is unlikely to arise with any regularity and, so, does not represent much of a trap for the unwary.[xvi]

I respectfully disagree. The fact pattern of the ruling is only one of many scenarios of indirect self-dealing that are encountered by advisers whose practice includes charitable planning for the owners of a closely held business.

There are two major factors that contribute to this reality: (i) the owner’s business will likely represent the principal asset of their estate, and (ii) the owner may have established a private foundation that they plan to fund at their demise (and thereby generate an estate tax deduction), either directly or through a split-interest trust.[xvii]

It is likely that the owner’s spouse, or some of their children, or perhaps a trust for their benefit, will be receiving an interest in the family business (an illiquid asset). It is also possible that the foundation will be funded with an interest in the business.

In these circumstances, the foundation may have to divest its interest in the family business in order to avoid the imposition of another private foundation excise tax (the one on “excess business holdings”).[xviii] Because of the limited market for such an interest, the foundation (or the owner’s estate or revocable trust) will probably have to sell its interest to the business itself (a redemption, as in the ruling above) or to another owner – each of which may be a disqualified person, thereby raising the issue of self-dealing. https://www.taxlawforchb.com/2018/10/private-foundations-and-business-ownership-a-new-day/.

In other circumstances, the divergent interests of the foundation to be funded, on the one hand, and of the individual beneficiaries of the owner’s estate or trust, on the other, may require that the foundation’s interest in the business be eliminated. For example, the foundation will need liquidity in order to engage in any charitable grant-making, while the other owners may prefer that the business reinvest its profits so as to expand the business; the foundation may prefer not to receive shares of stock in an S corporation, the ownership of which would result in the imposition of unrelated business income tax;[xix] or the foundation may be managed by individuals other than those operating the business, thereby setting the stage for a shareholder dispute as in the above ruling.

Bottom line:  It behooves the owners of the closely held business to consider these issues well before they arise. In many cases, it will be difficult to avoid them entirely, but the relevant parties should plan a course of action that is to be implemented after the demise of an owner.[xx] In this way, they may be able to avoid the personal, financial, and business disputes that may otherwise arise.


[i] IRC Sec. 1361; IRC Sec. 1362.

[ii] The ruling does not disclose the jurisdiction under the laws of which Corp was formed.

In New York, the holders of shares representing 20% or more of the votes of all outstanding shares of a corporation may present a petition of dissolution on the ground that the directors or those in control of the corporation are guilty of oppressive acts toward the complaining shareholders. In determining whether to proceed with involuntary dissolution, the court must take into account whether liquidation of the corporation is the only feasible means by which the petitioners may reasonably expect to obtain a “fair return” on their investment. BCL 1104-a. This typically involves the valuation and buyout of the petitioners’ shares. However, the other shareholder(s) or the corporation may also elect to purchase the shares owned by the petitioners at fair value. BCL 1118. “Fair value” is not necessarily the same as “fair market value.” See Friedman v. Beway Realty Corp. 87 N.Y.2d 161 (1995).

[iii] Go figure. If the goal was to be bought out, congratulations. Why fight it? Or was Dad concerned that Daughter would render Corp unable to buy him out and, so, he wanted to pursue his own remedies?

[iv] Exempt from federal income tax under Sec. 501(a) of the Code, as an organization described in Sec. 501(c)(3) of the Code (educational, religious, scientific, and charitable purposes); a “private foundation” in that it did not receive financial support from the “general public.”

[v] Although a decedent should fund their revocable trust to the fullest extent possible prior to their demise, it is often the case that they forget to transfer – or that they intentionally retain direct ownership of – an asset, which thereby becomes part of their probate estate. In that case, the decedent’s last will and testament typically provides that the probate estate shall “pour over” into the now irrevocable trust – which acts as a “will substitute” – to be disposed of in accordance with the terms of the trust.

[vi] It should be noted that, effective for tax years beginning after December 31, 1997, certain tax-exempt organizations became eligible to own shares of stock in an S corporation; however, a qualifying organization’s share of S corporation income is treated as unrelated business income. IRC Sec. 1361(c)(6) and Sec. 512(e).

[vii] In general, “fair market value” as of the date of a decedent’s death is the value at which the property included in the decedent’s gross estate must be reported on their estate tax return. Reg. Sec. 20.2031-1(b).

[viii] The term “disqualified person” means, in part, with respect to a private foundation, a person who is:

(A) a “substantial contributor” to the foundation,

(B) a “foundation manager”,

(C) an owner of more than 20% of:

(i) the total combined voting power of a corporation,

(ii) the profits interest of a partnership, or

(iii) the beneficial interest of a trust or unincorporated enterprise, which is a substantial contributor to the foundation,

(D) a “member of the family” of any individual described in subparagraph (A), (B) or (C), or

(E) a corporation of which persons described in subparagraph (A), (B), (C), or (D) own more than 35% of the total combined voting power.

The term “members of the family” with respect to any person who is a disqualified person includes the individual’s spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. IRC Sec. 4946.

[ix] The Code authorizes the imposition of certain excise taxes on a private foundation, on those who are disqualified persons with respect to such foundation, and on the foundation’s managers. These taxes are intended to modify the behavior of these parties – who are not otherwise dependent upon the public for financial support – by encouraging certain activities (e.g., expenditures for charitable purposes) and discouraging others (such as self-dealing).

[x] https://www.law.cornell.edu/uscode/text/26/4941

[xi] See EN iv, above.

[xii] See IRC Sec. 4947, which treats such a trust as a private foundation that is subject to all of the private foundation requirements.

A revocable trust that becomes irrevocable upon the death of the decedent-grantor, from which the trustee is required to distribute all of the net assets in trust for or free of trust to charitable beneficiaries, is not considered a charitable trust under section 4947(a)(1) for a reasonable period of settlement after becoming irrevocable. After that period, the trust is considered a charitable trust under section 4947(a)(1). The term “reasonable period of settlement” means that period reasonably required (or if shorter, actually required) by the trustee to perform the ordinary duties of administration necessary for the settlement of the trust. These duties include, for example, the collection of assets, the payment of debts, taxes, and distributions, and the determination of the rights of the subsequent beneficiaries.

[xiii] Reg. Sec. 53.4941(d)-1(b)(3); the so-called “probate exception.” https://www.law.cornell.edu/cfr/text/26/53.4941%28d%29-1 This exception had its genesis in the IRS’s recognition that a private foundation generally needs liquidity in order to carry out its charitable grant-making mission. With the appropriate safeguards (supervision by a probate court) to ensure that the foundation receives fair market value and attains the requisite liquidity, the act of self-dealing presented by the foundation’s sale of an interest in a closely held business may be forgiven.

[xiv] Interestingly, a substantial contributor’s status as such does not terminate upon their death; thus, a member of their family also remains a disqualified person.

[xv] See EN vii.

[xvi] A group of individuals to which the reader no longer belongs.

[xvii] For example, a charitable lead trust or a charitable remainder trust. IRC Sec. 2055(e). https://www.law.cornell.edu/uscode/text/26/2055.

[xviii] IRC Sec. 4943. https://www.law.cornell.edu/uscode/text/26/4943.

[xix] Taxable at 21% – as opposed to a 1% or 2% tax on investment income under IRC Sec. 4940 – and perhaps without a distribution from the corporation with which to pay the tax.

[xx] For example, corporate-owned life insurance to fund the buyout of the foundation’s interest, or the granting of options to family members to acquire the foundation’s interest.

Many not-for-profit organizations are dependent, in no small part, upon the generosity of successful businesses and their owners. The latter are motivated by a number of factors; for some, this generosity is an expression of their gratitude to the community that enables them to thrive; for others, it is a desire to share their good fortune with those in need; a not insignificant number are driven by a desire for public recognition.[i]

Whatever the motivation of these business owners, the tax laws have long played an important role in encouraging certain types of behavior relating to the contribution of property to a charity, and in discouraging certain activities that have the potential to harm a charitable organization, or to distract the organization from its charitable mission.[ii]

These tax-related, “charitable behavior modification” rules are intended to be most keenly felt by so-called “private foundations” and by those who control them.

Historical Behavior Modification

A private foundation (“foundation”) is a kind of charitable organization that is not dependent upon the “general public” for financial support;[iii] rather, it is generally controlled by the individual who created the foundation and funds its operations.[iv]

In general, the foundation limits its charitable activities to making grants to those “public charities” selected by this founder or their family, in the amounts and at the times determined by these individuals.[v]

Thus, it may be presumed that the foundation’s behavior cannot be readily influenced by the public in most instances.[vi] It is for that reason that the Code limits the tax benefits allowable to a foundation and its supporters, and also seeks to regulate certain activities in which they may engage.

Reduced Income Tax Deduction

For example, the owner of a closely held business may donate shares of stock in the business (i.e., capital gain property) to their foundation, but the amount that they may deduct for purposes of determining their income tax liability is limited to their adjusted basis in the donated stock – not its fair market value at the time of the donation – and their deduction is capped at a lower percentage of their adjusted gross income [vii] than would a similar contribution to a public charity.[viii]

The reduced tax benefit for the donor reflects the illiquid nature of an interest in a closely held business – the foundation cannot simply sell it on a public market. The Code also seeks to prevent the donor-business owner from receiving a more favorable tax benefit without giving up de facto control over the donated business interest.

Excess Business Holdings

Similarly, a foundation is generally not permitted to hold more than twenty percent of the voting stock of a corporation,[ix] reduced by the percentage of the voting stock owned by all disqualified persons[x] with respect to the foundation.[xi] If a foundation violates this rule, it may be subject to an excise tax equal to ten percent of the fair market value of its holdings in the business in excess of the permitted amount.[xii]

This prevents a business owner from contributing stock in their corporation to a foundation, either during their life or at their death, and thereby avoiding or reducing federal estate and gift taxes while at the same time enabling their family to retain indirect control of the donated stock through the foundation.

Depending upon the size of the gift or bequest, the foundation may have between five and ten years to dispose of the stock.

Minimum Distribution

Finally, a foundation is required to distribute annually an amount equal to at least five percent of the fair market value of its assets.[xiii] This rule is aimed, in part, at preventing a business owner from contributing to a foundation, and a foundation from investing in, an interest in a close business that is illiquid and that may not produce current income. A foundation that violates this rule faces a penalty tax equal to thirty percent of the distribution shortfall.

BBA of 2018

The foregoing rules have governed the relationship between foundations and closely held businesses for almost fifty years. Then, on February 9, 2018, the Bipartisan Budget Act of 2018 (the “Act”) was signed into law, effective for taxable years beginning after December 31, 2017.[xiv]

According to the accompanying committee report,[xv] in recent years, a new type of philanthropy has combined “private sector entrepreneurship” with charitable giving; for example, through the donation of a private company’s entire after-tax profits to charity.[xvi]  The report goes on to state that it is appropriate “to encourage this form of philanthropy by eliminating certain legal impediments to its use, while also ensuring that private individuals cannot improperly benefit from charitable dollars.”

Therefore, the Act amended the Code[xvii] to permit a business owner to gift or bequeath an entire business to a foundation, provided that the after-tax profits of the business will be paid to the foundation and certain other requirements are satisfied, while also ensuring that the donor’s heirs cannot improperly benefit from the arrangement.

The new provision creates an exception to the excess business holdings rules for certain “philanthropic business holdings.” Specifically, the tax on excess business holdings will not apply with respect to the holdings of a foundation in any business enterprise that, for the taxable year, satisfies:

  • the “exclusive ownership” requirements;
  • the “all profits to charity” requirement; and
  • the “independent operation” requirements.

Exclusive Ownership

The exclusive ownership requirements are satisfied for a taxable year if:

  • all voting ownership interests[xviii] in the business enterprise[xix] are held by the foundation at all times during the taxable year; and
  • all the foundation’s ownership interests in the business enterprise were acquired by the foundation as gifts during the life of the donor, or as testamentary transfers at the donor’s demise, under the terms of the donor’s will or trust, as the case may be.[xx]

All Profits to Charity

The “all profits to charity” requirement is satisfied if the business enterprise, not later than 120 days after the close of the taxable year, distributes an amount equal to its net operating income for such taxable year to the foundation.

For this purpose, the net operating income of any business enterprise for any taxable year is an amount equal to the gross income of the business enterprise for the taxable year,[xxi] reduced by the sum of: (1) the deductions allowed for the taxable year that are directly connected with the production of the income; (2) the federal income tax imposed on the business enterprise for the taxable year;[xxii] and (3) an amount for a reasonable reserve[xxiii] for working capital and other business needs of the business enterprise.

Independent Operation

The independent operation requirements are met if, at all times during the taxable year, the following three requirements are satisfied:

  • First, no substantial contributor to the private foundation, or a family member of such a contributor, is a director, officer, trustee, manager, employee, or contractor of the business enterprise (or an individual having powers or responsibilities similar to any of the foregoing[xxiv]).
  • Second, at least a majority of the board of directors of the foundation are individuals who are not (1) directors or officers of the business enterprise, nor (2) members of the family of a substantial contributor to the foundation.
  • Third, there is no loan outstanding from the business enterprise to a substantial contributor to the foundation or a family member of such contributor.

What Does It Mean?

In light of the foregoing, a foundation may now be able to own all of the issued and outstanding stock[xxv] of a corporation that operates an active business.

The Act

Of course, in order to do so, the foundation and the business must satisfy the requirements described above, some of which need to be clarified by the government; even then, there are still many issues to consider.

Of the three requirements described, the most challenging may be the “independent operation” requirement. It is clearly aimed at ensuring that the foundation’s charitable mission is not compromised because its managers are also overseeing, and are distracted by, the operation of a business.

However, we are talking about a closely held business. How likely is it that the owner or their family will give up control of the foundation or of the business (at least while the owner is alive)? In most cases, it is likely that the owner will wait until their death, or the death of their surviving spouse, before giving up their entire ownership of the business.[xxvi]

Might an owner split up their business into separate businesses – for example, geographically or according to line of business – in anticipation of contributing one of them to a foundation? Should the government be allowed to aggregate these businesses in certain situations so as to avoid abuse of the new rule?

Other Foundation Rules

Assuming the requirements established by the Act are met, the foundation must still consider the various “behavior modification” rules.

The Act did not change the limited income tax deduction available to the business owner who contributes an interest in a closely held business to a foundation. It remains limited to the owner’s adjusted basis in the interest.

Where the business contributed is an S corporation, the corporation’s election to be treated as a small business corporation will not be affected, but the foundation will be subject to the unrelated business income tax on its allocable share (100%) of the S corporation’s taxable income.[xxvii]

If all of the interests in an LLC, treated as a partnership, are transferred to a foundation, the LLC will become a disregarded entity, and the foundation will be treated as engaging directly in the LLC’s business.[xxviii] Obviously, this will raise unrelated business income tax issues, but it may also jeopardize the foundation’s tax-exempt status if the business is substantial relative to the foundation’s charitable activities.

Speaking of taxes – parum pum – although any dividends distributed to the foundation by a wholly-owned business corporation will not be subject to income tax,[xxix] the excise tax on the foundation’s net investment income will continue to apply.[xxx]

In addition, the foundation will continue to be subject to the five-percent-minimum annual distribution requirement. Query how difficult (and expensive) it will be to determine the fair market value of the closely held business every year for this purpose.

And what if the business does not make a distribution to the foundation in a particular year; for example, where it sets aside “reasonable reserves” for a bona fide business purpose? How will the foundation generate the necessary liquidity? Will it be forced to borrow money?

If there is a prolonged period during which insufficient dividends are paid, will the foundation’s continuing ownership of the business represent a “jeopardy investment” – one that jeopardizes the carrying out of its exempt purposes – with respect to which the ten percent penalty tax should be imposed?[xxxi] Might the foundation be forced to sell the business at that point?[xxxii]

Along that same line of reasoning, what if the business requires a capital contribution? If the foundation is somehow able to make the necessary infusion of cash, will it have engaged in a non-charitable activity of a type with respect to which the twenty percent, so-called “taxable expenditure,” penalty should be imposed?[xxxiii]

That’s All Folks

Lots of questions. It’s early yet – we’ll see how it plays out. Frankly, I don’t get it.[xxxiv]

[i] By now, you are aware of one of the themes of this blog: A business should only undertake an activity because it makes business sense, not because of the tax result. The same applies to charitable giving: One should not make a charitable transfer because of an expected economic benefit, but because one believes in the charitable organization or activity.

[ii] See the General Explanation of the Tax Reform Act of 1969, prepared by the Staff of the Joint Committee on Internal Revenue Taxation, December 3, 1970 (Joint Committee Explanation), for a good review.

[iii] Compare the public charity, the revenues of which come, by and large, from the general public (as contributions or as fees for services), including other charities and government. IRC Sec. 509(a).

[iv] Whether directly or through their business.

[v] Rather than providing any charitable service, itself.

[vi] The public cannot tighten the proverbial “purse strings.”

[vii] 30% vs 20%. IRC Sec. 170(e)(1) and Sec. 170(b)(1).

[viii] Query whether an independent public charity would accept equity in a close corporation that could not be converted into cash or a cash equivalent.

Note that the Small Business Job Protection Act of 1996 amended the Code to allow charities to own shares of stock in an S corporation.

[ix] Profits interest in the case of a partnership.

[x] Among others, this includes substantial contributors to the foundation, foundation managers, family members of such individuals, and certain business entities controlled by such individuals. IRC Sec. 4946.

[xi] If the foundation and its disqualified persons together do not own more than 35% of the voting stock of an incorporated business enterprise, then the foundation may own up to 35% of the voting stock, reduced by the amount owned by its disqualified persons, provided no disqualified person has effective control of the corporation.

[xii] IRC Sec. 4943.

[xiii] Other than those assets which are used directly in carrying out the foundation’s exempt purpose. IRC Sec. 4942.

[xiv] P.L. 115-123.

[xv] S. Rept. 114-20

[xvi] Newman’s Own, anybody?

[xvii] IRC Sec. 4943(g).

[xviii] What about non-voting interests? What about the “all profits” requirement? The provision should have stated that all of the equity must be owned by the foundation.

[xix] A “business enterprise” does not include a business that is functionally related to the foundation’s exempt activities, or a trade or business at least 95% of the gross income of which is derived from “passive sources.”

Might some donors with foresight be tempted to split up their business so as to satisfy the exclusive ownership interest as to those segments of the business intended for the foundation?

[xx] It appears that the donor cannot transfer some of the equity as a lifetime gift and the balance at their death. Presumably, the business may redeem a portion of the donor’s equity from their estate (thereby providing the estate with liquidity to pay taxes or make other testamentary transfers), and passing the remaining equity to a foundation.

[xxi] Including any investment income.

[xxii] Of course, the business remains subject to federal income tax. Moreover, if the foundation were to liquidate the business, such liquidation would be a taxable event under regulations issued under IRC Sec. 337.

[xxiii] Query what constitutes a “reasonable” reserve.

[xxiv] Query whether, in the case of a N.Y. membership corporation, this would cover a member of the foundation.

[xxv] Voting and non-voting.

[xxvi] For example, the owner may establish a QTIP trust for the benefit of the spouse, with the remainder passing to the foundation at the death of the spouse.

[xxvii] IRC Sec. 512(e). The gain from the sale of the S corporation stock will also be taxable.

[xxviii] IRC Sec. 512(c).

[xxix] IRC Sec. 512(b).

[xxx] IRC Sec. 4940.

[xxxi] IRC Sec, 4944.

[xxxii] If the foundation accepts a discounted price – a “fire sale” – will the state’s attorney general be knocking on the foundation’s door shortly thereafter?

[xxxiii] IRC Sec. 4945.

[xxxiv] Well, I guess I do. The Act was intended to benefit one taxpayer: Newman’s Own. Hell of a way to legislate. Just as bad as enacting provisions that are scheduled to expire only a few years later. I’ll get off my soapbox now.

The Charitably-Inclined Business

Many successful business owners attribute some part of their financial success to their community. The term “community” may have a different meaning from one business owner to another. In some cases, it may refer to the community in which the owner grew up, was educated, learned the values of hard work and sacrifice, and came to appreciate the importance of team effort. In other cases, it may refer to the community in which the business operates, from which it draws its workforce, to which it sells its services or products, and that supports the business in both good times and bad.

For some of these business owners, it is not enough to simply acknowledge this “debt” their community; rather, they feel an obligation to share some of their financial success with the community. Some owners or businesses will make contributions to local charities, religious organizations, schools, hospitals and civic groups. Others will provide scholarships or grants to local residents who otherwise could not afford to cover educational, medical, or other expenses. Still others will solicit the voluntary assistance of their workforce to support a local charitable organization in a fundraising or other public event.

These endeavors are commendable, but they are of an ad hoc nature, which means they are also of limited duration. This is because such activities are not necessarily institutionalized and they are dependent, in no small part, upon the business owner, who acts as the catalyst or motivating force for the charitable activities of the business.

Private Foundations

Recognizing these limitations, some business owners will establish a private foundation – typically, a not-for-profit corporation (separate from the business), that may be named for the owner, the owner’s family, or the business – which they will fund, either personally or through the business, with an initial contribution of cash or property. In later years, the owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner. With this funding, the foundation – which will not be financially dependent upon contributions from the general public (thus a “private” foundation, as distinguished from a “public” charity) – will have the wherewithal to conduct its charitable activities.

The foundation may be formed for a single charitable purpose or for a variety of charitable purposes. In most cases, the foundation’s only activity will be to make grants of money to other not-for-profit organizations that are directly and actively engaged in charitable activities (i.e., not grant-making), provided these grants and activities are in furtherance of the foundation’s stated purposes. In some cases, the foundation may, itself, be directly and actively engaged in conducting a charitable activity.

Whatever the nature of the foundation’s activities, the Code prescribes a number of rules with which the business owner must become familiar, and with which the foundation must comply if it hopes to secure and maintain an exemption from federal income tax. The following is a brief description of these rules.

Federal Tax-Exempt Status

Many business owners embark upon the establishment of a private foundation without first educating themselves as to the operation and tax treatment of a not-for-profit organization. Too often, they create the not-for-profit, transfer funds and other property to it, and begin conducting charitable activities. Years later, they learn that, under the Code, a not-for-profit is not per se exempt from federal income tax; indeed, they learn that the organization is fully taxable unless and until it applies to the IRS for recognition of its status as a tax-exempt organization; even then, they learn that the organization may lose its tax-favored status if it fails to file annual tax returns with the IRS.

In addition, because foundations are not dependent upon the public support for their financial survival – and, so, are not to “answerable” to the public – the Code provides a number of restrictions upon the use of foundation funds. These restrictions seek to discourage, and hopefully prevent, certain activities by a foundation that the IRS deems to be contrary to, or inconsistent with, the charitable nature, and tax-exempt status, of a foundation. The IRS enforces these restrictions through the imposition of special excise (i.e., penalty) taxes upon the foundation, the foundation’s managers (e.g., its board of directors), and so-called disqualified persons (“DP”; i.e., persons who are considered to be “insiders” with respect to the foundation).

Federal Tax Compliance Checklist

Securing recognition by the IRS of its tax-exempt status is only the beginning of a private foundation’s life as an organization for which tax considerations, and compliance with various tax rules, will play a significant role.

“It pays to know,” as the saying goes. In that spirit, the following “compliance checklist” should be reviewed by any business owner who has already formed, or who is contemplating the establishment of, a typical grant-making private foundation.

Is the Foundation being operated in furtherance of its charitable purposes? The Foundation must be operated in accordance with the exempt purposes set forth in its certificate of incorporation and described in its tax-exemption application (Form 1023) filed with the IRS. It must be operated to further a public interest, and no part of its net earnings may inure to the benefit of any private individual.  If the Foundation’s activities result in any prohibited private benefit or inurement, its tax-exempt status could be revoked by the IRS.

  • Does the Foundation have a grant-making policy? How does it select the organizations to which it make grants? What criteria are used? Does it accept applications for grants? How is the selection process recorded? How does the Foundation assure itself of a donee’s tax-exemption, its public charity status, and the grant’s furtherance of the Foundation’s charitable purpose, prior to making a distribution?
  • Is the Foundation authorized to make grants to organizations in addition to those that are recognized as tax-exempt charities by the IRS? How do such grants further charitable purposes?
  • Is the Foundation authorized to make grants to foreign charities? If so, how will it establish that the foreign charity would have qualified as a tax-exempt organization if it had been formed in the U.S.? Does it make pre-grant inquiries, including the donee’s financial status and its ability to accomplish the purpose for which the grant is being made? How does the Foundation verify that the grant funds are being used for the intended purpose?
  • Is the Foundation authorized to make grants to other private foundations? Is it prepared to exercise “expenditure responsibility” with respect to such grants? What types of reports does it require from the donee as to the use of the grant monies?
  • Is the Foundation authorized to make grants to individuals and, if so, for what purposes? How will it select individuals for grants? What criteria will it use? If the purposes are for travel or education, will it require periodic reports from the grantee? Does it maintain case histories?
  • Has the Foundation engaged in any political campaign activity? If the Foundation engages in any political activity, its tax-exempt status could be revoked by the IRS.
  • Has the Foundation sought to influence legislation? Has it engaged in any “lobbying” activity and, if so, to what degree? Does it limit itself to “educating” the public, to presenting both sides of an issue?
  • Has the Foundation distributed the prescribed minimum annual amount, equal to five percent of the fair market value of its non-charitable assets, to accomplish charitable purposes? In general, “qualifying distributions” include administrative expenses and grants to independent public charities.
  • Does the Foundation have, and has it complied with, a conflict of interest policy?
  • Does any DP have any business dealings with the Foundation? For example, has the Foundation sold property to, or purchased property from, a DP? Generally speaking, it shouldn’t have such business dealings.
  • Does the Foundation lease property from a DP? It may only do so on a rent-free basis.
  • Has the Foundation leased its property to a DP? It is prohibited from doing so.
  • Has the Foundation borrowed money from a DP? It may only do so on an interest-free basis.
  • Has the Foundation loaned money to a DP? It is prohibited from doing so.
  • Has the Foundation paid compensation to, or has it reimbursed the expenses incurred by, a DP? The Foundation may only pay compensation that is reasonable for the services rendered. How will it determine the reasonableness of the compensation? Has it looked for comparables? How does it memorialize its compensation decisions?
  • Has the Foundation paid the personal expenses, or satisfied the personal obligations, of any DP?
  • Has the Foundation invested in business entities, including any in which a DP owns an interest? A private foundation is not permitted any holdings in a sole proprietorship that is a “business enterprise.” In general, a private foundation is permitted to hold up to twenty percent of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by DP. (There are some exceptions.)
  • Has the Foundation invested any of its assets in such a manner that the carrying out of its exempt purposes is jeopardized?  An “ordinary business care and prudence” standard applies in determining whether the Foundation has made investments that may jeopardize its exempt purpose.
  • Has the Foundation reported the existence of any of the proscribed situations set forth above? Has it, along with its DP, “corrected” any of these?
  • Has the Foundation paid the annual excise tax on its investment income?
  • Has the Foundation engaged in any business that is unrelated to its exempt purpose? Has it reported this activity and the income therefrom to the IRS on Form 990-T?
  • Has the Foundation made its annual federal tax return (on IRS Form 990‑PF), its tax-exemption application (IRS Form 1023), and its IRS determination letter available for public inspection?
  • Has the Foundation issued a receipt to its donors in respect of any contribution to the Foundation of two hundred fifty dollars ($250) or more? Contemporaneous written acknowledgment of the contribution is required in order for the donor to claim a deduction.

Parting Advice

The above checklist may intimidate many business owners and their families. The operation of a private foundation, however, is no small matter. Because of its tax status, it is effectively a quasi-public organization. A business owner who is used to “doing things his own way” may find these rules too restrictive or onerous.

As was stated earlier, the foregoing is intended as a resource for those already operating a foundation, and for those thinking about starting one. However, it is no substitute for retaining the services of knowledgeable and experienced tax and not-for-profit corporate advisers. Although a sophisticated business owner may be familiar with, or may intuit, some of the rules described above, there are many more that will be foreign to one who is not immersed in the world of tax-exempt not-for-profits. These rules are the price exacted for the favorable tax treatment bestowed upon private foundations and their contributors.

As always, the well-intentioned, charitably-inclined business owner will be well-served, and will successfully accomplish his charitable goals (and avoid unpleasant surprises), if he educates himself and consults with a qualified professional.

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.