Section 53.4941(d)-1(b)(3)

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.

Self-Dealing

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.

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[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.