Charitable contributions of closely held stock.

There are certain situations for closely held corporations and their shareholders when the use of a "charitable bailout" can be beneficial.

A charitable bailout occurs when a shareholder contributes stock in another closely held corporation to a charity and that stock is later redeemed from the charity by the corporation.

Taxpayers have long relied on--and the IRS has accepted--the Tax Court decision in Palmer, 62 TC 684 (1984). In Palmer, the taxpayer had voting control of both a corporation and a tax-exempt private foundation. The taxpayer donated shares of the corporation's stock to the foundation, and the corporation redeemed the stock from the foundation.

The Service took the position that the substance of the transaction was a redemption of stock from the taxpayer, followed by a gift of the proceeds to the foundation. The Tax Court rejected this argument and treated the transaction according to its form. The court held that the transfer of the stock to the foundation was a valid gift, and the redemption of the stock by the corporation did not result in income to the donor.

In Rev. Rul. 78-197, the IRS stated that it would follow the court's decision in Palmer so long as there was no legal obligation requiring the charity to sell the stock back to the corporation. Even if there is an informal understanding that the stock will be redeemed from the charity, the form of the transaction will be followed, as long as there is no legal requirement for the charity to sell the shares.

These charitable bailouts can have considerable tax advantages. With individual tax rates higher than corporate rates, the charitable deduction could mean more to the shareholder than to the corporation. This also can reduce concern about excess accumulated earnings inside a corporation and serve as a method of reducing a shareholder's estate (by removing the value of the contributed stock).

If the corporation has family member minority shareholders, the contribution of stock can shift more of the future appreciation to the second-generation family members.

The value of charitable bailouts was greatly increased by the Revenue Reconciliation Act of 1993's permanent repeal of the alternative minimum tax (AMT) add-back for the charitable contribution of appreciated property. These transactions often involve low-basis stock that is substantially appreciated, and the AMT add-back negated the benefits by causing the shareholder to pay AMT.

The use of a charitable remainder unitrust (CRUT) can add significant planning opportunities with charitable contributions of closely held stock. In letter Ruling 9512016, a shareholder contributed stock in his closely held corporation to a CRUT. The shareholder owned half of the company's outstanding stock and was going to contribute as much as 21 % of the outstanding stock. The unitrust would pay the grantor and his spouse income for their lifetime and the trust assets would be paid to the charity on the second death.

The taxpayer received a favorable ruling that the trust qualified as a CRUT and that the disposition of the company shares held by the trust would not result in income to the grantor.

The use of a CRUT in this way provides some unique retirement planning opportunities for a shareholder.

Consider the typical situation of a company whose founder is nearing retirement age and is still the majority shareholder. One or more of his children are minority shareholders active in the business. The majority shareholder would like to retire and have lifetime income for him and his spouse. Therefore, he contributes a block of his stock to a CRUT. The company later redeems this stock from the trust and the trust pays the shareholder and his spouse a fixed percentage of the trust assets for their lifetimes.

Example: A shareholder and his spouse are both age 65 and they contribute $1,000,000 of closely held stock into a CRUT that has an annual payout rate of 8%. This would give them an immediate charitable income tax deduction of approximately $200,000 and lifetime payouts from the trust of approximately $80,000 per year.

Some of the advantages and disadvantages of this transaction include:

Advantages:

1. The retiring shareholder immediately gets a charitable income tax deduction for the calculated remainder interest in the trust.

2. The retiring shareholder gets income from the trust for him and his spouse for life.

3. The income paid from the trust to the retiring shareholder is not subject to payroll taxes and can be partially capital gains.

4. The value of the stock contributed and all future appreciation on that stock is removed from the retiring shareholder's estate.

5. Retained earnings are removed from the company, perhaps easing the concern of an excess accumulated earnings problem.

6. The strict rules under Sec. 302 that cause a redemption to be taxed as a dividend are avoided, and the retiring shareholder can still own stock-even majority control-in the company.

7. The reduction of the salary of the retiring shareholder enables the company to fund the redemption.

8. The retiring shareholder can satisfy philanthropic desires by publicizing a substantial contribution to a local charity.

Disadvantages:

1. The principal payments by the company for the redemption are not deductible.

2. The premature death of the taxpayer and his spouse end the payments from the trust.

3. The ownership/control of the remaining outstanding shares is increased (this may be an advantage).

4. The premature death of the taxpayers will be an obvious concern, and this should be considered carefully in planning.

The use of a two-life CRUT should be considered. In some cases, perhaps the children of the retiring shareholder should also be trust beneficiaries. Although this reduces the concern of a premature death stopping the trust payments, it also greatly reduces the calculated remainder interest (and therefore reduces the charitable income tax deduction at the time the trust is established).

A break-even analysis also should be done to determine how long the donors would need to live to make the transaction advantageous. (An example of this break-even calculation can be found in the Tax Clinic item, "Charitable Remainder Trusts--Even If You Don't Normally Make Charitable Gifts, You May Want This" (TTA, Oct. 1991, p. 656).

Valuation of the closely held stock is very important for these transactions, and an appraisal in accordance with IRS requirements must be performed. For any substantial transactions, a preliminary appraisal should be done in the early planning stages, to assess the contribution/ redemption amount, number of shares and shift in control.

Also, taxpayers who contribute minority shares will have to apply the appropriate discounts to the values. One exception to the full appraisal for smaller transactions can be found in Regs. Sec. 1.170A-13, in which an appraisal is not required for gifts of nonpublicly traded stock for which the deduction is more than $5,000, but not more than $10,000.

Charitable gifts of closely held stock can provide significant corporate and shareholder advantages in the right situation. Through the use of a CRUT, these transactions can be used in retirement, succession and estate planning for the closely held corporation and its shareholders.