Use of SMLLC to hold real estate of a public charity.
Ownership of real property will subject the charity to all the liabilities of an owner, such as injuries arising from conditions on the property or liability for environmental hazards. It is not prudent for a charity to accept a gift of real estate unless it can protect itself against such liabilities. The charity should require a thorough environmental inspection. In addition, to protect the other assets, the charity may consider the formation of a separate entity to hold the real estate.
In some cases, charities have formed Sec. 501 (c) (2) and (c) (25) title-holding companies. Under Sec. 501(c)(2), an exemption is granted to a corporation organized for the exclusive purpose of holding title to property and turning over the entire income it collects from the property (less expenses) to an exempt organization. Expenses include reasonable reserves for expected expenses and depreciation (Rev. Rul. 66-102). Each of the two types of title-holding companies is frequently organized as a liability shield.
Some charities form supporting organizations to hold real estate. A discussion of supporting organizations is beyond the scope of this item. However, the supporting organization regulations are complex and are enough to deter many charities.
One way to achieve a charity's objectives is by using a single member limited liability company (SMLLC). This approach differs from the traditional approaches. While it is simple and effective, it is still a new and relatively untested solution.
Limited liability companies (LLCs) are hybrid entities that are neither partnerships nor corporations under state law. In general, for state law purposes, an LLC is treated as a separate legal entity. Organizers must file articles of organization with the designated state authority, at which time the LLC is issued a certificate of organization and its existence begins.
From a tax perspective, the LLC offers all the flexibility of the partnership form; from a business perspective, it generally offers limited liability.
On May 13, 1996, Treasury proposed so-called "check-the-box" regulations, to simplify the task of classifying a business entity as an association (taxable as a corporation) or as a partnership; final regulations were issued on Dec. 18,1996. In contrast to earlier regulations (which operated to classify business entities based on the historical differences between corporations and partnerships), the check-the-box regulations account for the fact that, under modern state laws governing business organizations, taxpayers can, for tax purposes, generally classify as partnerships entities that are indistinguishable from corporations in all meaningful respects.
Under this strategy, a charity will form a SMLLC for each parcel of real estate it receives, with the real estate placed in the LLC. Under Regs. Sec. 301.7701-3, an eligible entity with only a single owner can elect to be classified as a corporation or it can be disregarded as an entity separate from its owner (i.e., treated as a tax nothing). The charity would elect to treat the SMLLCs as tax nothings. No Federal tax returns will be required from the lower-tiered LLCs. Rather, the results of the operations will be reported on the charity's
Form 990, Return of Organization Exempt from Income Tax. This structure avoids exposure of the assets of one activity to the liabilities of another. The charity's assets should not be exposed to the liabilities of each LLC.
Based on existing case law and IRS pronouncements, to best protect the tax-exempt status of an LLC, the operating agreement should require the LLC and its members to operate within the following parameters:
1. A specific business purpose should be established, with a prohibition against altering it.
2. Investors should lack influence over the exempt organization.
3. Capital contributions should determine each member's capital interest, and any additional capital contributions should be pro rata.
4. Profits, losses and cash should be allocated and distributed pro rata.
5. The rate of return on an investor's capital should be "reasonable" and most likely "capped" at a fixed rate.
6. The exempt organization should have the first right to acquire the LLC's assets and property.
7. All transactions between members, their affiliates or third parties and the LLC must be at arm's length and at fair value.
There are other issues that will need to be dealt with by the LLC members in the operating agreement. However, none of these guidelines should be difficult to follow when the charity is a SMLLC.
Charitable Contribution of Donor
It is presumed that the real estate will go directly into the LLC to avoid the charity taking ownership of the property even for a minute. However, because a SMLLC is a tax nothing, the transfer of the real estate for tax purposes should be viewed as going directly to the charity and, therefore, resulting in a charitable deduction to the donor. This appears to be consistent with the fact that all tax results are reported on the charity's tax return.
The Service has yet to issue a definitive statement on whether an LLC can qualify as a tax-exempt organization under Sec. 501(c)0). However, Federal tax law frequently looks to state law to determine the transfer of the property. Under state law, the property is going directly into the LLC, which is not a Sec. 501(c)(3) entity. So far, no state has enacted either a separate set of nonprofit LLC laws or a specific acknowledgment of nonprofit LLCs within its LLC laws.
The SMLLC strategy presumes that the LLC will not file for tax-exempt status. As discussed above, it will be a tax nothing. No official guidance on this topic has been issued, but informal sources have indicated that the LLC should be a qualified organization.
The Service is interested in the Sec. 508 implications of SMLLCs formed by exempts, and there is a question as to whether such LLCs should file their own exemption applications. It is possible (but very unlikely) that the IRS would take the position that there is not a charitable contribution to a qualified organization. This would be totally inconsistent with the notion that a SMLLC is a tax nothing.
The Service might attempt to argue that the gift is "for the use of" the charity rather than to the charity, as the girl is going directly to the LLC. Although a contribution qualifies in either case as a Sec. 170(c) charitable contribution, distinguishing whether gifts are to or for the use of a charitable organization may be crucial in determining the limit on the amount of deductible contributions. A 50% ceiling applies only for contributions made to, and not merely for the use of, 50% charities. A contribution that is for the use of a 50% charity is limited to a 30% ceiling. When the donation is appreciated property, the limitations are 30% and 20%, respectively
Clearly, there is no direct guidance on contributions of this nature. Thus, there is not 100% assurance to the donor that the contribution will be fully deductible.
An alternative approach would have the donor establish an SMLLC before the contribution to the charity. The donor first contributes the real estate to the LLC and then gives the LLC interest (not the real estate) to the charity. The donor should be entitled to the full charitable deduction, because the LLC interest was contributed to a Sec. 501(c)(3) organization. In this case, the donor has assumed the responsibility and cost of establishing the LLC, including any local transfer taxes.
The charity has to issue a substantiation statement to the donor. The IRS may ask for a statement showing:
* Whether the organization is a domestic organization;
* The contributor's name and address;
* The amount of the contribution;
* The date of actual receipt of the contribution; and
* Any other necessary information.
The point is that the charity will be required to issue this statement on behalf of the LLC. The donor will need this statement to partially support the deduction on audit. It is unlikely that the donor would want the statement issued directly by the LLC.
Environmental Issues: BestFoods
In BestFoods (Sup. Ct. 1998), the district court stated that "operator liability" may attach to a parent corporation both indirectly (when the corporate veil can be pierced under state law) and directly (when the parent has exercised power or influence over its subsidiary by actively participating in (and exercising control over) the subsidiary's business during a period of hazardous waste disposal). However, the Sixth Circuit reversed this decision, explaining that a parent's liability for operating a facility ostensibly run by its subsidiary depends on whether the degree to which the parent controls the subsidiary and the extent and manner of its involvement with the facility amount to an abuse of the corporate form that warrants piercing the corporate veil and disregarding the parent's and subsidiary's separate corporate entities. Applying state law, the court decided that the parent was not liable for controlling the subsidiary, because the two corporations maintained separate personalities and the parent did not use the subsidiary form to perpetrate fraud or subvert justice. It is possible (but not entirely certain) that the charity could avoid potential environmental concerns by using an SMLLC.
An SMLLC could provide some practical solutions to accepting real estate within a charity. Unlike a supporting organization that must file with the Service each time a new organization is established, an SMLLC has no such filing requirement. Moreover, it does not have the complexities of a supporting organization.
Because the SMLLC is a relatively new tax entity, there is little case law on which to base any conclusions. However, an SMLLC could conceivably eliminate many of the issues currently faced by a public charity in holding real estate.
FROM DAVID R. NAVE, SR., VP, TAX DIRECTOR, PITCAIRN TRUST COMPANY, JENKINTOWN, PA (NOT ASSOCIATED WITH SUMMIT INTERNATIONAL ASSOCIATES, INC.)
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|Title Annotation:||single member limited liability companies|
|Author:||Nave, David R.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1999|
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