Overview
I mentioned my year long writing sabbatical last week. Over the course of the year, I have accumulated a few ideas to cover in new articles. One of those ideas is threading the needle of tax-exempt organizations with personal tax planning. How does a taxpayer use charitable solutions to reduce personal income and estate taxation while retaining some semblance of control? The planning bottleneck always seems to arise around a confluence of tax planning issues – excess business holdings, excess benefit, self-dealing and unrelated business taxable income (“UBTI”).
Last week I wrote about 501(c)(4) (“C4”) charitable organizations which have proliferated in use among ultra-high net worth taxpayers who engage in charitable activities plus substantial political lobbying and political activity. Heretofore, or at least to the best of my knowledge, taxpayers with closely held businesses have not formed C4 organizations to explore their charitable interests and tax planning.
From a tax planning perspective, a few favorable attributes can be associated with the C4s that do not apply to public charities (“C3”). Self-dealing is not prohibited with C4s providing the taxpayer with the ability to engage in transactions on an arms-length basis. However, the excess benefit restrictions apply to the taxpayer. C4s can engage in political activities and endorse political activities. The UBTI rules apply to both C4s and C3s.
This article focuses on the use of private financial derivative contracts as a planning vehicle for C4s for investment in the taxpayer’s business without UBTI treatment.
Private Financial Derivative Contracts
First, professional credit must be given to David Handler, a partner at Kirkland & Ellis. David is one of the country’s premier tax and estate planning attorneys. He is responsible for the introduction of the planning use of private derivative contracts in tax and estate planning. His presentation at the Heckerling Institute of Estate Planning in 2016, is the authoritative technical resource on this subject.
A derivative is a financial contract that gives the holder a right to a payment from the counterparty to the instrument if certain events occur during the term of the contract. Derivatives can be tied to the price or performance of any asset including a stock of a public or private company. Historically, derivatives have been linked to the performance a stock, or the performance of a stock portfolio or stock index. In the planning context, the derivatives contracts contemplated are private derivatives between family members or family trusts. Unlike the public markets, the contracting parties do not lose money with private derivative contracts. A derivative contract can be customized to suit the client's needs and objectives.
Private derivatives can be structured as call options to transfer the appreciation in an asset whether the taxpayer owns the asset or not, plus perhaps any distributions or dividends paid during the term of the option contract. The option holder may exercise the option in a cashless exercise receiving the difference in the fair market value over the option strike price of the reference asset or stock rather than taking possession of the asset or company shares. Alternatively, the option contract can be structured as a private put option in which the bolder profits if the reference asset decreases in value.
A swap contract is an additional type of derivative contract. Swap contracts are financial derivatives that allow two transacting agents to “swap” the revenue stream form a reference asset held by each party. Hybrid swaps allow their holders to swap financial flows associated with a reference asset. The swap contract may provide one of the contracting parties to receive a “fixed payment during the term of the swap contract with the other party receiving the “variable” payment to the extent it exceeds the fixed payment. In a principal, a taxpayer’s business can serve as the reference asset for the swap contract.
Unrelated Business Taxable Income (UBTI)
Tax exempt organizations do not pay federal income tax on their income unless it is UBTI. IRC Sec 512 defines UBTI as the income from an unrelated business or trade of the charitable organization. This income may be K-1 income from an S corporation, or partnership. It can also arise from debt financed assets. Additionally, the gain or loss from the sale of S corporation stock or partnership may also constitute UBTI if the underlying business activity is unrelated to the charitable purpose of the organization.
The IRS has ruled at least ten times on the tax treatment of derivative contract investment, While a taxpayer may not rely on the ruling request of an unrelated taxpayer. Nevertheless, a private ruling outlines the IRS’s position on a tax issue. The IRS issued a series of rulings (PLR 200352017, 200352018 and 200352019) that were favorable to the taxpayer. In these rulings, the IRS ruled that the investment in the derivative contract was not an investment in the underlying asset that might generate UBTI. Consequently, the derivative contract did not generate UBTI treatment to the tax-exempt organization because the contractual interest was not an interest in the underlying asset that otherwise would generate UBTI tax treatment. Thus, a derivative contract may be helpful in converting business income into non-UBTI income.
Planning Example
Facts
Pedro Navaja is the one hundred percent shareholder of Acme, Inc., an S corporation. Acme was recently valued by a business valuation specialist for $2 million. A prospective buyer is willing to pay $6 million for the Company’s assets. Navaja has an exceptionally low basis in the assets and Company shares. He is seeking to minimize income taxes on the sale. A letter of intent to purchase the Company has yet to be executed. A 99 percent non-voting interest is valued at $1.2 million. If Navaja gifted his shares directly to a charity, the taxable gain would be treated as UBTI to the charity.
Solution
Navaja, with his attorney and business valuation specialist created a private call option with a two-year term to purchase a 99 percent non-voting interest in the Company. The call option has a strike price of $1.32 million and provides the option holder with the ability to exercise the option as a cashless exercise. The appraiser values the call option at $400,000.
Navaja creates a new C4 organization called Todo Por La Patria Charities. He created a new special purpose vehicle (“SPV”) as a limited liability company known as PN Charities, LLC. Navaja assigns the call option to the SPV and donates a 99.9 percent non-voting interest in the LLC to the new C4. The contribution is non-deductible for income tax purposes. Navaja is the manager of the SPV and retains a 0.1% voting interest in the SPV. Prior to closing, Navaja as the Manager of the SPV, exercises the call option for the benefit of the SPV in a cashless exercise. The escrow agent directs the difference between the sales price ($6 million) and strike price ($1.32 million) to the SPV ($4.68 million) to the SPV.
The tax character of the call option proceeds is non-UBTI income. The income allocated to the C4 (99.9%) is non-UBTI. Had Navaja gifted the shares of the S corporation to the C4, the gain would have been treated as UBTI. As manager of the SPV, Navaja retains management control for investment and distribution purposes. He also can engage in fair market value transactions with the C4 including tax-free loans to Navaja or other entities that he controls. Navaja can \ support his favorite charitable endeavors and political causes.
Summary
The tax planning landscape grows more difficult by the day. Taxpayers have always considered the utilization of charitable strategies in their personal tax planning. For business owners, the UBTI conundrum arises because of the tax treatment of business income and capital gains related to the donation of a business interest. This article has attempted to demonstrate that with some creativity and a combination of different planning techniques – (1) A 501(C)(4) organization and (2) Private derivative Contracts, business owners can demonstrably alter their tax results.
