Advisor's Quarterly Update

Gifts of Closely Held Business Interests

The tax benefits of philanthropy, including gifts to the American Red Cross, create incentives to make charitable gifts.  Nonetheless, a passionate devotion to the mission of an organization is the primary motivation to make a gift to charity.  As an advisor you can help achieve both goals by facilitating charitable gifts with the greatest tax benefits and making the largest gift possible.

For most high-net-worth clients, the bulk of their wealth is not in retirement accounts or their home, and certainly not cash.  Privately held business assets make up most of the wealth owned by high-net-worth individuals.  If your client owns an interest in a small business or other closely held company, consider the tax advantages of a charitable contribution of these assets to the Red Cross.

Because cash and publicly traded securities are liquid and easily transferred, they are the most common ways to make charitable gifts.  Charitable gifts of closely held businesses are less common but present the opportunity to make larger gifts than your client thought possible.  Gifts of these assets come with unique challenges and opportunities.  Structured properly, a gift of a closely held business to a public charity can

  • Avoid capital gain tax
  • Generate an income tax charitable deduction for the fair market value of the business interest donated. 

 

Tax Benefits

A gift of long-term closely held business interest made to a public charity can generate a full fair market value (FMV) deduction, and such gifts generally are deductible up to 30% of the donor’s adjusted gross income (AGI).  The income tax charitable deduction includes a five-year carry-forward for any excess not deductible in the year of contribution.

Another benefit of donating a closely held business interest, rather than donating net proceeds from selling the business, is that there is no taxable gain on the appreciation in the stock.

Appraisal Requirements to Determine Value

Valuing a contribution of more than $5,000 worth of a closely held business interest is established by a qualified, independent appraisal. The appraisal requirements include:

  • The appraisal must be prepared by a "qualified appraiser" who has earned a designation from a recognized professional organization.
  • The appraisal must include a description of the property transferred, the date of contribution, any terms or conditions put on the property transferred, information on the qualified appraiser, the basis for making the valuation, the appraiser's signature, and the date of the appraisal.
  • The appraisal cannot have been made earlier than 60 days before the date of the contribution.  The appraisal cannot have been made later than the due date (including extensions) of the return that includes the first claim of a deduction for the property.
  • If the appraised value of the closely held securities is over $500,000, the full appraisal must be attached to the return.
  • An appraisal summary (IRS Form 8283) must be signed by the appraiser and the donee charity and attached to the tax return.

 

Structuring the Gift

A gift of a closely held business interest raises issues not applicable to gifts of publicly traded stock.  The issues vary depending on the type of business entity donated.

  • Partnership Interests

A charitable gift of a partnership interest that has underlying indebtedness may trigger the bargain sale rules of IRC Sec. 1011-2(a)(3).  That could mean that a charitable contribution of debt encumbered partnership units might trigger recognition of gain to the partner/donor.  Carefully review the structure of the partnership to avoid such recognition of gain. 

  • Charitable Gifts of S Corporation Stock

The Small Business Job Protection Act of 1996 permitted charities described in IRC Sec. 501(c)(3) to be eligible shareholders of S corporations as of January 1, 1998.  The Act did not permit charitable remainder trusts to own S Corporation stock because they are taxed under IRC Sec. 664, not Sec. 501(c)(3).  The charity and donor want a mechanism to quickly liquidate the stock after the gift.  Nonetheless, see the cautions associated with a prearranged sale discussed below. 

  • Charitable Gifts of C Corporation Stock

A public charity can own stock in a closely held C Corporation.  The tax penalties of holding S stock do not apply.  The charity will not be taxed on dividends received from the stock or on capital gain in the stock when it is sold.

Naturally, as with all these gifts, the charitable recipient of closely held C corporation stock is interested in converting the shares to cash.  There are several ways this might be accomplished.

Prearranged Sale/Assignment of Income

By now it is clear that a charity wants to convert an interest in a closely held business as quickly as possible.  Despite the zeal to quickly liquidate these interests, there cannot be an agreement prior to the gift that obligates the charity to sell to any particular buyer.  The anticipatory assignment of income doctrine holds that the right to the proceeds from the disposition of an asset is established prior to the gift that the donor was, in effect, transferring the sale proceeds, not the asset.

In other words, there cannot be any pre-existing obligation on the part of the charity that it will offer the closely held interest for sale back to the business or that the business will buy back the closely held asset from the charity, as a condition of the donor making the gift to the charity. Whether the right to the proceeds from the disposition of the asset has become so firmly fixed is a question of fact.

The leading case on the assignment of income doctrine is Palmer v. Commissioner, 62 TC 684 (1974).  The IRS will treat the proceeds of a redemption of stock under facts similar to Palmer as income to the donor if the donee is legally bound or can be compelled to surrender the shares for redemption.

The consequences of such a prearrangement or obligation is found, the charitable contribution is reclassified as a deemed a sale of the closely held interest by the donor. Consequently, any capital gain on the sale must be recognized by the donor and the donor is deemed to have made a gift to the charity of the proceeds from the sale.

Conclusion

A charitable gift of a closely held business interest is a complex transaction giving rise to many legal and tax considerations.  Advisors are critical to ensure a gift of such assets generates the maximum tax benefit to their client and carries out the donor’s charitable intent.