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CGNA: Chapter 4 - Pass-through Entities, Intermediate | Toledo Community Foundation
Article posted in General by Randy Fox on 1 March 2018| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 2 March 2018
Below is a review of gifts of pass-through entities. Pass-through entity topics are based on Dennis Walsh’s “Navigating the Charitable Transfer of a Partnership Interest: A Primer,” and Jane Wilton and Nicole Spooner’s “Considerations in Making Charitable Gifts of Interests in Pass-Through Entities.” For quick take-aways on gifts of pass-through entities, see Pass-Through Entities Quick Take-Aways. For a review based on the articles, see Pass-Through Entities Intermediate. For an in-depth exam- ination adapted and excerpted from the articles, see Pass-Through Entities Advanced. For further details, see Pass-Through Entities Additional Resources.
This review of charitable gifts of interests in pass-through entities has seven parts in total. The first part discusses asset considerations, and the second reviews bargain sales. Third is a valuation discussion, while fourth is an examination of holding consid- erations. Following that are sale and transfer considerations. The final two parts discuss planned giving vehicles and miscellaneous other considerations.
Although cash and publicly-traded securities are the most common asset classes for donors to contribute to charity, interests in closely held businesses can be attractive gifts as well. Pass-through entities, such as limited liability companies (LLCs) and part- nerships, are a form of closely held business, and gifts of these interests have unique considerations.
Owners of these interests are referred to as members for LLCs and partners for partner- ships. In either case, they may wish to donate all or part of their interest to a nonprofit. Gifts or sales of a pass-through entity interest present both tax and estate planning opportunities for donors. They also can provide valuable income for the receiving charities. However, like many classes of assets, they come with unique considerations that require special preparation and planning.
Transfers of pass-through interests present special issues for both the donor and the nonprofit. For this reason, the two parties should work together to make the process go as smoothly as possible. Some methods of making the transfer that should be considered include outright gift, bargain sale, asset donations, and gift of proceeds from sale.
Review Part 1: Asset Considerations
The Internal Revenue Service allows for a tax deduction equal to the fair market value of the donated property—in this case, the LLC or partnership interest. The IRS allows this deduction provided it is “long-term capital gain property,” meaning capital assets held for over a year. Because the activities and assets of the entity are attributed to the partner, his or her pro rata share of various assets will reduce the benefit of the chari- table deduction.
Further, for the donation to be deductible, it must be an undivided portion of the entire interest. This means that the donation must be a proportionate share of every- thing, not solely a donation of the share of distributions for example. A good way to think of this is that the donation must be a “full slice” of the donor’s partnership or LLC interest. Note that the capital structure of most investment advisory partnerships were created for solid business reasons, and while they specifically may not have “full slices”, these types of entities may still be donated effectively.
Items that the parties need to calculate are as follows:
• Adjusted basis—Regulations limit recognition of loss or deduction to adjusted basis and amount at risk. The share of partnership liabilities is added to the donor’s basis to calculate adjusted basis.
At-risk amount—The amount is increased to the extent the donor is per- sonally liable for entity debt (less of a factor, therefore, for LLCs).
Passive activity losses—For partners who did not at all times materially participate in the business’s activities, unrecognized losses may present an issue. Tax benefits are foregone to the extent that such losses are allocated to the gifts. The benefits of the suspended losses are instead added to the donee’s carryover basis.
Hot assets—The presence of hot assets, as defined in Section 751, will impact both the character of gain on sale (if any), and the allowed deduc- tion amount. Hot assets are unrealized receivables, appreciated inventory, and Section 1245 and 1250 property to the extent of depreciation recap- ture. Gain on the sale of such property is ordinary income and the donor’s deduction, to the extent attributable to such property, will be limited to the partnership’s basis in the assets.
• Relief of debt—Relief of donor debt due to transfer of the interest is also treated as amount realized. If that debt was part of the at-risk amount, then the benefit was either already received via past deductions or will be offset against the remaining basis allocable to a sale. This treatment gen- erally applies to debt inside the partnership allocated to the donor, even if the donor is not personally liable for the debt.
Review Part 2: Bargain Sale
A bargain sale is the transfer of the interest to the charity by sale for below fair market value. In this case, the IRS prescribes part-gift, part-sale treatment, so that the differ- ence between actual sale price and fair market value is a gift. Further, the donor’s basis must be prorated between the portions gifted and sold. This means that the basis on the sale portion is proportionate to the basis on a fair market value sale.
Ordinary income and capital gain must be proportionally allocated using the same method in a bargain sale. Essentially, the sale portion of the transaction is a “smaller” version of what a normal fair market value transaction would be. However, no loss is recognized if the proceeds are less than the proportion of basis in the sale.
Review Part 3: Valuation
For outright gifts or bargain sales, the value of the interest is key to determining the allowable deduction. As discussed above, the parties must know the total value of the transferred interest in order to allocate the value and basis between the sale and gift portions for a bargain sale. Since there is rarely a market for minority closely held business interests, the value can be difficult to determine. If the donor acquired the interest through a broker, that route can be pursued again.
In the more likely case where there is no market for the interest, valuation is harder. IRS Revenue Ruling 59-60 is the defining methodology for valuing closely held interests, and should at least be consulted. Further, if the value exceeds $5,000, the donor needs a qualified appraisal (although the cost of such an appraisal may be prohibitive for small donations).
Review Part 4: Holding Considerations for the Charity
Unrelated business taxable income (UBTI) is often relevant to gifts of pass-through entities. A nonprofit member or partner is allocated a share of gains, income, losses, and deductions. This income may be UBTI, depending on the nature of the underlying business activities. Debt-financed income will also give rise to UBTI. Charities should either not accept UBTI-generating member interests, or should verify that it generates cash distributions sufficient to pay the resulting tax liability.
Another factor which charities should consider is the possibility of capital calls. LLC operating agreements in particular may require that members commit to future cap- ital contributions. Nonprofits will generally not accept an interest—whether in an LLC or partnership—which requires payments by the charity. For a similar reason, a charity is unlikely to accept a general partnership interest because of the attendant liability for the entity’s debts.
The IRS requires the business to disclose certain transactions, with harsh financial pen- alties for nondisclosure, even for participating charities. These transactions are ones that have the potential for tax avoidance or evasion. The donation itself may not be an issue, but later business transactions (even if the charity is not actively involved) may require disclosure. Those transactions will be legally attributed to the member charity.
Review Part 5: Sale Considerations
As with other asset types, the nonprofit should determine its exit strategy before accepting. A general policy is best. Will it hold all donated interests, sell all donated interests, or decide based on the attributes of the specific entity in question? Closely held businesses usually have a limited resale market—potential buyers include other partners or members, the entity itself, an acquiring firm, or the original donor.
Partnership or operating agreements may control conditions of a sale or transfer of an interest. Even if the agreement is silent, state law will govern. These agreements and laws can often require the assent of the other owners—clearly, both the donor and charity must verify if the transfer needs approval. Logically, the more owners there are, the more difficult it will be to get approval. This restriction may apply both on dona- tion and on sale.
If subsequent sale of an interest by the charity to a third-party is prearranged as part of the donation, there must not be any legal obligation to carry out such a sale. If the sale does not meet these requirements, the IRS may disregard the donation, and instead it may be classified as an assignment of income to the charity—meaning the donor must recognize any long-term capital gain. Further, if the sale occurs within three years of receiving the interest, the nonprofit must file Form 8282 with the IRS and send a copy to the donor.
Review Part 6: Planned Giving Vehicles
If the donor desires an income stream rather than simply making an outright gift, there are different ways to structure the planned giving vehicle. Charities should approach anything that guarantees an annual income stream with caution. A charitable remainder annuity trust is one example, since it is unlikely that the LLC or partnership will produce a guaranteed distribution stream which can be used to pay the donor. A charitable gift annuity has similar concerns, although either can be done if the non- profit has a buyer in mind.
However, a charitable remainder unitrust (CRUT) may be an appealing option, with important caveats. Partnership debt or liabilities may result in the donor recognizing gain. Note that if the interest is held in a CRUT, the income must be passive and not debt-financed to avoid UBTI. A net-income-with-makeup CRUT (NIMCRUT) might work. In most states, under some variation of the Uniform Principal and Income Act, trust agreements can define what qualifies as “income” for distribution to beneficia- ries.1 One of the problems with a CRT holding a partnership is that the partnership may pass through income to partners without making a distribution. A NIMCRUT solves this problem by including “only partnership distributions, not the actual items reflected on the partnership Schedule K-1 the trust received.”2
Review Part 7: Other Considerations
A number of other considerations are worth mentioning. These are as follows:
• The business entity itself may consider donating assets to the charity. This transaction would proportionally lower the basis of each member by the corresponding donation amount. If the property is long-term capital gain property, the proportional lowering of basis preserves the benefit of the fair market value deduction without recognition of appreciation.
• Publicly traded partnerships are uncommon, but worth mentioning. As the name implies, they are readily available on securities or secondary markets, easing valuation and marketability concerns. However, they receive corporate tax treatment unless 90 percent or more of its income is “qualifying income”—generally passive investment or capital gain income. The trade-off then is the advantage of easier valuation and marketability versus double taxation rather than normal pass-through treatment.
Real estate investment trusts (REITs) are corporations that own and manage a portfolio of real property and mortgages. REITs receive deduc- tions for dividends paid, meaning investors are taxed only on their
1. Phillips, M.S. (March 31, 2014), “Coordinating Charitable Trusts and Private Foundations for the Business Owner: Complying With UBIT and Self-Dealing Rules,”The Tax Adviser, http://www.thetaxadviser.com/issues/2014/apr/ clinic-story-05.html#sthash.m3VJ32Ff.dpuf.
resulting income—similar to partnership tax treatment. Charities should investigate a potential REIT gift carefully, since it may generate UBTI in the event of debt-financed income—unless the entity has a UBIT blocker. Further, the terms of the REIT may not even allow a charitable gift to begin with.
• Carried interests and potential changes to laws governing their tax treat- ment are another unique wrinkle. A carried interest is an ownership interest granted in exchange for services and in lieu of a capital contribu- tion. Current laws treat carried interests as capital assets, meaning they qualify for favorable capital gains tax rates. However, proposals abound to alter this treatment so that at least a portion of the interest would be
ordinary income. Effectively, this would reduce the value of the deduction. Both donors and charities should keep themselves apprised of these pos- sible legislative changes.
Donors with well-planned current or deferred gifts or bargain sales of their partnership interests can create estate and income tax advantages for themselves. This transfer
of interest can also be valuable as both an asset and an income-stream for the non- profit. However, the donor and nonprofit alike need to consider factors such as the transferred basis, liability exposure, transferability restrictions, and numerous other tax issues. These factors can affect how the gift is structured, and the resulting tax benefits to the donor.
They can also be make-or-break factors for the charity, who may not want to accept an asset that opens them up to considerable future expenses or other contingent liabil- ities. Further, the charity should consider the ongoing administrative costs, and the difficulty of disposing of the asset should the need arise. UBTI, capital calls, and report- able transactions are all unpleasant surprises to the unprepared charity. Pass-through interests such as partnerships are simple on their face, but come with a host of pos- sible tax complications. Since this is the case, careful analysis and planning is almost always required before making the go-ahead decision to donate.
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