CGNA: Chapter 4 - Pass-through Entities, Advanced - Part 2 of 3

CGNA: Chapter 4 - Pass-through Entities, Advanced - Part 2 of 3

Article posted in General on 15 March 2018| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 16 March 2018
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Summary

An even more in-depth look into the gifting opportunities of pass-through entities.

This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

Factors That May Affect a Charity’s Willingness to Accept a Gift of a Pass-Through Interest

Unrelated Business Income Tax: Although generally exempt from tax, charities pay tax on their unrelated business taxable income (UBTI), which is net income they derive from any trade or business that is not substantially related to the charity’s exempt pur- pose. As a result, if a charity becomes an owner in a pass-through entity that operates an unrelated trade or business, the charity will include in UBTI its share of the entity’s income or gain derived from any unrelated trade or business, regardless of whether that entity distributes cash. In addition, under the debt-financed income rules of Code Section 514, UBTI also may arise as a result of the business’s indebtedness. A charity is unlikely to accept an interest that will produce UBTI unless it gets assurances that it will receive sufficient cash distributions to pay the resulting tax liability.

Because hedge funds often raise money through borrowing, they are likely to produce UBTI as a result of the debt-financed income rules. To enable charities to invest in alternate investments such as hedge funds without incurring significant tax liabilities, U.S. hedge funds commonly create foreign corporations called “blocker corporations.” Through these entities, charities can invest in limited partnership hedge funds without incurring UBTI. The dividends that charities receive from these foreign blocker corporations are not subject to the debt-financed income rules and are not UBTI. Many charities include hedge funds in their portfolios, investing through foreign blocker corporations.

A donor who wishes to contribute a limited partnership interest in a hedge fund to charity may want to consider whether the interest can be converted to an interest in the offshore blocker corporation before donating the interest to charity. However, if the donor himself/herself contributes his or her interest to a non-U.S. blocker corporation, he/she will recognize gain under Code Section 367 and face IRS reporting obligations as well. If the charitable recipient were to contribute the hedge fund interest to a foreign blocker corporation, it likely would have gain that would be treated as debt-financed UBTI.

Other Potential Liabilities: Partnership and LLC operating agreements commonly include provisions for capital calls. This is particularly true in venture capital or private equity funds where investors pay in their capital commitments over a period of years. A charity receiving a contribution of an interest will want assurance that it will not be subject to any capital call provisions.

Tax Shelter Restrictions: Regulations require that investors in certain tax shelters and “reportable transactions” disclose their participation in those transactions. A reportable transaction is any transaction where information must be included with a return or statement because IRS has determined that the transaction is of a type that has a potential for tax avoidance or evasion.

The failure to include information about a reportable transaction is subject to penalties. In the case of a charity, the penalty is significant: $50,000 for a reportable transaction and $200,000 if the reportable transaction is one that IRS has publicly identified (known as a “listed transaction”).

Before accepting a gift of an interest in a closely held business, particularly an interest in a business structure with multiple layers, a charity will want to assess the activities of the entity at each level. Regulations will attribute the organization’s transactions to the charity if it accepts the interest. The charity may want representations from the business that it is not engaged in any reportable or listed tax shelter transactions.

Other Considerations

Transferability: Partnership and LLC interests generally are not freely transferable. The contributing owner and the charity will want to confirm that all requirements for transfer under the partnership or operating agreement are met.

Valuation: A contribution of an interest worth more than $5,000 will require a written appraisal from a qualified appraiser, unlike the case of a contribution of publicly traded securities.

Publicly Traded Partnerships: Under Code Section 7704, a publicly traded partnership (PTP) is a partnership whose interests are traded on an established securities market or are readily tradable on a secondary market. A PTP gets corporate tax treatment unless 90 percent or more of its gross income in the current taxable year and each preceding year is “qualifying income.” For this purpose, qualifying income includes interest, dividends, real property rents, gain from sale or disposition of real property, and gain on sale or disposition of a capital asset held for production of such income. If 90 percent of a PTP’s gross income is qualifying income, the PTP is taxed as a partnership. A PTP that the IRS taxes as a partnership may raise UBIT issues for a charity, although generally speaking, the enumerated types of income do not constitute UBTI unless debt financing is involved.

If the PTP units are worth over $5,000, a donor will need to evaluate whether the contribution of those interests requires a qualified appraisal. Although a qualified appraisal is not required for a gift of “publicly traded securities,” that term is limited to the stock of corporations. Units of a PTP which the owners treat as a corporation under Code Section 7704 are arguably equivalent to publicly traded stock of a corporation. However, the applicability of the qualified appraisal rules to those units is unclear.

Contribution of Assets by the Business Entity: Instead of an individual donating his/her interest to charity, the business itself can donate assets to charity. Each owner’s basis in their interest decreases by the corresponding share of the organization’s basis in the property contributed, because charitable deductions are separately allocated to and deductible by the owners under Code Section 702. The IRS has noted that, for long-term capital gain property, limiting the basis deduction to the share of the organization’s basis in the assets preserves the intended benefit of providing a deduction for the fair market value of appreciated property without recognition of the appreciation.

REITS: A real estate investment trust (REIT) is a corporation that owns and manages a portfolio of real estate properties and mortgages. Like mutual funds, the law entitles REITs to a deduction for dividends paid and generally are subject to tax only on undistributed income. As a result, investors in REITs are generally subject to only a single level of tax with respect to their investments and, as such, resemble partnerships.

A REIT interest may or may not be a suitable charitable gift. Although the income a charity receives from a REIT is treated as dividend income, it may in rare cases generate UBTI because of debt financing. However, regular dividend distributions from REITs,

as well as gain from a disposition of a REIT interest, are exempt from the UBTI rules. A donor interested in contributing his or her REIT interest to charity should determine whether the REIT’s activities might have negative tax consequences for the charity. The donor should also refer to the REIT’s prospectus to determine whether the charitable contribution would be permissible in the first instance.

Carried Interests: A carried interest in an LLC or partnership refers to an interest in the entity’s profits received in exchange for services, typically without any capital contri- bution by the provider of those services. Under current law, the carried interest gets capital asset treatment and as such is subject to favorable capital gains tax rates upon sale or realization. This rule has become controversial, particularly for carried interests of investment managers of hedge funds and private equity or venture capital funds. Various proposals have been put forth to change that characterization and treat a portion of that carried interest as ordinary income.15 However, “qualified capital interests”—meaning capital a service member or partner invests on the same terms as other capital investments in the organization—would still enjoy favorable treatment as a capital asset.

If proposed changes were enacted, it appears likely that a service member or partner’s charitable contribution of his or her carried interest (unless it is a qualified capital interest) would not give rise to a full fair market value deduction. This is because only a portion of it would be treated as a gift of a capital asset. Donors considering contributing a carried interest to charity should consult with their tax advisors and the charity about the possible tax consequences.

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