CGNA: Chapter 4 - Pass-through Entities, Advanced - Part 3 of 3 + Additional Resources

CGNA: Chapter 4 - Pass-through Entities, Advanced - Part 3 of 3 + Additional Resources

Article posted in General on 21 March 2018| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 22 March 2018
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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.

 

Planning Illustration

The following case illustrates the federal tax issues discussed thus far. For the past ten years Bob, age 60, has been a partner of XYZ, a general partnership engaged in a busi- ness activity. He does not materially participate in the business activities of XYZ. Bob has adjusted gross income of $175,000, a federal marginal tax rate of 25 percent, and files jointly with his spouse. Bob’s current contribution ceiling for capital gain property donated to a qualifying organization other than a private foundation is therefore $52,500 ($175,000 x 30 percent).16

Bob estimates the fair market value of his interest in XYZ to be $50,000. He reasonably expects XYZ to continue annual income distributions of approximately seven percent, or $3,500. Bob’s adjusted basis and amount at risk in XYZ is $26,000. He has $4,000 of suspended passive activity losses with respect to XYZ. He is personally liable for $5,000 of XYZ debt. His interest includes $3,000 of Section 751 hot assets.

Bob wants to provide for ABC, a 501(c)(3) public charity, by donating his interest but is unsure of the tax implications of such a transfer. He is undecided whether to donate the entire interest, sell it to a third party and then contribute the cash proceeds, offer it for sale to ABC at a bargain price, or take no current action. Assume for illustration purposes that ABC is willing to accept an interest in a general partnership (unlikely in most circumstances). Bob has asked you for help determining his best course of action.

Scenario A – Outright gift of the entire interest to ABC

Scenario B – Sale to a third party for $50,000 in cash and contribution of the proceeds to ABC

Scenario C – Bargain sale to ABC for a cash price of $10,000

A

B

C

Sale and gift elements:

Value of interest

$50,000

$50,000

$50,000

Amount realized:

Cash received

-

$50,000

10,000

Relief of debt

5,000

5,000

5,000

Amount realized & sale

5,000

10%

$55,000

100%

15,000

30%

Gift element & gift %

$45,000

90%

$35,000

70%

Tax effect of sale element:

Amount realized

$5,000

$55,000

$15,000

Basis of partnership interest (1)

2,600

26,000

7,800

Gain realized

$2,400

$29,000

$7,200

Gain recognized:

Ordinary income (hot assets) (2)

300

3,000

900

Long-term capital gain (3)

2,100

26,000

6,300

Total gain recognized

$2,400

$29,000

$7,200

Tax:

Ordinary income (25%)

75

750

225

Capital gain (15%)

315

3,900

945

Total tax on sale

$390

$4,650

$1,170

Passive loss recognized (4)

$400

$4,000

$1,200

Tax savings (25%)

100

1,000

300

Tax effect of gift element:

Gift

45,000

50,000

35,000

Less allocated ordinary deduction (5)

2,700

             -

2,100

Charitable contribution deduction

$42,300

$50,000

$32,900

Tax savings (25%)

$10,575

$12,500

$8,225

Net cost of gift:

Value of interest

50,000

50,000

50,000

Less cash received

-

(50,000)

(10,000)

Plus cash contributed

-

50,000

-

Plus tax paid on sale element

390

4,650

1,170

Less tax saved on passive loss

(100)

(1,000)

(300)

Less tax saved on gift element

(10,575)

(12,500)

(8,225)

Net cost of gift

$39,715

$41,150

$32,645

Step 1 – Determine the separate sale and gift elements. The resulting percentages will be used to allocate basis, long-term capital gain, and ordinary income where the bargain sale rules apply.

Step 2 – Calculate the separate tax effect of the sale and gift elements.

Step 3 – Summarize the results to determine the net cost of the gift:

(1)  $26,000 x sale percentage

(2)  $3,000 x sale percentage

(3)  Total gain realized less ordinary income recognized

(4)  $4,000 x sale percentage

(5)  $3,000 x gift percentage

Comparing Outcomes

Although scenario A involves an outright gift with the donor receiving no cash, the $5,000 relief of debt is treated as an amount realized on sale and triggers application of the bargain sale rules.

In scenario B, it is assumed that the buyer would be willing to pay fair market value for Bob’s share of net assets and in addition assume contingent liability for his share of XYZ debt. In practice the total consideration from the buyer at the time of purchase will of course depend upon assessments of the financial strength and future earning capacity of the entity.

In scenarios A and C, if ABC prefers to liquidate the interest immediately instead of carrying it for future cash flow, it may be possible for XYZ to liquidate the interest subsequent to the donation, while preserving Bob’s deduction on the appreciated value of his share of long-term capital gain assets.

Alternatively, if XYZ initially liquidates Bob’s interest and he then contributes the cash proceeds to ABC, he will lose the benefit of a charitable deduction on such untaxed appreciation. However, this may result in the initial transfer to ABC being disregarded under the assignment of income doctrine, and treated instead as a taxable liquidation of Bob’s interest. To avoid this, there must be no legally binding obligation among the parties to carry out a subsequent liquidation.17

Comparing scenarios A and B, if Bob does not consider the added tax savings from an outright gift to be substantial, he might prefer instead to give ABC the cash realized from a fair market value sale of the entire interest to a third party. This would save ABC the costs incident to disposition or ongoing administration of the asset.

In addition, the greater the proportion of hot assets represented in a partnership interest, the less will be the added tax benefit of an outright gift as opposed to sale to a third party and contribution of the proceeds. Unlike long-term capital gain, no charitable deduction is allowable on an ordinary income element.

This alternative may also be more attractive where the sum of the adjusted basis (or at-risk amount if less) plus any suspended passive losses is in excess of the fair market value of the interest (i.e. the interest is depreciated). Significantly, recognition of suspended passive losses occurs where the entire interest is disposed of in a fully taxable transaction; that is, one in which any gain or loss realized is fully recognized.

In such case, regulations free up suspended passive losses for deduction in addition to any remaining basis in the interest. Depending on the amount of suspended passive losses, unrecovered basis, and marginal tax rate of the donor, the resultant added tax saving can reduce the gift’s net cost.

As scenario C illustrates, a bargain sale can provide a good deal of planning flexibility and may be attractive to the charity where the purchase price is nominal in relation to expected cash flow. ABC would expect to realize an annual return of 35 percent, with its income distributions from XYZ of $3,500, divided by its investment of $10,000. In addition, a donor may combine cash it receives in a bargain sale with current tax savings to provide for wealth replacement as discussed next.

A fourth scenario would be for Bob to retain ownership of the interest, contribute cash distributions from XYZ to ABC, and revisit this analysis from time to time as circumstances change.

Wealth Replacement

Where donor objectives warrant, consider the use of life insurance to replace wealth lost to the estate as a result of a charitable transfer.

Building on the example, at age 60 Bob’s life expectancy is 25 years.18 Further, assume that Bob will be able to realize a similar investment yield of seven percent over the long term. And for simplicity assume that the underlying assets of XYZ are not of a nature that will further appreciate in value.

Accordingly, the future value of the forfeited year-end XYZ income distributions of $3,500 over Bob’s life expectancy is approximately $237,000. Adding this amount to the $50,000 value of the interest Bob replaced, his total insurance requirement is $287,000.

Bob is in good health and has an insurance quote of a guaranteed annual premium of $1,335, payable at the beginning of each policy year, for a suitable universal life policy with a death benefit of $287,000. In scenario C, cash flow from his immediate net tax savings of $7,355 combined with the bargain sale proceeds of $10,000, totaling $17,355, exceeds the present value of the insurance premiums paid over his life expec- tancy, $16,600.

Thus, if Bob elects the bargain sale alternative, he will provide ABC with a high-yielding asset and stands a reasonable likelihood of fully restoring wealth otherwise lost to his estate as a result of the charitable transfer.

Conclusion

A well thought out gift or sale of a partnership or LLC interest may create an income tax and estate planning opportunity for a transferring partner as well as vital support for a preferred charitable organization. But such an interest carries special issues that the parties must explore in advance in order to capture maximum tax benefit and avoid unintended outcomes. They should consider any costs incident to transfer and ongoing administration as part of this analysis.

Planners can also aid the charity in the exercise of its stewardship by alerting principals to important concerns before accepting this type of gift, such as unrelated business income tax and transfer of liabilities. If the entity has certain types of property, the donor may not be able to take the full fair market value as a deduction, which may defeat the purpose of donating the interest. If the pass-through entity could generate more than insignificant amounts of UBTI from its assets or activities, the charity may not want to accept the interest. Therefore, before contributing such an interest to charity, the charity and donor alike must thoroughly understand the pass-through entity’s structure and should become familiar with its governing documents and activities. They should also have a conversation in order to better understand the charity’s needs and possible limitations around such a contribution.

Pass-Through Entities     Additional Resources

Below are further details on 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 examination adapted and excerpted from the articles, see Pass-Through Entities Advanced. For further details, see Pass-Through Entities Additional Resources.

For an examination of the IRS applying close scrutiny to a donation of a partnership interest, see Fox, R. (March 19, 2015), “Chief Counsel Advice Applies Substance-Over-Form Doctrine in Disallowing Deduction for Charitable Contribution of Partnership Units,” Planned Giving Design Center, http://www.pgdc.com/pgdc/cheif-counsel-advice-applies-substance-over-form-doctrine-disallowing-deduction-charitable-cont.

For advice on charities considering accepting gifts of LLC interests, see Sangster, C.B. and Buckley, S.C. (2010), “Gifts of LLC Interest,” Journal of Gift Planning, https://connect.wels.net/AOM/Subsidiaries/foundation/Leadership%20Resources/Educational%20Resources/Partnership%20for%20 Philanthropic%20Planning%20Papers/Gifts%20of%20LLC%20Interest.pdf.

For a discussion of LLC transfers and basis, see Ellentuck, A.B. (May 31, 2008), “Handling Gifts and Bequests of LLC Interests,” The Tax Adviser, http://www.thetaxadviser.com/issues/2008/jun/handlinggiftsandbequestsofllcinterests.html.

For an example of a college’s policies towards acceptance of privately held securities, see Duke University, “Frequently Asked Questions: Privately Held Securities,” https://dukeforward.duke.edu/ways-to-give/gift-planning/gift-plans/outright-gifts/faqs-privately-held.

Treas. Reg. §§ 1.170A-13(c)(iv)(F)-(G) (requirements for partners’ tax documentation of appraisal)

Rev. Rul. 75-194, 1975-1 C.B. 80 (tax treatment for donation of limited partnership liabilities)

Rev. Rul. 96-11, 1996-1 C.B. 140 (partnership’s donation of partnership assets and effect on bases in respective interests)

Private Letter Ruling 9533014 (IRS ruling favorably on the donation of a partnership interest to a CRUT)

Private Letter Ruling 201012050 (IRS ruling on self-dealing when donating LLC interests)

Private Letter Ruling 201435017 (IRS ruling on potential UBTI for a charity receiving an LLC interest)

Estate of Petter v. Comm’r, 653 F.3d 1012 (9th Cir. 2011) (court approves defined-value clause for LLC gift)

  • 16. IRC § 170(b)(1)(C)(i) (2015)
  • 17. Rev. Rul. 78-197, 1978-1 C.B. 83
  • 18. IRS Publication 590-B, Appendix B, Table I.

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