Maximizing Charitable Strategies When Cash is Short
This series has focused on strategies to reduce taxation for the current tax year and the impending fall off the Cliff. This installment will focus on charitable strategies when cash is “short”.
Generally speaking, it should come as no surprise that public charities prefer cash contributions under the theory that “Cash is King”, in order to pay for current operations. In recent times, the planned giving officers of these charities have become very skilled on reaching the “high hanging fruit” or non-cash and illiquid assets under the alternative theory that “Necessity is the Mother of Invention”.
As a business owner, you may find yourself short on cash and under-withheld for current taxes while suffering panic attacks over how you are going to come up with the cash to pay your Uncle Sam. How about payroll and Xmas bonuses? At the same time, you may find alternative strategies to reduce and defer taxation such as a qualified retirement plan are equally problematic – requires cash or exposes you to the alternative minimum tax.
One perspective is to view the requirement for the payment of taxes as a charitable contribution -forced charity. The Government picks its causes versus you selecting your own charitable contributions.
This installment will focus on methods to contribute stock in your closely business without giving away the Farm. I have been advocating in past installments the need for corporate executives to start their own businesses. I will also have a strategy for them as well.
B. It’s a Long Fall Off of the Cliff?
The top marginal tax bracket increases to 39.6 percent in January 2013. In my view, high income earners will not receive any reprieve at the last minute despite the best efforts of Congressional Republicans. I believe this will be the result regardless of whether or not the tax increases raise a dime of tax revenue. The tax increase is a political (et Tu Brute) point.
The long term capital gains rate increases to 20 percent. Dividends will return to being taxed as ordinary income once again. The implementation of ObamaCare adds another 3.8 percent of taxation on unearned income for joint filers with taxpayers with adjusted gross income (AGI) in excess of $250,000.
Top bracket income earners are also exposed to the phase out of personal exemptions and itemized deductions. The phase outs have the effect of adding an additional two percent to the marginal bracket. The total effect is to give the New Yorker or Californian a top bracket of 53-55 percent.
C. Contributing Closely Held Stock to Charity
The benefits of charitable contributions are generally well known. Contributions of cash to a charity are limited to 50 percent of the taxpayer’s adjusted gross income (AGI). Contributions of appreciated closely held stock to a charity are limited to 30 percent of the taxpayer’s AGI. Excess contributions may be carried forward for an additional five tax years.
Contributions of short term capital gain property are limited to the property’s basis. In the case of the family investment LLC, the basis should be virtually equal to the capital contribution to the LLC. Additionally, a taxpayer may make a special election that allows a taxpayer to use the 50 percent threshold for long term capital gain property by electing to use the cost basis as the contribution amount instead of the property’s fair market value.
While there has been a flurry over recent years to form new businesses as limited liability companies (LLC), two-thirds of small businesses are incorporated as S corporations according to IRS statistics from 2006. Sixty percent of those corporations had a sole shareholder and at least 30 percent where owned by husband and wife.
In many cases, these corporations previously operated as regular corporations and have assets with significant built in gains as well as being subject to double taxation for prior retained earnings and profits. In this case, the S corporation shareholder has a few choices – (1) Contribute an asset to charity (2) Distribute the asset to the shareholder who can donate it to charity or (3) Contribute S corporation stock.
The problem with distributing the asset to the shareholder is that the distribution could result in a taxable distribution while being partially offset by the charitable contribution. If the S corporation contributes the corporate asset directly to the charity, the tax benefits flow through to the Shareholder as if the Shareholder had made the gift directly. In the event the asset has built in gain, the charitable contribution will not trigger the built in gain. The contribution reduces the Shareholder’s tax basis by the amount of the contribution.
One planning consideration for the Shareholder as an intermediary step in a planning scenario where the business still needs the use of the corporate asset, is to transfer the asset to an LLC and contribute a non-controlling interest in the LLC to the charity coupled with an arms-length lease of the equipment.
The shareholder can retain control over the asset for business purposes as the managing member of the LLC. The Shareholder as managing member can make regular distributions of the leasing income to the charity.
Another option is the transfer of corporate stock. As S corporations are restricted to a single class of stock, the Shareholder can possibly reorganize the company and reissue the shares as common voting and non-voting shares. The Shareholder can transfer the non-voting shares subject to a discount for lack of marketability and control to the charity.
The Shareholder is able to retain management control over the business as well as determine when and how much to distribute to shareholders as a corporate dividend.
One of the limitations of the contribution of S corporation shares to the charity is its tax treatment as unrelated business taxable income (UBTI) for the charity. Clever charities use a planning strategy using a business trust to reduce the amount of UBTI by fifty percent. The charity could also face UBTI on its income when it sells the S corporation shares.
As a practical matter, the Shareholder should develop a pattern of making dividend distributions to the charity. Ultimately, the business can provide for the redemption of the shares when the business is sold or at the death of the Shareholder.
Family Investment LLC
Many corporate executives earn substantial incomes between salary, bonus, non-qualified stock options and restricted stock. Unfortunately, all of these items are taxed at ordinary rates, and the corporate executive is not as blessed as the business owner in the availability of tax deductions. Most of these deductions are taken on Schedule A of tax return and treated as preference items in calculating the alternative minimum tax.
The corporate executive may have accumulated substantial wealth and considerable investment holdings in marketable securities and real estate. In this case, corporate executive should give serious consideration for multiple reasons to the creation of a family investment limited liability company – (1) Centralized Management (2) Asset protection and (3) Tax planning.
The corporate executive should create a family limited liability company or limited partnership. The executive can capitalize the LLC with cash and marketable securities and investment real estate. The LLC can be structured so that the taxpayer is able to retain management control while transferring non-voting interests to the charity.
In a manner similar to the shareholder of the S corporation, the taxpayer is able to retain management control over the LLC and its investment assets. This management authority extends over to the discretion to make annual distributions from the LLC to its member, i.e. the charity(ies). As a practical matter, regular distributions should be made to the Charity.
The family investment LLC is a valid business purpose for state law purposes and federal tax purposes. In that respect, the family investment LLC can and should operate the LLC like any other legitimate business. The retention of management control is a valuable management “string” that must be operated on an arms-length basis.
The LLC structure allows the taxpayer to retain a management fee for his duties as managing member. The managing member can elect to defer receipt of this income. Additionally, the LLC will provide significant asset protection benefits. Under the laws of most states, the creditor exemptions allow you to barely keep the clothes on your back. The LLC provides “charging order” protection.
Sometimes it does not hurt to have some other factors to motivate our charitable intent. Tax planning is one of those motivating factors. Additionally, the absence of cash should not be a limitation to your charitable intent. This article outlines a few strategies for the taxpayer that is short on cash to obtain meaningful tax benefits and reduction utilizing closely held stock or assets. Additionally, the article shows the corporate executive how to create a business to implement this strategy. The strategies leave the taxpayer in a pretty comfortable position with respect to management and voting control.