It has been my experience and observation in business that most fortunes are created through ownership of a small business. In 2018, the Small Business Administration stated that 10,312 businesses sold at an average price of $275,000.
In some cases, small businesses can result in great fortunes when the business is sold. The cliché that the only thing in life that is certain is “death” and “taxes” is certainly true when the business is sold. Most small business sales usually result in the sale of the corporation’s assets to the Buyer instead of the sale of the corporation’s shares to the Buyer.
Following the passage of the Tax Cuts and Jobs Act and the reduction of the corporate marginal tax rate to 21%, many businesses have been restructured or newly created as regular corporations. An asset acquisition generally is more favorable for a Buyer from an income tax perspective, compared to a stock acquisition. The asset sale allows the Buyer to receive a step-up in the tax basis of the assets acquired based on the purchase price. The step up in cost or tax basis allows the Buyer to depreciate or amortize the purchased assets. The acquired goodwill is an asset that may be amortized over fifteen years. In contrast, an increase in the corporate stock tax basis from a stock acquisition (that is not treated as a deemed asset acquisition under the tax laws) does not allow the Buyer to amortize the purchase the shares.
Generally, a Seller, prefers a stock sale over an asset sale. A shareholder who has held its stock for more than a year, is taxed on gain on the stock upon the sale of the shares at the shareholder level, the gain is taxed at the long-term capital gains rate.
If the target corporation is a C corporation or an S corporation subject to entity-level tax on built-in gain (because, for example, it had converted from a C corporation to an S corporation within the last five years), an asset sale, in contrast, generally would result in two levels of tax — once at the corporate level on gain in the asset sale and a second time on the distribution of the net proceeds to the selling shareholder.
This article focuses on the use of two powerful techniques used together to minimize and defer corporate level taxation and eliminate taxation upon the liquidation of the corporation. The planning combines the use of the charitable remainder unitrust (CRUT) but with the corporation as the settlor or grantor of CRUT. The Malta Pension Plan is integrated into the planning to eliminate taxation on the liquidation of the corporation. The planning results of the two planning techniques produce a very powerful tax result.
Tax Strategy Overview
The proposed tax strategy involves the regular corporation forming a charitable remainder unitrust and contributing a substantial portion of the corporation’s asset (65-80%) to a newly formed charitable remainder unitrust (CRUT). The design of the CRUT will seek to optimize the charitable gift so that the value of the charitable remainder interest is equal to ten percent of the gift. Based on the current IRC Sec 7520 rate, the retained life interest would be equal to approximately 11.896%. Concurrently, the Seller would create a Malta Pension Plan and contribute his corporate shares to the Malta Pension Plan.
In the next tax year, the corporation and CRUT would agree to an early termination of the CRUT. In an early termination, the charity would receive a payout of the actuarial value of the remainder interest and the payment of the income of beneficiary (corporation) is made after the corporation is liquidated and the income interest is distributed to the trustee of the Malta Pension Plan. The value of the CRUT income interest is made to the trustee of the Malta Pension Plan.
The Charitable Remainder Unitrust
The Charitable Remainder Trust (CRT) is an irrevocable agreement in which the taxpayer/donor transfers assets to a trust in exchange for an income interest. The trust is known as a split interest trust. The trust is "split" between an income interest and a remainder interest which passes to one or more charities. The charitable remainder trust is exempt from income taxation and allows the donor to claim an income tax charitable deduction based on the value of the remainder interest. The value of the remainder interest needs to be at least ten percent of the gift.
The arrangement permits the tax-free sale of appreciated assets and irrevocably designates the remainder portion between one or more charitable beneficiaries. The charitable beneficiary can be a single beneficiary, donor-advised funds, and private foundations.
The donor enters into a trust agreement with the trustee to transfer certain assets to be managed and maintained by the trustee. In accepting the assets, the trustee agrees to pay an income stream to one or more designated income beneficiaries for the rest of their lives or a designated period of time (term of years). At the expiration of the trust term, the trustee of the charitable remainder trust delivers the remaining trust assets to the charitable remainder beneficiary.
CRT distributions to income beneficiaries are taxed using a unique four-tier system of accounting. This system utilizes a "worst -in-first-out" method for characterizing income distributions in the hands of the income beneficiaries. Each item of income earned by the trust must be separately tracked according to type (e.g. interest, dividends, capital gains, tax-exempt interest, etc.). Then each type of income is "used up" starting with items taxed at the highest rate moving to items that are taxed at the next lower rate. The end result is that ordinary income items, such as interest, are passed out first (Tier I), followed by short-term capital gains, then long-term capital gains (Tier II), tax exempt interest (Tier Ill), and finally trust principal (Tier IV).
Any CRT earnings in excess of the income beneficiary distributions are retained in the trust in a tax-free environment and combined with future transactions for characterizing future income beneficiary distributions. Note that while the CRT avoids taxation on capital gains realized from the sale of appreciated assets, such gains may be used to characterize future income beneficiary distributions.
The taxpayer may use several forms of a charitable remainder trust. The principal distinction between the various forms of charitable remainder trust is the manner in which the trust agreement defines the income interest. The trust must specify that the income interest will be paid as: (a) a fixed amount (annuity) k n o w n as a Charitable Remainder Annuity Trust, or CRAT) or (b) a fixed percentage of the trust's assets revalued annually (a Charitable Remainder Unitrust, or CRUT).
The longer the charity must wait, and the greater the income payments to the income beneficiaries, the lower the amount of the charitable deduction. This computation is complex and is generally performed using specialized software. The amount of the deduction of the gift of the charitable remainder interest is generally limited to thirty percent of the donor's adjusted gross income for most long-term capital gain property for public charities and twenty percent to private foundations. Deductions that are denied because of the deduction limitations, may be carried over for the next five tax years.
One major limitation of the CRT are the rules dealing with self-dealing and unrelated business taxable income (UBTI). The UBTI rules are designed to prevent tax-free treatment to investment income that is unrelated to the charitable purpose of the public charity. The consequences of UBTI treatment are severe for a charitable remainder trust. Previously, even a dollar of UBTI within a charitable remainder trust would disqualify the trust. IRC Sec 664(c) now imposes a 100 percent excise tax on any UBTI within a charitable remainder trust.
As a practitioner, you are hard pressed to find any articles dealing with a corporation as a grantor or settlor of a charitable remainder trust. Nothing in IRC Sec 664 precludes a corporation from forming a charitable remainder trust. A corporation is entitled to a charitable deduction up to 10% of the corporation’s taxable income. The amount of the deduction is established by the value of the charitable remainder interest.
If a regular corporation chooses to contribute assets to a charity or a CRT, the corporation must contribute less than substantially all of its assets. Under Treas. Reg. 1.337(d)-4, a corporation that transfers all or substantially all of its assets to a charity or CRT must recognize gain or loss immediately as if the corporation had sold the assets for the asset’s fair market value. As a consequence, the benefits of transferring appreciated property to charity and avoidance of capital gains tax treatment are lost.
Whether a transfer involves “substantially all” of a corporation’s assets is determined based upon facts and circumstances. The IRS has generally held that the substantially all requirement is satisfied- (1) When assets representing 90% of the value of the corporation’s net assets are transferred,(2) The assets transferred represent at least 70% of the value of the gross assets prior to the transfer under IRC Sec 368(a)(1). Other parts of the Code interpret the phrase “substantially all” to mean 85%. Treas. Reg. 1.514(b)-1(b)(1)(ii). Reg. 53.4942(b)-1(c). Reg. 53.4946-1(b)(2). Reg. 1.401(k)-1(d)(1)(ii) uniformly interpret the phrase "substantially all" to mean 85%.
When a CRT terminates before its stated term, the CRT assets are apportioned between the income interest and charitable remainderman based on the relative present value of the respective interests. Prior to 2008, the method for calculating the present value of the respective interests was subject to a number of private letter rulings.
The Path Act amended IRC Sec 664(e) provides the methodology for calculating the respective interests. IRC Sec 6649e) was intended to allow charities to access trust assets earlier than would otherwise be the case. The early termination can be viewed as protecting the charity from the risk that the value of the principal will decline over the trust term.
Overview of Malta Pension Plan (MPP)
The Malta Pension Scheme in many respects is a surrogate to the Roth IRA. A taxpayer can make an unlimited contribution to the Malta Pension Plan. Unlike the Roth IRA, the taxpayer may make in kind contributions to the MPP through the contribution of the asset or an interest in an entity holding the asset.
The MPP is treated as a grantor trust from a federal perspective. As a result, the contribution of an appreciated asset will not trigger any tax consequences on the transfer of an asset. The contribution to the MPP is not deductible. FIRPTA (IRC Sec 897) and effectively connected income to a U.S. trade or business (IRC Sec 1445) is not applicable because the trust is treated as a foreign grantor trust for tax purposes.
Malta law permits distributions to be made from such plans as early as age 50. The rules allow an initial lump sum payment of up to 30% of the value of the member’s pension fund to be made free of Maltese tax. Based on treaty provisions, distributions that are non-taxable for Malta tax purposes are also non-taxable in the United States.
Under Malta law, three years must pass after the initial lump sum distribution before additional lump sum distributions could be made to a resident of Malta tax-free. In Year 4, the MPP may distribute additional funds to the participant without triggering a tax liability. The amount that may be distributed tax-free is based on the annual national minimum wage where the participant resides. Fifty percent of the excess of the difference between the plan balance and the participant’s lifetime retirement income can be withdrawn tax-free each year.
To calculate how much can be distributed free of tax, it is necessary to first determine the pension holds “sufficient retirement income.” This amount in turn is based, pursuant to Maltese law, on the “annual national minimum wage” in the jurisdiction where the member is resident. To the extent the pension plan balance exceeds the member’s “sufficient retirement income” (on a lifetime basis), 50% of the excess can be withdrawn tax-free each year.
Additional periodic payments generally must then be made from the pension at least annually thereafter, and while such payments may be taxable to the recipient, they are usually significantly limited in amount (generally being tied to applicable minimum wage standards in the recipient’s home jurisdiction). Beyond those minimum wage amounts, excess lump sum distributions of up to 50 percent of the balance of the plan generally can be made free of Malta tax.
Participation in the MPP requires compliance with the FinCEN reporting requirements for foreign bank and financial accounts. FinCEN Form 114 (Report of Foreign Bank and Financial Accounts) must be filed annually with the Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of the Treasury.
Code Section 6038D, also enacted as part of FATCA, requires that any individual who holds any interest in a “specified foreign financial asset” must disclose such asset if the aggregate value of all such assets exceeds $50,000 (or such higher dollar amounts as may be prescribed).IRS Form 8938 is used to report specified foreign financial assets if the total value of all the specified foreign financial assets in which you have an interest is more than the appropriate reporting threshold. The filing threshold for a married taxpayer filing a joint tax return if the specified financial assets is more than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year. As a foreign grantor trust, the taxpayer will most likely be required to file Form 3520.
The combination of techniques, the Charitable Remainder Unitrust and the Malta Pension Plan provide a powerful combination of tax benefits – tax deferral and a tax deduction in the sale of a business. The Buyer receives a step up in basis for corporate assets. The Seller achieves a tax deduction on the contribution on corporate assets to the CRUT. The deduction offsets taxable gain for the corporate assets that are retained and sold by the corporation. The early termination of the CRUT and the transfer of the Seller’s shares to a newly created Malta Pension Plan provides for a vehicle for tax deferral and capital gains avoidance on the sale of personal goodwill and the liquidation of the corporation and the distribution of the CRUT income interest to the Malta Pension Plan.
This combination of tax strategies using a little finesse can dramatically overcome the ugliness of double taxation as a result of the sale of corporate assets to the Buyer. As more corporations continue to operate as regular corporations due to the reduction in the corporate tax rate, this strategy is an important planning idea to keep in the Seller’s pocket when the deal of a lifetime roles around.