IRS Rules Favorably on Bailout of Stock Contributed to Charitable Trust

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IRS Rules Favorably on Bailout of Stock Contributed to Charitable Trust
March 1, 2004
From March 2004 Riker Danzig Tax and Trusts & Estates UPDATE.
Area(s) of Practice:
Estate Planning & Administration, Tax Law

A popular tool for tax and financial planning is the charitable remainder trust (CRT). The CRT is a split interest trust, i.e. the lead interest provides an annual dollar amount (either a fixed sum or a sum calculated based upon a fixed percentage of the trust's annual fair market value) to be paid to a non-charitable beneficiary for either the beneficiary's lifetime or a term of years not to exceed 20 years. The remainder interest is then payable to a charity.

There are several reasons to consider establishing a CRT. Generally, a CRT is utilized to defer tax on the sale of appreciated assets. A CRT is exempt from federal income tax. Therefore, appreciated property can be contributed to a CRT and sold within the CRT without triggering an immediate federal tax (keep in mind that this gain may be passed out to the individual over time as he or she picks up income on the annuity or unitrust payments). Additionally, the donor is generally entitled to an immediate federal income tax charitable deduction for the value of the remainder interest passing to the charity.

Taxpayers may utilize the tax benefits of a CRT to monetize a portion of their stockholdings through a contribution of stock to a CRT that is later redeemed or repurchased by the company For example, a 100% stockholder could make a gift of 20% of his or her stock in closely-held company to a CRT. If structured properly, the donor will get an income tax deduction equal to the fair market value of the remainder interest of the CRT. Additionally, if the company subsequently repurchases or redeems the stock from the CRT, the CRT shouldn't pay any federal income tax on its sale of stock. Instead, as the unitrust or annuity amount is received, portions of the gain may be taxed to the individual beneficiary.

The IRS previously blessed this form of transaction, so long as the sale or redemption was not arranged before the stock was contributed to the CRT. If the sale or redemption was prearranged, the IRS has taken the position that the CRT is merely serving as an agent for the donor, and the donor would be subject to income tax on the sale/redemption of the stock held by the CRT.

Recently, however, there have been concerns that the IRS may back away from its more favorable position.1 But Private Letter Ruling 200230004 reaffirms the position that the IRS is unlikely to tax the donor on a sale or redemption (other than pursuant to a pre-arranged plan) of stock held by a CRT. Under the facts of this letter ruling, at the time the stock was donated to the CRT, the board of directors of the corporation was considering (but had not decided) whether to redeem the donated stock. The IRS ruled that no taxable income would be incurred by the donors if the redemption took place because there was no binding agreement for the redemption at the time of donation of the stock.

PLR 200230004 is significant for another reason as well. Generally, "self dealing" rules prohibit a transfer of assets between the CRT and certain related persons, such as the grantor, significant donors, family members of any of those persons, and any corporation in which the grantor/significant donor owns a large ownership percentage (such as the corporation whose stock is contributed to the CRT). The "self dealing" rules present a problem when stock in a closely-held corporation is contributed to a CRT, because typically, this stock would only be marketable to the aforementioned related persons. However, in PLR 200230004 the IRS allowed the underlying corporation to redeem the shares held by the CRT, since the redemption offer was (i) made to all shareholders and (ii) made for a price equal to the shares' fair market value.

The PLR provides the taxpayer with a way to have stock held by a CRT purchased/redeemed from the CRT without adverse consequences to the taxpayer, even with respect to stock in a closely held corporation. Bear in mind that private letter rulings are not binding on the IRS. Therefore, please consult with your tax advisor before engaging in any similar transaction.


1 See Rauenhorst v. Commissioner, 119 T.C. 157 (2002)