Leaving significant assets to charity may be admirable, but not necessarily simple. Let’s focus on leaving business assets to a private foundation (PF)—the excise tax risks and planning considerations so that donors can confidently leave their assets to charity, not chance.
Excess Business Holdings Tax
The Internal Revenue Code Section 4943 excess business holdings rules impose an excise tax on PFs owning more than 20% of the voting stock of a business enterprise, reduced by the percentage of voting stock owned by all disqualified persons (DPs). The initial excise tax due by the PF is 10% of the value of the holdings and accrues annually until the transaction is corrected.
The stringent restrictions can catch well-meaning taxpayers and their advisors by surprise. The good news is that a cushion is built in for gifts and bequests. If a business enterprise is donated, a PF can avoid the 10% excise tax if it brings ownership of the business enterprise below the 20% threshold within five years. The Internal Revenue Service may grant a grace period of an additional five years for certain large gifts or bequests if there exists evidence of an effort to sell the business and a plan to do so. Furthermore, as we’ll discuss later, the estate administration period can be managed to provide additional flexibility.
A PF won’t be treated as having excess business holdings if the PF and all of its related PFs own less than 2% combined of a business enterprise. But, if the PF is unable to reduce the excess business holdings to an allowable level, it’s subject to the 10% excise tax annually. Once the IRS notifies the PF that there’s an excess business holding, the PF has one year to correct the situation, or the tax rises to a punitive tax of 200% of the value of the business enterprise.
Notably, as a result of the electronic filing mandate enacted for all Forms 990 with tax years beginning after July 1, 2019 as a result of the Taxpayer First Act, it will be easier for the IRS to review returns to identify excess business holdings reported on Forms 990-PF or 4720.
Who’s a DP?
IRC Section 4946(a) defines a DP as it relates to the PF. It includes:
• A substantial contributor to the PF;
• A PF manager (officer, director or trustee);
• An owner of more than 20% of the total combined voting power of a corporation, the profits interest of a partnership or the beneficial interest of a trust or unincorporated enterprise that’s a substantial contributor to the PF;
• A member of the family of any individual described above;
• A corporation, partnership or trust/estate in which persons described above hold more than 35% of the voting stock, profits interest or beneficial interest, respectively.
Self-Dealing
Section 4941 imposes an excise tax on certain prohibited transactions between a PF and a DP. These self-dealing transactions include:
• Sale, exchange or lease of property;
• Lending money or other extension of credit;
• Providing goods, services or facilities;
• Paying compensation or reimbursing expenses to a DP;
• Transferring PF income or assets to or for the use of a DP.
The initial tax assessed on the DP is 10% of the amount involved in the act of self-dealing, with the possibility of an additional 200% tax if the act isn’t corrected. There’s an additional 5% tax imposed on a PF manager who knowingly participates in the transaction. There are many exceptions to the prohibited transactions listed above, but when working through charitable planning, it’s important to be aware of how these rules may affect the transactions between the PFs and any family members or other DPs.
Four Approaches
What can be done? Here are some possibilities:
Do nothing. An estate intended for a PF that holds a significant interest in a business likely involves challenges. But, there’s a grace period available of up to
10 years or possibly more. Some taxpayers will let the PF deal with it when they’re gone. Yet, this seemingly selfless charitable act may not actually be in the best interest of the business, its employees, any family owning interests or the PF itself. It’s hard to maximize value in a sale if an informed buyer knows there’s a countdown to get the deal done.
Manage the timeline. In the case of a bequest, the 5- or 10-year clock for excess business holdings doesn’t start ticking until the business enterprise is distributed from the estate to the PF. A large estate owning a significant business enterprise is likely to have a prolonged estate administration period.
Often, the taxpayer is interested in transferring the value the business represents to the PF, not the business itself. A sale during the period of administration eliminates concerns of excess business holdings in the PF. Thought may be given to third-party buyers, of course, but possibly also family members, established trusts and related entities that may entirely buy out the PF’s interest in the business given the right conditions. For example, if an estate owns an S corporation (S corp) that will likely be sold either in the estate administration period or by the PF in the future, it may be advantageous to sell the S corp in the estate administration period to mitigate potential excess business holdings issues by the PF and unrelated business income (UBI) from the ownership or sale of the S corp.
Determining when to establish a PF and the timing of the contribution of assets can also be important. Integral to determining the “when” is understanding that once the estate establishes the PF, whether by contributing assets or even paying the PF filing fee, the estate becomes a DP of the PF. As a DP, the self-dealing rules and other prohibited transactions rules become effective. Thus, rather than racing to transfer the easy-to-transfer assets from the estate or trust into a PF, it may make sense to group or stagger the contribution of assets from the estate to the PF to better manage the self-dealing rules and unintended consequences. For example, once the estate becomes a DP of the PF, the estate may be limited in its ability to sell assets of the estate to family members or related entities, even at an appraised, arms-length price.
Notably, the PF may already have individuals that are DPs on the PF board. Case law and private letter rulings focus on indirect self-dealing when an estate transacts business with a PF’s DP and the PF is an estate beneficiary. It’s important to proceed with caution with any sale to a DP.
Furthermore, thoughtful management of the timeline may allow the estate to resolve other issues, such as loans from the decedent to a family member or vice versa. If there’s an existing PF that’s the beneficiary of an estate, and the decedent had a loan to a DP of the PF, there’s an indirect self-dealing situation as of the date of death. However, if the PF isn’t yet formed, it may be possible to proactively resolve the loan situation. Similarly, there may be time to address encumbered property that will transfer to the PF—a potential self-dealing and/or UBI problem. An estate should also consider any post-death events and marketability or minority interest discounting on the value of business enterprises that are donated to a PF for purposes of a charitable estate tax deduction. The courts affirmed in Estate of Chenoweth v. Commissioner1 and recently in Estate of Dieringer v. Comm’r2 that estates will only receive a charitable estate tax deduction for the amount a charity actually receives.
Some charitable families, in an effort to preserve flexibility, have discussed leaving the assets to family in the estate plan, but designing the plan so that if an intended heir executed a qualified disclaimer, the disclaimed assets would transfer to the PF instead. A qualified disclaimer is an irrevocable and unqualified refusal by a person to accept an interest in property. There are specific timelines and procedures to be a qualified disclaimer.3 Here too, managing the timeline can be advantageous to set up an appropriate governance structure at the PF level to make for a qualified disclaimer and valid charitable deduction as was done in PLR 200519042 (Feb. 3, 2005).
Count the votes. The permitted holdings of any PF in an incorporated business enterprise are 20% of the voting stock, reduced by the percentage of the voting stock owned by all DPs. Notably, the IRC refers to voting stock. If all DPs together own less than 20% of the voting stock, the non-voting stock owned by the PF is also treated as a permitted holding.4 This provides a planning consideration—reduce the PF and family’s voting ownership of the business enterprise below 20%.
This approach was highlighted in PLR 8830084 (April 20, 1988), issued over 30 years ago. In the PLR, a PF owned 100% of the stock of a business enterprise. To meet the standards set forth in Section 4943 in force at that time, the business enterprise undertook a business reorganization, exchanging all of its single class voting common stock for Class A voting common shares and Class B non-voting common shares.
Class A shares had the right to vote on all matters, including the election of officers. Class B retained the ability to vote only with regard to extraordinary transactions (events relating to the substantial sale of the business or its assets, a merger, liquidation or amendment to its Articles). Additionally, the Class B shares would convert to voting shares on the occurrence of specific conversion events, such as significant non-payment of dividends or, notably, the sale of the shares to a third party.
The PF sold 80% of its Class A shares to identified third parties, leaving it with 20% ownership of the Class A voting shares and 100% of the Class B non-voting shares, representing 92% of the fair market value of the total common shares.
The IRS opined that the transaction allowed the PF to meet the requirements under Section 4943, allowing the PF to hold its remaining interests in the business enterprise as a permitted holding, not subject to the excess business tax excise tax.
This approach would be useful when the PF or DPs (likely the family or family-owned entities) wanted to retain substantial ownership of the business enterprise. Notably, the IRS allowed for the springing conversion of the non-voting shares to become voting shares on sale to a third party, maintaining the inherent market value of the shares while underscoring the point of the rules—independent operations of the business and PF.
Raise the roof. It’s possible to raise the ownership ceiling from 20% to 35% with the IRS’ approval, if the PF and all disqualified persons don’t own more than 35% of the voting stock and one or more non-disqualified persons have effective control of the business enterprise.5 With an independent management team of the business and mostly independent board for the PF, the business owners’ PF and family combined could retain as much as 35% of the voting control of the business and potentially all of the non-voting interest without triggering an excess business holding problem.
The IRC generally refers to stock throughout the Section, but it’s inclusive of other business forms as well. In the context of a partnership, profits interest is substituted for voting stock and capital interest is substituted for non-voting stock. A proprietorship isn’t a permitted holding, and in all other instances, beneficial interest should be substituted for voting stock.6
Newman’s Own Exception
Lettuce get excited. Included in the Tax Cuts and Jobs Act enacted in 2017 was a tasty addition—an exception to the excise business holdings tax commonly referred to as the “Newman’s Own exception” due to its relevance to the Newman’s Own Foundation, a PF founded by philanthropist and actor, Paul Newman, and used to donate the profits of Newman’s Own line of food products.
This exception provides PFs like the Newman’s Own Foundation a way to keep 100% ownership of a for-profit business if the PF and business enterprise meet the three requirements under the newly added Section 4943(g):
1. Ownership test. 100% of the voting stock is held by the PF for the entire tax year, and all of the PF’s ownership interest was acquired by means other than purchase.
Note that the acquisition requirements apply only to the PF. Thus, if a substantial owner of a business enterprise intended to leave the business interests to the PF through his estate, lifetime acquisitions or those done during the period of estate administration to reacquire 100% voting control, if necessary, could position the PF to meet this test after receiving the bequest.
2. All profits to charity. Net operating income of the business enterprise must be distributed to the PF within 120 days of the end of the taxable year, less Chapter 1 deductions, Chapter 1 tax and a reasonable reserve for working capital and other business needs.
3. Independent operation. A 3-pronged test that must be met at all times during the year:
A. During the taxable year, no substantial contributor or any family members may be a director, officer, trustee, manager, employee or independent contractor of the business enterprise.
B. At least a majority of the board of the PF aren’t directors or officers of the business enterprise or family members of a substantial contributor, and
C. There are no loans outstanding from the business enterprise to a family member of a substantial contributor.
The Newman’s Own exception may be useful for a family that no longer runs the operations of the business enterprise. Or, consider a business in which the founder actively managed the operations until the day he died, but left the management in capable, independent hands after his death. For some families who are intimately ingrained in the operations of both the business and PF, the final requirement may be the most difficult to meet.
However, in the planning process, keep in mind the impact of IRC Section 2704(a), which may cause the estate to have a taxable asset representing the value of the voting interest that lapses at death in a situation in which the family will control the value after death.
Both the Newman’s Own exception and the PLR 8830084 approach would allow family and other DPs to own non-voting stock, unrestricted. However, in the application of the Newman’s Own exception, all net profits of the business must be distributed to the PF, which could present some challenges if there are other owners of the non-voting shares. Also, the Newman’s Own exception covenants are somewhat challenging. And, there remains a large gap among 20% percent, 35% and 100% voting ownership, effectively a no man’s land in the excess business holdings world. Notably, as seen in PLR 8830084, structuring may allow the non-voting shares to convert to voting shares on a sale to a third party.
Other Charitable Planning
Some taxpayers are redefining what it means to be charitable. The Giving Pledge, frequently associated with Bill and Melinda Gates and Warren Buffett, is a publicly announced, personal commitment to support charitable giving without specific parameters on the means or methods. Similarly, with the Chan Zuckerberg Initiative LLC (CZI LLC), Mark Zuckerberg and
Dr. Priscilla Chan pledged to give nearly all of their shares of Facebook stock to advance human potential and promote equality for all children in the next generation. While CZI LLC’s charitable pledge isn’t unique, its tax status is. CZI LLC isn’t organized as a PF or other tax-exempt vehicle—instead it’s organized as a limited liability company (LLC) and, as such, isn’t subject to the same tax restrictions as other tax-exempt entities.7
The limited legal/tax structure of The Giving Pledge and CZI LLC provide more flexibility than traditional charitable vehicles in terms of types of investments—such as environmental, social and governance or impact investing. However, it’s important to note that simply making the pledge or funding an LLC isn’t a charitable contribution for tax purposes—it doesn’t qualify for an income tax or estate tax charitable deduction. Thus, if a taxpayer ultimately wants to leave his estate, and particularly any business assets, to charity, it’s still important to think through the issues and considerations outlined above, let alone the family dynamics and cash flow considerations.
Endnotes
1. Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987).
2. Estate of Dieringer v. Comm’r, 146 T.C. 117 (2016).
3. Internal Revenue Code Section 2518(b).
4. IRC Section 4943(c)(2) flush language.
5. Section 4943(c)(2)(B).
6. Section 4943(c)(3).
7. The authors note that individuals mentioned in the article may make charitable contributions in other forms, independent of The Giving Pledge or Chan Zuckerberg Initiative LLC.