Selling a Business: The Charitable Way
As more baby boomers begin to retire and sell their businesses, there will be an increasing demand for alternative exit strategies that achieve the owner's personal financial goals. This article discusses one structure for selling a business that establishes a stable income stream and a charitable deduction for the owner.
For purposes of discussion, assume that our baby boomers have owned and operated a moderately successful dry cleaning business for over twenty years and now they are looking to sell the business. Our baby boomers do not think that the business can remain an ongoing enterprise because (1) the business revenues would not support the debt payments someone would have to pay on a loan to purchase the business and (2) there is now a new dry cleaner business in the same shopping complex that has a better and more accessible location.
Our baby boomer's dry cleaning business owns two assets, namely the business real estate and the laundry equipment. It has one full time employee who has been with the company since it started, who is also considering retirement. The dry cleaning business has been operated as a Subchapter S corporation since its inception.
Our baby boomer's goals are to: sell the business assets for as much as possible to provide for their retirement years (i.e., retain as much as possible on an after tax basis) and set aside a portion of that money to support breast cancer research (their daughter lost her life to breast cancer at an early age).
We will discuss two concepts for this example: the Subchapter S corporation and the Charitable Remainder Unitrust.
The S corporation is a flow through entity in that gain or loss is calculated at the corporate level, the gain or loss flows through to the owner's individual owners, and the owner's account for their share of the S corporation gain or loss on their own federal income tax returns. Unlike a regular C corporation, taxes are not imposed at the corporate and shareholder level; with S corporations taxes are only imposed at the shareholder level.
The charitable remainder unitrust (CRUT) is an irrevocable trust. The trust qualifies for tax exempt status. The trust splits the interest in the trust property between the income beneficiary and the remainder beneficiary. The business owners are the income beneficiary and they are paid a set amount (generally between 5% and 50% of the trust assets) on set intervals (usually monthly, quarterly or annually). The owners can select whether they want to receive their income stream for one or both of their lives.
The breast cancer charity, as selected by the business owners and named in the trust, is the remainder beneficiary and they will receive the trust assets outright upon the owner's demise.
The typical CRUT entitles the creator to a charitable deduction, in the year that the CRUT was created, equal to the present value of the remainder that will pass to the charity in the future. The CRUT creator can then use this charitable deduction to reduce their federal income tax obligations (there are some limitations, which may cause the creator to carry over part of the charitable deduction to offset taxes in future tax years).
With these two concepts explained, you might be thinking that our baby boomers would just transfer ownership of their S corporation to a CRUT. Unfortunately S corporations are not able to hold S corporation stock without compromising the corporation's S status. This does not prevent our baby boomers from having the business contribute the business assets to the CRUT.
But our boomers are tax savvy (or they have savvy tax advisors), so they know that there are a number of other limitations that may prevent them from achieving their goals. They consider the following three factors:
First, they know that the charitable deduction that they will receive will be severely limited if they contribute the laundry equipment to the CRUT, because the deduction for this type of contribution is limited to the businesses taxable basis in the assets (which is the purchase price less the depreciation deductions that have been taken on the property).
Second, our boomers also know that they cannot contribute substantially all of the business assets to the CRUT or they will not be entitled to the charitable deduction.
Third, our boomers understand that the CRUT will lose its tax exempt status if it receives any unrelated business income. Therefore if the boomer's CRUT rents the property until it is sold, the lease payments would cause the CRUT to lose its exempt status.
Fourth, our boomers understand that there are self-dealing rules which may prevent them from serving as trustee of any CRUT if they continue to use or benefit from the CRUT property.
So here is what our boomers decide to do: First, they have their employee enter into a lease to lease the business real estate from the laundry business. The lease is for a fixed payment and terminate upon the sale of the property. This will prevent any rental payments from passing to the CRUT, causing the CRUT to lose its tax exempt status. Second, they establish a CRUT with their attorney as the trustee (to avoid the self dealing rules) and they transfer ownership of the real property (but not the laundry equipment, to avoid the "substantially all" of the business assets charitable deduction limitation) and a small amount of cash to the CRUT (the cash is used to pay the employee the lease payments -- payment in lieu of a severance payment). Third, they have the business sell the laundry equipment and the CRUT sell the business real estate to third parties.
The result is that the S corporation receives the proceeds for the sale of the laundry equipment, the CRUT receives the proceeds from the sale of the business real estate (the CRUT does not have to pay tax on the gain realized on the sale due to its tax exempt status), and the S corporation is entitled to a charitable deduction for the present value of the amount contributed to the CRUT. The income and charitable deduction flow through the S corporation to out boomer's personal tax return.
The CRUT is now able to invest the proceeds in a diversified portfolio (that is managed by their own financial planner) that will (hopefully) provide a lifetime income stream sufficient to provide for our boomer's retirement years. The CRUT will continue to make regular payments to the S corporation which will pass through to our boomers – which reduces the S corporation to being merely an entity that the boomers pass their investment income through and that provides some asset protection against future creditor's claims. When our boomers eventually pass away, the charity that the boomers selected will receive the CRUT assets.
While the mechanics of this type of transaction can be tricky in the first couple of years, the complexity is greatly reduced in subsequent years. Best of all, the boomers were able to realize most if not all of their financial goals.
For purposes of discussion, assume that our baby boomers have owned and operated a moderately successful dry cleaning business for over twenty years and now they are looking to sell the business. Our baby boomers do not think that the business can remain an ongoing enterprise because (1) the business revenues would not support the debt payments someone would have to pay on a loan to purchase the business and (2) there is now a new dry cleaner business in the same shopping complex that has a better and more accessible location.
Our baby boomer's dry cleaning business owns two assets, namely the business real estate and the laundry equipment. It has one full time employee who has been with the company since it started, who is also considering retirement. The dry cleaning business has been operated as a Subchapter S corporation since its inception.
Our baby boomer's goals are to: sell the business assets for as much as possible to provide for their retirement years (i.e., retain as much as possible on an after tax basis) and set aside a portion of that money to support breast cancer research (their daughter lost her life to breast cancer at an early age).
We will discuss two concepts for this example: the Subchapter S corporation and the Charitable Remainder Unitrust.
The S corporation is a flow through entity in that gain or loss is calculated at the corporate level, the gain or loss flows through to the owner's individual owners, and the owner's account for their share of the S corporation gain or loss on their own federal income tax returns. Unlike a regular C corporation, taxes are not imposed at the corporate and shareholder level; with S corporations taxes are only imposed at the shareholder level.
The charitable remainder unitrust (CRUT) is an irrevocable trust. The trust qualifies for tax exempt status. The trust splits the interest in the trust property between the income beneficiary and the remainder beneficiary. The business owners are the income beneficiary and they are paid a set amount (generally between 5% and 50% of the trust assets) on set intervals (usually monthly, quarterly or annually). The owners can select whether they want to receive their income stream for one or both of their lives.
The breast cancer charity, as selected by the business owners and named in the trust, is the remainder beneficiary and they will receive the trust assets outright upon the owner's demise.
The typical CRUT entitles the creator to a charitable deduction, in the year that the CRUT was created, equal to the present value of the remainder that will pass to the charity in the future. The CRUT creator can then use this charitable deduction to reduce their federal income tax obligations (there are some limitations, which may cause the creator to carry over part of the charitable deduction to offset taxes in future tax years).
With these two concepts explained, you might be thinking that our baby boomers would just transfer ownership of their S corporation to a CRUT. Unfortunately S corporations are not able to hold S corporation stock without compromising the corporation's S status. This does not prevent our baby boomers from having the business contribute the business assets to the CRUT.
But our boomers are tax savvy (or they have savvy tax advisors), so they know that there are a number of other limitations that may prevent them from achieving their goals. They consider the following three factors:
First, they know that the charitable deduction that they will receive will be severely limited if they contribute the laundry equipment to the CRUT, because the deduction for this type of contribution is limited to the businesses taxable basis in the assets (which is the purchase price less the depreciation deductions that have been taken on the property).
Second, our boomers also know that they cannot contribute substantially all of the business assets to the CRUT or they will not be entitled to the charitable deduction.
Third, our boomers understand that the CRUT will lose its tax exempt status if it receives any unrelated business income. Therefore if the boomer's CRUT rents the property until it is sold, the lease payments would cause the CRUT to lose its exempt status.
Fourth, our boomers understand that there are self-dealing rules which may prevent them from serving as trustee of any CRUT if they continue to use or benefit from the CRUT property.
So here is what our boomers decide to do: First, they have their employee enter into a lease to lease the business real estate from the laundry business. The lease is for a fixed payment and terminate upon the sale of the property. This will prevent any rental payments from passing to the CRUT, causing the CRUT to lose its tax exempt status. Second, they establish a CRUT with their attorney as the trustee (to avoid the self dealing rules) and they transfer ownership of the real property (but not the laundry equipment, to avoid the "substantially all" of the business assets charitable deduction limitation) and a small amount of cash to the CRUT (the cash is used to pay the employee the lease payments -- payment in lieu of a severance payment). Third, they have the business sell the laundry equipment and the CRUT sell the business real estate to third parties.
The result is that the S corporation receives the proceeds for the sale of the laundry equipment, the CRUT receives the proceeds from the sale of the business real estate (the CRUT does not have to pay tax on the gain realized on the sale due to its tax exempt status), and the S corporation is entitled to a charitable deduction for the present value of the amount contributed to the CRUT. The income and charitable deduction flow through the S corporation to out boomer's personal tax return.
The CRUT is now able to invest the proceeds in a diversified portfolio (that is managed by their own financial planner) that will (hopefully) provide a lifetime income stream sufficient to provide for our boomer's retirement years. The CRUT will continue to make regular payments to the S corporation which will pass through to our boomers – which reduces the S corporation to being merely an entity that the boomers pass their investment income through and that provides some asset protection against future creditor's claims. When our boomers eventually pass away, the charity that the boomers selected will receive the CRUT assets.
While the mechanics of this type of transaction can be tricky in the first couple of years, the complexity is greatly reduced in subsequent years. Best of all, the boomers were able to realize most if not all of their financial goals.
Labels: business succession, charitable giving, charitable remainder trust
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