One of the changes made by the new tax act was to increase the standard deduction to $12,000 or $24,000 for a married couple filing jointly.  The upshot of that will be that many people will claim the standard deduction rather than itemize.  If they make any charitable contributions but total itemized deductions are still less than the standard deductions, those deductions will no longer be deductible.

There is a way to still achieve the charitable deduction, however, if the taxpayer can bunch his or her charitable contributions into a single year.  For example, if the taxpayer makes charitable contributions of $6,000 per year and has the financial ability to make a contribution of $24,000 in one year, the taxpayer’s contribution of $24,000 will exceed the standard deduction of $12,000 and it will benefit the taxpayer to itemize.

If the charity or charities would benefit more by receiving the $6,000 per year rather than $24,000 in one year, the taxpayer can establish a donor advised fund.  The donor advised fund is a mutual fund in which you make tax deductible charitable contributions to the fund and establish an account.  The contributed funds remain in the account until the taxpayer decides to direct them to charity.  So in this case the taxpayer would contribute $24,000 to the fund in year one, and could direct the fund to distribute $6,000 per year to his or her preferred charity or charities.

Variable prepaid forward contracts (VPFC) are used to diversify a concentrated position in a publicly traded stock, and defer tax on the sale.  Here is how they work: taxpayer (i) pledges the stock to a counterparty, (ii)  receives cash equal to a percentage of the fair market value of the stock (typically 75-85% of the stock), and (iii) agrees to transfer to the counterparty cash or a variable number of shares of the stock at expiration of the contract.  In Rev. Rul. 2003-7, http://www.unclefed.com/Tax-Bulls/2003/rr03-07.pdf, the IRS ruled that, since it was uncertain what the taxpayer would settle the contract with cash or a variable number of shares, the transaction could not be taxed until contract expiration based on the open transaction doctrine.  Thus the taxpayer has use of cash during the contract period, but is not taxed until the contract expires.

VPFCs got a big boost from the Tax Court in McKelvey v. Commissioner recently, https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=11187.   McKelvey involved a typical VPFC entered into by the founder of Monster Worldwide, Inc. in 2007.  The IRS did not challenge the original VPFC.  Instead what was at issue in McKelvey was whether an extension of the VPFC in 2008 was a taxable exchange.  More interesting is that taxpayer died shortly after entering into the extension, which resulted in a step up in the basis of the Monster stock.   Accordingly, since the stock had appreciated, income tax on the increase in the stock price would be permanently avoided.  The IRS argued that the extension was a taxable exchange of the original VPFCs for new ones under Code Section 1001.  The Tax Court disagreed holding that Code Section 1001 applies only to “property” and that the VPFCs were an “obligation” instead of property.   The implications of McKelvey are fascinating…indefinite extension of VPFCs until death to obtain basis step up.  The IRS has not yet indicated whether it will appeal.

VPFCs should be given consideration to someone with a concentrated stock position.  Care must be exercised in structuring the VPFC.  For example, coupling the VPFC with a lending transaction will cause the VPFC to be taxable, see Anschutz, http://www.ustaxcourt.gov/InOpHistoric/anschutz.TC.WPD.pdf.   And, of course, the transaction costs of a VPFC can be substantial.

Charitable remainder trusts (“CRTs”) are split interests trusts, with the taxpayer retaining an income interest and charity receiving the remainder.  The CRT often is used to defer gain on the sale of highly appreciated property.  The taxpayer receives an income deduction for the value of the remainder interest going to charity and defers the capital gain on the sale of the property until he or she receives distributions from the CRT. The administration of the CRT can be tricky, however, since the private foundation rules on self-dealing apply to a CRT.

The IRS recently issued PLRs 201713002 and 201713003 in which the IRS ruled that a CRT that qualifies under Code Section 664 as a charitable remainder trust so that a deduction is available but where the taxpayer fails to take the deduction is not subject to the self-dealing rules.

Since the income tax deduction typically is not significant, a client may be willing to forgo the deduction so that he or she is not subject to the onerous self-dealing rules while still achieving tax deferral.  Forgoing the deduction could create estate and gift tax issues, and PLRs are not binding on anyone other that the taxpayer who sought and received the ruling.  Still, the rulings are fascinating and present an interesting planning option to pursue with tax counsel.

Time to Lighten Up

With markets, both private and public, at all time highs, a lot of people are coming to me for ideas to mitigate the income tax hit of selling an appreciated asset.  There are a number of charitable structures that a client may want to consider (i) charitable remainder trusts, (ii) donor advised funds, (iii) charitable lead trusts and (iv) pooled income funds.

Pooled Income Fund-What is it?

This post will introduce an old idea that is finding a new life, the pooled income fund (“PIF”).  The concept of a PIF is quite simple.  The client gives an appreciated asset to a PIF, the PIF sells the assets and invests the proceeds, and the client receives the income generated by the fund for life.  PIFs have been around a long time, but, for various reasons, had gone out of favor.  Recently, given the low interest rate environment, PIFs have made a comeback.  Here is why.

Why is it Popular Again?

Given the low interest rate environment coupled with the rule that a PIF that is less than three years old can use the average of the last three years AFRs to calculate the charitable deduction means the charitable deduction for a PIF is substantially greater than a charitable remainder trust.  This is because the deduction is for the value of the assets remaining at the end of the term, and using a low interest rate to determine that value means that the discount for time is smaller.   When you couple this with the fact that most state laws allow the PIF to define income to include not only interest, dividends, rents and royalties, but also short and some long term capital gains, you have a very powerful income tax planning strategy.  We are finding charities very interested in working with us to create these donor friendly PIFs.

Bottom Line

A PIF can (i) produce an income tax deduction of 60-80% of the value of the substantially appreciated asset depending on the client’s age, (ii) avoid taxation of the sale of the substantially appreciated asset, and (iii) pay the client a lifetime income interest enhanced by a definition of income that includes some capital gain.  If the client takes a bit of the tax savings and purchases an insurance policy to cover the amount passing to charity and mitigate the risk of a premature death, he or she has all the bases covered.

I generally don’t recommend structuring a business as an S corporation.  Unlike LLCs and partnerships, the S corporation rules (i) restrict the number and type of owner, (ii) provide no flexibility in allocating income and loss, (iii) do not allow a step up of the assets at death of the shareholder and (iv) unlike other pass-through entities, the sale of assets and liquidation are both taxable events. This creates a sticky wicket to navigate.

Straight Stock Sale Tax Treatment Unlikely with S Corporations

A business sale can be structured as either a stock sale or a sale of the assets.  Buyers like asset sales because they can pick and choose what they want, and they do not inherit the existing liabilities of the company.  Sellers like stock sales because there is only one taxable event, rather than two.  However, even if an S corporation shareholder is able to negotiate a stock sale, the tax code allows buyer and seller to elect to treat the sale as an asset sale by making a Section 338 election.  Buyers like to do this because it allows them to step up the basis of the assets.  In a simple sale for cash the 338 election often works fine.  Assuming the asset sale results in a taxable gain.  It is passed through to the seller and taxed, and the gain increases his basis in his stock, so the distribution of the sale proceeds, which is deemed a sale, results in no gain because the basis in the stock equals the cash distributed.

Earnouts and Contingent Payments Cause a Sticky Wicket

The problem is that most transactions are not straight stock for cash.  Typically, a portion of the payments are made over time, and, when we introduce the installment sale rules to the mix, we find a huge disparity in tax treatment.  It is possible to have a situation where the seller has a large gain in the year of sale, but not enough cash to pay the tax.  That is a bad situation in its own right, but it can be made downright intolerable later when it turns out the seller reported too much gain in the year of sale, and only has a capital loss in later years that he cannot use.  A lot of these problems can be mitigated by structuring all of the sale consideration as notes, but that introduces business risk to the seller that the notes do not get paid.

Plan Ahead

Given the sticky wicket discussed above, an S corporation shareholder contemplating the sale of his company needs to consult with counsel before he starts the sales process.