The sale of a family business often represents the culmination of a lifetime’s work. It can also present an opportunity to achieve philanthropic objectives with a little bit of business and tax planning.
To illustrate the potential opportunities to both monetize a family business and achieve philanthropic objectives, here are three case studies based on real-life situations. The businesses described in the first two case studies had a single stockholder who had founded the business and was presented with an opportunity to monetize it through a sale or merger. Despite those similarities, each situation presented unique planning issues and opportunities, which is why these two case studies were selected. In addition, the third case study briefly discusses planning opportunities when the business is held in a partnership.
Case Study #1: Timing of Sale of Stock
Craig was a serial entrepreneur who, in recent years, had developed and operated for-profit career colleges through a privately held corporation. After several years of operating the colleges successfully, Craig received an all-cash offer to sell the colleges to another company in a similar line of business. This opportunity presented Craig with a dilemma: should he contribute stock of the corporation to his family foundation prior to executing an agreement to sell the stock to the buyer, or should he sell the stock and make a cash contribution to his foundation?
After consulting with his tax advisor, Craig concluded that selling the stock and making a cash contribution to his foundation was the optimal choice for two reasons. First, a contribution of this privately held stock would have allowed Craig to claim a charitable contribution deduction for an amount equal to only his adjusted basis in the stock, and not for the fair market value of the stock as reflected in the sale price. Second, from his foundation’s standpoint, although gifts of stock aren’t treated as excess business holdings for 60 months from the date of the gift, the foundation eventually would have to sell most of the stock to fall within the excess business holdings limits to avoid a violation even if the anticipated sale didn’t close.
Had the privately held corporation been structured as an S corporation, another important consideration would be that any distributive share of net income from the S corp received by the foundation would be treated as income from an unrelated trade or business, which is taxed at the for-profit rates, and a subsequent sale of the stock likewise would be treated as a taxable gain under the unrelated business income tax rules.
In light of the above, Craig and his advisors concluded that the optimal strategy was for Craig to sell the stock and make a contribution of the cash proceeds, which would allow him to receive a charitable contribution deduction equal to the amount of cash he contributed to his foundation.
Case Study #2: Sale to REIT
Samantha was a successful architect who, after many years of association with other firms, established her own architectural firm that she operated through an S corp of which she was the sole stockholder. After several years of successful operations and expansion of the business, Samantha was presented with a once-in-a-lifetime opportunity to sell her company to a publicly traded real estate investment trust. The transaction was structured to qualify as a tax-free reorganization because Samantha received the stock of the REIT in exchange for 100 percent of the stock of her S corp. After a short lock-up period of six months, Samantha was free to dispose of the stock by sale or gift.
After consulting with her tax advisor, Samantha decided to make a contribution of the REIT stock to her newly formed family foundation. The stock Samantha received from the REIT qualified as long-term capital gain property because Samantha’s holding period for the S corp stock was tacked onto the holding period for the REIT stock.
Equally important from Samantha’s standpoint was the fact that the S corp stock was converted, tax-free, into publicly traded stock, and, therefore, when Samantha contributed the stock to her family foundation, she obtained a charitable contribution deduction for an amount equal to FMV of the stock rather than one that was limited to the stock’s adjusted basis.
Case Study #3: Estate Tax Deduction for FMV of Partnership Interest
George was a co-founder and 50 percent owner of a limited partnership that constructed and purchased commercial office buildings for investment purposes. George’s partner, who’s unrelated to George, owns the other 50 percent of the partnership. As part of his estate planning, George made a bequest of a 30 percent profits interest in the partnership to his family foundation and the balance to his children and grandchildren. Because his estate received a step-up in basis on his death, his estate obtained an estate tax deduction for the FMV of the partnership interest. And because more than 95 percent of the partnership’s revenue was in the form of rents from real property, the foundation was permitted to retain ownership of the partnership interest under the excess business holdings rules generally applicable to private foundations. While the foundation couldn’t sell its partnership interest to George’s family members because of Internal Revenue Service rules prohibiting certain transactions with insiders, the foundation could always sell its interest to an unrelated third party or have its interest redeemed by the partnership.
Thoughtful tax planning can help philanthropic-minded individuals achieve their charitable objectives when they’re looking to monetize a business that they founded or inherited. On the other hand, don’t forget that failure to invest the time in tax planning can result in devastating consequences.
Jeffrey D. Haskel is Chief Legal Officer at Foundation Source and Douglas M. Mancino is a Partner at Seyfarth Shaw LLP.