When you’re a charitably-inclined business owner on the verge of selling your business, adding a philanthropic component to the transaction can be a powerful strategy to reduce taxes due on the sale — unless you and your buyer have gone too far.
The issue is what’s known as a pre-arranged sale. And the IRS doesn’t like those.
Before we get to the pre-arranged sale, let’s review the most common charitable strategy employed when a business owner sells his or her company.
Using a Charitable Remainder Trust to Transfer Business Ownership
Assuming the business is a C-corporation, the owner can transfer low-basis company stock into a charitable remainder trust (CRT). The buyer can purchase the company stock at fair market value from the CRT, which receives cash that can be invested in a diversified portfolio.
During the term of the CRT, the former business owner receives income from the trust. At the termination of the trust, the assets remaining in the CRT go to charity.
The advantages of using a CRT to transfer ownership of a business are:
- The seller bypasses capital gains that would otherwise be due in the year of the sale;
- The seller receives a significant charitable deduction;
- The income received by the seller from the CRT will primarily be taxed at favorable capital gains rates; and
- The seller makes a major, albeit deferred, gift to charity.
Enter the Pre-Arranged Sale
The one pitfall that can blow up this deal is the pre-arranged sale, which occurs when there is a binding obligation for the trustee of the CRT to sell to a buyer.
[The IRS laid down the bright-line test for the pre-arranged sale in Revenue Ruling 78-197, which followed the Tax Court’s decision in Palmer v. Commissioner (1974).]
Basically, if you have a written contract or a signed deal in which the CRT is legally bound or can be compelled by the buyer to redeem the shares, you likely have a pre-arranged sale.
And when that happens, there is no deferral of the capital gains — which is the primary motivation for establishing the CRT in the first place.
How to Avoid the Pre-Arranged Sale?
The first step is to not sign any legally binding sale agreement prior to transferring stock to the CRT. It’s fine to have a “buyer in the wings,” but not be so far down the road with that buyer that the deal is all but done when the stock is transferred to the CRT.
Note: because state contract laws differ, ask your legal counsel to quantify and disclose risks of a potential pre-arranged sale.
Another prudent move would be to appoint a third party as trustee of the CRT, at least until the sale is consummated.
After the stock is transferred to the CRT (with a third-party trustee), it is advisable to wait some amount of time before completing the deal — ideally one to two months.
What if It’s Too Late?
If you are contemplating using a CRT but already have a binding deal in place, stop. Seek expert counsel to ascertain if you have gone too far in the process. (For instance, an argument can be made that a Letter of Intent will not be deemed a pre-arranged sale.)
Assuming you have crossed that line, there is an option after the fact. You can use a vehicle known as a grantor charitable lead trust (CLT) to generate a sizable charitable income tax deduction in the year of the transaction, to offset any gains that are due.
While not as powerful as the CRT would have been, the CLT offers one major advantage over the CRT. The money you transfer to the CLT is not irrevocably given away to charity. Rather, charitable distributions are made during the term of the trust, and at the end of the trust term the assets in the trust revert back to you. You can read more about this strategy in an earlier post here.
The Bottom Line: Plan Ahead
No matter which option you choose, the key to a successful business sale + charitable gift is to plan ahead. Doing so ensures that you won’t run afoul of the pre-arranged sale.
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