Not Your Typical CRT - The Venture Capital Unitrust

Not Your Typical CRT - The Venture Capital Unitrust

Article posted in Charitable Remainder Trust on 12 June 2000| comments
audience: National Publication, Dan Rice, Philanthropy Architect | last updated: 3 March 2016
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Summary

Does a donor's entrepreneurship have to end when their philanthropy begins? Not according to Dan Rice who, in this edition of Gift Planner's Digest, describes one of the more creative giving arrangements with which he has been involved -- the Venture Capital Unitrust.

by Dan Rice

For 20 years I've been asking cheerful donors for stop and think sized current and deferred gifts. After all, the Lord loves a cheerful giver! Occasionally, these gifts were quite challenging because of the asset and planning complexities. Nevertheless, brilliantly creative attorneys routinely and capably designed and crafted the required trusts and sophisticated collateral arrangements for these unusual donors. Following is an account of a gift that applied the unique goals and abilities of the donor to truly become a venture philanthropist!

Selling the Family Business

Charitable remainder trusts are commonly used to facilitate the sale of closely-held business interests or other highly appreciated assets. In many cases, when one business is sold, the seller will use a portion of the sales proceeds to fund the start of a new enterprise.

Example: Mr. Jones owns 100% of the shares of a closely-held C-corporation. The company is worth $3,000,000 with a potential buyer waiting in the wings. Mr. Jones wants to use one-third of the sales proceeds to provide current income for himself and the remaining two-thirds to launch a new company.

In the context of using a charitable remainder trust to facilitate the sale, most planners commonly consider only one course. They recommend their clients transfer only that portion of the business that will be used for immediate income to the CRT and sell the portion that will be used for the new business outside the trust, on a taxable basis. These planning recommendations are based on the planner's belief that a CRT cannot or should not invest in and own a startup enterprise. I used to think so as well.

Properly planned and executed, the income tax benefits of a split gift/sale arrangement can be quite compelling. The trustor avoids recognizing capital gain on the portion of the company sold via the charitable remainder trust and generates an income tax charitable deduction that mitigates the income tax liability on the portion sold outside the trust. Such arrangements, however, can put the planner's spreadsheet software to the test. Trying to decide which percentage to transfer to the CRT can become quite complicated given the interrelated tax computations that arise as a function of juggling taxable gains, with income tax charitable deductions and potential valuation discounts.

However, what if the donor desires to use a portion of the sales proceeds to start a new company and earmark them, undiminished by income taxes, for charity? Can both goals be accomplished? Can the entire original business be placed in a CRT, sold, and a portion of the proceeds used to fund the start of a new business? Perhaps it can through a Venture Capital Unitrust (or "VCUT").

What is a VCUT?

You won't find the term Venture Capital Unitrust anywhere in the Code or regulations; rather, VCUT is simply a term used to describe a charitable remainder unitrust that is designed to capitalize or invest in a startup business enterprise. It is important to note that a VCUT does not use any legal slight of hand or rely on any legal fictions to accomplish its objectives; rather, it carefully follows the existing rules that govern CRTs to take advantage of the unique entrepreneurial talents of the trustor to maximize the remainder interest for charity.

How the VCUT is Structured

Typically, the VCUT takes the form of a net income Unitrust. The net income provision protects the trust from having to make distributions during periods when the business is not distributing income to the trust.

Trust accounting income is defined as that term is defined under IRC §643(b) and, depending on state law, may be expanded to include post contribution capital gains. As will be discussed later, including capital gains as income can be very helpful in producing distributable income.

VCUTs may also include a make-up provision that enables the trustor to recapture income distributions the business may have been unable to pay before it became profitable. In the event the new company is subsequently sold at a profit, the combination of a make-up provision and including post-gift gains as income may cause of flood of income (to the extent of the trust's deficiency account balance at the time of sale). Some people may consider this a good problem to have while others may desire to conserve capital for the charitable remaindermen. If this is a concern, there are several alternatives:

The first is to simply use a Type II unitrust, or net income without make-up provision format. The second method is described in Ltr. Rul. 1999907013. In that ruling, a charitable remainder trust allowed the trustee the sole discretion to reasonably allocate to income some or all of the post-contribution capital gains realized by the trust on the sale of any stock, bond, or other security that produced limited or no income during the period owned by the trust. Some legal scholars are, however, guarded in their enthusiasm for this ruling and question whether the Service may, at some point in the future, reverse its position. It may, therefore, be prudent for trustors desiring to include this provision to obtain their own ruling.

In addition to all of the above, the trust can include a "flip" provision that converts it to a standard CRT upon the sale of the second business (or upon the occurrence of some other creatively drafted triggering event). Conversion to a standard payout format would facilitate total return investing thereby reducing investment risk and optimizing return, and would also permit distributions of trust principal to satisfy payment of the unitrust amount, if necessary.

Are Two Trusts Better than One?

It may also be appropriate to actually consider two CRTs for the VCUT strategy--one to produce current income for the trustor, and the second to launch the new enterprise (which may not produce distributable income to the trust for some time). The first "income now" trust could be drafted with a standard payout format (or as a flip unitrust with the triggering event the sale of the contributed assets) to facilitate immediate income distributions. The second trust would be structured as a net income or net income/ with or without makeup / flip combination as described above.

Following the Private Foundation Excise Tax Rules

The model charitable remainder trust instruments found in the Revenue Procedures include prohibitions against all private foundation excises taxes. However, charitable remainder trusts are not required to include the prohibitions against excess business holdings (IRC §4943) or jeopardizing investments (IRC §4944) unless an IRC §170(c) organization is also an income recipient.1

Because a charitable organization is not included as a co-income recipient of a VCUT, the document does not include these prohibitions. Although closely-held businesses are not specifically defined as a jeopardizing investment, the excess business holdings rules would, if applicable, generally limit the ownership by the CRT of a closely-held corporation to 35% of the total outstanding shares. The absence of these restrictions enables the VCUT to receive and hold as much as a 100% interest in an existing or new business enterprise, if desired.

Self-Dealing

All charitable remainder trusts are subject to the private foundation prohibitions against self-dealing (IRC §4941). If a disqualified person, such as Mr. Jones or a member of his family, is to own an interest in the new enterprise, great care must be taken to ensure that no direct or indirect acts of self-dealing occur between the trust, corporation, and disqualified persons.

Even though there may be an entity interposed between private foundation and a disqualified person, IRC §4941(d) prohibits indirect as well as direct acts of self-dealing. Generally, a self-dealing transaction between a disqualified person and an organization controlled by a private foundation is considered indirect self-dealing.2 An organization is controlled by the private foundation if the foundation, or one or more of its foundation managers may require the organization to engage in a transaction which, if engaged indirectly by the private foundation, would constitute self-dealing.3

Example: If a child purchases authorized but unissued shares directly from a corporation which is controlled by the trust, with limited exceptions, such a transaction would be treated as though the purchase was made directly from the trust itself and would, therefore, constitute an indirect act of self-dealing.

For this reason, if ownership of a portion of the new enterprise by the trustor or family members is desired, such arrangements should be made when the new company is formed. Otherwise, the self-dealing rules may prevent subsequent transfers of interests between the trust and disqualified persons.

Speculative Investment Issues

As mentioned earlier, VCUTs are exempt from the private foundation excise tax rules that prohibit jeopardizing investments. But may the closely-held investment be speculative in nature under the Uniform Prudent Investor Act? Yes, under certain circumstances and depending upon the state law governing the Unitrust. For example, the California Uniform Prudent Investor Act provides that a trustee must invest and manage trust assets as a prudent investor would and must exercise reasonable care, skill and caution. If, however, taking into account the trust's investment strategy, the trustee determines that an investment in risky or speculative assets is appropriate for the trust, then such investment is permissible.

Asset Diversification

Must a charitable remainder trust's assets be diversified? Depending on state law, perhaps not. For example, the general rule under the California Prudent Investor Act is that, unless the trust document otherwise provides, the trustee in making and implementing investment decisions must diversify assets unless he or she can show that it is prudent not to do so. The VCUT instrument includes language stating that the trustee shall have no duty to diversify Trust investments. This provision complies with the California Act and relieves the trustee from the general requirement to diversify.

Suitable Business Forms

What business form can the new enterprise take? Typically, VCUT businesses are structured as C corporations. This is the form of choice because it insulates the CRT from any unrelated business income produced by business operations or as a result of the company incurring indebtedness.

Controlled Organization Issues

On that note, planners must be aware that if a tax-exempt organization (including a CRT) owns more than a 50% interest in a tax-exempt or taxable entity, that entity is considered "controlled" for purposes of the unrelated business income rules. In such cases, certain items of income normally excluded for purposes of calculating the recipient organization's unrelated business taxable income are included for this purpose. These items include interests, rents, royalties, and annuities.4

These rules are of particular importance to the VCUT because the presence of even one dollar of unrelated business taxable income will cause a CRT to lose its tax exemption for that year.

It is important to note that dividends received from a controlled entity are excluded under this rule. Therefore, a CRT can still own 100% of the stock of a C corporation, receive dividends from it, and exclude them from its computation of unrelated business taxable income.

There may be limited situations that may make the use of a partnership or limited liability company an appropriate business form. In no case, however, is a CRT permitted to own stock in an S corporation.

Planning for Income Distributions

As mentioned earlier, there may be little, if any, income produced by the business for several years. When the business does begin making a profit, the company can either declare dividends or offer to redeem some of its stock from the VCUT itself. Provided a cash offer to redeem is made to all shareholders of the same class of stock for fair market value, the transaction will qualify for a special exception from the self-dealing rules.5 Because such redemptions will most likely be characterized as long-term capital gain, the VCUT will need to expand its definition of income to include post-contribution capital gains.

Conclusion

The VCUT is not for the novice planned giver or inexperienced advisor; rather, it combines the highly technical rules that govern CRTs with the unique entrepreneurial abilities of the donor to facilitate the creation of a business for the ultimate benefit of charity. For those with a charitable heart and who are willing to follow the rules of the road, the benefits to the community can be substantial.


Footnotes


  1. See IRC §4947(b)(3)(B); Treas. Reg. § 1.664-1(b); Rev. Rul. 72-395, Sec. 6.07; Ltr. Ruls. 9707027 and 199952086.back

  2. See Dealing with the Self-Dealing Rules, David Wheeler Newman, Esq.back

  3. Reg. §4941(d)-l(b)(5)back

  4. See IRC §512(b)(13)back

  5. IRC §4941(d)(2)(F); Ltr. Rul. 9339018back

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