Case Study: Selling a Closely-Held Corporation with a Charitable Remainder Unitrust

Case Study: Selling a Closely-Held Corporation with a Charitable Remainder Unitrust

Case study posted in Privately Held Business Interests on 9 May 2005| 7 comments
audience: National Publication | last updated: 18 May 2011
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Abstract

The majority of U.S. wealth is held in the form of family-owned businesses. This case study compares the tax and cash flow economics of selling a C-corporation by two common methods -- stock sale and asset sale followed by liquidation -- and then illustrates how these two methods can be incorporated with a charitable remainder unitrust.

Facts

Pete and Mary Anderson are the co-founders and 100% owners of a small manufacturing company. They are now both age sixty and have been thinking about selling the company so they can travel and enjoy their golden years. That thinking has now accelerated because another company recently expressed interest in buying them out. As a result, the Andersons had the business appraised and were pleased to find that it is worth $3,000,000.

The Andersons then met with their tax accountant to discuss ways they could structure the sale and the income tax consequences associated with various alternatives.

Stock Sale. The accountant explained that because they founded the company with $50,000, if they were to sell the company stock for $3,000,000, they would recognize a $2,950,000 long-term capital gain. Assuming the Andersons are in a 20% combined federal and state capital gains tax bracket, they would pay $590,000 in tax, leaving them with $2,410,000 after tax.

Asset Sale/Liquidation. Their accountant then explained that a potential buyer might not be interested in purchasing their stock but, rather, the assets of the corporation. By purchasing assets, the buyer could establish a new depreciation base for the company's depreciable assets and would insulate itself from any contingent liabilities from prior business operations. Although purchasing assets would help the buyer, because the corporation is its own tax paying entity, an asset sale followed by a corporate liquidation and distribution of cash to the Andersons would result in taxation at both the corporate and shareholder levels, more than doubling the total income tax bill.

Assuming the adjusted cost basis of the company's assets is $750,000, if the corporation were to sell its assets for $3,000,000, it would recognize a capital gain of $2,250,000. Assuming the corporation is in a 40% combined federal and state income tax bracket, it would pay $900,000 in taxes, leaving the corporation with $2,100,000.

The Andersons would then presumably liquidate the corporation and distribute the cash to its shareholders (i.e., themselves); however, they would also recognize a long-term capital gain in an amount equal to the difference between the $2,100,000 amount distributed to them and their cost basis in their stock of $50,000 -- $2,050,000. In a 20% individual capital gains bracket, they would pay $410,000 of additional tax. The combined corporate and individual taxes would equal $1,310,000, leaving the Andersons with only $1,690,000. The combined tax erosion under this scenario would exceed 43%!

Planning Goals

Armed with this information, the Andersons were very interested in structuring the sale in a way that would result in the least amount of tax and largest bottom line. They were also in the process of planning their estates and were interested in how they could reduce gift and estate taxes, and optimize the amount passing to their three children.

Having prepared their income tax returns for many years, the Anderson's accountant was also aware that they are very charitably inclined, volunteering their time and giving generously to many organizations in their community. Their accountant proposed the following idea.

Planning Strategy - The Charitable Alternative

As an alternative to a taxable sale, the Andersons could contribute all or a portion of their stock to a Charitable Remainder Unitrust, as described in Internal Revenue Code section 664. The trust would sell the company's stock or liquidate as described above and use the proceeds to provide the Andersons with income for their lifetimes, after which, the trust would terminate and transfer its assets to the charitable organizations they had chosen. Income payments would be based on a fixed percentage of the trust's annual value.

Capital Gains Planning. When property is transferred to a charitable remainder unitrust, the trust takes over the donor's holding period and cost basis. When the trust sells the property, it realizes the same amount of capital gain as would have the donor; however, it pays no tax because it is income tax-exempt.1 This feature is of tremendous value when highly appreciated property, such as appreciated stock, is sold by such trusts because the entire amount of the net proceeds can be reinvested for the production of income.

Stock Sale by Trust. If the trust were to sell the stock, there would be no capital gains tax paid at the shareholder (trust) or corporate levels. From an income tax planning point of view, a stock sale by the trust would produce the optimum result.

Asset Sale / Liquidation by Trust. As an alternative, if the Andersons contributed the stock to the trust, and the company then sold its assets followed by a complete liquidation and distribution, the corporation would still pay tax at the corporate level as mentioned above; however, there would be no tax paid by the charitable remainder unitrust on the trust's receipt of the net cash liquidation proceeds because the trust is tax-exempt.

Income Tax Deduction. In addition to avoiding the payment of personal capital gains tax on the sale of the company, the Andersons would receive a sizable charitable income tax deduction in the year they transferred their stock to the unitrust. The deduction is based on the fact that Mr. and Mrs. Anderson will retain income from the unitrust for their lifetimes; after which, the trust will terminate and distribute its assets to the charitable organization(s) of their choice. In essence, the Andersons would be making a present irrevocable commitment to a future charitable gift. Because of that commitment, they would receive an immediate charitable income tax deduction even though charity would most likely not receive the remainder interest for many years.

The amount of the deduction is equal to the net present value of the future charitable gift. It is calculated using actuarial tables that consider the fair market value of the contributed property, the Andersons' ages, and the payout rate of the trust.

Based on an appraised fair market value of $3,000,000, the net present value of the Andersons' gift is $542,790. Assuming they are in a 40% marginal income tax bracket, the charitable deduction will reduce their income taxes by $217,116. 2

Cash Flow Planning

As mentioned earlier, the Andersons would receive income from the unitrust each year for both their lives. The amount of income is determined by multiplying the fair market value of the trust assets on the date of contribution and on the first day of each year thereafter by the trust's payout rate. The payout rate is fixed and cannot be changed; therefore, careful thought must be given to its selection.

Comparing the Benefits

The personal financial and philanthropic benefits of a charitable remainder unitrust are best illustrated by comparing it to an outright taxable sale of the contributed property:

Option 1 - illustrates an asset sale followed by complete liquidation
Option 2 - illustrates a taxable sale of the stock
Option 3 - illustrates an asset sale followed by a complete liquidation inside a charitable remainder unitrust
Option 4 - illustrates a stock sale by a charitable remainder unitrust

The following projections assume the Andersons will live 25 years. It is further assumed that the Andersons are in a 40% ordinary income and 20% capital gains marginal tax bracket, and the corporation is in a 40% bracket. It is assumed the proceeds from the sale of the stock are reinvested at an 8% rate of return (comprised of 5% ordinary income and 3% LTCG).3 Finally, the payout rate of the charitable remainder unitrust is 7%.



Option 1
Option 2
Option 3
Option 4

Asset Sale /
Liquidation
Stock
Sale
CRT / Asset
Sale /
Liquidation
CRT /
Stock
Sale





Asset Sale:




Sale Price of Assets
$3,000,000
n/a
$3,000,000
n/a
Cost Basis of Corporate Assets
$750,000

$750,000

Realized Gain
$2,250,000

$2,250,000

Corporate Income Tax @ 40%
$900,000

$900,000






Net After-Tax Proceeds
$2,100,000

$2,100,000






Liquidation / Stock Sale:




Proceeds
$2,100,000 $3,000,000 $2,100,000 $3,000,000
Cost Basis of Stock
$50,000
$50,000 $50,000 $50,000
Realized Gain
$2,050,000
$2,950,000 $2,050,000 $2,950,000
Shareholder Capital Gains Tax
@ 20%

$410,000

$590,000

$0

$0





Net  After-Tax Proceeds
$1,690,000
$2,410,000
$2,100,000
$3,000,000
(+) Tax Savings from
Charitable Deduction*

$0

$0

$217,116

$217,116
(=) Net Proceeds and Tax Savings
$1,690,000
$2,410,000
$2,317,116
$3,217,116
Combined Tax Erosion
(as % of sales price)

43.7%

19.7%

22.8%

-7.2%





Projected Cash Flow:




Net Cash Flow During Life**
$2,450,000
$3,494,500
$2,690,152
$3,961,096





Projected Estate to Heirs:




Taxable Value of Asset
$1,690,000
$2,410,000
$0
$0
(-) Estate Taxes***
$929,500
$1,325,500
$0
$0
(=) Net Amount to Heirs
$760,500
$1,084,500
$0
$0





Benefit Summary:




Net Cash Flow + Net Estate=
Total Family Benefit

$3,211,000

$4,579,000

$2,690,152

$3,961,096
(+) Amount to Charity
$0
$0
$2,693,107
$3,847,296
(=) Total Benefit
$3,211,000
$4,579,000
$5,383,259
$7,808,392

* The Andersons will receive an income tax charitable deduction of $542,790. Based on a marginal tax bracket of 40% they will save $217,116. It is assumed the stock is transferred to the CRT prior to any asset sale.

** Assets are reinvested at projected total return of 8% (5% ordinary income and 3% LTCG). Tax savings from charitable deduction are included.

***Assumes death following 2010 at a rate of 55%.


Estate Planning Considerations

Because Pete and Mary will be the sole income recipients of the unitrust, the entire amount that is ultimately distributed to charity will receive an unlimited gift and estate tax marital and charitable deductions.

It is important to note that even though the Andersons' heirs will not receive an inheritance from the unitrust, their opportunity cost will not be the original value of the property transferred to the unitrust; rather, it is the amount the heirs would have received had the Andersons 1) kept the stock and passed it through their estates, subjecting the transfer to possible estate taxes, or 2) sold the stock, paid capital gains taxes, and then passed the remainder through their estates, again subjecting it to possible estate taxes.

This latter scenario could leave the children with as little $760,500 from the original $3,000,000. This represents a combined tax erosion exceeding 74%!

Wealth Replacement

One of the Andersons' stated objectives is to optimize the amount passing to their family. As an adjunct to the charitable remainder unitrust, the Andersons will create a second trust called a Wealth Replacement Trust. As its name implies, the purpose of wealth replacement is to replace, for the Anderson family, the amount being transferred to charity via the charitable remainder trust.

The Andersons will make annual cash gifts of $19,700 to the Wealth Replacement Trust for as long as either are alive. The gifts will be structured so they qualify for the annual gift tax exclusion; accordingly, no taxable gifts will occur (until the death of one spouse). The trustee will use the annual gifts to purchase a life insurance policy that insures the lives of Mr. and Mrs. Anderson.

After Mr. and Mrs. Anderson have both died (or they reach age 100), $3,000,000 will be distributed to the Andersons' heirs, in accordance with the terms of the trust. Most importantly, because the Andersons retain no incidents of ownership in the life insurance policy, the heirs will receive the policy proceeds income, gift, and estate tax-free.4



Option 1
Option 2
Option 3
Option 4

Asset Sale /
Liquidation
Stock
Sale
CRT / Asset
Sale /
Liquidation
CRT /
Stock
Sale
Benefit Summary with
Wealth Replacement:





Net Cash Flow During Life
$2,450,000 $3,494,500 $2,690,152 $3,961,096
(-) Insurance Premiums*
n/a
n/a
$492,500
$492,500
(=) Net Cash Flow with
Wealth Replacement

n/a

n/a

$2,197,652

$3,468,596
Wealth Replacement / Estate Proceeds
$760,500 $1,084,500 $3,000,000
$3,000,000
Net Cash Flow + Net Estate=
Total Family Benefit

$3,211,000

$4,579,000

$5,197,652

$6,468,596
(+) Amount to Charity
$0
$0
$2,693,107 $3,847,296
(=) Total Benefit
$3,211,000
$4,579,000
$7,890,759
$10,315,892

* Assumes annual premium of $19,700 payable for joint lives of 25 years or until the policy endows at age 100. Assumes variable life contract at 8% projected rate of return. Rates not guaranteed.


Summary

By creating a charitable remainder unitrust, not only can the Anderson family mitigate their income tax liability at the shareholder and possibly the corporate levels, they can:

  • enjoy approximately equal or greater cash flow over their lifetimes,
  • provide a mechanism for the management of their financial assets,
  • increase the net estate to their heirs, and
  • place millions of dollars with the worthy charitable organization(s) of their choice!


Disclaimer: Case studies are provided by the Planned Giving Design Center for educational purposes only and are not intended to constitute legal, tax, accounting, or investment advice. The reader should be aware that interpretations of tax law and fact patterns, financial returns, and tax projections contained herein are not guaranteed and can vary significantly. You are, therefore, urged to seek independent counsel prior to relying upon any concept contained herein.


  1. A charitable remainder trust is taxable if it produces any unrelated business taxable income; however, with proper planning, this can be avoided.back

  2. When long-term capital gain property is contributed to a public charity, the deduction can be used against 30% of the donor's adjusted gross income in the year of contribution with a five-year carryover of any excess deduction. Depending on the amount and tax character of the donor's income, the donor may not be able to utilize all of the deduction in the time allowed or may realize tax savings based on a lower marginal tax bracket (e.g., if the taxpayers are subject to alternative minimum tax).back

  3. Although the charitable remainder unitrust can avoid paying capital gains tax on the sale of the stock, the income payments may be taxable based what is known as the "four-tier system." In general, ordinary income produced by the trust is considered distributed first, following by capital gains, tax-exempt income, and principal, in order.back

  4. The use of a trust to own life insurance is not mandatory to accomplish these results. As an alternative, insurance can be owned directly by the heirs. Trusts are frequently used to insulate the policy from potential creditors of the heirs and to otherwise provide greater flexibility with respect to policy distributions.back

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Comments

Great comparison and examples

This was very helpful. It's difficult to find real information on the web, and this article goes into the right level of depth on weighing four obvious ways to sell a c corp. I have friends that have formed new companies with the intent of selling via attracting a c-corp buyer. Oddly, some of them formed as LLC's. Found this article that described some of the startup/operation differences: Incorporate as an LLC, S-Corp, or C-Corp. It didn't however, touch on the exit strategy. This article does.

Valuation and assignment of income

I appreciate that a case study can't be "muddied" by every "reality", but two consideration should be addressed. First, if a sale is "at the door" caution must be exercised to not fall into an "anticipatory assignment of income" attack. As most clients don't come to this point without an acceptable offer in hand this is not a remote a concern. Second, assuming that you avoid the first issue, can't the value of the CRUT contibution be "tax effected" to reflect at least the taxes likely paid on a liquidation? Or, worse, tax effected for a "taxable owner's situation"? These could meaningfully reduce the charitable deduction. When the proceeds "hit" the unitrust amount would recover.

Observations on C Corp Sale vs. CRT

Two observations: 1. The format to analyze the four alternatives is very good, but I have to believe that the selling price of the stock would be significantly less than a sale of assets due to the inherent C corp. tax. Thus, I don't believe the numbers as stated are a fair comparison. 2. The final chart of numbers adds the life insurance component but does not adjust for the fact that the premiums are all paid before the proceeds kick in. An interest factor should be included to make an apples-to-apples comparison.

Anderson Case Study

I would like to see the premiums for life ins based on Gtd Survivor UL policy...8% is a bit bullish for these times, especially when you look at the very poor performance of VUL over the past several years.

Response to Observations

Tom, Thanks for your comments; both are well taken. Contingent tax liabilities are certainly an issue that can, depending on the type of business and its depreciable asset structure, drive the price of a stock sale down. However, for purposes of education and not to confuse a comparison of the numbers any further, we decided to stick with like values. Donors contemplating using a CRT for these purposes should explore the tax economics of taking a lower price to facilitate a stock sale. Regarding your second comment, it is certainly prudent to apply discounted cash flow analysis to all cash flows contained in the analysis, not only the terminal value of the life insurance.

Payment of income tax by corp owned by CRT

If the trustee is owner of the shares in a closely held C corp, and the assets of that corp are sold, wouldn't the payment of income tax upon such asset sales proceeds be an impermissible distribution that would disqualify the CRT?

Payment of income tax by corp owned by CRT

No, because the tax payment would be made by the corporation and not by the CRT; therefore, it would not be a distribution from the trust.

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