Privately-Held Business Interests

Privately-Held Business Interests

Technical Report posted in Privately Held Business Interests on 2 May 2003| comments
audience: National Publication | last updated: 16 September 2012
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Abstract

Privately-held business forms include sole proprietorships, general and limited partnerships, C-corporations, S-corporations, and recently created limited liability companies. In the context of charitable gift planning, the diversity of business forms and the rules that apply to each regarding taxation, ownership, transferability, liquidity, marketability, and income producing capability place them, as a category, at the pinnacle of complexity. This memorandum focuses on outright transfers of privately-held business interests to public charities and private foundations, as well as transfers to charitable remainder trusts and charitable lead trusts.

Privately-held business forms include sole proprietorships, general and limited partnerships, C-corporations, S-corporations, and recently created limited liability companies. In the context of charitable gift planning, the diversity of business forms and the rules that apply to each regarding taxation, ownership, transferability, liquidity, marketability, and income producing capability place them, as a category, at the pinnacle of complexity.

This section focuses on outright transfers of privately-held business interests to public charities and private foundations, as well as transfers to charitable remainder trusts and charitable lead trusts.

  1. Sole Proprietorships
  2. Partnerships - General and Limited
  3. C Corporations
  4. S Corporations
  5. Limited Liability Companies
  6. Other Issues

Sole Proprietorships

Sole proprietorships are the simplest business form. They require no formal documentation or registration other than, perhaps, securing a business license and filing or publishing a fictitious name statement. Although sole proprietors avoid the complexities inherent in other business forms, such simplicity comes at the cost of the proprietor remaining personally liable for all debts and other legal liabilities of the enterprise.

A sole proprietorship can be owned by an individual or by a husband and wife. A sole proprietorship cannot be owned by a charitable organization or charitable trust. Therefore, the transfer of a sole proprietorship to such an entity consists of a transfer of the assets of the proprietorship.

Sole proprietorships are comprised of capital, tangible, and intangible assets. These assets may include real property, plant and equipment, inventory, receivables, and goodwill. For tax purposes, the assets of the business and the owner are considered one and the same. Therefore, all items of income and expense, gain and loss, are considered those of the owner.

Outright Gifts

In general, net taxable income produced by a sole proprietorship is considered unrelated business income.

The term "unrelated business taxable income" is defined as the gross income derived by any organization from any unrelated trade or business (as defined in IRC §513) regularly carried on by it, less the deductions allowed which are directly connected with the carrying on of such trade or business, both computed with certain modifications.1

For this reason, transferring the assets of an operating sole proprietorship to a public charity or private foundation may be inappropriate because the continuation of the business may produce taxable income to the recipient. The effect on the organization can range from benign to catastrophic. In general, the receipt of unrelated business taxable income (UBTI) by an IRC §170(c) organization will not cause the recipient to lose its tax-exempt status, thereby exposing all its income to tax; rather, it will pay income tax on amounts attributable only to its UBTI. However, if the organization exploits its tax-exempt status with a disproportionate share of UBTI to its overall income, it may place its tax-exempt status at risk.

Transfers of Sole Proprietorship Assets to Charitable Remainder Trusts

As stated earlier, a charitable organization or trust cannot own a sole proprietorship. Therefore, a transfer will consist of the underlying assets of the business. The continued operation of the business by a charitable remainder trust is not generally recommended because the trust loses its tax-exempt status for any year in which it generates unrelated business taxable income (UBTI). In such years, the trust is taxed as a complex trust paying tax on ALL its net income (including non-UBI and gains from the sale of trust assets). In addition, the transfer of debt-encumbered property may cause the trust to have "unrelated debt-financed income" under IRC §514 and otherwise cause it to be treated as a grantor trust.2

Finally, the continued use of trust assets for the benefit of a disqualified person (e.g., the trust/former business owner) may constitute a prohibited act of self-dealing under IRC §4941.

Transfers of Sole Proprietorship Assets to Charitable Lead Trusts

The transfers of assets of an operating sole proprietorship to a grantor or nongrantor charitable lead trust may not be so onerous. All income attributable to a grantor CLT is taxable to the grantor regardless of its characterization as unrelated business income. On the other hand, nongrantor CLTs are taxed as complex trusts. Under normal circumstances, the trust receives a charitable deduction against its taxable income for amounts distributed to charity in satisfaction of its annuity or unitrust amount. However, the deduction is unavailable for unrelated business taxable income. In essence, the trust may pay income tax on amounts distributed to charity.

Planning Alternatives

As an alternative to transferring an operating sole proprietorship, it may be more appropriate to discontinue business operations and/or contribute selected assets of the business that do not produce unrelated business taxable income (e.g., certain rents from unencumbered real property).

These issues are discussed in greater detail in the following section on Partnerships -- General and Limited.


  1. IRC §512(a)(1)back

  2. Ltr. Rul. 9015049back

Partnerships - General and Limited

A partnership is a joint undertaking by two or more individuals or entities whereby they pool their money, labor, skills or other items in a business and they share in the profits and losses that result. The partnership may own virtually any type of asset. The partners may or may not enter into a written partnership agreement.

In general, a business entity with two or more members may be classified as either a partnership or a corporation for tax purposes.1 The "check-the-box" rules under the Regulations to IRC §7701 now determine whether an entity with two or more members is to be classified as a partnership for federal tax purposes.2 A partnership is subject to special tax treatment under Subchapter K of the Internal Revenue Code. Most partnership items of income, gain, loss, deduction and credit simply pass through to the partners on some agreed basis, such as on a pro rata basis, and the partners report these items on their own tax returns. The partnership itself does not pay tax but it files informational returns reporting the items that have passed through to the partners. Certain elections must be made at the partnership level.

Because of the nature of the partnership entity, the partners may agree to place various restrictions on the transfer of interests in the entity.

General Partnership

General partnerships may be established without any formal documentation or registration, although it may be necessary to obtain business licenses and/or secure the right to use fictitious names. In a general partnership, each partner is personally liable for the debts of the partnership.

Limited Partnership

As distinguished from general partnerships, limited partnerships are creatures of state law and formal registration is necessary to create a limited partnership. Although the specific requirements may vary from state to state, in most cases a certificate of limited partnership is filed with the appropriate state agency and registration fees are paid. Note that a family limited partnership is simply a limited partnership where most or all of the interests are held by family members.

A limited partnership has at least one partner, known as a general partner, who is personally liable for the debts of the partnership and at least one partner, known as a limited partner, who is not personally liable for the debts of the partnership. In other words, a limited partner is only liable for the partnership's debts to the extent of the assets he or she has contributed to the partnership. The general partners usually have more rights to manage the partnership business than do the limited partners. State law often determines to what extent a limited partner may participate in management without being treated as a general partner.

Outright Gifts

In order for the transfer to be valid, the partnership agreement must contain language that permits the transfer of a partnership interest to a charity or permits a transfer with appropriate consent.

Self-Dealing

If a partnership interest is contributed to a private foundation, the self-dealing rules are implicated. Since a partnership for tax purposes is generally viewed as a pass-through or conduit entity, any business activity conducted by the partnership must be analyzed in this regard (i.e., leases, loans, and debt of the partnership). For further reading, see Application of Private Foundation Excise Taxes in Other Issues.

Intermediate Sanctions

If a partnership interest is contributed to a public charity, the intermediate sanctions rules should be considered.

Excess Business Holdings and Jeopardy Investments

If a partnership interest is contributed to a private foundation, the excess business holdings and jeopardy investment rules of IRC §§4943 and 4944 are implicated. For further reading, see Application of Private Foundation Excise Taxes in Other Issues.

Unrelated Business Income Tax

As with a sole proprietorship, if the partnership is engaged in an unrelated trade or business, gross income and deductions from such trade or business will be included within a private foundation's or public charity's computation of unrelated business taxable income.3

Bargain Sale of Limited Partnership Interest

If a limited partner contributes his entire limited partnership interest to a charitable organization, a charitable contribution deduction is allowed under IRC §170 if the value of his share of the partnership assets exceeds his share of partnership liabilities at the time of the transfer. However, pursuant to IRC §§752(d) and 1011(b), the value of the donor's share of partnership liabilities at the time of the transfer constitutes an amount realized by the donor. Therefore, the donor must recognize gain on the transfer equal to the excess of the amount realized by the donor over that portion of the adjusted basis of his partnership interest, at the time of the transfer, allocable to the sale under IRC §1011(b).4

See Gift Vehicle Review -- Bargain Sales

Transfer Taxes

State and county transfer taxes may apply to a transfer of real estate. Some jurisdictions also require the payment of transfer taxes when a partnership interest in a partnership that owns real estate is transferred.

Planned Gifts

As with the assets of a sole proprietorship, partnership interests may prove to be poor candidates for transfer to a charitable remainder or lead trust because the underlying enterprise may conduct activities that could adversely impact both donor and trust. The contribution of a partnership interest is only appropriate after a full consideration of all potential issues.

Transfers of Partnership Interests to Charitable Remainder Trusts

As a pass-through entity, the major concern regarding the transfer of a partnership interest to a charitable remainder trust involves the character of the income earned by the trust. A charitable remainder trust loses its tax-exempt status in any taxable year in which it incurs unrelated business taxable income (as described in §IRC 513). Unrelated business income can be produced by 1) a trade or business that is regularly carried on by the partnership which is unrelated to the tax-exempt purpose of the trust (presumably any trade or business would be unrelated), or 2) ownership by the partnership of property that causes debt-financed income (as described in IRC §514).

The loss by the trust of its tax-exempt status could be particularly devastating in a year in which an appreciated asset is sold (such as contributed property).5

Self-Dealing

Charitable remainder trusts are subject to private foundation excise taxes imposed on acts of self-dealing between the trustee and a disqualified person.6

Excess Business Holdings and Jeopardy Investments

A charitable remainder trust will not be subject to the excess business holdings or jeopardizing investment rules unless it includes as an income recipient an IRC §170(c) organization.7 Specimen trusts published by the IRS include these two prohibitions (most likely in an effort to cover the possibility that charity will be an income recipient).

If applicable, the jeopardizing investment rules could come into play if the trustee decides to hold the one issue of stock for investment purposes (due to lack of diversification). Regarding excess business holdings, the trustee has five years to dispose of the stock (with a possible five-year extension).8 Accordingly, if the transfer is followed by a sale, these two problems should disappear. Ltr. Rul. 9210005 confirms that charitable remainder trusts are exempt from the excess business holdings and jeopardizing investment rules per IRC §4947(b)(3)(B).

Limited Partnership as a Trustor

In Ltr. Rul. 9419021, a taxpayer asked (a) if a limited partnership is a permissible grantor of a charitable remainder trust, (b) if the partnership is a permissible recipient of the unitrust payments, and (c) whether the trust is a qualified charitable remainder unitrust under IRC §664(d).

The trust will pay the unitrust amount to the donor for a term not to exceed 20 years. It has also been represented the unitrust amount will be greater than five percent of the net fair market value of the assets to be determined annually and that an independent trustee will be appointed.

The Service ruled there is nothing in IRC §664 or the underlying regulations that would prohibit a partnership from being a permissible donor to an otherwise qualified charitable remainder unitrust as long as all the partners are permissible donors. In addition, the Service noted that IRC §7701(a)(1) defines a "person" to include an individual, trust, estate, association, company, corporation, and partnership.

In the present situation, the proposed trust will provide that the unitrust amount is payable to the donor, a partnership, for a term not to exceed 20 years. Because the term of the trust is for a term of years, the recipient of the unitrust amount may be any person or persons, including a partnership, so long as at least one such person is not a charitable organization. The partners are not charitable organizations. Thus, both the partnership and the partners are permissible recipients, and the donor is a permissible recipient of the unitrust amount.

Planning Opportunity: Distribution Followed by Transfer

The potential problems created by transferring a partnership interest to a charitable remainder trust can be mitigated or eliminated by partial or complete distribution of partnership assets to the partner. A distributee partner realizes gain only to the extent that distributed money exceeds the partner's basis in his or her interest.9 No gain is recognized to a distributee partner, with respect to a distribution of property other than money, until he sells or otherwise disposes of such property, except as otherwise provided by IRC §736 (relating to payments of a retiring partner or a deceased partner's successor in interest) and IRC §751 (relating to unrealized receivables and inventory items).10 Therefore, under certain circumstances, a partner might be able to receive a distribution of property from a partnership followed by the transfer of compatible property from such distribution to a charitable remainder trust without recognition of gain. However, it should be noted that the definition of money also includes marketable securities.11

Publicly Traded (Master Limited) Partnerships

Whether a publicly traded or master limited partnership is suitable for transfer to or investment in a charitable remainder trust depends on whether the partnership produces unrelated business taxable income under IRC §512(c). The Omnibus Budget Reconciliation Act of 1987 amended §512(c) by adding §512(c)(2). It provided that any organization's share (whether distributed or not distributed) of the gross income of a publicly traded partnership (as defined in IRC §469(k)(2)) acquired after December 17, 1987 is treated as income derived from an unrelated trade or business. The section further provided that an organization's share of partnership deductions are allowed in computing unrelated business taxable income.12

IRC §512(c)(2) was short-lived, however. The Omnibus Budget Reconciliation Act of 1993 repealed it for partnership years beginning on or after December 17, 1994. While the repeal removed the automatic classification of publicly traded partnership income as UBTI, a determination must still be made as to whether the partnership income represents UBTI on the basis of IRC §512(c) itself.

Installment Obligations Owned by Partnership

The transfer to a charitable remainder trust of a partnership interest that owns an installment obligation may accelerate any gain attributable to the installment obligation to the donor.13 The amount recognized is the partner's share of the fair market value of the obligation over his or her share of the partnership's basis in the obligation. Like other transfers of installment obligations, the donor's deduction is based on the fair market value of the obligation.

Debt-Encumbered Property Owned by Partnership

Debt on partnership assets is treated as a liability of the owner of the property.14 Accordingly, the transfer of a partner's interest to a charitable remainder trust is considered a relief of such indebtedness to the partner. Such transfers expose the donor and trust to all of the issues of debt-encumbered property including self-dealing, grantor trust and unrelated business income tax issues.15

Transfers of Partnership Interests to Charitable Lead Trusts

Certain types of partnership interest (e.g., a family limited partnership) interests may be ideal funding assets for certain forms of charitable lead trusts -- specifically, the nongrantor/nonreversionary CLT, which is used to transfer the remainder interest to heirs at reduced gift and estate tax cost.

Discounts

From a gift and estate tax valuation standpoint, the sum of the parts of certain types of partnerships do not always make a whole. A number of value discounts may be available. These include:

  • Minority interests;
  • Marketability and liquidity;
  • Business risks; and/or
  • Key person

Unrelated Business Income Tax

If the trust is a non-grantor charitable lead trust, i.e. the donor is not treated as the owner of the trust for income tax purposes, then the trust is a taxable entity (unlike a charitable remainder trust). The trust itself, however, is entitled to a charitable deduction for amounts distributed to the charity.16 However, a deduction is not allowed for amounts allocable to unrelated business income realized by the trust during the taxable year.17 Since the partnership's activities determine whether unrelated business income tax will be incurred18, great care must be given prior to the contribution of a partnership interest to a non-grantor charitable lead trust. In contrast, the unrelated business income tax rules should have no application to a grantor charitable lead trust, because the grantor (a non-charity) will incur all taxable income of the trust.

See Charitable Lead Trusts -- Taxation of Charitable Lead Trusts

Self-Dealing

Charitable lead trusts are subject to private foundation excise taxes imposed on acts of self-dealing between the trust and a disqualified person.

Excess Business Holdings and Jeopardy Investments

The excess business holdings and jeopardy investment rules regarding private foundations apply when the value of the charitable lead interest at the creation of the trust exceeds 60% of the total value of the trust's assets or if a portion of the income interest is not paid to charity.19


  1. Reg. §301.7701-2(a)back

  2. Prior to the check-the-box rules, the Regulations provided complex rules which determined an entity's classification depending upon how many corporate characteristics the entity possessed.back

  3. IRC §512(c)back

  4. Rev. Rul. 75-194, 1975-1, C.B. 80back

  5. IRC §664(c). See also Ltr. Ruls. 7943062 and 9633007, and Leila G. Newhall Unitrust v. Commissioner, 104 T.C. 236back

  6. IRC §4947back

  7. IRC §4947(b)(3)(B)back

  8. IRC §4943(c)(6), (7)back

  9. IRC §731(a)(1)back

  10. Reg. §1.731-1(a)(1)back

  11. IRC §731(c)back

  12. §10213(a) of the Omnibus Budget Reconciliation Act of 1987, Pub. L. 100-203, 101 Stat. 1330-406back

  13. IRC §453Bback

  14. IRC §752back

  15. Ltr. Rul. 9533014back

  16. IRC §642(c)back

  17. IRC §681back

  18. IRC §512(c)back

  19. IRC §4947(b)(3)back

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