This cautionary tale is based on the recent tax case of Hohenshead Estate v CommissionerTC note 2023-34. When company owners plan to sell their business, there is often a desire to minimize the income tax generated. This tax actually taxes the increase in the value of a business often acquired over many years and decades in one year. The resulting tax is often at the highest marginal rate, which greatly reduces the net proceeds for the seller.
Several tools are used to reduce income tax in this state Charitable giving an item. When properly planned and executed, three separate objectives are achieved.
Firstly, A portion of the taxable gain from the sale becomes tax-free because a portion of the asset being sold is transferred to an IRS-recognized charitable structure.
second, There is an income tax deduction equal to the fair market value of the estimated assets contributed to the charitable structure. This exacerbates the economic value of the tax savings structure. A portion of the profit is sold tax-deductible by the charitable organization, and the seller receives a charitable deduction equal to the fair market value of the contributed asset. For example, if we sell a business for a taxable profit of $20 million, we can expect a tax of $6 million based on a combined federal and state tax rate of 30%. That leaves the net proceeds at $14 million.
Also note that the seller has no say in how the government spends the $6 million in taxes. If we donate a portion of the company to an IRS-recognized charitable organization, you may direct the funds to be used for Wounded Warrior Projectthe Wish Fulfillment Foundation Or any legitimate charitable cause you are interested in. Note that these funds must be distributed to a 501(c)(3) charitable organization focused on this intended purpose.
If we transferred $5 million to charity before the sale, the same taxable gain is now only $15 million. This is because the net profit decreased by $5 million that was donated to charity. Shares owned by the charity are sold tax-free. The taxable profit is then reduced further by a charitable contribution deduction equal to the fair market value of the share that was contributed to the charity. This results in a net tax of approximately $3 million. However, this is only a small part of the story.
Third goal It is where the magic happens. Contributing valued assets to a well-planned charitable structure provides an economic benefit to the charity and builds significant wealth for the family, usually due to the time value of money. These structures provide independent economic value or wealth to the family and to charities. Careful consideration must be given to the financial and non-financial objectives of each client.
These charitable structures are commonly referred to by acronyms, which leads to a truly alphabetical array of alternatives: CRT (charitable remaining trusts), CLTs (charitable trusts), PIFs (pooled income funds), CHLLCs (charitable limited liability companies), to name a few. For my clients, we always recommend a structure that gives the client control over the investment of the money while it is invested within the charitable structure. These structures can also provide significant asset protection for the client and his family.
An example of a $7 million investment in a PIF (a form of pooled income fund) would provide the following results for a family where the father is 49 and have children ages 28, 24, and 11:
- A contribution of $7 million
- Income tax deduction: $2,171,200
- Expected annual income at 6%: $420,000 annually for the father throughout his life, and upon his death, for his children throughout their lives
- The client can maintain control of the investment
- The trust can own real estate with investment income, if desired
Alternatively, a $3 million investment in a deferred inheritance fund (a form of CLAT) could provide the family with a total benefit of more than $16 million. The charity will also receive more than $8 million. Income tax deduction is provided dollar for dollar in the amount of $3 million. This provides tax savings of $1,289,100. With the tax savings, the net cost of the $3 million investment is only $1,710,900.
Here’s how it works: The client invests $3 million in a deferred inheritance fund. Of this amount, $150,000 is invested in municipal bonds to pay the required annual charitable distributions. The sum of $2,850,000 will be used to obtain a life insurance policy under the deferred inheritance fund. This will provide more than $8 million for the charity and nearly $17 million for the client’s children, exempt from income and estate taxes.
These are just a few of the economic possibilities available with this type of planning. The key is to first define your financial and non-financial goals, such as determining your minimum cash flow and non-earnings needs. Goals may include providing a secure, risk-free income for yourself and your children or other loved ones, or protecting assets for yourself or your loved ones. Then identify the alternatives that best achieve these goals.
What was lost in the case of Hohenshead’s estate v Commissioner
Any potential benefit of the aforementioned type of planning has been lost to the owners of the Commercial Steel Treaty Company (CSTC). CSTC was owned by the taxpayer in the case and his two brothers (collectively, the business owners). The loss in planning benefits is directly attributable to taxpayers’ attitude and behavior of waiting too long for implementation and trying to save money on assessment costs.
The business owners received a letter of intent in April 2015 from a buyer who will pay $92 million for their company. Business owners wanted to contribute to the benefit of this kind Tax planning referred to above, but only if the sale of the company has already closed or been completed. In correspondence with their tax attorney, the brothers indicated they wanted to “wait as long as possible to pull the trigger” on the shareholder. This is partly because if the sale did not go through, the shareholder would own less stock than his two brothers and would have less control over the company.
The stock was donated to Fidelity Charitable two days before the sale actually closed. The taxpayer (who was likely hoping to save a few dollars) did not hire a qualified, IRS-recognized appraiser.
The Court relied on the Income Disclaimer Doctrine to determine that the sale has advanced too far for Fidelity Charitable to be an owner for income tax purposes. This means that the entire gain, including the portion transferred to the Fidelity Charitable, is considered to be owned and taxable in full by the taxpayer at closing for income tax purposes. In other words, the sale or transaction was almost certain to be closed or completed even though the sale had not officially closed for another two days.
The appropriation of income principle is a longstanding “first principle of income tax” that recognizes that income is taxable on those “who earn or create a right to receive it” and that the tax cannot be avoided by “preemptive arrangements and contracts, but skilfully devised.” The Court held that the charitable transfer of shares was subject to a pre-negotiated pending transaction with an established right to the proceeds of the transaction. The court did not believe that the charity Fidelity or the taxpayers had any significant risk that the sale would not close.
Qualified evaluation is important, focus on “qualified”
The case itself is littered with harmful correspondence and testimonial evidence that the taxpayers did not want to contribute any amount if the sale did not close. The result is that our first objective above was lost because the entire sale was taxable to the owner. The court then went further and denied the charitable contribution deduction itself. The taxpayer has not complied with regulatory requirements for proof of deductions Internal Revenue Code Section 170. In particular, the court decided that the taxpayer had not received a “qualified assessment”. Taxpayers got a quote from a qualified appraiser, but used an unqualified, and presumably cheaper, alternative.
The end result was particularly harsh for taxpayers. Fidelity Charitable was contractually entitled to a portion of the sale proceeds even though the entire gain was taxable to the business owner. The business owner also had no right to deduct the charitable contribution due to the lack of a qualified appraiser/appraiser. Certainly not the desired economic result for the taxpayer and his family.
Three lessons we can learn from this case
1. All planning should be implemented much sooner. All planning especially charitable and non-charitable alternatives that involve transfer of ownership prior to the sale should be completed well in advance of the official closing of the sale or transaction. If the sale or transaction progresses too far, you run the risk of disregarding any pre-sale transfers for tax purposes under the Income Allocation Principle. ‘Very far away’ means that there is a real possibility that the sale will not actually close.
Issuance of a letter of intent (LOI), which is usually a non-binding letter, begins the countdown to completion. Try to implement the plan before issuing the LOI, even though the LOI is subject to negotiation. Note that the best planning is done well in advance of the sale. Some of the best results are obtained by planning at least two years in advance of selling.
2. Seek the advice of a qualified tax attorney. A qualified tax attorney can guide you through the maze of decisions regarding business sales. Note that many M&A attorneys specifically say they do not provide tax advice. Reserve and listen to the advice of your tax attorney. Be honest about concerns you may have, such as the possibility that the sale will not go through. Creative solutions may be available.
3. Carefully follow the IRS rules regarding tax planning or tax structure. In tax planning and in life, we should strive to minimize risks and maximize benefits. Here, taxpayers did not bother to hire an IRS-qualified appraiser.
The valuation itself did not include a statement that the valuation was prepared for federal tax purposes, included an incorrect date of contribution (possibly as a result of applying the income appropriation principle), included an earlier date of the valuation, did not adequately describe the method of valuation, was not even signed by the appraiser, and did not include Qualifications of the appraiser, did not describe the contributing property in sufficient detail, and did not include an explanation of the specific basis for the appraisal.
The simplest tip here is to dot the i letters and skip the t letters in time. The cheapest tip may actually be the most expensive, as happened here.