Coordinating charitable trusts and private foundations for the business owner: complying with UBIT and self-dealing rules.

• Author: Phillips, Matthew S.
• Position: Unrelated business income tax

For many closely held business owners, the bulk of their wealth is tied to the business to which they have devoted the better part of their life growing. With such a concentration of assets, and the illiquidity that generally goes along with it, charitable planning using charitable trusts and private foundations can be more difficult. This item details some charitable giving options for owners of closely held businesses, the applicable unrelated business income and self-dealing rules, and best practices for taxpayers who have these charitable desires and restrictions.

Charitable Trust and Private Foundation Basics

Through the use of charitable trusts, donors can achieve their goals of providing meaningful gifts to their favorite charity, with the added benefits of passing wealth to the next generation and obtaining favorable tax treatment. From a tax perspective, charitable remainder trusts (CRTs) and charitable lead trusts (CLTs) can offer three main benefits. First, the donor may take an income tax deduction for the remainder interest or lead interest that is calculated as going to charity (Sec. 170(b)(1)(A)), reduced by the amount that would be taxed as ordinary income if sold by the donor, though a CLT must be a grantor trust to qualify.

When computing the charitable deduction for transfers of long-term capital gain property, no reduction for the allocable built-in gain is necessary, although special rules apply to transfers of tangible personal property unrelated to the charity's exempt purpose (Sec. 170(e)(1)(A) and Regs. Sec. 1.170A-4(a)). Second, the portion of the trust given to charity will be removed from the donor's estate and thus avoid the 40% estate tax (for persons with estates over $5.34 million, the 2014 unified estate and gift tax exemption amount). Lastly, creating a charitable trust and transferring appreciated property allows the donor to avoid the capital gains tax that would have been due if the property were sold by the donor individually. Because CLTs are required to be grantor trusts to receive the income tax deduction upon creation, there will be no double income tax benefit if appreciated property is transferred to the trust and later sold, as any future sale by the trust will be recognized by the grantor.

Charitable remainder trusts: Just as its name implies, a CRT pays an annuity or percentage amount (known as a unitrust, if the trust agreement calls for a percentage payout) to a designated beneficiary for a term of years (not to exceed 20) or the life of the beneficiary, with the remainder passing to a charity selected by the trust's settlor. The trust agreement needs to meet a number of specific requirements for the trust to qualify as a CRT and obtain the favorable treatment outlined above (see Sec. 664(d) and Regs. Secs. 1.664-1(a) and -3(a)). To make the drafting of charitable trusts more of a science than an art, the IRS published "safe-harbor" draft trust agreements with alternate provisions and annotations, giving examples of trusts that would satisfy all the requirements of a qualified CRT (see Rev. Procs. 2005-52 through 2005-59).

CRTs are the best alternative when settlors would like to provide a current benefit to themselves, or their descendants, for life or a term of years, with the remainder passing to a charity of their choice. These trusts can provide a stable, annual cash flow stream for the settlor or the settlor's loved ones, bringing peace of mind. The optimal time for creating a charitable remainder trust is during a tax year when the settlor expects to recognize greater-than-average taxable income.

Charitable lead trusts: A CTT is essentially the reverse of a CRT. The grantor establishes a trust that makes an annual payment to charity for a stated number of years or for a period measured by one or more related persons' lives, with the remainder passing to the donor or a person selected by the donor in the trust agreement (Regs. Sec. 20.2055-2(e)(2)(vi)(a)). As discussed above, a CLT must be set up as a grantor trust, with all the trust's income reported on the grantor's individual return, in order to qualify for an income tax charitable deduction. In addition, if the grantor dies during the term of the CLT and is thus no longer responsible for...