Using and Abusing Charitable Llcs

• Publication year: 2019
• Author: By Justin T. Miller

Using and Abusing Charitable LLCs

By Justin T. Miller¹

Synopsis: Charitable limited liability companies avoid restrictions that apply to traditional tax-exempt charitable organizations, such as public charities and private foundations. While there is no tax benefit for creating a charitable limited liability company, this article examines how such entities may be used (or potentially abused) to generate charitable contribution deductions.

I. INTRODUCTION

An individual can avoid many of the substantial restrictions that otherwise apply to traditional tax-exempt charitable vehicles—such as donor advised funds, private foundations and charitable remainder trusts—by using a for-profit limited liability company for both charitable purposes and non-charitable business purposes (a "Charitable LLC"). Although the Charitable LLC would not be a tax-exempt entity and the individual would not be entitled to a charitable contribution deduction upon funding the Charitable LLC, the individual would be entitled to passthrough deductions if and when the Charitable LLC actually makes a donation to a charitable organization under section 170 of the Internal Revenue Code of 1986, as amended (the "IRC").

Even though the individual receives no tax benefit for creating a Charitable LLC, the individual arguably could be entitled to a deduction—subject to a likely discount for lack of marketability and lack of control—for donating a membership interest in the entity to a public charity (a "Charity"). However, a new IRC section, Treasury Regulation section, or ruling from the Internal Revenue Service ("IRS") is needed to inform taxpayers whether any of the following circumstances would cause the charitable contribution deduction to be disallowed:

• the individual could receive a reasonable management fee from the Charitable LLC;
• the individual could borrow from the Charitable LLC at a relatively low interest rate;
• the Charity might only be entitled to receive relatively minimal annual distributions; or
• the individual or a related party could repurchase the Charitable LLC interest from the Charity.

In other words, can taxpayers form Charitable LLCs that they control, avoiding the limitations applicable to other charitable vehicles, and still get a charitable contribution deduction for donating a membership interest in the Charitable LLC to a Charity? Can they have their cake and eat it, too?

II. BACKGROUND

In December 2015, Mark Zuckerberg, the founder of Facebook, Inc., announced that he and his wife, Priscilla Chan, were forming the Chan Zuckerberg Initiative as a Charitable LLC to accomplish their philanthropic goals. He pledged to contribute 99 percent of his shares in Facebook (worth approximately $45 billion) to the Charitable LLC.² Given the size of the pledge and the fact that traditional charitable giving structures—such as a donor advised fund,³ private foundation⁴ or charitable remainder trust⁵—were not being used, Zuckerberg's announcement substantially increased the public's and the media's interest in using Charitable LLCs for charitable giving purposes.⁶

Unlike the typical vehicles used for charitable giving, Charitable LLCs are not subject to the same restrictions and limitations under the IRC, Treasury Regulations or state laws.⁷ Although Charitable LLCs are more flexible vehicles for charitable giving, there are two significant reasons why they are not a true substitute for traditional charitable structures:

• Charitable LLCs are not exempt from federal income tax,⁸ and income generally is passed through and taxed to owners;⁹ and
• individuals are not entitled to a charitable contribution deduction upon funding a Charitable LLC, although the owners will be entitled to a passthrough deduction if the Charitable LLC ever makes a donation to a Charity.¹⁰

While there is no tax benefit from funding a Charitable LLC, a huge question remains: what happens if the individual who forms the Charitable LLC donates a membership interest to a Charity that qualifies as a public charity?¹¹ Arguably, the individual could be entitled to a charitable contribution deduction, subject to a discount for lack of marketability¹²and lack of control,¹³ despite the following:

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• the individual could continue to control and manage the Charitable LLC and even receive a reasonable management fee;
• the individual could borrow from the Charitable LLC at a relatively low interest rate;
• the Charity might only be entitled to receive relatively minimal distributions from the Charitable LLC on a regular basis, even though interest, dividends and capital gains from the Charitable LLC's investments generally would be allocated to the Charity (but would typically be exempt from tax for the Charity) based on the Charity's percentage interest;¹⁴ and
• the individual or a related party—such as an irrevocable trust created by the individual for family members for estate planning purposes— could repurchase the Charity's membership interest in the Charitable LLC, as long as the transaction is at arm's length and not part of a prearranged plan or legally binding agreement.¹⁵

Those issues should be addressed by the Legislature, Treasury Department or IRS in the form of a new IRC section, Treasury Regulation section, or ruling, otherwise a taxpayer could be faced with significant taxes, interest and penalties if the IRS later determines that the donation of a Charitable LLC membership interest does not qualify for a charitable contribution deduction. To add to the uncertainty, the IRS announced in January 2017 that it will not rule on whether a charitable contribution deduction under IRC section 170 is allowed for a transfer of an interest in a Charitable LLC to a Charity.¹⁶

Consider the following hypothetical situation:¹⁷

Example 1. Andrew is a senior executive at a large publicly-held company. Upon exercising his nonqualified stock options, Andrew is required to recognize $40 million of ordinary income based on the spread between the exercise price of the options and the value of the stock on the date of exercise.¹⁸ In order to offset a significant portion of that ordinary income with a charitable contribution deduction, Andrew is contemplating various charitable gifting strategies using $20 million in assets. In addition to the benefit of a charitable contribution deduction for income tax purposes, Andrew would like to: (1) continue to have control over the $20 million; (2) have flexibility to utilize the assets for both charitable and non-charitable purposes; and (3) be able to borrow back the $20 million at a low interest rate for personal use and investment purposes. A Charitable LLC may be the only strategy that could offer him that control and those benefits, unlike other traditional philanthropic vehicles, such as a donor advised fund, private foundation or charitable remainder trust.¹⁹

III. AVOID CHARITABLE ORGANIZATION RESTRICTIONS

Charitable LLCs avoid a plethora of restrictions and limitations that otherwise apply to tax-exempt charitable entities and trusts. The Treasury Regulations make clear that an IRC section 501(c)(3) tax-exempt charitable organization must serve a public rather than a private interest.²⁰ They require the organization to "establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests."²¹

Unless a charitable organization qualifies as a public charity²²—generally meaning that it receives a substantial portion of its support from the public²³—it will be classified as a private foundation subject to a significant number of additional operating restrictions. Charitable remainder trusts also are subject to many of the private foundation limitations.²⁴ The restrictions are intended to ensure that charitable vehicles are serving legitimate charitable purposes and not solely acting as a means for the creator of the charitable structure to minimize personal taxes. In contrast, Charitable LLCs are non-transparent, for-profit entities that allow the individual creator to retain absolute management control for private interest as opposed to public interest.

A. No Mandatory Distribution Requirements

Charitable LLCs have no requirement to distribute a specific amount of money each year, which means that Charitable LLCs are not required to actually donate or use any funds for charitable purposes. On the other hand, private foundations typically are required to annually spend a certain amount of money or property—generally, five percent of the fair market value of the private foundation's assets²⁵— on charitable purposes, such as grants to other charitable organizations or reasonable and necessary administrative expenses. If a private foundation fails to distribute the required amount by the end of the subsequent fiscal year, it is subject to a 30 percent excise tax on the undistributed amount. If the required amounts remain undistributed, the private foundation may be subject to an additional 100 percent excise tax on the undistributed amount.

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For charitable remainder trusts, there also are specific requirements for assets to benefit a charitable organization. For instance, federal tax laws require the present value of the remainder interest that will go to a charitable organization at the end of the charitable remainder trust's term be at least 10 percent of the net fair market value of the property transferred in trust on the date of transfer.²⁶ Because a Charitable LLC is not a tax-exempt entity, there are no similar requirements for it to make distributions to a charitable organization or use assets for charitable purposes.

B. No Prohibitions on Self-Dealing

An individual who creates a Charitable LLC is allowed to transact with the entity. In contrast, federal tax law has strict rules prohibiting direct and indirect self-dealing transaction between a private foundation and its...