Charitable Planning Technique for Selling Shareholders

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By Dan Weinmann,
Managing Director

For owners fortunate enough to have a business value that exceeds what they need to support their retirement lifestyles, many options on reducing estate taxes and taxable gain on a sale of the business are available.  One option involves giving significant money to charities, while passing an equivalent amount to their children/heirs—estate tax free—and while avoiding tax on the sale of their business.  Even for owners not particularly charitably inclined, this strategy offers the ability to avoid tax, make a large charitable gift, and still deliver more money to children (heirs) as a result, which most business owners would consider a win-win(-win).

Most shareholders in privately held businesses have a relatively small tax basis in their companies. This is a result of either forming the business many years ago and achieving growth in the company, or pulling their basis out in the form of distributions as income.  In either case, when they sell their companies, they will have a gain to the extent the sale price exceeds their basis.  Just like any other appreciated property (art, coins, collectibles, etc.), the IRS allows a tax deduction at full market value for property contributed to a 501(c)(3) charitable organization.  This goes for stock or membership units (ownership) interests in a business as well, resulting in a tax-deductible charitable gift at the “pre-tax” value, and the owner never pays taxes on the gain attributable to the gifted portion of the company.  This is fine for those charitably-inclined people that don’t have other purposes for those proceeds, but it is a problem for those who need to use some of that money for income during their lifetime or prefer giving the money to their heirs.

In order to replace the money donated to charity, the primary options are investing the tax deduction and/or using the income from a Charitable Remainder Trust (CRT) to invest. But, using life insurance as a “replacement” for the funds donated accomplishes another purpose: a leveraged, tax-free payment to the heirs of the estate.  Insurance also allows you to target the exact amount you want to leave to heirs, and using an Irrevocable Life Insurance Trust (ILIT) allows you to make a gift of the premiums, not the final “replacement” amount.  Using a CRT does help in that regard to fund the life insurance because you can use not only the tax deduction proceeds from the pre-tax transfer of shares, but you can also take income from the trust to help fund the life insurance (if you need to).  Otherwise, you can use trust income during the donors’ lifetimes for income needs.

Bringing the concepts together results in the following example plan:

  1. Business owner gives gift of shares (units) to a CRT before a sale of the company identifying charities as beneficiaries on a pretax basis.
  2. Buyer buys shares (or proportional assets) from the CRT to fund eventual cash gift (CRT pays no tax).
  3. Seller uses tax deduction and/or income from the CRT to fund a life insurance policy inside of an ILIT for the benefit of the heirs.

Result:  Sale of a portion of the company (tax free) with a deduction for the full amount of the pre-tax value, and gifts of similar or equal amounts to charity and heirs without paying tax on the sale of the company.  If structured with the use of exemption amounts, a Seller may be able to pass on the ILIT proceeds without any estate taxes either.  This result would be a tax-free gift to children and charity of a similar amount using the tax deductions to fund the transfer.  You are effectively able to give more money on a tax-free basis to children and heirs by giving money to charity instead of paying tax on the sale of the business.

This is a simplified explanation of the technique, and this type of plan needs to be coordinated with your comprehensive estate plan, tax advisors, and insurance providers in order to maximize plan benefits.  Nonetheless, this strategy is available to most business owners as long as it is identified and planned for in advance of the selling transaction.

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