Suitability Key to Utilizing a CRT to Sell a Business
In Part 1 of this two-part series, we met a business owner confronted with the need to reduce the tax bite arising from implementing an exit strategy from his family business. We introduced a CRT as a component of an overall strategy to avoid capital gains and net investment income tax, create a significant income tax deduction, provide the business owner with income for life, and fund a significant charitable gift at death. In Part 2, we will discuss four suitability considerations in creating a CRT and explore ways to avoid the two most common hazards encountered when using a CRT to sell a business.
Four Key Suitability Considerations
Not All Business Entities Are Created Equal
Throughout Parts 1 and 2, we refer to “company stock” by which we mean C-corporation stock or limited liability company (LLC) membership interests where the LLC is taxed as a C-corporation. This choice is intentional because businesses taxed as C-corporations are the easiest to sell using a CRT.
However, businesses are frequently organized in other forms, such as S-corporations, LLCs taxed as S-corporations or partnerships, or general or limited partnerships. While it may be possible to utilize a CRT with each of these forms, the use of a CRT requires additional analysis and significant care. For example, if an ownership interest in an entity taxed as an S-corporation is contributed to a CRT, the entity’s S-election will automatically terminate because a CRT is not a permissible shareholder or member (but preserving this election may not always be important to the buyer). Further, because the operating income of pass-through entities retains its character in the hands of the CRT trustee, the potential imposition of the 100% excise tax on unrelated business taxable income (UBTI) must be considered.
Finally, regardless of the business form, if a business interest has been pledged as security for a loan, the security interest should be removed prior to transfer to a CRT.
Not All Business Sale Transactions Are Created Equal
The sale of a family business may be structured as the sale of an ownership interest in the entity (e.g., stock, partnership interest, or LLC membership interest) or as a sale of the entity’s assets followed by a liquidation of the entity (an asset sale). Funding a CRT with C-corporation stock when the sale transaction is an asset sale will not generate the same tax benefits as a sale of the stock because the corporate-level tax on the sale of the corporation’s assets cannot be sheltered by the CRT. The sale of a pass-through interest using a CRT is generally tax neutral when comparing an asset sale with a sale of the ownership interest. However, note that in this case, the sale of assets securing a loan will produce UBTI, which should be avoided.
A CRT is a separate legal entity that must keep its own records and file its own tax returns. Further, in exchange for the tax benefits conferred on a CRT by the Internal Revenue Code, a CRT trustee cannot engage in prohibited acts of self-dealing such as:
- Selling the company to the donor or certain members of the donor’s family,
- Loan transactions between the company and the donor or certain members of the donor’s family while the company is owned by the CRT, or
- The company’s leasing of property from the donor or the donor’s family while the company is owned by the CRT.
These same transactions are also self-dealing outside the company context when entered into between the CRT trustee and the donor or certain members of the donor’s family. Monetary penalties are imposed on both the CRT trustee and the disqualified party when they engage in an act of self-dealing.
The transfer of company stock to a CRT is irrevocable and cannot be unwound, even if a potential buyer walks away. Accordingly, a business owner should carefully consider the probability of a sale (including the possibility of no sale) prior to committing to a CRT.
Two Common Hazards
CRTs can confer great benefits to business owners, but there are traps for the unwary. Therefore, when using a CRT to sell a family business be sure to avoid the following hazards: (a) failing to transfer the company stock before entering into a binding agreement, and (b) failing to obtain a qualified appraisal.
Failing to transfer company stock before entering into a binding agreement
The biggest danger we encounter is the failure to transfer company stock before entering into a binding agreement to sell the stock. Under the tax rules, the owner of the stock at the time an agreement to sell the stock becomes binding must pay any tax resulting from the sale even if the deal hasn’t closed. When does an agreement become binding? As a general rule, an agreement is binding when the buyer can compel the seller to sell. The most obvious example of a binding agreement is a signed purchase agreement. Additional examples include a binding letter of intent and a purchase option binding on the seller.
Failing to obtain a qualified appraisal
When a company’s stock is not traded on an exchange, to substantiate the charitable income tax deduction, the owner of the stock must obtain (and pay for) a qualified appraisal of the stock actually transferred to the CRT. What happens if the stock owner fails to obtain a qualified appraisal? The IRS has consistently denied (and successfully defended the denial of) a charitable income tax deduction where an appraisal is deficient or was not obtained. To be a “qualified appraisal,” an appraisal must comply with strict IRS guidelines. Therefore, the stock owner should ensure the selected appraiser is familiar with these guidelines and will certify the valuation to the IRS. Moreover, a qualified appraisal (paid for by the trust) may be required to re-value the stock annually until the CRT sells the stock.
In this two-part series we laid out a roadmap for business owners and their advisors to successfully use a CRT to sell a family business. We explained that a CRT can help a business owner avoid capital gains and net investment income tax, create a significant income tax deduction, provide the business owner with income for life, and fund a significant charitable gift at death. Finally, we’ve identified traps for the unwary and other relevant considerations.
For more information on CRTs, download our CRT Handbook.