2013 booklet by Central New York Community Foundation

making charitable estate planning work for business owners October 22, 2013

Central New York Community Foundation 315-422-9538 www.cnycf.org

Where the Smart Money Gives. Thank you to our sponsors for making this program possible! gold sponsors Michael Miller, CFA, Managing Director 750 Third Avenue, 20th Floor New York, NY 10017 212-218-4900 ∙ www.colonialconsulting.com Christine Woodcock Dettor, Esq. One Lincoln Center, Suite 900, Syracuse, NY 315-701-6351 ∙ www.bhlawpllc.com Kenneth J. Entenmann, CFA, Chief Investment Officer 120 Madison Street, Syracuse, NY 315-475-8300 ∙ www.for-what-its-worth.com

Estate Planning Council of Central New York

Charlotte G. Crandall, Council Executive 606 State Tower Building, 109 S. Warren Street Syracuse, NY 13202 315-474-6775 ∙ cgcrandall@usadatanet.net Bettina Lipphardt, CPA, CIA 580 South Salina Street Syracuse, NY 13202 315-422-7109 ∙ lipphardt@bonadio.com

continuing education sponsors Gay M. Pomeroy 101 South Salina Street, Suite 600, Syracuse, NY 315-474-7571 ∙ www.mackenziehughes.com Susan Hansen, CFP, CLU, AIF, AEP, President 315-637-5153 ∙ Sue@hansensfinancial.com Madelyn Hornstein, CPA, CEO 443 North Franklin Street, Suite 100 Syracuse, NY 13204 315-471-9171 ∙ www.dbbllc.com Lee M. Gatta, CLU, CLTC, AEP, ChFC 5786 Widewaters Parkway Dewitt, NY 13214 315-350-2460 ∙ www.prudential.com/us/l.gatta Central New York Community Foundation 315-422-9538 www.cnycf.org

Where the Smart Money Gives. October 22, 2013 Good morning, Business owners represent a large portion of the assets in our community. The structure of businesses and their assets presents opportunities and traps for the unwary with respect to charitable giving. Whether a client is transitioning the business assets as part of their retirement plan or as part of their estate plan, there are many ways to create a plan that honors heirs, provides tax savings, and creates a charitable legacy for your clients. Hopefully, our presentation today will help illustrate how to make charitable planning for businesses a success. The Community Foundation staff is available to be a part of your team whenever charitable planning is on the list of topics for your clients. This is true even in situations where the Community Foundation is not going to be a part of the solution. Of course, we are proud of the fact that our framework offers the flexibility to accomplish a wide spectrum of charitable goals. Whether we are helping your client to structure a planned gift for the benefit of our community, or simplifying their current giving through a donor advised fund, we will partner with you to leave your clients feeling happy with the outcome of their planning process. The best way to find out if the Community Foundation can support you in accomplishing your clients’ goals is to ask. We are available when needed to help find the right giving option for your client’s particular situation – be it legal, financial or other. We hope that you will come to think of us as your ‘charitable back office’, freeing you to focus on your area of core competency. We have a wealth of written materials that you can use when working with clients. Additionally, we are also available to meet face-to-face with you individually or including your client. Please contact Tom Griffith, Gift Planning Officer, at 315-883-5544 or tgriffith@cnycf.org with questions or to schedule a meeting. Thank you for joining us this morning. I hope we have an opportunity to work together in the future. Sincerely, Peter A. Dunn President & CEO

Central New York Community Foundation 315-422-9538 www.cnycf.org

Where the Smart Money Gives.

Agenda 7:30 am:

Registration

8:00 am:

Welcome and Introductions

8:10 am:

Presentation by Jonathan Ackerman

9:50 am:

Questions & Answers

Central New York Community Foundation 315-422-9538 www.cnycf.org

Where the Smart Money Gives.

Jonathan Ackerman, Esq. Jonathan Ackerman, Esq. is an attorney from the Baltimore, MD area who focuses on planning giving work for donors and non-profits. He represents donors and tax-exempt organizations on a national basis. For more than 25 years, Jonathan has developed considerable experience in the areas of charitable gift planning, tax-exempt organizations, charitable solicitation laws, federal corporate and partnership taxation, estate planning and probate, IRS practice and procedure, real estate and business formations and transactions. He is a frequent speaker on the topics of charitable gift planning and taxexempt organizations and has published articles in The Journal of Gift Planning, the Planned Giving Design Center, Planned Giving Today, Charitable Gift Planning News, the American Bankers Association Journal, the Southeast Regional Wealth Management Magazine, and the Maryland State Bar Journal. He holds a Law Degree from the University of Baltimore School of Law, as well as a Master of Laws in Taxation Degree from Georgetown University. Jonathan was the 2002 President of the National Committee on Planned Giving and was a member of the NCPG Board of Directors. He was Chair of the 2000 NCPG Conference Committee and served on NCPG's Government Relations Committee. Jonathan recently served on the Partnership for Philanthropic Planning Board of Directors and is currently a Co-Government Relations Advisor to the Board. He also served on the Ad Hoc Committee on Ethics and Accountability in the Nonprofit Sector for the Maryland Association of Nonprofit Organizations. Contact Information: Jonathan Ackerman, Esq. Phone: (410) 363-1187 Fax: (410) 581-0123 jonathan@ackermanlaw.net

Central New York Community Foundation 315-422-9538 www.cnycf.org

[Divider Page] Tab: “Resources for Advisors”

What is a Community Foundation? •

A tax exempt public charity

•

Receives, manages and distributes charitable funds

•

A collection of permanent charitable funds reflecting numerous purposes and philanthropic goals

•

Through its Community Funds, a grantmaking foundation having impact on local needs, concerns and issues

•

A convener and resource for local nonprofits

•

A resource for personal and family philanthropic planning and complex charitable gift plans

Central New York Community Foundation 315-422-9538 www.cnycf.org

Discussing Philanthropy With Your Clients As a professional advisor, you earn the respect of your clients in large part by your willingness to discuss delicate topics and to help clients reach important decisions. A client who knows how to use professional advisors to their fullest will expect them to have independent viewpoints and information about the world that is beyond the client’s own knowledge. Today, philanthropy can be an integral part of a client’s financial and family goals. Much of the growth of community-based philanthropy is due to the efforts of professionals like you suggesting philanthropy as part of the tax and estate planning strategy. The Central New York Community Foundation recognizes the additional time necessary to develop in-depth conversations about charitable giving. We hope to provide valuable opportunities for you to help you solve problems for your clients. This morning’s presentation is one such opportunity. How do you, the professional, initiate the topic of philanthropy with your clients? Think about questions such as these when discussion their goals. 

Beyond family and business, what is important to you?



What does giving mean to you?



What do you want your philanthropy to say about you? Your family?



Which volunteer experiences have been most rewarding to you?

Central New York Community Foundation 315-422-9538 www.cnycf.org

Discussing Philanthropy With Your Clients (cont.) What options does the Central New York Community Foundation offer your clients? We offer a variety of options for permanently endowed funds that provide perpetual support for your community or temporary funds that address needs of immediate interest to your clients.  Community Fund: Responds to the ever changing needs of the community  Fields of Interest Fund: Supports particular causes such as health, human services, education or the arts  Designated Fund: Allows donors to identify specific grants for not-for-profit organizations  Donor-Advised Fund: Offers participation in the grant process by allowing donor suggestions of grants for not-for-profit organizations  Memorial Fund: Becomes a permanent living memorial to a special person  Scholarship Fund: Assists students in a specified area of study or at a particular school, college or university. How can these funds be established? Current Gifts: Cash Appreciated Securities Life Insurance Policies Closely held Stock Corporate Giving Programs Real Estate Charitable Lead Trust

Deferred Gifts: Bequest Under Will Pooled Income Fund Charitable Remainder Trust Charitable Gift Annuity Life Insurance

The Central New York Community Foundation is here to serve the charitable giving and estate planning needs of your clients. For assistance call Thomas Griffith, Gift Planning Officer at (315) 422-9538 or visit our web site at www.cnycf.org.

Central New York Community Foundation 315-422-9538 www.cnycf.org

Ten Reasons To Partner with the Community Foundation ONE

We enable you to broaden your practice by building on our philanthropic expertise.

TWO

We provide highly personalized service tailored to each individual's charitable and financial interests.

THREE

We are a local organization with deep roots in the community.

FOUR

Our professional program staff's knowledge on community issues and needs is available to donors on request.

FIVE

Our donor-advised funds help people invest in the charities they already care about, and learn about new causes to invest in.

SIX

We accept a wide variety of assets, and can facilitate even the most complex forms of giving.

SEVEN

We offer maximum tax advantage under state and federal law.

EIGHT

We multiply the impact of gift dollars by pooling them with other gifts and grants.

NINE

We offer permanence to donors, through endowment funds and multigenerational involvement.

TEN

We are community leaders, convening agencies and coordinating resources to create positive change.

Central New York Community Foundation 315-422-9538 www.cnycf.org

Typical Community Foundation Clients are: Ages 45-75 • •

• • • •

• • • • • • •

Single or Married Facing Tax Consequences or Capital Gains – Sale of Business – Inheritance – Investment Appreciation Civically Engaged; Starting to be or Has Been on NPO Boards Business Owners Wanting to Give Back to Community Entrepreneurial Approach to Giving Anonymity a Possible Concern Ages 70 and Up Single or Married No Heirs, Children are Comfortable or Children are Disengaged Civically Engaged; Been on Many NPO Boards Charitable Intent Perhaps not Self-Perceived as “Wealthy”, “Millionaire Next Door” Desire to Sustain Long Term Charitable Interests Linkage to Estate Planning Conversations

Central New York Community Foundation 315-422-9538 www.cnycf.org

[Divider Page] Tab: “Presentation”

Making Charitable Estate Planning Work for Business Owners

4 Ways to make the list of America’s oldest family companies

October 22, 2013

• STAY SMALL – Half have less than 15 employees

Jonathan Ackerman, Esq. Law Office of Jonathan Ackerman, LLC Owings Mills, Maryland www.ackermanlaw.net

• DO NOT GO PUBLIC – only three are listed on the stock market • AVOID BIG CITIES – of the 50 oldest companies only 7 are located in major urban areas • KEEP IT IN THE FAMILY

Brought to you by:

1 2

America’s 150 Largest Family Businesses

Privately Held Business Entities

• Must have 1 Billion in Annual Revenue to make the list

• C Corporation

Common Characteristics –

• S Corporation

• Single family controls company’s ownership

• Partnerships

• Controlling family members active in top management

• Limited Liability Company

Family involved for at least two generations

• Sole Proprietorship

• 63 are public & 87 are private companies 3

Example #1

ASSUMPTIONS:

• Fred owns 100% of a business that has been in his family for ages – the Bedrock Quarry Company. Fred’s daughter, Pebbles, has no interest in the Company after marrying Moonrock. Fred is ready to sell his stock interest to a willing buyer. Mr. Slate, a planned giving officer at the Bedrock Foundation, suggests that he consider contributing his stock to a CRT and then have the trust sell the stock interest.

• Fair Market Value of Company stock = $5 Million • Fred has 0 basis in the stock • Fred is subject to a 20% federal and state capital gains tax, and a 45% income tax rate

• Fred is attracted to the idea, but wants to know the tax and financial ramifications of such a gift.

•

7% is the gross rate on investments

• The Company stock is Fred (age 68) and Wilma’s (age 65) sole asset 5

Tax

Income Estate Taxes Benefit to Charity

Fred Sells Stock Fred contributes to Outright Charitable Remainder Trust

Example #2

$1 million capital gains tax, leaving $4 million to reinvest $280,000 per year (before tax)

Approximately $1.2 million income tax deduction, which saves in real dollars $540,000, leaving $5 million to reinvest

Now Let’s Say:

Value of the investments are includible in gross estate None

CRT principal excluded but income not spent includible in gross estate

• Peebles gets involved in the family business • Fred owns 51%

$350,000 per year (before tax)

Pebbles owns 49%

• Fred wants to contribute his 51% interest to a CRT and then have the Company buy the stock back, so Pebbles will own a 100% stock interest in the Company

CRT principal will benefit charity at CRT termination 7

The Steps:

The Steps (cont’d):

• Fred creates and funds the CRT with the 51% stock interest in Company

• Pebbles becomes 100% owner of the stock interest in the Company

• Company redeems 51% stock interest from the CRT for cash

• CRT pays income to Fred and Wilma for the rest of their lives, and

• CRT reinvests the entire net proceeds from the sale into a diversified portfolio of investments

• Upon the death of Fred and Wilma, the assets of the CRT will be distributed to the Bedrock Foundation. 9

SO DO WE HAVE A SELF-DEALING ISSUE?

NO, as long as the Company redeems the 51% interest pursuant to a plan of redemption in which the same offer for redemption is made to all shareholders for cash at a purchase price no less than fair market value of the Company stock, Section 4941(d)(2)(F).

YES, the Company is a disqualified person for the self-dealing rules, because more than 35% of the Company stock is owned by Pebbles, a disqualified person. 11

IS THERE SELF DEALING PROBLEM?

Example #3 • Fred also owns some bank stock in two closely-held companies.

NO -

• He created a revocable trust which will become irrevocable upon his death, and his private foundation will be entitled to all of the corpus and undistributed income in the trust. At such time, the private foundation will not want to retain this stock, as it is not income producing and will offer the stock for sale to disqualified persons.

If the requirements of Treasury Regulation Section 53.4941(d)1(b)(3)(i)(a) are met.

Some Other Technical Issues Also See, PLR 9501038 for the implementation of a family business succession plan using this self-dealing exception.

• Unrelated Business Income

• Excess Business Holdings • Jeopardy Investment • Intermediate Sanctions • Imputation of Gain

How to Spot Opportunities

Example #4 Let’s say, Fred owns 100% of the Bedrock Quarry Company and Pebbles has no interest. Fred wants to make a charitable contribution to the Bedrock Foundation, but the company stock is his only significant asset of value. Fred understands the tax, financial and corporate ramifications of this gift.

• Taxable Event • Business Succession Planning • Diversification

The Foundation is interested in accepting this gift – what would you do on behalf of the Foundation?

• Understand the Wealth Tied up in Family-Owned Businesses 17

Example #5

• What if the Bedrock Quarry Company had already entered into a plan of redemption which had been approved by its shareholders?

What if the Company was engaged in the first ever tender offer of its stock to the conglomerate, Dino Dynasty, and then contributed the stock to the CRT? Will Fred incur gain on the sale of the stock by the CRT?

• Fred then took the advise of Mr. Slate and contributed his stock interest into the CRT.

What would happen if the Company Board had already accepted a nonbinding letter of intent to authorize the sale of the Company stock?

• Who is taxed on the redemption? 19

Privately Held Business Entities (cont’d)

Example #6

• C Corporation

•

The Bedrock Quarry Company was operated in an S Corporation.

• S Corporation

•

Fred’s advisors suggested that he contribute his 51% stock interest into a CRT and conduct the redemption plan in accordance with the self-dealing exception.

•

Mr. Slate, the planned giving officer for the Bedrock Foundation advised Fred that there may be some issues to consider further.

• Partnerships • Limited Liability Company • Sole Proprietorship 21

• The S Corporation may convert into a C Corporation and Fred can than contribute his stock into the CRT.

What is the effect of a gift of this stock to a CRT?

• The S corporation could use a valuable asset and contribute that asset to the CRT for no more than 20 years with income paid to the S Corporation.

What about an outright gift to a charity?

(Care must be exercised with these options)

Are there any viable options for S Corporation stock? 23

Planned Giving Vehicles of Interest

Privately Held Business Entities (cont’d)

to Business Owners

• C Corporation • S Corporation

• NIMCRUT (as spigot) • FlipCRUT

• Partnerships

• CLT

• Limited Liability Company

• Private Foundation v DAF v SO

• Sole Proprietorship 25

Example #7 •

Wilma created a family limited partnership (or LLC) which holds marketable securities and income producing real estate and wants to contribute her limited partnership (or LLC) interest to a CLT.

•

Wilma’s advisor warns Wilma that a partnership (or LLC) interest can constitute a “business enterprise” for purposes of the excess business holdings excise tax.

So long as 95% of the income is passive in nature, the partnership (or LLC) interest will not constitute a business enterprise (Code Section 4943(d)(3)(B))

Example #8

The excess business holdings tax will not apply if the value of the lead interest is 60% or less of the value of the property contributed to the trust. What if EBH does apply?

• Wilma, Fred’s wife, owns a parcel of income producing real estate and contributes the real estate to a CLT

The trust could hold the gifted partner (LLC) interest for 5 years without the imposition of this tax and possibly extend that time for an additional 5 years

• Wilma’s advisor is concerned that unrelated business income may adversely affect the benefits from the CLT

(Code Section 4943(c)(6)and (7)) 29

• Can you revise the terms of the lease prior to the transfer into the trust to comply with 512(b)(3)?

If the income constitutes “rents from real property” under Section 512(b)(3), no UBI will be generated

• What if the real estate was debt encumbered?

In general, so long as the rental is fixed, triple net and no substantial services are provided by the landlord, the rents should constitute “rents from real property”

• What if Wilma contributes the real estate along with marketable securities into a family limited partnership (or LLC) – same result? 31

Example #9 The Donor’s status as a “Dealer” should not taint the trust’s sale of the land – BUT BEWARE, maybe too much to lose now with UBI

• Fred also has many parcels of land that he buys and sells regularly • He wants to contribute some or all of these properties to a CRT

What is the benefit of this result?

• Fred’s advisor does not want him to do so, because Fred is a “dealer” and the sale by the trust will constitute UBI

What might change this result? What if the property is debt encumbered? 33

Section 501(c)(3) All Charities are Private Charities, EXCEPT –

Why Create a Private Foundation? • Social Capital

(i) a publicly supported organization under either Section 509(a)(1) or (2);

• Transfer Values

(ii) an SO under Section 509(a)(3); and

• Absolute Control

(iii) a public safety organization under Section 509(a)(4) … 35

Impact of Tax Rates on Charitable Giving

Why NOT Create a Private Foundation? • Private Foundation Excise Taxes Section 4940 - Excise Tax Based on Investment Income

DOUBLE BENEFIT FROM GIFT OF APPRECIATED L.T.C.G. PROPERTY

2 / 1% of net investment income

Section 4941 - Self-Dealing Excise Tax Two-tier tax on disqualified person and private foundation manager First Tier - 10% / 5% Second Tier - 200% / 50%

Section 4942 - Taxes on Failure to Distribute Income 30% tax on undistributed income up to 5% of net asset value

<< AVOID LONG-TERM CAPITAL GAIN TAX << CHARITABLE INCOME TAX DEDUCTION

Section 4943 - Excess Business Holdings Tax Two-tier tax on private foundation of 10%/200%

Section 4944 - Tax on Investments which Jeopardize Charitable Purpose Two-tier tax on private foundation and private foundation manager First Tier - 10%10% Second Tier - 25%/5%

Section 4945 - Tax on Taxable Expenditures Two-tier tax on private foundation and private foundation manager First Tier - 20%/5% Second Tier - 100%/50%

• Charitable Contribution Deduction Limitations 37

Donors in 2012

Donors in 2013

50% 50%

64.4% 64%

<< 15%* LTCG Tax Rate << 23.8%* LTCG Tax Rate

<< 35% Marginal Tax Rate

<< 39.6% Marginal Tax Rate (3.8% surtax not avoided by charitable deduction)

* 25% - Depreciable real estate * 28% - Collectibles

* 28.8% Depreciable real estate * 31.8% Collectibles

Why Create a Private Operating Foundation (as defined in Section 4942(j)(3))?

Why Create a Public Charity? • Avoid Application of Private Foundation

• “Hybrid” - Subject to all of the private foundation rules, BUT favorable charitable deduction rules apply • Technical Requirements • Distributions Test - Qualifying distributions of substantially all (85% or • more) of the lesser of its (i) ANI, or (ii) minimum investment return, AND • Donee Test - Assets, Support, or Endowment Test

Taxes • Maximize Charitable Income Tax Benefits • Social Capital • Transfer Values • Maximize Control

Section 501(c)(3) “Public Charities”

Why Create a Donor Advised Fund (as defined in Section 4966(d)(2))?

Section 509 (a)(1) - 170(b)(1)(A) Org

• Easy to create and administered by a public charity • Not subject to all private foundation rules • Favorable charitable deduction rules apply • Maintain continued involvement • BUT no legal control over investments or distributions

• Churches • Hospitals • Educational Institutions • Publicly Supported Organizations

Section 509(a)(2) - Exempt Revenue Org Section 509(a)(3) - Supporting Org 43

Types of Supporting Organizations

Supporting Organization Tests under Section 509 Regulations •

Publicly Supported Organization (PSO)

Organizational and Operational •

•

Type 1 Parent / Sub

Relational

Not Controlled

Controls

Supporting Organization ( ) (SO) 45

Types of Supporting Organizations

Publicly Supported Organization (PSO)

Type 2Brother Sister

Type 3 “In Connection With” SO Supervised or Controlled in Connection with a PSO

Controls

Supporting Organization ( ) (SO)

Supporting Organization (SO)

Publicly Supported Organization (PSO) 48

Public Charities

SO must meet the following tests:

170(b)(1)(A)(i)-(iv) =

§509(a)(3) Supporting Organizations (“SO”)

§509(a)(2)

§509(a)(1)

Public Charities

1) Organizational and Operational = §509(a)(3)(A) 2) Relational = §509(a)(3)(B) 3) Not controlled directly or indirectly = §509(a)(3)(C)

SO must meet the following tests: 1) Organizational and Operational = §509(a)(3)(A) 2) Relational = §509(a)(3)(B) 3) Not controlled directly or indirectly = §509(a)(3)(C)

170(b)(1)(A)(i)-(iv) =

§509(a)(3) Supporting Organizations (“SO”)

§509(a)(2)

§509(a)(1)

Relational Tests

Operated, supervised & controlled by a PSO

Operated in connection with a public supported organization (“PSO”)

Supervised or controlled in connection with a PSO

Operated, supervised & controlled by a PSO

Operated in connection with a public supported organization (“PSO”)

Type 3

Type 2

Type 1

Type 3

Type 1 e.g. parent = PSO & sub = SO

Both

Responsiveness Test

Integral Part Test

Either A

e.g. parent = PSO & sub = SO

Either B

1. Trustees of PSO must have significant voice in investments, distributions and donees. + 2a. One of SO Trustees must be elected by PSO; or 2b. One of SO Trustees must also be a member of PSO; or 2c. Trustees of SO must maintain close relationship with Trustees of PSO.

e.g. management & control in same persons who manage & control PSO

1. Must be a charitable trust; and 2. Each PSO must be named in governing instrument; and 3. PSO must have power to enforce trust & compel accounting.

Activities of SO must perform functions of or carry out purposes of PSO + but for SO, PSO would do this also.

New Qualifications of a Type III Supporting Organization Under Section 509(a)(3)

cannot accept any contribution from a person who directly or indirectly controls, either alone or together with a controlled entity or family members, the governing body of a PSO.

85% or > of income must be paid to PSO & income to PSO must be sufficient to insure PSO’s attentiveness to SO’s operations. 49

An SO must meet the following tests: 1) Organizational and Operational = §509(a)(3)(A) 2) Relational = §509(a)(3)(B) 3) Not controlled directly or indirectly = §509(a)(3)(C)

Responsiveness Test 1. (a) one or more of the SO’s officers, directors, or trustees are elected or appointed by the officers, directors, trustees or membership of its PSOs, (b) one or more members of the governing bodies of the SO’s PSOs are also officers, director or trustees of, or hold other important offices in, the SO, or (c) the officers, directors, or trustees of the SO maintain a close continuous working relationship with the officers, directors or trustees of its PSOs; and 2. by reason of such arrangement, the officers, directors, or trustees of the SO’s PSOs have a significant voice in the investment policies of the SO, the timing and the manner of making grants, the selection of the grant recipients by the SO, and otherwise directing the use of the income or assets of the SO.

Foreign Charity Prohibition SO cannot support a foreign charity

Integral Part Test Functionally Integrated – Must meet Activities Requirement or Parent Trap Activities Requirement – The SO engages in activities (1) substantially all of which directly further the exempt purposes of the PSO to which the SO is responsive, by performing the functions of, or carrying out the purposes of, such PSO; and (2) that, but for the involvement of the SO, would normally be engaged in by the PSO.

Definition of “Directly Further” – Holding title to and managing exempt-use property are activities that directly further the exempt purposes of the PSO (funding, investing and managing non-exempt-use property and making grants do not “directly further” – But See, Government Entity Exemption)

Parent Trap – The SO is the parent of each of its PSOs. An SO is the parent of a PSO if the SO exercises a substantial degree of direction over the policies, programs, and activities of the PSO and a majority of the officers, directors, or trustees of the PSO is appointed or elected, directly or indirectly, by the governing body, members of the governing body, or officers (acting in their official capacity) of the SO.

Must meet Distribution and Attentiveness requirements Distribution Requirement - SO must make distributions annually to or for the use of one or more of its PSOs in an amount equal to the “annual distributable amount,” which generally is the greater of (i) 85% of ANI, or (ii) 3.5% of the aggregate FMV of its assets (other than assets that are used, or held for use, directly in supporting the charitable programs of its PSOs).

Attentiveness Requirement – SO must distribute one-third or more of its “annual distributable amount” to one or more PSOs that are attentive to the operations of the SO and to which the SO is “responsive”.

Integral Part Test

e.g. management & control in same persons who manage & control PSO

Either 1. Must be a charitable trust; and 2. Each PSO must be named in governing instrument; and 3. PSO must have power to enforce trust & compel accounting.

A Activities of SO must perform functions of or carry out purposes of PSO + but for SO, PSO would do this also.

B 85% or > of income must be paid to PSO & income to PSO must be sufficient to insure PSO’s attentiveness to SO’s operations. 50

Integral Part Test Functionally Integrated

Notification Requirement

Non-Functionally Integrated -

Responsiveness Test B

“Operated in connection with” an organization described in Code Section 509(a)(1) or (2) for whose benefit the SO is organized and operated, or with respect to which the SO performs the functions of, or carries out the purpose of (“PSO”) – Must comply with the following five (5) requirements:

Donor Test - SO (Type I or Type III)

Type 2

Both

Either B

Supervised or controlled in connection with a PSO

Annually, the SO must provide the PSO with: Written notice addressed to a principal officer of the PSO indicating the type and amount of support provided by the SO to the PSO in the past year. A copy of the SO’s most recently filed Form 990. A copy of the SO’s governing documents, including its charter or trust instrument and bylaws, and any amendments to such documents. Copies of governing documents need not be provided in a given year if such documents have previously been provided and not subsequently been amended.

Notification may be provided by electronic media.

Activities of SO must ‘directly further’ exempt purposes of PSO by performing functions of or carry out purposes of PSO and OR but for SO, PSO would normally engage in.

The required notifications shall be postmarked or electronically transmitted by the last day of the 5th month after the close of the SO’s tax year.

Integral Part Test

Can I Control “MY” Charitable Entities?

Non-Functionally Integrated Distribute greater of (i) 85% of ANI or (ii) 3.5% of aggregate FMV of non-exempt use assets, to one or more PSOs, AND distribution to PSO must be sufficient to insure PSO’s attentiveness to SO’s operations

• • • • •

Other “Unrelated” Public Charity Other “Related” Public Charity Type III SO Private Operating Foundation Private Non-Operating Foundation

Can I Control “MY” Charitable Gifts And Gift Planning Vehicles? • • • • • •

CHARITABLE LEAD TRUSTS

The Basic Concepts:

Outright Gift Endowed Gift Donor Advised Fund Charitable Gift Annuity Charitable Lead Trust Charitable Remainder Trust

•

Estate & Gift Tax v. Income Tax

•

Present Value

•

Income Taxation of Trust

•

CLT v. CRT

CHARITABLE LEAD TRUSTS . . . is a trust

Donor

Asset

Trust

. . . which is taxable

CHARITABLE LEAD TRUSTS EXCEPT, when the Donor is Paying the Taxes

Income Beneficiary

• If the trust earns $100 of taxable income and distributes $100 to the income beneficiary, the trust and the beneficiary pay no tax and the Donor pays tax on $100

Remainder Beneficiary

Trustee

Somebody’s Paying the Taxes Concept

• If the trust earns $200 of taxable income and distributes $100 to the income beneficiary, the trust and the beneficiary pay no tax and the Donor pays tax on $200

• If the trust earns $100 of taxable income and distributes $100 to the income beneficiary, the trust pays no tax and the beneficiary pays tax on $100 • If the trust earns $200 of taxable income and distributes $100 to the income beneficiary, the trust pays tax on $100 and the beneficiary pays tax on $100

Grantor Trust 57

CHARITABLE LEAD TRUSTS

Two Types Donor

Donor

Asset

CRT

CLT

Non-Charity

Donor Charity

Asset

Charity

Donor Non-Charity

Asset

Grantor CLT

Non-Grantor CLT

Charity Donor

Charity Non-Charity

CHARITABLE LEAD TRUSTS

Donor

•

Charity

Grantor CLT

Asset

CHARITABLE LEAD TRUSTS

Asset

Donor

Donor Taxed on Trust Income

Charity

Grantor CLT

Donor

• Donor Entitled to Charitable Income Tax

• Donor Entitled to Charitable Income Tax Deduction

Deduction on Contribution of Assets to CLT

• Income Tax Deduction May Be Recaptured

• Gift to Charity = Income Tax Deduction: Present

• No Annual Income Tax Charitable Deduction to Trust

Value of Income Stream to Charity

• Trust Assets Includable in Donor’s Gross Estate 61

CHARITABLE LEAD TRUSTS

Charity Donor

Non-Grantor CLT

Asset

Donor Non-Charity

•

Donor Not Taxed on Trust Income

•

Donor Not Entitled to Income Tax Charitable Deduction

•

Trust Entitled to Annual Income Tax Charitable Deduction

•

Trust Assets Not Includable in Gross Estate

Charity

Non-Grantor CLT

Asset

Non-Charity

• Trust Assets Not Includable in Donor’s Gross Estate • Gift to Donor’s Heirs - Fair Market Value of Assets contributed to CLT LESS Present Value of Income Stream to Charity 63

CHARITABLE LEAD TRUSTS

Two Types Grantor

Non-Grantor Two Types

Charitable Lead “Unitrust” Percentage of fair market value of Trust assets determined annually

Testamentary

Annuity Trust

Charitable Lead “Annuity” Trust Percentage of fair market value of assets initially contributed to Trust 65

Living

Annuity Trust

Unitrust

Grantor

Non-Grantor Non-Grantor

Unitrust

Grantor

Non-Grantor

CHARITABLE LEAD TRUSTS

BEWARE:

Why Would a Donor Create a CLT?

Private Foundation Excise Taxes: Self-Dealing (Section 4941) Taxable Expenditures (Section 4945) Excess Business Holdings (Section 4943) Jeopardy Investment (Section 4944)

Grantor CLT: Accelerate Charitable Income Tax Deduction in Year of Gift to CLT Non-Grantor CLT: Pass Wealth to Heirs with a Reduced or No Estate and Gift Tax Cost

Unrelated Business Income Tax 67

CLAT Calculations Contributed Annual

Amount Payment Timing CMFR CLAT

$1M

Taxable Portion

CLAT Calculations Contributed Annual Discount Taxable Amount Payment Timing Rate Portion Tax CLAT $1M $70,000 15 Years 10% $467,570 $196,055

Tax

$70,000 15 Years 10% $467,570 $196,055

CLAT

$1M

$70,000 15 Years 1.4% $58,829 $20,590

CLAT Calculations

Contributed Annual Discount Taxable Amount Payment Timing Rate Portion Tax CLAT $1M $70,000 15 Years 10% $467,570 $196,055 CLAT

$1M

$70,000 15 Years 1.4% $58,829 $20,590

CLAT

$1M

$70,000 17 Years 1.4%

Contributed Annual Discount Taxable Amount Payment Timing Rate Portion

Tax

CLAT

$1M

$70,000 15 Years 10% $467,570 $196,055

CLAT

$1M

$70,000 15 Years 1.4% $58,829 $20,590

CLAT

$1M

$70,000 17 Years 1.4%

CLUT

$1M

$70,000 15 Years 1.4% $338,024 $118,308

CLAT Calculations Contributed Annual Discount Taxable Amount Payment Timing Rate Portion CLAT $10M

$700,000 17 Years 1.4%

CLAT Calculations Contributed Annual Discount Taxable Amount Payment Timing Rate Portion

Tax $0

Tax

CLAT $10M

$700,000 17 Years 1.4%

CLAT $10M

$500,000 24 Years 1.4%

CLAT Calculations Contributed Annual Amount Payment

Timing

Discount Taxable Rate Portion

CLAT Calculations Contributed Annual Amount Payment

Tax

Timing

Discount Taxable Rate Portion

Tax

CLAT $10M

$700,000 17 Years 1.4%

CLAT $10M

$700,000 17 Years 1.4%

CLAT $10M

$500,000 24 Years 1.4%

CLAT $10M

$500,000 24 Years 1.4%

CLAT $10M

$500,000 11 Years

CLAT $10M

$500,000 11 Years

1.4%

$4.9M

CLAT $10M $500,000 11 Years in 2013

1.4%

$4.9M

1.4%

$4.9M

$1.72M

$1.72M $0

CHARITABLE LEAD TRUSTS

Discount Planning

Building on the Fundamentals:

Mom & Dad

• Discount Planning

Transfer $1 M assets

FLP

1% GPI each 49% LPI each

• Transfer real estate to heirs Mom & Dad

• Unique Assets – Super Grantor CLT

Gift 98% LPI

CLAT

Inc.

Charity

Remainder

Kids 77

CLAT Calculations Contributed Annual Amount Payment CLAT $700K

Term

Taxable CMFR Portion

CLAT Calculations Contributed Annual Amount Payment

Tax

$49,000 12 Years 1.4% $162,185 $56,764

Term

Taxable CMFR Portion

Tax

CLAT $700K

$49,000 12 Years 1.4% $162,185 $56,764

CLAT $700K

$70,000 12 Years 1.4%

CLAT Calculations

Contributed Annual Taxable Amount Payment Term CMFR Portion Tax CLAT $700K $49,000 12 Years 1.4% $162,185 $56,764

CLAT $700K

$49,000 12 Years 1.4% $162,185 $56,764

CLAT $700K

$70,000 12 Years 1.4%

CLAT $700K

$70,000 12 Years 1.4%

CLAT $700K

$70,000 10 Years 1.4%

CLAT $700K

$70,000 10 Years 1.4%

CLAT $700K

$70,000 8 Years

Contributed Annual Amount Payment

$51,016 $17,855

Term

Taxable CMFR Portion

Tax

$51,016 $17,855

1.4% $173,698 $60,794

CHARITABLE LEAD TRUSTS

CLAT Calculations Contributed Annual Amount Payment

Term

Taxable CMFR Portion

Discount Planning

$49,000 12 Years 1.4% $162,185 $56,764

CLAT $700K

$70,000 12 Years 1.4%

CLAT $700K

$70,000 10 Years 1.4%

CLAT $700K

$70,000 8 Years

CLAT $700K

$70,000 11 Years 1.4%

Contributed Annual Discount Taxable Amount Payment Timing Rate Portion

Tax

CLAT $700K

$51,016 $17,855

Tax

CLAT

$10M

$500,000 12 Years

1.4%

$4.51M

CLAT

$7M

$500,000 12 Years

1.4%

$1.54M

1.4% $173,698 $60,794 $0

CHARITABLE LEAD TRUSTS Transfer Real Estate to Heirs Donors

Marketable securities and real estate

CHARITABLE LEAD TRUSTS

Unique Assets

Step #1: Facts Mom & Dad

FLP

30% GPI

Income Producing Real Estate* (Encumbered)

*produces $150k/yr. of cash but no taxable income due to depreciation deduction

49% LPI each 1% GPI each

Step #2: Creation of limited partnership Donors

Gift 92% LPI

Gift 6% LPI

CLAT

$Y for 13 months

Mom & Dad

Charity

Remainder after 13 months

Kids

49% LPI each 1% GPI each 30% GPI

Step #3: Creation of Grantor CLAT Mom & Dad

Kids 85

98% LPI

Grantor CLAT

Income Remainder

Charity Kids 86

Making Charitable Estate Planning Work for Business Owners

Thank you for coming! Jonathan Ackerman, Esq. Law Office of Jonathan Ackerman, LLC Owings Mills, Maryland www.ackermanlaw.net

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Making Charitable Estate Planning Work for Business Owners – Use of Charitable Vehicles & Case Studies Central New York Community Foundation, Inc. October 22, 2013

Planned Giving Vehicles of Interest to Entrepreneurs Charitable Remainder Trusts (CRT) NIMCRUT -

Character of Income Stream - A net income with makeup charitable remainder unitrust (“NIMCRUT”) pays the unitrust amount from the lesser of (i) the net fiduciary income earned by the trust’s assets or (ii) a percentage of the net fair market value of the trust’s assets (determined annually). A deficiency account may accrue, which may be “made up” in subsequent years when and if the net fiduciary income of the trust for that year exceeds the stated percentage payout rate. Use as a Flexible Tool for Special Needs - The definition of “fiduciary income” is one of the components in calculating the unitrust amount. If the unitrust amount generates no fiduciary income, no payment will be made to the income beneficiary of the trust. Fiduciary income is a term of art and is defined by the terms of the trust agreement and state principal and income laws. Although state law trends have been significantly changing, interest income and dividends are generally allocable to fiduciary income, and capital gains are not allocable to fiduciary income. However, the IRS permits the allocation of post-contribution gain to fiduciary income. For instance, upon the sale of privately-held C corporation stock by a CRT soon after its contribution, no fiduciary income will likely be incurred, because capital gains on the stock relate to gain accruing prior to the contribution to the trust (pre-contribution gain). However, if the CRT holds the stock and its goes up in value, then the appreciation accrued after the date the stock is contributed to the trust (post-contribution gain) will constitute fiduciary income when the stock is ultimately sold and the cash proceeds are generated. Upon the trust’s receipt of fiduciary income, the cash must be distributed to the income beneficiary in accordance with the definition of the unitrust amount. If a donor/income beneficiary desires to use the trust as a supplemental device for retirement planning, for instance, the trust should contain language which affirms that use in the definition of fiduciary income and state law should be reviewed. On the other hand, an appreciating diversified portfolio of marketable securities will likely generate fiduciary income each year, 1

because these investments will be more readily traded. Likewise, the annual distributions from a mutual fund will constitute fiduciary income, if the fund has appreciated in value. As you know and bucking recent trends, individual stocks or mutual funds may not always go up in value. If the assets of the trust fail to appreciate in value, the unitrust amount payout is directly affected. For instance, if the trust acquires only IBM stock and it goes down in value, no fiduciary income will be produced upon its sale, because the IBM stock did not appreciate in value. Concomitantly, no payment of the unitrust amount will be made to the income beneficiary. Use of Annuity Contract for Deferral – If the intended use of the trust is for a particular financial planning purpose, special consideration must be given prior to the execution of the trust and implementation of such purpose. For instance, some donors desire to use a NIMCRUT as a supplement to their retirement planning. In that event, the mix of investments will dictate the ability to control the timing of the receipt of fiduciary income, and therefore, the timing of the receipt of the unitrust amount. If an annuity contract or an investment partnership or LLC is being considered for reinvestment of the trust’s assets, special care must be exercised. It should also be noted that the IRS is unwilling to render a private letter ruling to determine whether such an investment structure disqualifies a CRT. Deferred Annuity Contract in a CRT – Historical Background 1. §664 Legislative History - Congress passed specific legislation in the Tax Reform Act of 1969 with an eye toward curbing abuses of some charitable trusts. The major concerns of Congress and the drafters of §664 were the invasion of principal and the amount of the charitable contribution deduction. The JCT staff did not feel that the NIMCRUT posed any danger, because principal could not be invaded for payments to the noncharitable income beneficiary: “The modifications of the general annuity trust and unitrust rules will allow greater flexibility in the making of charitable gifts in the form of remainder interests in trust but at the same time will adequately protect against abuse. Allowing a charitable remainder unitrust to distribute to the income beneficiary the lesser of the trust income or the stated payout will prevent a trust from having to invade its corpus when the income for a year is below that originally contemplated”. See, the “General Explanation of the Tax Reform Act of 1969" relating to §664 [Emphasis Added]. 2. §664(d)(2)(A) - a charitable remainder unitrust is a trust from which a fixed percentage (which is not less than 5 percent nor more than 50 percent) of the net fair market value of its assets, valued annually, is to be paid, not less often than annually, to one or more persons (at least one of which is not an organization described in §170(c) and, in the case of individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals. 2

3. §664(d)(3) -- Notwithstanding the provisions of paragraphs (2)(A) ... , the trust instrument may provide that the trustee shall pay the income beneficiary for any year -- (A) the amount of the trust income, if such amount is less than the amount required to be distributed under paragraph (2)(A), and (B) any amount of the trust income which is in excess of the amount required to be distributed under paragraph (2)(A), to the extent that (by reason of subparagraph (A)) the aggregate of the amounts paid in prior years was less than the aggregate of such required amounts. 4. §4941(d)(1)(E) - an act of self-dealing includes a transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation. 5. §4947(a)(2)(A) and Treas. Reg. §53.4947-1(c)(2) - §4941 does not apply to amounts payable under the terms of a charitable split-interest trust to income beneficiaries, unless a deduction was allowed under §170(f)(2)(B), 2055(e)(2)(B), or 2522(c)(2)(B). See Also, Rev. Rul. 72-395, 1972-2 C.B. 340, (“Section 4947(a)(2) makes sections 4941, 4943, 4944, and 4945 ... applicable to such trusts except for the payment of the unitrust amount to the income beneficiary”). 6. §643(b) - The term “income”, when not preceded by the words “taxable”, “distributable net”, “undistributed net”, or “gross”, means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. 7. Treas. Reg. §1.643(b)-1 - Trust provisions which depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized for this purpose. For example, if a trust instrument directs that all the trust income shall be paid to A, but defines ordinary dividends and interest as corpus, the trust will not be considered one which under its governing instrument is required to distribute all its income currently for purposes of §642(b) (relating to the personal exemption) and §651 (relating to “simple” trusts). 8. T.D. 2202 (July 26, 1971) - Treasury contemplated the possibility of a deferral of income payments to the non-charitable beneficiaries when it was preparing its Final Regulations under §664. Treasury begins its analysis of permissible investments with the statement, “One area of tax avoidance appears to be permitted by section 664.” Treasury then explains that an investment in unproductive assets which produce no income, or assets which produce tax-exempt income, will produce no taxable income to the recipient. 9. PLR 9009047 (December 5, 1989) - The IRS approved a NIMCRUT’s investment in a deferred annuity contract. The IRS held that (i) the NIMCRUT will qualify as a charitable remainder unitrust for federal income tax purposes; (ii) the NIMCRUT will include in its ordinary income for any tax year the “income on the [annuity] contract”, because the NIMCRUT will not hold the annuity 3

contract as an agent for a natural person; and (iii) the annuity contract shall be valued at its “account value”, i.e., the value on which earnings are computed for purposes of determining the annual net fair market value of the trust assets under the terms of the trust instrument. 10. PLR 9442017 (July 19, 1994) - A charitable remainder unitrust may give the trustee the authority to make reasonable allocations between fiduciary income and principal of any gains from the disposition of unproductive assets, as permitted under the applicable Principal and Income Act. The allocation of all realized capital gains in a NIMCRUT, including pre-gift appreciation, to fiduciary income was implicitly approved. In this PLR, it was expected that a significant portion of the assets of the trust would be contributed to an investment partnership. 11. PLR 9511007 (December 12, 1994) and PLR 9511029 (December 16, 1994) - The IRS again confirmed in these rulings that the trustee of a NIMCRUT may allocate all gains realized on trust assets after contribution to the trust (whether attributable to appreciation occurring before or after the contribution) to fiduciary income. Applicable State Law permits the terms of the governing instrument to control the allocation of receipts and expenditures. However, in these rulings the IRS added a new governing instrument requirement for NIMCRUTs. The IRS stated that the NIMCRUT governing instrument must require the trustee to treat as a liability any deficiencies in the unitrust amount for prior years, as computed under §664(d)(3)(B), in determining the fair market value of the trust assets on the annual valuation date if realized capital gains are allocated to fiduciary income under the governing instrument and applicable local law. The IRS limited the amount of this liability “to the trust’s unrealized appreciation that would be trust income under the terms of the governing instrument and applicable local law if the trustee sold all the assets on the valuation date.” The IRS was concerned that the timing of the realization of gain by the trustee may be manipulated to the detriment of the charitable remainder interest. In this context, the IRS also evaluated the impact on charity between a NIMCRUT and a standard charitable remainder unitrust under §664(d)(2)(A), as follows, “The income exception of Section 664(d)(3) ... may not be used in a manner that would allow the value of assets actually passing to the charitable organization to be less than it would have been under Section 664(d)(2)(A).” 12. PLR 9609009 (November 20, 1995) - The IRS again approved a NIMCRUT in which capital gains were allocated to fiduciary income. However in this PLR, the trust instrument made the distinction between pre- and post-gift appreciation, in which only post-gift appreciation could be allocated to fiduciary income. The governing instrument, in accord with PLR 9511007, included the new IRS-imposed liability language. 13. IRS Training Manual - IRS Personnel Ron Shoemaker and David Jones wrote an article in 1996 entitled, “Charitable Remainder Trusts: The Income Deferral Abuse and Other Issues” in the 20th edition of Exempt Organizations Continuing Professional Education Textbook. They contend that §664(d)(3) was enacted 4

for the purpose of providing trustees with payout flexibility when they receive illiquid assets. However, they argue that it is now being used for “a tax deferral purpose not contemplated by Congress,” and postulate that, under §4941(d)(1)(E), an intentional deferral of fiduciary income may constitute self-dealing. 14. Revenue Procedure 97-23, I.R.B. 1997-17 (April 28, 1997) - The IRS and Treasury first announced that they will study the use of the so-called “spigot trust”: whether creating or using NIMCRUTs to control the timing of the trust’s receipt of fiduciary income for the benefit of the unitrust recipient causes the trust to fail to function exclusively as a charitable remainder trust. Specifically, the IRS announced that it will not rule on requests pending with the IRS on April 17, 1997 and for ruling requests received after that date, on the following subject: whether a NIMCRUT qualifies as a charitable remainder trust when a grantor, a trustee, a beneficiary or a person related or subordinate to a grantor, a trustee or a beneficiary can control the timing of the trust’s receipt of trust income from a partnership or a deferred annuity contract to take advantage of the difference between trust income under §643(b) and income for federal income tax purposes for the benefit of the unitrust recipient. Subsequently, the IRS created a ‘no rule’ position on this issue, which continues in subsequent annual pronouncements by the IRS. 15. Proposed Amendments of Regulations to §664 - Article VII of the Proposed Regulations reiterates that Treasury is studying whether NIMCRUTS that take advantage of the timing difference between the receipt of income (as defined in §643(b)) and income for federal income tax purposes would cause the trust not to function exclusively as a charitable remainder trust. Citing to Rev. Proc. 97-23, the IRS and Treasury are requesting comments on drafting guidance on this issue. 16. TAM 9825001 - The IRS held that (i) the purchase of two annuity contracts, and the intentional deferral of the receipt of fiduciary income, did not constitute acts of self-dealing; (ii) the NIMCRUT was a qualified charitable remainder trust; and (iii) the NIMCRUT’s right to receive either the cash value or surrender value of the deferred annuity contracts did not create fiduciary income under §643(b). TAM 9825001 involved a classic retirement NIMCRUT invested in variable annuities. These issues were apparently raised in an examination of the tax returns of either the donor or the trust, and technical advice from the IRS national office was requested. The TAM analyzed the self-dealing issue at length before concluding that this type of investment, even if done for the purpose of creating a device to time the realization of fiduciary income, did not constitute self-dealing. It dealt with the qualification issue more summarily, merely concluding: "The purchase of the deferred annuity contracts does not adversely affect the trust's qualification as a charitable remainder unitrust under section 664 of the Code and the current regulations thereunder." 17. Issues with the Purchase of a Deferred Annuity by a NIMCRUT – Despite the IRS’ increasing interest in examining investment strategies pursued by 5

NIMCRUTs, there are several benefits related to deferred annuity investments. The trustee generally has better investment flexibility and control. When the unitrust recipient can rely on other sources of income, the trustee can invest the trust assets in variable deferred annuities that do not provide much current income, but which have significant appreciation potential. Variable annuity owners are often offered a wide range of investment options (such as money market funds, balanced income and growth funds and other different types of stock funds with various investment objectives and appreciation potential). By investing in equity mutual funds via annuity policies instead of outright, the NIMCRUT is able to control the reinvestment (and subsequent liquidation of the assets if the trustee deems it desirable to generate income from an appreciated policy). At the same time, more assets could be made available for investment and to maximize the trust's total return over the long term. However, after years of experience with this device, planners have recognized some limitations with use of the annuity contracts to time the income of NIMCRUTs. (i) All withdrawals from an annuity contract are ordinary income, filling tier 1 of the CRT and, therefore, characterizing all distributions from the NIMCRUT as ordinary income until tier 1 is exhausted. This can have the deleterious effect of converting longterm capital gain into ordinary income, reverse alchemy in the world of tax planning, in situations where most of the investment return within the annuity contract results from realized capital appreciation rather than interest or dividends. Thus, many planners are recommending an investment LLC to hold the CRT investments and control the receipt of fiduciary income by the distributions from the LLC, as opposed to an annuity contract. (ii) The insurance company issuing the annuity contract may also limit the types of investments that may be purchased within the annuity contract. As investors and their advisors have become more sophisticated, they increasingly seek alternatives to publicly traded stocks and bonds, such as real estate, hedge funds and private equity opportunities that are typically not offered by the insurance companies providing these annuities. Lastly, certain planning considerations are pertinent to preserve the potential benefits of the deferred annuity investments. First, the NIMCRUT should be the owner, beneficiary and annuitant of the annuity policy. If the donor is named as the annuitant on the policy, he will receive the annuity payments personally once he attains the stated age for payments; and the charity would potentially receive nothing. Second, the trust agreement should clearly define fiduciary accounting income as cash receipts and not cash buildup within the annuity policy. The governing state law can often be ambiguous in defining whether the right to receive income from an annuity policy is equivalent to the actual cash receipts from the policy. Third, investment and withdrawal decisions should be made by an independent trustee. If the donor controls the investment decisions in a manner that unreasonably affects the charity's remainder interest, the Service could argue that the use of the trust assets in purchasing the annuity contract was an impermissible use, thus constituting an act of self-dealing.

18. Revenue Procedure 2013-3 – Section 4 provides that the IRS will not ordinarily rule (in a private letter ruling) on the following issue: “(39) Section 664.—Charitable Remainder Trusts.—Whether a trust that will calculate the unitrust amount under § 664(d)(3) qualifies as a § 664 charitable remainder trust when a grantor, a trustee, a beneficiary, or a person related or subordinate to a grantor, a trustee, or a beneficiary can control the timing of the trust’s receipt of trust income from a partnership or a deferred annuity contract to take advantage of the difference between trust income under § 643(b) and income for Federal income tax purposes for the benefit of the unitrust recipient.” Thus, great care must be exercised by tax and insurance professionals prior to recommending that a charitable remainder trust invest in a variable or deferred annuity contract. FlipCrut - The final Regulations adopted in 1997 permit a “one-time” flip of the character of the unitrust amount to be received by the income beneficiary from a NIMCRUT interest to a standard CRT interest. The “triggering event” which causes the change in unitrust method must (i) be stated in the governing instrument, and (ii) arise (A) on a specific date or (B) by a single event whose occurrence is not discretionary with, or within the control of, the trustees or any other person. However, the initial unitrust method can only be an income exception method which flips into a standard unitrust interest, and the flip to the standard interest must take effect at the beginning of the taxable year following the year in which the triggering event occurs. As a consequence of the flip, any NIMCRUT make-up account will be forfeited. The final Regulations provide ten examples of permissible and impermissible triggering events. The permissible triggering events are generally those events that are outside of the control of any person. For instance, the IRS has stated that the sale of an unmarketable asset as defined in Treas. Reg. Section 1.664-1(a)(7)(ii), such as the donor’s former personal residence, is a permissible triggering event. In addition, if an unregistered security for which there is no available exemption permitting public sale is used to fund a FlipCrut, a permissible triggering event is the earlier to occur of the date when the stock is sold or the time the restrictions on its public sale lapse or are otherwise lifted. The IRS also provides the following permissible triggering events: when the income beneficiary reaches a certain age, when the donor gets married, when the donor divorces, when the income beneficiary’s first child is born, and when the income beneficiary’s father dies. It does not appear that these safe harbors are exclusionary in nature. As should be expected, the impermissible events relate to occurrences, which are within the discretion of some person. For instance, the sale of publicly traded stock is not a permissible triggering event, because that decision is within the discretion of the trustee. In addition, a request by the income beneficiary or his or her financial advisor will likewise not be permissible events. Charitable Lead Trust (CLT)

Character â&#x20AC;&#x201C; As it relates to the payout, a charitable lead trust works in an inverse fashion as the charitable remainder trust. For instance and in general, a CLT pays the lead interest to charity for a period of years or the life of an individual with the remainder either reverting back to the donor or to or for the benefit of another private individual. A CLT can be created during life or at death and the lead payout can either be in the form of a unitrust amount or an annuity amount. Types: Non-Grantor - In a non-grantor CLT, the donor is not subject to income tax on the income and gain incurred by the CLT. Correspondingly, the donor is not entitled to an income tax deduction. The trust is a taxpaying entity, but receives a charitable income tax deduction for the lead payments to charity. The present value of the remainder interest in the CLT is treated as a gift for gift tax purposes. Grantor - In a grantor CLT, the donor is subject to income tax on all income and gain incurred by the CLT. Correspondingly, the donor is entitled to a charitable income tax deduction. The present value of the lead charitable interest is the amount the donor will be entitled to as a charitable income tax deduction. This deduction, however, will have to be recaptured for income tax purposes on a pro rata basis if the donor dies during the term of a term-of-years CLT. The trust is a tax nothing and does not receive a charitable income tax deduction for the lead payments to charity. Super-Grantor â&#x20AC;&#x201C; The super-grantor CLT is a hybrid and special creature. It is essentially a defective grantor trust for income and estate and gift tax purposes. In other words, the donor is subject to all of the income and gain incurred by the trust (a grantor trust for income tax purposes), but the CLT assets are not includable in the gross estate of the donor. Thus, the donor can implement income and estate tax planning into his or her philanthropic planning. II.

Public Charity v Private Foundation v Donor Advised Fund A.

Character of Public & Private Charities: A public charity is generally funded by a broad group of people to carry out some type of direct, charitable activity or is recognized under Code Section 501(c)(3) of the tax law as a tax-exempt organization (e.g., a church, a school, a hospital). Public charities represent the largest share of active 501(c)(3) organizations. A public charity must represent the public interest and it is recommended that they have a diversified board of directors that are not all related and not compensated by the organization. A private charity or foundation is normally established by a single funding source, such as an individual, family, or corporation, rather than broadly supported by the general public. The Code defines a private foundation by what it is not, i.e., it is any 501(c)(3) other than a public charity, publicly supported organization or supporting organization, See Code Section 509. The donor establishes the PF, funds it, and controls it. The donor receives a tax 8

deduction in the year of the gift and is generally required to pay out at least 5% every year. B.

Why Create a Private Foundation: The benefits of a private foundation include the following: 1.

4. 5.

III.

Social Capital: The moral identity or public profile of the private foundation can be formed by the causes it decides to support. Further, some are unknown to the public and others have garnered a large amount of social capital and presence in their communities. Social capital is also a method by which taxpayers move tax dollars to charity. Transfer of Values – Junior Board: Donors hope that the foundation will be a place of collaboration, cohesiveness, and transference of values for the family which will carry on their tradition of giving. Employment Opportunities: There are no restrictions as to who can serve on the board, and as long as the self-dealing restrictions are met, family members can be paid by the private foundation a reasonable compensation for necessary services rendered. Absolute Control: The donor and family can control the foundation, including trustee succession, its investments and its grant-making. Naming Opportunity – Legacy: The foundation can carry the name of the donor and be a source of perpetual legacy in the community it serves.

Why Create a Public Charity: Many of the same benefits discussed above apply to a public charity, such as social capital, transfer of values, and naming opportunities. However, a public charity can be a preferred tax status, because public charities have higher donor tax-deductible giving limits and they can attract support from other public charities and private foundations, See more below. Further, many of the restrictions in place to limit abuses with the private foundations do not apply to “public charities” including the private foundation excise taxes, which are also discussed in detail in the next section.

Benefits of Public Charity v. Private Foundation Status A.

Benefits of a Public Charity 1.

More Favorable Income Tax Deductions a.

A Public Charity receives favorable income tax deduction treatment as opposed to the treatment given donors to Private Foundations. For instance, cash contributions are 9

deductible up to 50% of adjusted gross income (technically the donor's contribution base for the taxable year) and gifts of long-term capital gain property are deductible up to 30%. Cash contributions to Private Foundations are limited to 30% of adjusted gross income and 20% in the case of gifts of long-term capital gain property. Gifts of long-term capital gain property to a Public Charity are deductible to the extent of the fair market value of the contributed asset, whereas gifts of this type of property to a Private Foundation are limited to the donor's adjusted basis in the asset. 2.

Exemption from the Prohibited Transaction Rules Applicable to Private Foundations a.

Private Foundations are subject to extensive regulation and specifically are subject to an excise tax regime covering the Private Foundationâ&#x20AC;&#x2122;s administration, investments, distributions and business transactions under Sections 4940 through and including 4945 of the Code: (1)

Section 4940 imposes a 1 or 2% tax on investment income of a Private Foundation.

(2)

Section 4941 imposes an excise tax (from 10% to 200%) on a Private Foundation for direct or indirect acts of "self-dealing" between a Private Foundation and a disqualified person (as defined above), including any direct or indirect: (a) (b) (c) (d) (e)

(3)

sale or exchange, or leasing, of property; and lending of money or other extension of credit; and furnishing of goods, services, or facilities; and payment of compensation (or reimbursement of expenses); and transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a Private Foundation.

Section 4942 imposes a tax on the failure to distribute income of a Private Foundation.

IV.

(4)

Section 4943 imposes a tax on the acquisition and retention of "excess business holdings" of any Private Foundation.

(5)

Section 4944 imposes a tax on "jeopardy investments" of a Private Foundation.

(6)

Section 4945 imposes a tax on "taxable expenditures" of a Private Foundation for expenditures related to propaganda or any attempt to influence legislation.

(7)

These rules effectively prohibit a donor from contributing a privately-held business interest to a private foundation. However, control is absolute with the private foundation - the donor (and his or her family) may maintain absolute control over the administration of the private foundation, investment of its assets and the amount, character and timing of its distributions.

Definition of a Charity A.

Description of a Section 501(c)(3) Organization: An entity “operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition ... or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation...and which does not participate in, or intervene in ... any political campaign on behalf of (or in opposition to) any candidate for public office.” i

Definition of a “Public Charity” and “Private Foundation” – a process of elimination: 1.

Section 509 defines all charities as private foundations, except for those listed in Section 170(b)(1)(A)(i)-(vi); a publicly supported organization which meets support and income tests under Section 509(a)(2); an SO under Section 509(a)(3); and an organization organized and operated exclusively for testing for public safety under Section 509(a)(4).

Generally, a Public Charity is:

a. b. c. d. e. f. g. h. i. 3. C.

a church; an educational institution; a hospital; a charity supported by the government; a governmental unit; an organization normally receiving a substantial part of its support from the public; ii an organization which is publicly supported under Section 509(a)(2); a public safety organization; and a supporting organization under Section 509(a)(3).

Thus, a Private Foundation is a Section 501(c)(3) charity, which is not a Public Charity.

Definition of a supporting organization (“SO”): Section 509(a) General Rule.-- For purposes of this title, the term "private foundation" means a domestic or foreign organization described in section 501(c)(3) other than-... (3) an organization which-(A) is organized, and at all times thereafter is operated, exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified organizations described in paragraph (1) or (2), (B) is operated, supervised, or controlled by or in connection with one or more organizations described in paragraph (1) or (2), and (C) is not controlled directly or indirectly by one or more disqualified persons (as defined in section 4946) other than foundation managers and other than one or more organizations described in paragraph (1) or (2).

Origin of the SO – Tax Reform Act of 1969: 1.

SOs achieve Public Charity status, because their purposes were limited to the purposes of one or more Public Charities described in Section 509(a)(1) or (2) which the SO specifically supports ("Designated Public Charities") and were operated, supervised or controlled by or in connection with one or more Designated Public Charities. iii The SO was created at the behest of Mr. Hershey, who

desired a charitable vehicle to support a school for orphans that he created and funded with stock in the Hershey Candy Company. 2.

The Senate bill expanded the concept to include more than one school, and then the Conference bill expanded it to include any organization described in Sections 509(a)(1) or (2) and 501(c)(4), (5) or (6). iv

Definition of a Private Operating Foundation

1. In order to meet the private operating foundation rules, the following tests must be fulfilled: a. The Foundation must make distributions directly for a charitable function of at least 85% of the lesser of (i) the Foundation’s adjusted net income (which is defined generally as interest, dividends and short-term capital gains) or (ii) the Foundation’s minimum investment return (which is defined generally as 5% of the fair market value of its assets); and b. The Foundation must meet at least one of three other tests (Assets Test, Support Test or Endowment Test). (i)

Assets Test – Treasury Regulation Section

53.4942(b)-2(a). A private foundation will meet the assets test if substantially more than half (65% or more) of its assets are: a. Devoted directly to the active conduct of its exempt activity, to a functionally related business, or to a combination of the two, b. Stock of a corporation that is controlled by the foundation (by ownership of at least 80% of the total voting power of all classes of stock entitled to vote and at least 80% of the total shares of all other classes of stock) and substantially all (at least 85%) the assets of which are devoted as provided above, or c. Any combination of a. and b. This test is intended to apply to organizations such as museums and libraries. (ii)

Support Test – Treasury Regulation Section

53.4942(b)-2(b). A private foundation will meet the support test if:

a. Substantially all (at least 85%) of its support (other than gross investment income) is normally received from the general public and five or more unrelated exempt organizations, b. Not more than 25% of its support (other than gross investment income) is normally received from any one exempt organization, and c. Not more than 50% of its support is normally received from gross investment income. This test is intended to apply to special-purpose foundations, such as learned societies and associations of libraries. (iii)

Endowment Test â&#x20AC;&#x201C; Treasury Regulation Section

53.4942(b)-2(c). a. A foundation will meet the endowment test if it normally makes qualifying distributions directly for the active conduct of its exempt function of at least two-thirds of its minimum investment return. The minimum investment return for any private foundation for any tax year is 5% of the excess of the total fair market value of all assets of the foundation (other than those used directly in the active conduct of its exempt purpose) over the amount of indebtedness incurred to acquire those assets. In determining whether the amount of qualifying distributions is at least two-thirds of the organization's minimum investment return, the organization is not required to trace the source of the expenditures to determine whether they were derived from investment income or from contributions. This test is intended to apply to organizations such as research organizations that actively conduct charitable activities but whose personal services are so great in relationship to charitable assets that the cost of those services cannot be met out of small endowments. c. Computation Periods â&#x20AC;&#x201C; Treasury Regulation Section 53.4942(b)-3. (i) The computation periods for determining status as a private operating foundation are based on the year in question and the three immediately preceding years. The tests may be met on an aggregate basis for the four years or for any three separate years out of the four-year period, so long as both the income test and the alternative test are met on the same basis. The fact that a foundation chooses one method for satisfying the tests for one taxable year will not preclude it from using the other method in a subsequent year. (Treasury Regulation Section 53.4942(b)-3(a), See TAMs 9646002 and 9108001 â&#x20AC;&#x201C; private foundation is recognized as having operating status only in the fourth year of the test; recognition is not retroactive to the first year of the testing period, and See 14

PLR 9509042 â&#x20AC;&#x201C; private foundation which has met the private operating foundation tests on a year-by-year basis may convert to three-out-of-four-years method without jeopardizing its status). Example: P, a private foundation, meets the income test for 1987, 1988 and 1990 and for the 1987-1990 period in the aggregate. P also satisfies the assets test for 1987, 1989, and 1990, but not for the 1987-1990 period in the aggregate. P is not a private operating foundation for 1990. If, however, P had met the assets test for 1988 rather than 1989, or had met it in the aggregate for the 1987-1990 period, it would have been a private operating foundation for 1990. (ii) New organizations have special rules that require that the aggregate method be used for each of the first three years of the organization's existence, See Treasury Regulation Section 53.4942(b)-3(b)(1). Although rulings can be obtained on a year-by-year basis as to private operating foundation status, a special rule can be used to obtain some of the benefits of an advance ruling. Under Treasury Regulation Section 53.4942(b)-3(b)(2), a new organization is conclusively treated for its first year as an operating foundation if the organization makes a good faith determination that it will meet the private operating foundation tests for its first taxable year. A "good faith determination" is considered to exist where the determination is based on an affidavit or opinion of counsel to the organization, setting forth facts to enable the IRS to confirm that the organization is likely to meet the operating foundation tests. (iii) An organization which has been treated as an operating foundation for its first taxable year, but actually fails to qualify as an operating foundation, will be treated as a private foundation which is not an operating foundation as of the first day of its second taxable year. Such treatment will not apply if such organization establishes to the satisfaction of the Commissioner that it is likely to qualify as an operating foundation on the basis of its second, third and fourth taxable years. If such an organization fails to qualify as an operating foundation in its second, third, and fourth taxable year after having failed in its first taxable year, it will be treated as a private foundation which is not an operating foundation as of the first day of such second, third or fourth taxable year in which it fails to qualify as an operating foundation. V.

The Requirements of an SO A.

The Organizational and Operational Test â&#x20AC;&#x201C; Generally 1.

An SO must be organized and operated exclusively for the benefit of, or to perform the functions of, or to carry out the purposes of 15

one or more specified organizations described in Section 509(a)(1) or (2) (“Supported Organization”). 2.

The Organizational Test a.

The governing documents which create or organize the SO ("Articles") cannot empower the SO to engage in activities which are not Qualified Purposes or benefit or support any entity other than the Supported Organization. v

Purpose: The Articles must limit its purposes vi as described above, must not expressly empower the organization to engage in activities which are not in furtherance of such purposes and must not expressly empower the organization to support or benefit any organization other than a Supported Organization. (1)

There are three different types of SOs: (a) (b) (c)

Those “operated, supervised or controlled by” a Supported Organization (“Type 1"); Those “supervised or controlled in connection with” a Supported Organization (“Type 2"); and Those “operated in connection with” a Supported Organization (“Type 3").

Designating the Supported Organizations: (1)

The manner of specifying the Supported Organizations will vary, depending on whether the SO is a Type 1, Type 2 or Type 3 SO. In general, Type 1 and Type 2 SOs must specify one or more Supported Organizations or may identify a class of Supported Organizations or identify a common purpose(s). Type 3 SOs, however, must specify by name one or more Supported Organizations and cannot identify a class or purpose. vii

(2)

For a Type 1 or Type 2 SO, the Articles may permit (i) substitution of one Supported Organization within a designated class for another Supported Organization either in the same or a different designated class, (ii) the SO to operate for the benefit of a new or additional Supported Organization of the same or a different designated 16

class, or (iii) the SO to vary the amount of its support among different Supported Organizations within the designated class, See Treasury Regulation Section 1.509(a)-4(d)(3)(i) – (iii). (3)

With regard to a Type 3 SO, the Articles do not need to specify the Supported Organizations if there has been an historic and continuing relationship between the SO and the Supported Organizations, and by reason of that relationship, there has developed a substantial identity or interest between such organizations. viii The historic relationship need only arise in the context of the history of the relationship, and does not require any given period of time. ix In addition, there is no limit on the number of Supported Organizations which may be specified by an SO and there is no requirement that an SO support each of the Supported Organizations in any given year or during any specific period of time.

(4)

For a Type 3 SO, the Articles may allow for substitution of Supported Organizations in limited situations where such substitution is conditioned upon the occurrence of an event which is beyond the control of the SO, such as a loss of exemption, substantial failure or abandonment of operations, or dissolution of the Supported Organizations. x

An SO may also benefit a Section 501(c)(4), (5) or (6) organization which and meets the one-third support tests required of a publicly-supported organization and otherwise meets the SO requirements. xi

In a recent case, a foundation did not qualify as a Type II supporting organization of specified publicly supported organizations due to the failure of its articles of incorporation to identify the supported organizations by name or in another manner that made the supported organizations readily identifiable. In this case, the foundation's articles designated as supported organizations the class of organizations “which support, promote and/or perform public health and/or Christian objectives, including but not limited to Christian evangelism, edification and stewardship.” This designation did not make the foundation's supported organizations readily identifiable. 17

Further, there was neither a geographic limit, nor limit by type of publicly supported organization (i.e., churches or seminaries). In light of the broad purposes mentioned in the articles of incorporation, the court concluded that it would have been difficult, if not impossible, to determine whether the foundation would receive oversight from a readily identifiable class of publicly supported organizations, See, Polm Family Foundation, Inc v. U.S., (2009, DC, Dist Col), 655 F Supp 2d 125, affd (2011, CA, Dist Col), 107 AFTR 2d 2011-2100. 3.

The Operational Test a.

This test focuses on the operations of the SO, and requires that the SO engage solely in activities which support or benefit the Supported Organizations.

The SO can fulfill the Operational Test by: (1) (2) (3) (4)

Paying its income to one or more of the Supported Organizations; or Carrying on an independent program or activity which supports or benefits the Supported Organizations; or Engaging in fund raising activities on behalf of the Supported Organizations; or Making payments to or for the use of, or providing services and facilities for, the individual "members" (i.e., donees or beneficiaries) of a class benefited by the Supported Organizations. xii

c. An SO cannot support a Private Foundation. Example (3) under Treasury Regulation Section 1.509(a)-4(e)(3) highlights an example of this issue: P is an organization described in section 501(c)(3). Its primary activity is providing financial assistance to S, a publicly supported organization which aids underdeveloped nations in Central America. P's articles of organization designate S as the principal recipient of F's assistance. However, P also makes a small annual general purpose grant to T, a private foundation engaged in work similar to that carried on by S. T performs a particular function that assists in the overall aid program carried on by S. Even though P is operating primarily for the benefit of S, a specified publicly supported organization, it is not considered as operated exclusively for the purposes set forth in section 509(a)(3)(A). The grant to T, a private foundation, prevents it

from complying with the operational test under section 509(a)(3)(A). d. An organization isn't considered a private foundation merely because it supports a foreign, rather than a domestic organization, if it comes under the exceptions of Code Section 509(a)(1) and Code Section 509(a)(2), and meets the requirements of as an SO under Code Section 509(a)(3). However, a Type III SO cannot support a foreign organization, See Code Section 509(f)(1)(b). B.

The Relationship Test 1.

As stated above, an SO must have a relationship with Supported Organizations. That relationship can be in one of 3 forms: xiii Type 1 is "operated, supervised and controlled by" one or more Supported Organizations, in which a Supported Organization exercises a substantial degree of direction over the SOâ&#x20AC;&#x2122;s operations. Picture a parent-subsidiary relationship which exists if a majority of the officers, directors or trustees of the SO are appointed or elected by the governing body, officers or membership of one or more of the Supported Organizations. xiv Type 2 is "supervised or controlled in connection with" one or more Supported Organizations. Picture a "brother-sister" relationship which exists if common supervision or control is in the same persons supervising or controlling both the SO and the Supported Organization. xv Type 3 is "operated in connection with" one or more Supported Organizations. xvi The distinguishing feature is that the SO is responsive to the Supported Organization, which is significantly involved in the operations of the SO. However, legal control by the Supported Organization is not required, and thus provides maximum flexibility of control to the creators. With such flexibility, two additional tests correspondingly arise, namely the "Responsiveness Test" and the "Integral Part Test", which are derived from the relevant Treasury Regulations under Section 509(a)(3). (1) "Responsiveness Test": An SO is considered to have met this test if it is responsive to the needs or demands of the Supported Organizations, by satisfying (a) below:

(a)

Significant position and significant voice: The Designated Public Charities have a significant position with the SO: (1) (i) One or more of the officers, directors or trustees of the SO are elected or appointed by the officer, directors or trustees (or members) of the Supported Organizations; or (ii) One or more of the members of the governing bodies of the Supported Organizations are also officer, directors or trustees of, or hold other important offices in, the SO; or (iii) The officers, directors or trustees of the SO maintain a close and continuous working relationship with the officers, directors and trustees of the Supported Organizations; and (2) The officers, directors or trustees of the Supported Organizations have a significant voice in the investment policies of the SO; the timing and manner and recipients of grants; and in otherwise directing the use of income or assets of the SO.

(2) "Integral Part Test": An SO will be considered to have met this test if it either meets the Functionally Integrated standard or the Non-Functionally Integrated standard.

The Control Test 1.

Section 509(a)(3)(C) provides that one or more disqualified persons cannot directly or indirectly control the SO. xvii The term "disqualified person" (as defined in Section 4946) includes: a.

Any substantial contributor, which is a donor or decedent who made gifts or bequests to the SO exceeding the greater of: (1) $5,000; or (2) 2% of the total gifts and bequests received by the SO through the end of the year in which the donor's or decedent's gifts or bequests are received; and

b. c. d. e.

A person with a voting, profits or beneficial interest exceeding 20% of a corporation, partnership or trust that is a substantial contributor; and A foundation manager, including an officer, director or trustee of the SO; and A member of the family xviii of any of the above; and A corporation, partnership, trust or estate if any of the above own more than 35% of its voting stock, profits interest or beneficial interests.

An SO will be considered "controlled" if the disqualified persons, by aggregating their vote or authority, may require the SO to perform any act which significantly affects its operations or may prevent the SO from performing such act. Control on the part of the disqualified persons will be deemed to exist if the voting power of such persons is 50% or more of the total voting power of the SO's governing body, or if one or more of such persons have the right to exercise veto power over the actions of the SO. If the governing body of the SO consists of 5 trustees, none of whom has a veto power over the actions of the SO, and no more than 2 trustees at any time are disqualified persons, the SO will not be considered to be controlled directly or indirectly by one or more disqualified persons by reason of this fact alone. Whether an SO is under the indirect control of a disqualified person is a question of facts and circumstances.

D. Pension Protection Act of 2006 - This Act made substantive changes relating to charities. Though Congress gave us the Charitable IRA Rollover for a twoyear period, Congress made substantive changes to charities and charitable giving, including but not limited to, an enhanced deduction for certain gifts of food and book inventory, increasing excise tax penalties and penalties for failure to file Form 5227, restrictions on the deduction for clothing and household items, new rules relating to gifts to charity of fractional interest in tangible personal property, among many others. The two most pervasive statutory changes related to supporting organizations and donor advised funds (and note that qualified charitable distributions pursuant to the Charitable IRA Rollover do not include payments to a supporting organization or a donor advised fund). 1.

Supporting Organizations â&#x20AC;&#x201C;

a. A supporting organization (SO) is a public charity under Code Section 509(a)(3) which supports other public charities. In general, there are three types of supporting organizations: Type-1, in which a public charity legally controls the supporting organization (i.e., a parentsubsidiary relationship); a Type -2, in which a public charity legally operates or supervises the supporting organization (i.e., a brother-sister 21

relationship); and a Type-3, in which a public charity oversees the operations of the supporting organization. Many fundamental changes were made relating to the qualification, funding and operation of an SO. Though this handout will only touch on a few of these rules, it is important to note that certain provisions under this Act apply to all three types of SOs. For instance, if a an SO (Type I, Type II, or Type III) makes a grant, loan, payment of compensation, or other similar payment to an SO substantial contributor (or person related to the substantial contributor), the substantial contributor is treated as a disqualified person and the payment is treated “automatically” as an excess benefit transaction with the entire amount of the payment treated as an excess benefit, subject to the excise tax under Code Section 4958. In addition, all SOs are required to file an annual information return (Form 990 series) with the Secretary, regardless of the organization's gross receipts. An SO must indicate on such annual information return whether it is a Type I, Type II, or Type III and must identify its supported organizations and demonstrate annually that the organization is not controlled directly or indirectly by one or more disqualified persons (other than foundation managers and other than one or more publicly supported organizations) through a certification on the annual information return. b. While other provisions of the Act only relate to a Type III SO, as follows: (i) completely re-defining the existing tests for qualification as a Type III SO, (ii) authorizing the IRS to promulgate new regulations on required annual payments for Type III SOs that are not “functionally integrated,” and (iii) applying the excess business holdings rules under Code Section 4943 to Type III SOs (other than functionally integrated Type III SOs) (please note that these rules may in some circumstances also apply to a Type II SO). Lastly, some of the Act provisions relate to other charities that may fund an SO. For instance, a non-operating private foundation may not count as a qualifying distribution under Code Section 4942 any amount paid to (i) a Type III SO that is not a functionally integrated, or (ii) any other SO if a disqualified person with respect to the foundation directly or indirectly controls the SO or a supported organization of such SO. Any amount that does not count as a qualifying distribution under this rule is treated as a taxable expenditure under Code Section 4945. 2. Donor Advised Funds – Prior to the enactment of this legislation, the IRS had reported seeing abuses relating to donor advised funds, both in examinations and in applications for exemption from new organizations. For example, some promoters were encouraging donors to contribute funds and then use those funds to pay personal expenses, which might include school expenses for the donor's children, payments for the donor's own ‘volunteer work,' and loans back to the donor. In addition, a court denied tax-exemption to an organization that received gifts, invested donated funds at donors' direction, and transferred income or principal to charities as donors directed, finding that 22

“one of the purposes of the Fund is to allow persons to take a charitable deduction for a donation to the Fund while retaining investment control over the donation.” Fund for Anonymous Gifts v IRS, 97-2 USTC par 50,710 (DDC 1997) (this case was initially remanded and overturned after the charity amended its organizational documents, See Fund for Anonymous Gifts v IRS, 194 F3d 173 (DC Cir 1999) (and subsequently remanded for the purpose of determining that the charity was a private foundation, Fund for Anonymous Gifts v IRS, 2001-2 USTC par 50,649 (DDC 2001); See Also, National Foundation v US, 13 Cl. Ct. 486, 87-2 USTC, par 9602 (1987) (recognizing tax exemption of sponsor of donor advised funds); and Lapham Foundation, Inc v CIR, 84 TCM (CCH) 586 (2002). Aside from providing a statutory definition of a DAF (See Code Section 4966(d)(2)(A)), the provisions enacted in 2006, generally include the following: (i) an excise tax on “taxable distributions” from a donor advised fund, which are, very generally, distributions to individuals, distributions for noncharitable purposes, and distributions to organizations that do not exercise expenditure responsibility, (ii) an excise tax on “prohibited benefits,” which occur if a donor, donor advisor, or a related person receives a benefit, more than incidental, from advice given to a donor advised fund, (iii) an excise tax on “excess benefits,” which occur in this context if a donor advised fund makes a grant or loan or pays compensation to a donor, donor advisor, or a person related to either, (iv) a denial of income, estate, and gift tax deductions for gifts and bequests to some donor advised funds, (v) a special requirement of contemporaneous acknowledgment of deductible contributions to donor advised funds, and (vi) additional reporting requirements for organizations that sponsor donor advised funds. VI.

Some Common Technical Issues for Gifting Illiquid or Sophisticated Assets Unrelated Business Income Tax (“UBIT”)

Character of Tax - A public charity is generally not subject to income tax, See, Section 501(a). Likewise, a CRT is generally not subject to income tax, See, Section 664(c). However, a substantial exception to this "tax-exempt" status applies to both a charity and a CRT (and in effect, a CLT) where such entity has unrelated business income. UBIT will apply to the activities of a public charity if three (3) factors are present: (i) income is derived from a trade or business, (ii) which is regularly carried on by the charity and (iii) the conduct of which is not substantially related to the charity's performance of its tax-exempt function, See, Section 512(a) and Treas. Reg. Section 1.513-1(a). Section 513 specifically addresses unrelated trade or business activity and defines it as, "any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501..." There are a variety of activities which can be conducted by a charity and not rise to the level of an "unrelated trade or business", such as where the charity's activity is "primarily for the convenience of its members, students, patients, officers, or employees....", See, Section 513 (i.e., college cafeteria and book shop). Under Section 511(a), the amount of income subject to UBIT (which includes debt-financed income, as discussed below) will be taxed under the corporate rates under Section 11. 23

Applications of Tax - It should be noted that the impact is different if a charity, a CRT or a CLT incurs UBIT. For instance, a charity will pay tax only on its unrelated business income, and the incurrence of UBIT will generally not otherwise adversely affect the charity. However, a charity may lose its tax-exempt status if the revenue generated from "unrelated" sources is substantial (one-half of the charity's annual revenues, See, GCM 39108) or if the operation of the unrelated trade or business is not in furtherance of its tax-exempt purposes and the charity is operated for the primary purpose of carrying on a trade or business. Whereas a CRT will be subject to a 100% excise tax on all income that constitutes UBIT, See, Sections 511 and 664(c). A non-grantor CLT loses, on a dollar for dollar basis, its charitable income tax deduction under Sections 642(c) and 681. A charity, CRT or CLT may incur UBIT even if it indirectly owns a business activity. For instance, a limited partner, member of an LLC, or member of another non-corporate entity will have attributed to it UBTI of the enterprise as if it were a direct recipient of its share of the entity's income which would be UBTI if it were itself carrying on the business of the entity, See, Section 512(c), Revenue Ruling 79-222, 19792 C.B. 236 and Service Nut & Bolt Co. Profit Sharing Trust v. Commissioner, 724 F.2d 519 (6th Cir. 1983). Unrelated business income is not restricted to income from operations but also applies to gains from the disposition of debt financed property. Notwithstanding the exclusions for rent, capital gains and interest from UBTI discussed below, UBIT applies if debt financed income is generated. Under Section 514, certain income that would otherwise be excluded from the scope of UBIT must be included in UBIT because such income is incurred with respect to debt financed property. Section 514(b) defines "debtfinanced property" as any property which is held to produce income and with respect to which there is "acquisition indebtedness" at any time during the year. Property held to produce a capital gain upon disposition, as well as property which produces a recurring income stream, is "held to produce income" for purposes of this definition, See, Treas. Reg. Section 1.514(c)-1(a)(1). The gain from the sale of such property is also subject to tax as UBIT. Keep in mind also that the sale of debt financed property within twelve (12) months of mortgage satisfaction will trigger this tax, See, Treas. Reg. Section 1.514(b)1(a). In order to have a DFP, the property must be subject to "acquisition indebtedness". As stated in Treas. Reg. Section 1.514(a)-1(a)(1)(v), "acquisition indebtedness" means the outstanding amount of -- (i) the principal indebtedness incurred by the organization in acquiring or improving such property; (ii) the principal indebtedness incurred before the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement; and (iii) the principal indebtedness incurred after the acquisition or improvement of such property if such indebtedness would not have been incurred but for such acquisition or improvement and the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement. Treas. Reg. Section 1.514(a)-1(a)(1)(v) describes the method to calculate the taxable portion of the gain generated upon the sale of DFP, as follows: If debtfinanced property is otherwise sold or disposed of, there shall be included in computing unrelated business taxable income an amount with respect to such gain (or loss) derived from such sale or other disposition as - (a) the highest acquisition indebtedness with 24

respect to such property during the 12 month period, preceding the date of disposition, is of (b) the average adjusted basis of such property. Exceptions to Tax - Aside from the type of activities excepted from UBIT, Congress has recognized that the nature of the income arising from certain activities should be considered in determining whether the income should be treated as unrelated business income and taxable. 512(b) exceptions - For instance, dividends and interest (Section 512(b)(1)), royalties (Section 512(b)(2)) and certain rents from real property (Section 512(b)(3)) are all excepted from UBIT, because such income is passive in nature. However, great care must be exercised in considering these technical qualifications of each exception. For instance, “rents from real property” is a term of art and generally requires that the rental of real property be fixed in amount and on a triple net basis and the landlord is prohibited from providing substantial services (as is more explicitly described under the real estate investment trust rules). Another significant exception to UBIT is gains on the sale of property (Section 512(b)(5)), unless such property is "inventory" (as discussed below under “Dealer Issues”) or is "debt-financed property" (as discussed above). Holding Rule DFP Exception - An exception to the DFP rule is provided under Section 514(c)(2)(B) where, among other things, the encumbrance is placed on the property more than 5 years before the date of the gift. Special School DFP Exception for Real Property - A substantial exception to the DFP acquisition indebtedness rules is described in Section 514(c)(9). Debt which is incurred in the acquisition of property by certain "qualified organizations" will not be treated as acquisition indebtedness, so long as such organizations do not violate certain statutory prohibitions. This exception applies only to schools (and their affiliated supporting organizations) and Section 501(c)(25) organizations. Excess Business Holdings Tax Character of Tax – In order to discourage private foundations from holding investments in business enterprises, Congress enacted Section 4943, which basically subjects a private foundation to a two-tier excise tax for its "excess business holdings". In enacting this Section, Congress was concerned that private foundation managers would focus their attention on the success of a business enterprise and away from the charitable purposes for which the private foundation was created. In addition, such enterprise, as owned by a tax-exempt entity, could unfairly compete with another similarly situated enterprise which was owned by a taxable entity. The excise tax imposed under Section 4943 is 10% of the highest value of the holdings in a business enterprise in excess of the "permitted holdings". A harsh second-tier excise tax equal to 200% of such excess business holdings may apply if (i) the 10% tax is imposed and (ii) the private foundation still has excess business holdings at the close of the earlier to occur of (A) the date of mailing of a notice of deficiency by the IRS relating to such holdings or (B) the date on 25

which the 10% tax is assessed by the IRS, See, Sections 4943(b) and (d)(2), Also See, Section 6684 for a possible third-tier tax. "Permitted holdings" means 20% of the voting stock in an incorporated business enterprise, or 20% of the profits or beneficial interest in a non–incorporated enterprise, reduced by the percentage such interests owned by all disqualified persons (as defined in Section 4946(a)) (“Disqualified Persons”, who are generally substantial contributors to, and trustees of, the private foundation, and any person related by family to such individuals and entities significantly owned by such individuals), See, Section 4943(a)(1) and (2). Once the permitted holdings have been determined, the permitted holdings are subtracted from the percentage held by the foundation to determine the amount of "excess business holdings", See, Treas. Reg. Section 53.4943-3(d). The net effect of these formulas is to assure that the combined holdings of all Disqualified Persons and the private foundation in a business enterprise are not more than 20%. Any readjustment of the assets (e.g., a recapitalization, redemption, merger) may also impact the excess business holdings rules, See, Treas. Reg. Section 53.4943-7(d). Exceptions to Tax - If the excess business holdings tax applies, there are several methods by which the “private foundation” (a CLT, in this case) can limit the impact of, or altogether avoid, such tax. Five-year period - The private foundation is given a five-year period beyond the date of the gift to dispose of the business holdings in excess of the combined 20% permitted holdings, See, Section 4943(c)(6). The law treats the business holdings as being held by Disqualified Persons for such five-year period. Thus, the private foundation is not deemed to own any business holdings for such period. There are, however, exceptions to this favorable rule. These exceptions basically attempt to prohibit an end run around this rule, i.e., transfer from the private foundation to another commonly controlled or related private foundation, a purchase by an entity effectively controlled by a Disqualified Person or the private foundation or a Disqualified Person's plan to purchase during the five-year period additional holdings in the same business enterprise held by the private foundation, See, Treas. Reg. Section 53.5953-6(c). Effective control exception - Under certain circumstances, the permitted holdings may be increased from 20% to 35%, See, Section 4943(c)(2)(B). Such an increase is permitted if (i) persons other than the private foundation and Disqualified Persons have "effective control" of the enterprise and (ii) the private foundation establishes to the satisfaction of the Commissioner that effective control is in one or more persons (other than the private foundation itself) who are not Disqualified Persons. Effective control means the power to direct or cause the direction of the management and policies of a business enterprise, whether through the ownership of voting stock, the use of voting trusts, or contractual arrangements, or otherwise. For example, the effective control test is met if individuals holding a minority interest, none of whom is a Disqualified Person, have historically elected a minority of the corporation's directors. The key is to prove that another person or group of persons do control the company, not that the Disqualified Persons don't control the company, See, Revenue Ruling 81-111, 811 CB 509. 26

Passive source exception - The third possible method of avoiding the Section 4943 tax is the passive source exception. The definition of a "business enterprise" includes the active conduct of a trade or business, including any activity which is regularly carried on for the production of income from the sale of goods or the performance of services, See, Section 4943(d)(3)(B). If 95% or more of the gross income of a business enterprise is "passive", the entity will not be deemed to be a business enterprise. The definition of what is passive is a term of art and basically includes dividends, interest, payments with respect to securities loans, annuities, royalties measured by production of income from the property, rents from real property (unless taxable as unrelated business income) and gains or losses on sales and exchanges of property (other than inventory and property held for the sale to customers), See, Section 4943(d)(3). This concept is consistent with the Congressional intent in attempting to discourage foundation managers from spending too much time on the business enterprise, See, PLR 9211067. If the activity is passive, by definition, the managers would not be spending time on the business enterprise. Extension of initial five-year period - The IRS has the statutory power to extend the initial five-year period (discussed in (i) above), for unusually large gifts or bequests of diverse holdings or holdings with complex corporate structures, for up to an additional five years, Section 4943(c)(7). The private foundation must prove to the Secretary of the Treasury that it has made diligent efforts to dispose of such holdings during the initial period, and a disposition of such holdings within the initial period has not been possible (except at a price substantially below fair market value) due to the size and complexity or diversity of such holdings. The private foundation must submit a plan with the Secretary and the state official having the authority over the foundation's affairs (usually the Attorney General's Office) for disposing of the excess during the extended period. This plan may be accepted by the Secretary if it can be reasonably expected to be carried out during the extension period. De minimis rule - A de minimis rule is provided in which Disqualified Persons may retain any percentage of holdings, so long as the private foundation holds no more than 2% of the voting stock (or profits or beneficial interest) or 2% by value of all outstanding shares, See, Section 4943(c)(2)(C). 90-day grace period - A private foundation will have at least 90 days from the date of the gift to dispose of the excess business holdings without incurring this excise tax, See, Treas. Reg. Section 53.4943-2(a)(1)(ii). This 90-day period is extended to include the period during which a private foundation is prevented by federal or state securities laws from disposing of such excess business holdings, See, Treas. Reg. Section 53.4943-2(a)(1)(iii). Applications of Tax â&#x20AC;&#x201C; Although Section 4943 deals with a private foundation and not a CLT, Sections 4947(a)(2) and (b)(3)(A) cause the excess business holdings tax to apply to a CLT where the aggregate value of the charitable lead interest exceeds 60% of the fair market value of the property contributed to such trust. In addition, Section 27

4947(a)(2) and (b)(3)(B) cause the excess business holdings rule to apply to a CRT only if an income beneficiary is a charity and a deduction was allowed for such charitable income interest. Jeopardy Investment Tax Character of Tax - Section 4944 subjects a private foundation and a manager of the private foundation (i.e., a trustee) to a two-tier excise tax for making investments in such a manner as to jeopardize the carrying out of the private foundation's exempt purposes. If such a jeopardizing investment is made, Section 4944(a)(1) imposes on the private foundation a tax of 10% of the amount of the investment for each year or part thereof in the "taxable period" (defined below), and Section 4944(a)(2) imposes a similar 10% tax on any foundation manager who knowingly and willfully participated in making such investment. However, the tax on the foundation manager is limited to $10,000 per investment. The second tier tax of 25% of the investment is imposed whenever (i) an initial tax is imposed pursuant to Section 4944(a)(1) on the making of a jeopardy investment and (ii) the investment is not removed from jeopardy within the "taxable period", Section 4944(b)(1). The "taxable period" is the earlier to occur of (A) the date of mailing of the deficiency notice by the IRS, (B) the date on which the 4944(a)(1) tax is imposed or (C) the date on which the amount so invested is removed from jeopardy, Section 4944(e)(1). A foundation manager is liable for an additional tax equal to 5% of the amount invested, only if an additional tax has been imposed on the foundation and the manager has refused to agree to part or all of the removal from jeopardy of such investment. This second-tier tax on the foundation manager is limited to $20,000 per investment (Also See, Section 6684 for a possible "third-tier" tax where the private foundation or manager had been liable for the Section 4944 tax in a prior year and became liable for the same tax in a subsequent year or where the act or failure to act giving rise to the excise tax is both willful and flagrant). Exception to Tax – Gratuitous Transfer - The tax under Section 4944(a)(1) is imposed on the private foundation if it "invests” any amount in such a manner as to jeopardize its taxexempt purpose, See, Treas. Reg. Section 53.4944-1(a). Although neither the Code nor the legislative history address the application of this tax to gifted property, Treas. Reg. Section 53.4944-1(a)(2)(ii)(a) provides that Section 4944 shall not apply to an investment made by any person which is later gratuitously transferred to a private foundation. This Regulation Section further provides that, if such foundation furnishes any consideration to such person upon the transfer, the foundation shall be treated as having made an "investment" in the amount of such consideration. One commentator describes this Regulation Section as follows, "Property received as a gift or bequest is not a jeopardizing investment regardless of how imprudent it might be if purchased by the foundation", Bittker & Lokken, Federal Taxation of Income Estates and Gifts, Second Edition, 1993, ¶101.7.3, p.101-111. Thus, it appears clear that the receipt by way of gift of a speculative asset by a private foundation cannot be described as an "investment", causing the private foundation to be subject to the tax under Section 4944. However, 28

what is less clear is the ability of the foundation to retain such asset without incurring the jeopardy investment tax. In fact, another commentator has indicated that an implied duty to dispose of highly speculative property, even if acquired by gift, can arguably be read into Section 4944, See, Chiechi and Maloy, 338-3rd T.M., Private Foundations - Section 4940 and Section 4944, p.A-17 ("Chiechi"). [Two private letter rulings which relate directly to CLTs, and as recognized by Chiechi, indicate a contrary and favorable taxpayer result, See, PLRs 8125038 and 8038180, Also See, PLR 8135040 and 9320052. The IRS, however, adds the following qualification to that conclusion: the trust does not change the form or terms of such investment.] Treas. Reg. Section 53.4944-1(a)(2)(iii) provides in effect that if a private foundation changes the form or terms of an investment (including property gratuitously transferred to a private foundation), the trust will be considered to have entered into a new investment which will be judged at the time of such change as to whether that investment carries out the organization's exempt purposes. Thus, a change in the form or terms of an investment triggers a reapplication of the jeopardy investment standard. Applications of Tax â&#x20AC;&#x201C; Although Section 4944 deals with a private foundation and not a CLT, Section 4947(a)(2) and (b)(3)(A) cause the jeopardy investment tax to apply to a CLT where the aggregate value of the charitable lead interest exceeds 60% of the fair market value of the property contributed to such trust. In addition, Section 4947(a)(2) and (b)(3)(B) cause the jeopardy investment tax to apply to a CRT only if an income beneficiary is a charity and a deduction was allowed for such charitable income interest. Jeopardy Investment Defined - Treas. Reg. Section 1.4944-1(a) states the general trustee standard to be applied in determining when an investment is a "jeopardy investment" under Section 4944, as follows: when the foundation managers, in making such investment, have failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investments, in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes. This standard as established in the legislative history has been described as a "prudent trustee" approach, See, S. Rep. No. 91-552, 91st Cong., 1st Sess. 45 (1969), 1969-3 C.B. 423, 453, and reaffirmed as such by the IRS in Revenue Ruling 74-316, 1974-2 C.B. 389. As provided in Treas. Reg. Section 53.4944-1(a), the managers may, in the exercise of the requisite standard of care and prudence, take into account the expected return (including both the income and appreciation of capital), the risks of rising and falling price levels, and the need for diversification within the investment portfolio (for example, with respect to type of security, type of industry, maturity of company, degree of risk and potential for return). In addition, the determination whether the investment of a particular amount jeopardizes the carrying out of the exempt purposes of the foundation shall be made on an investment by investment basis, in each case taking into account the foundation's portfolio as a whole. Such Regulation Section also provides that no category of investments shall be treated as a per se violation of Section 4944. However, this Regulation does cite certain investments which will be closely scrutinized, as follows: trading on margin, trading in commodity futures, investments in working interests in oil and gas wells, purchase of puts, calls and straddles, purchase of warrants and selling short. The determination whether the investment of any amount jeopardizes 29

the carrying out of a foundation's exempt purposes is to be made as of the time that the foundation makes the investment and not subsequently on the basis of hindsight. Therefore, once it has been ascertained that an investment does not jeopardize the carrying out of such purposes, the investment shall never be considered to jeopardize the carrying out of such purposes, even though as a result of such investment, the foundation subsequently realizes a loss, See, Treas. Reg. Section 53.4944-1(a)(2). Self-Dealing Tax Character of Tax - Section 4941 imposes an excise tax (from 10% to 200%) on a private foundation for direct or indirect acts of "self-dealing" between a private foundation and a Disqualified Person, including any direct or indirect: sale or exchange, or leasing, of property; and lending of money or other extension of credit; and furnishing of goods, services, or facilities; and payment of compensation (or reimbursement of expenses); and transfer to, or use by or for the benefit of, a Disqualified Person of the income or assets of a private foundation. Note that the definition of a Disqualified Person does not include a charity defined under Section 509(a)(1), (2) or (3). Application of Tax - There are two persons upon whom the Section 4941 selfdealing excise tax can be imposed, the Disqualified Person and the foundation manager (i.e., Trustee). The self-dealing excise tax has two tiers, the (a)(1) and (2) tier and the (b)(1) and (2) tier. Each tier's tax is imposed during the taxable period, See Sections 4941(a) and (b). The taxable period begins upon the act of self-dealing and ends upon the earlier of (i) the date of the mailing of the notice of deficiency, (ii) the date on which the tax imposed under (a)(1) is assessed, or (iii) the date on which the correction of the act of self-dealing is completed, See, Section 4941(e)(1). The taxable period may otherwise close on any particular act of self-dealing if the statute of limitations for the assessment of the excise tax arising thereunder expires. These self-dealing rules apply to a CLT as if such trust was a private foundation, See, Section 4947(a)(2), Also See, Section 6884 for a possible third tier tax. Exceptions to Tax - Even if a transaction would constitute self-dealing, no excise tax will be imposed if the transaction satisfies one of the following overall exceptions. Furnishing of Goods, Services or Facilities on Same Basis as to Public The furnishing of goods, services, or facilities by a private foundation to a Disqualified Person where such goods, services, or facilities are made available to the general public on at least as favorable a basis as they are made available to the Disqualified Person is exempt from the self-dealing tax, Section 4941(d)(2)(D). Compensation for Certain Personal Services - The payment of compensation (or the payment or reimbursement of expenses) by a private foundation to a Disqualified Person (other than a government official) for the performance of personal services which are reasonable and necessary to carry out the exempt purposes of the private foundation is not self-dealing, as long as such compensation (or payment or reimbursement) is not excessive, Section 4941(d)(2)(E). 30

Corporate Transactions - A transaction between a private foundation and a corporation which is a disqualified person and which is pursuant to a liquidation, merger, redemption, recapitalization, or other corporate adjustment, organization, or reorganization is not self-dealing so long as all of the securities of the same class as that held (prior to such transaction) by the foundation are subject to the same terms and such terms provide that the foundation will receive no less than fair market value, See, Treas. Reg. Section 4941(d)(2)(F). Self-Dealing Corrective Act - The correction of a previous act of self-dealing is not self-dealing, See, Treas. Reg. Section 53.4941(e)-1(c)(1). Initiation of Disqualified Person Status - A transaction between a private foundation and Disqualified Person where the Disqualified Person's status arises only as a result of the transaction at issue is not self-dealing, See, Treas. Reg. Section 53.4941(d)1(a). Certain Indirect Transactions - Certain specific transactions, not directly involving a private foundation as a party but involving an organization, estate, or trust in which the private foundation owns an interest are excluded from self-dealing. For example, indirect self-dealing does not include certain transactions with respect to a foundation's interest or expectancy in property held by an estate (or revocable trust) where the transaction is approved by the probate court having jurisdiction over the estate or trust, See, Treas. Reg. Section 53.4941(d)-1(b)(3). The IRS has approved the use of this exception to self-dealing in several instances, including a disqualified person's purchase of a private foundation's interest in corporate stock (PLR 8901039), a private foundation's interest in a deed of trust and the related note receivable (PLR 9127052) and a private foundation's remainder interest in nonresidential real property (PLR 9112012). Imputation of Gain to Donor: With respect to donor pre-arranged sales of an appreciated asset being gifted to charity, the IRS can impute the inherent built-in gain in such appreciated asset back to the donor. There are many cases and IRS rulings that involve the imputation of gain to the donor on the sale of an appreciated asset by a done/charity. However, there are several overriding principles and seminal cases and rulings which must be analyzed in this regard and are discussed in detail below. Assignment of Income & Step Transaction Doctrines - In Palmer v. Commissioner, 62 T.C. 684 (1974), the court held that the gain on the sale of the stock of a closely-held company by a charity would not be imputed back to the donor on the corporate redemption of the stock. In Palmer, the donor controlled both the company and the charitable foundation and donated appreciated stock in the company to the foundation. The court found that, in light of the presence of an actual, valid gift and because the foundation was not a sham, the gift of stock was not a gift of the proceeds of redemption. One day after the gift, the corporation redeemed its stock from the foundation. The IRS acquiesced to the decision in Palmer, See, Revenue Ruling 78-197, 1978-1 C.B. 83. In this Revenue 31

Ruling the Service specifically acknowledged that the taxpayer in Palmer had voting control of both the corporation and a tax-exempt private foundation and that the gift, followed by the redemption, was pursuant to a single plan. Nonetheless, the Service will treat the proceeds of a stock redemption under facts similar to those in Palmer as income to the donor only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption. Subsequent to Palmer, the court in Blake v. Commissioner, 697 F. 2d 473 (2d Cir., 1982), aff’g 42 TCM 1336 (1981), held that the mere prearrangement of the sale caused an imputation of gain to the donor. Many in the planned giving community believe that this case is a good example of the maxim, “bad facts make bad law.” In Blake, the donor gifted $700,000 of marketable securities to a charity “to purchase the yacht AMERICA”. The charity accepted the gift and sold the stock. The charity then purchased from the donor the yacht for $675,000, in a so-called “quid pro quo” transaction. However, the charity sold the yacht 3 - 4 months thereafter for only $200,000. On the basis of the Tax Court's factual findings, the Second Circuit had little trouble concluding that Blake had expected the charity to purchase his vessel and that he had an enforceable cause of action under a promissory estoppel theory, as a matter of law, if the charity refused. The court treated the transaction as a “unitary one”, where the appreciated stock was used for the purpose of purchasing another asset of the donor. Thus, the donor was taxable on the sale by the charity of the $700,000 of marketable securities. Despite the apparent inconsistencies between Palmer, Revenue Ruling 78-197 and Blake, there are logical interpretations of these and other relevant cases and rulings. In effect, Blake dealt solely with a situation in which there was a gift of an appreciated asset to charity, so that the charity in turn could purchase an asset from the donor. In effect, there was a donor-required "quid pro quo", in order to consummate the gift. There are many other relevant cases that should be considered in analyzing the imputation of gain issue, such as Greene v. United States, 13 F.3d 577 (1994), aff’g, 806 F.Supp. 1165 (1992), in which gain was not imputed to the donor where the donor contributed futures contracts to a private operating foundation with no strings attached or prearrangement for resale by the charity, and Ferguson v. Commissioner, U.S. Court of Appeals, 9th Circuit, 98-70095, 4/7/99, aff’g 108 T.C. 244 (1997), where, in the context of a tender offer, gain was imputed to the donor where at the time of contribution of the corporate stock, it was practically certain that the tender offer and merger would be completed successfully. The most recent case in this arena is Rauenhorst v Commissioner, 119 T.C., No. 9 (2002), in which the IRS asserted that the taxpayer should be subject to the imputation of gain on the sale of stock by a charity after a charitable gift. In Rauenhorst, WGP, a corporation, sent the management of NMG (another corporation) a letter stating its intention to purchase all of the stock of NMG. Several officers of NMG accepted this letter of intent. Management of NMG accepted the offer and on October 22, 1993, the Board of Directors of WGP adopted a resolution authorizing management to proceeds with the purchase. On November 9, 1993, Rauenhorst contributed stock warrants (representing approximately 18% of the stock) to 4 charities on November 9, 1993, and the 32

transfer was reflected on the corporation’s books 3 days later. On November 22, the NMG shareholders (including the charities) entered into a purchase agreement and sold the shares on December 22 at a price of $7,598 per share. Each charity filed Form 8282 reporting the sale of the NMG stock. On audit, the IRS claimed that the almost $5 Million capital gain on the sale of this NMG stock was taxable to the Rauenhorsts, on the grounds that the gain had already accrued when they transferred the warrants to charity. On partial summary judgment, the Tax Court rejected the IRS argument and required the IRS to accept the holding of its own ruling (Revenue Ruling 78-197). Capital gain will only be imputed back to the donor in a corporate redemption if at the time of the gift, the charity was legally bound, or could be compelled, to sell the shares. The Tax Court again thankfully relies on the legally binding standard and distinguishes this valuable new decision from the Ferguson decision. Also See, in the U. S. Fourth Circuit Court of Appeals (which includes the State of Maryland), Martin v Machiz, 251 F. Supp 381 (MD District, 1961). Use of Irrevocable Life Insurance Trust Oftentimes, the patriarch may in structuring a gift transaction involving only one of the children – for any number of reasons, including, the fact that such child is actively involved in the business, the other children could potentially be disinherited through a philanthropic gift structure. In addition, if the parents use a charitable remainder trust and the assets of the trust ultimately are distributed to charity (and outside of the family unit), their children could again be disinherited. Thus, the incorporation of an irrevocable life insurance trust can resolve these types of obstacles. “Dealer” Issues Dealer status usually produces unfavorable income tax consequences. For instance, an asset that would normally produce capital gain on sale will produce ordinary income to a dealer of that asset. In addition, contributions of dealer property will limit the charitable income tax deduction in accordance with the ordinary income reduction rule under Section 170(e)(1). Lastly, if a CRT or CLT is deemed a dealer itself in assets which it holds, UBIT will be generated on its receipt of operating income or on sale and the exception under 512(b)(5) will not apply. The litmus test for a dealer is represented by frequent, regular and continuous development or sales of property, See Also, Section 1237 and the regulations thereunder for a statutory exception to dealer status for the limited subdivision and sale of real property. In Adam v. Commissioner, 60 T.C. 996 (1973), acq., 1974-1 C.B. 1, six factors were relevant in determining whether the sale of land had been carried out in the ordinary course of business, as follows: (i) the purpose for which the asset was acquired, (ii) the frequency, continuity and size of the sales, (iii) the activities of the owner in improving and disposing of the property, (iv) the extent of improvements made to the property, (v) the proximity of purchase and sale, and (vi) the purposes for which the property was held. In Adam and subsequent cases, the Tax Court found that no one of these factors is controlling but all are relevant facts to consider in what is basically a facts and circumstances test, See, Houston Endowment, Inc. v. United 33

States, 606 F. 2d 77 (5th Cir. 1979), Biedenharn Realty Co. v. United States, 526 F. 2d 409 (5th Cir. 1976) and Buono v. Commissioner, 74 T.C. 187 (1980). Dealer status has been similaraly applied under the UBIT rules. Whether a particular activity engaged in by a charity is unrelated within the meaning of Section 513(a) and therefore subject to the tax imposed by Section 511, depends in each case on the particular facts and circumstances present, See, PLR 8734005. In Malat v. Riddell, 383 U.S. 569 (1966), the Supreme Court interpreted the meaning of the phrase "held primarily for sale to customers in the ordinary course of the trade or business" under Section 1221(1). The Court interpreted the word "primarily" to mean "of first importance" or "principally". By this standard, ordinary income would not result unless a sales purpose is dominant. The Service has often applied the principles derived under Section 1221 to rulings interpreting the language of Section 512(b)(5). Valuation Issues - Fair market value is generally determined under the definition found in Treas. Reg. Sections 25.2512-2(b)(1) and 20.2031-2(b)(1) – “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” In Revenue Ruling 77-287, 1977-2 C.B. 319, the IRS has provided factors to analyze in determining value of corporate stock that is privately-owned: (i) the nature of the business and the history of the enterprise from its inception; (ii) the economic outlook in general and the condition and outlook of the specific industry in particular; (iii) the book value of the stock and the financial condition of the business; (iv) the earning capacity of the company; (v) the dividend-paying capacity; (vi) whether or not the enterprise has goodwill or other intangible value; (vii) sales of the stock and the size of the block of stock to be valued; (viii) the market price of stock of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter. Treas. Reg. Sections 20.2031-3(c) and 25.2512-3(a)(3) indicate that many of these factors also apply in valuing other business interests, such a partnership or LLC interests. Special CRT Rules – Treas. Reg. Section 1.664-1(a)(7) provides rules for valuing unmarketable assets that are transferred to or held by a CRT. A CRT holding unmarketable assets will be disqualified unless any required valuations are (i) performed exclusively by an independent trustee or (ii) determined by a current qualified appraisal as defined under Treas. Reg. Section 1.170A-13(c)(3). An independent trustee is defined as a person who is not a grantor or a noncharitable beneficiary of the CRT and is not a related or subordinate party (under Section 672 and the regulations thereunder) to a grantor, a grantor’s spouse or a noncharitable beneficiary of the CRT. Unmarketable assets are defined in Treas. Reg. Section 1.664-1(a)(7)(ii) as assets that are not cash, cash equivalents or other assets that can be readily sold or exchanged for cash or cash equivalents and include real property, closely-held stock and unregistered securities with no available exemption permitting public sale. Charitable Contribution Deduction – A donor who claims a charitable contribution deduction in excess of $5,000 for the contribution of property, other than certain publicly traded securities, must among other things satisfy the requirements of 34

Treas. Reg. Section 1.170A-13(c): (i) the donor must obtain a qualified appraisal to determine the property’s fair market value; (ii) the donor must attach a fully completed appraisal summary (Form 8283) to the tax return on which the deduction is first claimed; and (iii) the donor must maintain certain records, and possibly attach a copy of the qualified appraisal to the tax return. In addition, if a donor was required to file Form 8283 in order to claim a charitable deduction, the donee recipient must also file an informational return (Form 8282) if the donee sells, exchanges or disposes of the property within 3 years of its receipt. Form 8282 may bring to light facts that would indicate that the donor overvalued the property. A donee recipient would also include a CRT or a CLT. VII.

CASE STUDIES

Case Study #1: Fred owns 100% of a business that has been in his family for ages – the Bedrock Quarry Company. Fred’s daughter, Pebbles, has no interest in the Company after marrying Moonrock. Fred is ready to sell his stock interest to a willing buyer. Mr. Slate, the planned giving officer at the Bedrock Foundation, suggests that he consider contributing his stock to a charitable remainder trust and then have the trust sell the stock interest. Fred is attracted to the idea, but wants to know the tax and financial ramifications of such a gift. Let’s assume the following: The fair market value of the Company stock is $5 Million; Fred has a zero basis in the Company stock; Fred is subject to a 20% (federal and state) capital gains tax rate and a 45% (federal and state) income tax rate; 7% is the growth rate of investments; the Company stock is Fred (age 68) and Wilma’s (age 65) sole asset. If Fred sells the stock he will incur a $1 Million capital gains tax, leaving him and Wilma with $4 Million to reinvest. Thus, they will accrue $280,000 of income (before tax) for the rest of their lives. At death, their estates will be subject to estate tax depending upon the value of the investments at that time and the applicable exclusion amount. Foundation will not receive any benefit from this plan. If however, Fred contributes the stock to a charitable remainder trust, he will be entitled to an income tax deduction in the year of the gift equal to approximately $1.2 Million, which saves in real dollars approximately $540,000. Fred and Wilma also increase their income (before tax) to $350,000 per year. At death, the value of the tax savings and net income not spent will grow for the benefit of Pebbles and may be subject to an estate tax; however, the value of Fred’s estate does not effectively include the value of the charitable remainder trust at his death, as his estate will be entitled to a charitable and/or marital estate tax deduction. Of course, Pebbles will not receive any benefit from the principal of the trust, as the principal is irrevocably designated for the benefit of the charity chosen by Fred and Wilma to receive the remainder of the trust. Case Study #2: 35

Pebbles became involved in the family business, and after ten years, Fred owned 51% of the Company stock and Pebbles owned a 49% interest. Fred generally liked the idea of a CRT and now contemplated contributing his 51% interest to a CRT and having the Company redeem it from the CRT. In that event, Pebbles would end up with 100% of the Company stock. Fred’s advisor suggests that self-dealing is implicated and maybe we shouldn’t run any risks in making this gift. STEPS: (i) Fred creates and funds the charitable remainder trust with the 51% stock interest in the Company; (ii) the Company redeems such stock interest from the CRT for cash; (iii) the CRT reinvests the entire net proceeds from the sale into a diversified portfolio of investments; (iv) Pebbles becomes the 100% owner of the Company stock; (v) the CRT pays income to Fred and Wilma for their lives; and (vi) upon the death of Fred and Wilma, the assets of the CRT will be distributed to the Bedrock Foundation. If the Company redeems the 51% interest pursuant to a plan of redemption in which the same offer for redemption is made to all shareholders for cash at a purchase price no less than the fair market value of the Company stock, the self-dealing rules are not violated (Code Section 4941(d)(2)(F)). Case Study #3: Fred also owns some bank stock in two closely-held companies. He created a revocable trust which will become irrevocable upon his death, and his private foundation will be entitled to all of the corpus and undistributed income in the trust. At such time, the private foundation will not want to retain this stock, as it is not income producing and will offer the stock for sale to disqualified persons. Self-dealing will not apply if the requirements of Treasury Regulation Section 53.4941(d)-1(b)(3)(i)(a) are met, including but not limited to: • the transaction is approved by the local probate court • the trustee possesses a power of sale with respect to the property • the foundation receives at least fair market value at the time of the transaction • the foundation receives an interest at least as liquid as the one it gave up Also See, PLR 9501038 for the application of this self-dealing exception to a business succession plan. Case Study #4 Let’s say, Fred owns 100% of the Bedrock Quarry Company and Pebbles has no interest. Fred wants to make a charitable contribution to the Bedrock Foundation, but the company stock is his only significant asset of value.

Fred understands the tax, financial and corporate ramifications of this gift. The Foundation is interested in accepting this gift â&#x20AC;&#x201C; what would you do on behalf of the Foundation? Case Study #5: The Company had already entered into a plan of redemption which had been approved by its shareholders. Fred then took the advice of Mr. Slate and contributed his stock interest into the charitable remainder trust. What if the Company was engaged in the first ever tender offer of its stock to the conglomerate, Dino Dynasty, and then contributed the stock to the charitable remainder trust. Will Fred incur gain on the sale of the stock by the charitable remainder trust? What would happen if the Company Board had already accepted a nonbinding letter of intent to authorize the sale of Company stock? Case Study #6: The Bedrock Quarry Company was operated in an S corporation. Fredâ&#x20AC;&#x2122;s advisor suggested that he contribute his 51% stock interest into a charitable remainder trust and conduct the redemption plan in accordance with the self-dealing exception. Mr. Slate, the planned giving officer for the Bedrock Foundation advised Fred that there may be some issues to consider further. The S corporation may convert into a C corporation and Fred can then contribute his stock into the charitable remainder trust. In addition, the S corporation could use a valuable asset (like, a big crane) and contribute that asset to the charitable remainder trust for no more than 20 years with income paid to the S Corporation. Case Study #9: Case Study #7: Wilma created a family limited partnership (or a family LLC) which holds marketable securities and income producing real estate and wants to contribute her limited partnership interest to a charitable lead trust. Wilmaâ&#x20AC;&#x2122;s advisor warns Wilma that a partnership interest can constitute a business enterprise for purposes of the excess business holdings excise tax. So long as 95% of the income is passive in nature, the partnership interest will not constitute a business enterprise (Code Section 4943(d)(3)(B)). The excess business holdings tax will not apply if the value of the lead interest is 60% or less of the value of the property contributed to the trust. What if EBH does apply? The trust could hold the gifted stock for 5 years without the imposition of this tax and possibly extend that time for an additional 5 years (Code Sections 4943(c)(6) and (7)). Case Study #8:

Wilma, Fred’s wife, owns a parcel of income producing real estate and contributes the real estate to a charitable lead trust. Wilma’s advisor is concerned that unrelated business income may adversely affect the benefits from the charitable lead trust. If the income constitutes “rents from real property” under Code Section 512(b)(3), no UBI will be generated and will not adversely affect the trust. In general, so long as the rental for real property is fixed and triple net, and no substantial services are provided by the landlord, UBI should not be an issue of concern. Can you revise the terms of the lease prior to the transfer into the trust to comply with 512(b)(3)? What if Wilma contributes the real estate along with marketable securities into a family limited partnership or LLC – same result? What if the real estate was debt encumbered? Case Study #9: Fred also has many parcels of real property that he buys and sells on a regular basis. He wants to contribute some or all of these properties to a charitable remainder trust. Fred’s advisor does not want him to do so, because Fred is a “dealer” and the sale by the trust will constitute UBI. The donor’s status as a dealer should not taint the trust’s sale. What is the benefit of this result? What might change this result? What if the property is debt encumbered?

Jonathan Ackerman, Esquire Law Office of Jonathan Ackerman, LLC 6 Park Center Court, Suite 102 Owings Mills, MD 21117 410-363-1187 410-581-0123 fax

i. Section 501(c)(3). All references to Section herein means a section of the Internal Revenue Code of 1986, as amended, except as otherwise referenced. ii. These six entities are delineated in Section 170(b)(1)(A)(i)-(vi). iii. See, General Explanation of the Tax Reform Act of 1969, H.R. 13270, 91st Cong., 1st Sess., P.L. 91172. iv. Conf. Rep. No. 91-782, 91st Cong., 1st Sess. (1969). v. Treas. Reg. Sec. 1.509(a)-4(c)(3).

vi. Treas. Reg. Sec. 1.509(a)-4(c)(1). vii. Treas. Reg. Section 1.509(a)-4(d)(4)(i). Also See PLR 201019034 for a recent ruling disqualifying an SO for failing the organizational and operational tests. viii. Treas. Reg. Sec. 1.509(a)-4(d)(2)(iv). ix. See, Change-All Souls Housing Corporation v. The United States, [82-1 USTC ¶9194], 229 ClsCt 380, 671 F.2d 463 (1982), where a substantial identity of interest arose between the two organizations. x. Treas. Reg. Sec. 1.509(a)-4(d)(4)(i). See Also, Quarrie Charitable Fund v. Comm’r, 70 T.C. 182 (1978), aff’d, 603 F.2d 1274 (7th Cir. 1979), where the trustee had the power to substitute new charitable beneficiaries for the named beneficiaries if the trustee determined that the original charitable uses have become "unnecessary, undesirable, impracticable, impossible or no longer adapted to the needs of the public." The Tax Court held that the trust was a private foundation, not an SO, because the trustee's power of substitution was not conditioned upon an event which was beyond its control as required by the organizational test under Treas. Reg. Section 1.509(a)-4(d)(4). xi. Treas. Reg. Sec. 509(a)-4(c)(2) and Rev. Rul. 76-401, 1976-2 C.B. 175. xii. Treas. Reg. Sec. 1.509(a)-4(e). xiii. Treas. Reg. Sec. 1.509(a)-4(f)(2). xiv. Treas. Reg. Sec. 1.509(a)-4(f)(4) and (g). xv. Treas. Reg. Sec. 1.509(a)-4(f)(4) and (h). xvi. Treas. Reg. Sec. 1.509(a)-4(f)(4) and (i). xvii. Also See, Treas. Reg. Sec. 1.509(a)-4(j). xviii. "Family" is defined under Sec. 4946(d) as spouse, lineal descendants and their spouses, and lineal ascendants.