overview

I mentioned my year-long writing sabbatical last week. Over the course of the year, I’ve collected a few ideas that I’ll cover in new articles. One of those ideas is to penetrate the tax-exempt organization needle with personal tax planning. How can a taxpayer use nonprofit solutions to reduce personal income and estate taxes while retaining some level of control? The planning bottleneck always seems to arise at a confluence of tax planning problems – excessive corporate ownership, excessive benefits, self-dealing, and unrelated business taxable income (“UBTI”).

Last week, I wrote about 501(c)(4) nonprofit organizations (“C4s”), which are increasingly being used by very wealthy taxpayers who engage in significant lobbying and political activity in addition to their charitable activities. To date, or at least to the best of my knowledge, taxpayers with closely held businesses have not established C4 organizations to pursue their charitable interests and tax planning.

From a tax perspective, C4s can be attributed some favorable characteristics that do not apply to public charities (“C3s”). Self-dealing is not prohibited in C4s, which gives the taxpayer the opportunity to conduct transactions on an independent basis. However, the restrictions on excessive benefits apply to the taxpayer. C4s can engage in political activity and support political activities. The UBTI rules apply to both C4s and C3s.

This article discusses the use of private financial derivative contracts as a planning tool for C4s for investments in the taxpayer’s business without UBTI treatment.

Private financial derivatives

First, professional recognition must be given to David Handler, partner at Kirkland & Ellis. David is one of the country’s leading tax and estate planning attorneys. He is responsible for introducing the planned use of private derivative contracts in tax and estate planning. His presentation at the Heckerling Institute of Estate Planning in 2016 is the definitive technical resource on the subject.

A derivative is a financial contract that gives the holder the right to receive payment from the instrument’s counterparty if certain events occur during the contract’s term. Derivatives can be tied to the price or performance of any asset, including the stock of a public or private company. Historically, derivatives have been tied to the performance of a stock or the performance of a stock portfolio or stock index. In the planning context, the derivative contracts being considered are private derivatives between family members or family trusts. Unlike in public markets, in private derivative contracts, the contracting parties do not lose money. A derivative contract can be customized to meet the client’s needs and objectives.

Private derivatives can be structured as call options to increase the value in an asset, whether or not the taxpayer owns the asset, plus possibly any distributions or dividends paid during the term of the option contract. The option holder may exercise the option in a cashless exercise and receive the difference between the market value and the option’s exercise price of the reference asset or stock, rather than taking possession of the asset or stock. Alternatively, the option contract can be structured as a private put option, where the investor benefits if the value of the reference asset falls.

A swap contract is another type of derivative contract. Swap contracts are financial derivatives that allow two transaction parties to “swap” the revenue streams from a reference asset held by each party. Hybrid swaps allow their holders to exchange financial streams associated with a reference asset. The swap contract may provide that one of the contracting parties will receive a “fixed payment” during the term of the swap contract, while the other party will receive a “floating” payment to the extent that it exceeds the fixed payment. In a principal, a taxpayer’s entity may serve as the reference asset for the swap contract.

Taxable income from non-business activities (UBTI)

Tax-exempt organizations do not pay federal income tax on their income unless it is UBTI. IRC Sec 512 defines UBTI as income from an unrelated business or trade of the nonprofit organization. This income can be K-1 income from an S corporation or partnership. It can also come from debt-financed assets. In addition, gain or loss from the sale of stock in an S corporation or partnership can also constitute UBTI if the underlying business activity is unrelated to the organization’s nonprofit purpose.

The IRS has ruled on the tax treatment of investments in derivatives contracts at least 10 times. While a taxpayer cannot rely on an unrelated taxpayer’s private ruling, a private ruling sets out the IRS’s position on a tax issue. The IRS has issued a number of rulings (PLR 200352017, 200352018, and 200352019) that were favorable to the taxpayer. In those rulings, the IRS ruled that the investment in the derivatives contract was not an investment in the underlying asset that could generate UBTI. Consequently, the derivatives contract did not generate UBTI treatment for the exempt organization because the contractual interest was not an interest in the underlying asset that would otherwise generate UBTI tax treatment. So a derivatives contract can be helpful in converting business income into non-UBTI income.

Planning example

Facts

Pedro Navaja is a wholly owned shareholder of Acme, Inc., an S corporation. Acme was recently valued at $2 million by a business valuation specialist. A potential buyer is willing to pay $6 million for the company’s assets. Navaja has an exceptionally low basis in assets and company shares. He is trying to minimize income taxes on the sale. A letter of intent to purchase the company has yet to be signed. A 99 percent non-voting stake is valued at $1.2 million. If Navaja were to gift his shares directly to a charity, the taxable gain would be treated as UBTI for the charity.

Solution

Navaja, along with his attorney and a business valuation specialist, created a private call option with a term of two years to acquire a non-voting 99 percent interest in the company. The call option has an exercise price of $1.32 million and offers the option holder the opportunity to exercise the option without cash. The appraiser estimates the value of the call option at $400,000.

Navaja creates a new C4 organization called Todo Por La Patria Charities. He creates a new special purpose vehicle (“SPV”) as a limited liability company called PN Charities, LLC. Navaja transfers the call option to the SPV and donates 99.9 percent non-voting interest in the LLC to the new C4. The contribution is not deductible for income tax purposes. Navaja is the manager of the SPV and retains a 0.1% voting interest in the SPV. Prior to closing, Navaja, as manager of the SPV, exercises the call option in favor of the SPV in a cashless exercise. The trustee passes the difference between the sale price ($6 million) and the exercise price ($1.32 million) to the SPV ($4.68 million) to the SPV.

The tax nature of the call option proceeds is not UBTI income. The income allocated to the C4s (99.9%) is not UBTI. Had Navaja gifted the S corporation stock to the C4s, the gain would have been treated as UBTI. As manager of the SPV, Navaja retains management control for investment and distribution purposes. He can also conduct fair market value transactions with the C4s, including tax-free loans to Navaja or other entities he controls. Navaja can support his favorite charitable ventures and political causes.

Summary

Tax planning is becoming more complicated by the day. Taxpayers have always considered the use of charitable strategies in their personal tax planning. For business owners, the UBTI dilemma arises due to the tax treatment of business income and capital gains associated with the donation of a business interest. This article has attempted to show that with some creativity and a combination of different planning techniques – (1) a 501(C)(4) organization and (2) private derivative contracts – business owners can demonstrably change their tax results.