Sunday December 21, 2014

Article of the Month

Gifts of Pass-Through Business Interests


A charitable gift of a business interest can make a wonderful gift to charity. At the same time, however, business entities that are subject to pass-through taxation, such as partnerships, S- corporations and limited liability companies (LLC) can create potential challenges. In the years to come, charities are likely to be presented with more and more opportunities to accept gifts of closely-held business interests, including gifts of a "membership interest" in an LLC where the LLC has made the election with the IRS to be taxed as a partnership.

LLCs are popular because they afford the owners, typically called "members," the same limited liability protection that C-corporations provide to shareholders while also offering the favorable pass-through taxation that a partnership affords to its partners. A donor interest in a closely-held business, such as an LLC, S-corporation or partnership, may have significantly appreciated in value. As such, it is important for donors, their professional advisors and recipient charities to be acquainted with the complexities and challenges of such gifts.

Pass-Through Nature of Partnerships

LLCs, S-corporations or partnerships are pass-through entities that differ from C-corporations because the business does not pay tax at the entity level. Instead, the owners of these pass-through business entities must include their share of the pass-through entities' income, gain, losses, deductions and credits on their individual income tax returns - even if the business income isn’t actually distributed to the business owners. This is called “pass-through” taxation because the business entity “passes” its income, gain, losses, deductions and credits “through” to the persons who own the business. LLCs, S-corporations and partnerships are the most common types of pass-through entities and they elect this pass-through treatment by making an election with the Internal Revenue Service.

With typical pass-through entities, each LLC member, S-corporation shareholder and, in the case of many partnerships, each partner shares in the profits and losses of the business. In addition, many closely-held businesses have debt that has been guaranteed by the owners of the business. As discussed below, this has important implications when the business owner transfers their ownership interest in the company in cases where there is relief from indebtedness. Under Sec. 741, the ownership interest in these entities is considered a capital asset, so any sale or exchange of that interest will produce gain from the sale of a capital asset.

Overview of a Partnership Interest

Closely-held business interests are made up of several elements. These elements include the owner's basis in the interest, capital gain, ordinary gain, and then the allocated portion of any expenses and losses of the partnership. One other element that may be present in the case of a closely-held business owner, where the owner does not materially participate in the trade or business of the partnership (such as most rental activities), are passive activity losses. These passive activity losses are lost to the extent they are allocated to a gift.

Most partners will have an adjusted basis in their partnership interest. In addition, the partnership may own items that, if sold, would produce ordinary income. Such items would include unrealized receivables, inventory or recapture of accelerated depreciation. Sec. 751. The interest will also consist of capital appreciation in the form of long-term capital gain. Finally, the interest may consist of debt that would be treated as an amount realized if transferred to charity.

Example of George and Lucille

George and Lucille collectively own 50% in TBA, LLC, a pass-through entity which is taxed as a partnership. The approximate value of their interest is $1 million. Their adjusted basis in their interest is $200,000. George and Lucille have personally guaranteed a loan to the company in the amount of $100,000 and pledged their LLC interest as collateral to the lender. In addition, their share of the company's ordinary income assets in the form of inventory, receivables and recapture of accelerated depreciation is $50,000. George and Lucille's tax advisor, Tobias, has advised them that they need to find tax savings to offset taxes owed from an unrelated transaction. Accordingly, George and Lucille want to make a gift of their interest in TBA, LLC to their favorite charity.

Before making the gift, George and Lucille should consider any restrictions on the transferability of their interest as provided in the LLC’s operating agreement (or partnership agreement for a partnership). Assuming the operating agreement permits them to freely transfer their interest to charity, they may proceed with the gift. (Advisors should keep in mind that there are additional rules related to the transfer of S-corporation stock to non-taxpaying entities such as a charity or charitable remainder trust. These issues are not discussed in this article.)

If George and Lucille were to sell their LLC interest, they would have $50,000 of ordinary gain, $750,000 of long-term capital gain and $200,000 return of basis. If their LLC interest were gifted to charity they would receive a deduction for the fair market value of their interest. However, this amount would be reduced by $100,000 if they received relief from indebtedness and by a portion of the ordinary gain of $50,000.

Relief of Debt

When George and Lucille transfer their interest to their favorite charity, there is a bargain sale under Sec. 1011 for the value of the indebtedness relief related to the sale. Under the bargain sale rules, the equity in the property will produce a charitable deduction, but release of the indebtedness will be treated as a taxable event. Therefore, if George and Lucille gift their interest in TBA, LLC to their favorite charity, they will realize $100,000 on the relief of indebtedness. Reg. 1.1011-2(a)(3).

George and Lucille’s cost basis in their interest is prorated between the equity and the value of the debt. In most cases, the gift is an appreciated property gift, and the donor will recognize gain on the difference between the face value of the debt and the prorated basis. If property has been held for more than one year, then the donor will receive an appreciated property charitable deduction for the value of the equity and recognize long-term capital gain (or ordinary income, if there is recapture for accelerated depreciation) on the relief from indebtedness.

In George and Lucille’s case, their $200,000 cost basis in their interest is allocated between the gift portion and the debt portion. Thus, because the debt is 10% of George and Lucille's value of the LLC interest, 10% of the basis or $20,000 will be allocated to the $100,000 relief of debt. This would produce $80,000 realized as gain on the relief of debt, which will be long-term capital gain except for the pro-rata ordinary element attributable to the receivables, inventory and recapture of accelerated depreciation. If George and Lucille had any passive activity losses in their interest, the portion of those losses allocated to the sale of the debt could be used to offset some of the gain.

Valuation of George and Lucille’s Interest

For gifts of property greater than $5,000, a donor must get a qualified appraisal or the deduction may be denied. The timing for an appraisal is important. Under Sec. 170, a qualified appraisal must be completed to value the gift not earlier than 60 days prior to the date of the gift and not later than the time that a donor files their federal income tax return claiming the deduction related to the gift. Because George and Lucille’s LLC interest is a closely-held business interest that is greater than $5,000 in value, they will need to get a qualified appraisal.

However, because George and Lucille’s LLC interest is a closely-held interest, the qualified appraiser will likely produce a valuation that includes discounts for both minority interest and lack of marketability. That combined discount could be 20% to 40% of the fair market value of the interest. There may, however, be situations where such a steep discount is not justified and should not be applied. If the LLC members have already entered into negotiations to sell the business or they have even already received a tender offer to sell the business, these facts would support substantially limiting the scope of any minority/marketability discounts. Keep in mind, however, that George and Lucille cannot bypass any capital gain related to the charitable transfer of their interest under the assignment of income and prearranged sales rules if the tender offer has been accepted and thus created a binding obligation to sell. Accordingly, to maximize their deduction, George and Lucille can negotiate a tender offer, thus minimizing valuation discounts, but that tender offer cannot be accepted prior to the transfer of their LLC interest.

Assuming that the value of George and Lucille’s LLC interest is discounted by 20%, the value of their deductible interest will be $800,000. That deductible value will then be partially offset by the recognition of the ordinary income and capital gain on the debt. Finally, because the interest is a capital asset, the deduction will be a 30% type appreciated property deduction.

Acquisition Indebtedness and UBTI

The debt on George and Lucille’s interest poses a problem for the recipient charity as well. Property acquired by a charity that is encumbered may give rise to “acquisition indebtedness.” Sec. 514(c)(2)(A). The amount of the mortgage or lien is indebtedness even if the charity does not formally assume the debt obligation.

If a charity acquires and retains property with acquisition indebtedness, then income earned by the debt financed property may subject the charity to unrelated business taxable income (UBTI), unless the use of the property is substantially related to the charity's exempt purpose. Sec. 514(b)(1)(A).

If property subject to debt is transferred to charity, then the charity could be subject to UBTI upon the sale of that property. However, there is an exception for property that has been owned by the donor for more than five years, and the debt has been on the property for more than five years. Sec. 514(c)(2)(B). In this case, the charity may receive the property and there will be no acquisition indebtedness for a period of ten years. Therefore, if the donor passes the “five and five” test, then the charity may receive and sell the property within the ten-year period, without payment of any unrelated business income tax on the gain. If not, then the acquisition indebtedness will cause the charity to pay capital gains tax on the sale of the property, though it has a $1,000 exclusion it can use for some of the gain. Sec. 512(b)(12).

Because a closely-held business interest is subject to pass-through taxation, any income earned by the business passes through to the owners. When the income is passed through to the owners, it maintains the same character in the hands of the owners as it had in the business. As a result, if the business is closely-held, its income will pass-through as active trade or business income.

If a charity holds a closely held business interest, so that it is an LLC member or a partner, the charity will pay unrelated business income tax (UBIT) on all active trade or business income that passes through to the charity from the pass-through entity. While charities are permitted to pay UBIT, they need to be concerned with the amount of UBIT they pay each year because it could jeopardize the charity’s tax-exempt status. Small amounts of UBIT, however, should not cause great concern.


With the popularity of LLCs and other closely held businesses, charities will be presented with many more opportunities to receive gifts of interests in these businesses. That is good news because such gifts can create powerful income tax, estate and charitable planning opportunities for donors. Recipient charities and professional advisors should therefore acquaint themselves with the complexities and challenges that come with these gifts.

Specifically, qualified counsel should be consulted to determine the potential tax consequences associated with gifts of pass-through entities, especially if the entity holds inventory, receivables or debt encumbered property. In addition, donors should check the partnership or operating agreement to ensure there are no restrictions on the transferability of the interest. If these challenges can be met, then the gift of a pass-through interest can be a great gift to charity or to a charitable remainder trust. In the end, these gifts can help donors ensure that they achieve their personal and philanthropic goals.

Published December 1, 2014

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