Using a CRUT to Transition a C Corporation to the Next Generation, While Providing Retirement Income

By: Lynn M. Coles, Esq.

How many of you have clients who own a C Corporation and have children whom they want to transition the business to?  How many of these clients are concern about the “double taxation” that will occur when they transition the C Corporation to their children?  How would these clients like to get the business to their children, benefit their favorite charities and provide themselves with retirement income, all with little gift, income and capital gain tax consequences?  May sounds too good to be true, but there is a business succession plan that involves a complex charitable remainder trust to produce this tax efficiency.  This strategy is based upon PLR 200230004. 

            In PLR 200230004, a married couple, the Taxpayers, sought the guidance of the IRS involving the following scenario.  Taxpayers were grantors of a Net Income (with) Make-Up (provisions) Charitable Remainder Unitrust (NIMCRUT).  They owned all 500 outstanding shares in their C Corporation.  Their C Corporation had only one class of shares.  Taxpayers wanted to contribute 495 of their shares in the Corporation worth $594,000.00 and a basis of $495.00 to their NIMCRUT.  The value of the stock was set by a qualified independent appraiser.  Taxpayers proposed that the board of directors of the Corporation would redeem the stock owned by the NIMCRUT for the fair market value as determined by a qualified independent appraiser.  This redemption offer would not occur until a least one year had passed after the funding of the NIMCRUT. Taxpayers explained that neither them nor their family members would acquire any of the Corporation’s shares from the NIMCRUT within one year of its funding.  In addition, Taxpayers stated that there was no plan or intention to have any person acquire any of the Corporation’s stock from the NIMCRUT.

            Based upon the above fact pattern, the IRS held that any income earned by the Corporation while its stock was owned by the NIMCRUT would not be deemed unrelated business taxable income to the NIMCRUT.  In addition, the redemption of the Corporation’s stock owned by the NIMCRUT would not be an act of self-dealing.  Finally, the redemption of the Corporation’s stock by the NIMCRUT would not result in capital gain attributed to the Taxpayers. 

            It is important to note the following details.  First, the charitable remainder trust was a NIMCRUT, i.e. it had net income makeup provisions.  This is important since the trust had no income to pay the annuity to the grantors until the stock was actually redeemed.  Second, the stock was appraised by a qualified appraiser, who conformed to all the guidelines for determining such value and filed Form 8283.  Third, the redemption was a bona fide offer made on a uniform basis to all of the shareholders and was for fair market value.  Fourth, the NIMCRUT was not compelled to sell the stock to the Corporation.  This is a critical point, because if the NIMCRUT was compelled to sell the stock to the Corporation, then such a transaction would be deemed a sale from the grantors and would result in capital gains taxes being allocated to the grantors. 

How does this benefit your clients?  For one thing, the NIMCRUT, once the redemption is complete, will provide the clients with an income stream with the annuity payments.  Second, the capital gains attributable to the redemption will only be taxed to the clients as part of the annuity payments, so they can defer the taxes.  But, you may ask how does this technique transition the business to the children?  The answer is outlined below.

First, before any transfer of stock occurs, ensure that there is a shareholder’s agreement in place that gives the corporation the right to redeem stock before it can be sold to a third party.  Then, proceed with the funding of the NIMCRUT.  Next, have the clients transfer their remaining stock in the corporation to their children.   As you can see, after this is done, the only shareholders will be the NIMCRUT and the children.  Thus, when the shares owned by the NIMCRUT are redeemed by the corporation, the children will be the only shareholders. 

Even though this sounds simple, there are some potential issues to be aware of.  The main potential issue is how does the corporation afford the redemption of the stock.  A careful review of the corporate finances will be necessary to determine if the redemption can even be achieved.  The answer may be that a combination of retained earnings and outside financing, such as a bank loan, will be required to enable the corporation to afford the redemption. 

A second potential issue is the possible loss of control in the corporation.  If a majority of the shares in the C Corporation has to be transferred to the NIMCRUT to generate a sufficient income stream for the clients, the trust will have control of the corporation.  To prevent this, the clients can simply assign their rights to the stock to the NIMCRUT, thereby preserving control of the corporation. 

Another potential issue is gift tax consequences.  When transferring the interest to the children, if the clients receive nothing in return, the transaction will constitute a gift.  Therefore, other asset transfer strategies, such as obtaining applicable discounts and utilizing a part sale and part gift technique, should be explored to help minimize or even eliminate gift tax consequences.

A fourth potential issue is the loss of inheritance for their children that the charity will be receiving.  To solve this dilemma, wealth replacements techniques, such as utilizing an ILIT to purchase a second-to-die policy, should be analyzed.  The ILIT will keep the insurance proceeds outside the clients’ taxable estates and replace the net wealth (the inheritance minus applicable estate taxes) that the children would have received if the NIMCRUT strategy was not used. 

To summarize: Not only can clients use a NIMCRUT to generate an income stream and benefit their favorite charities, but the NIMCRUT can be part of an estate planning strategy that transitions the C Corporation to the next generation, all while minimizing gift, income and capital gains tax consequences.  However, as set forth above, there are many components of the strategy that must be analyzed to ascertain if this technique is appropriate for your client’s situation. 

If you have any questions about the matters discussed in this e-letter, please contact Louis W. Pierro or Lynn M. Coles at (518) 459-2100.  Prior Tax Planning E-Letters may be accessed at www.pierrolaw.com.