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Supercharge the sale of your business with a charitable remainder trust

Key takeaways:

  • If you own a closely held business, choosing how and when to exit your business is a critical part of your planning. You’ve worked hard to build your business and want to ensure that you get rewarded appropriately. You undoubtedly also want to ensure the continued success of your business. The number of options for achieving these goals — and the amount of time involved — can be daunting.
  • If one of your goals also involves benefiting charity, you might consider the use of a charitable remainder trust (CRT).
  • You are likely continuing to assess options to reduce your current income tax bill and may be concerned about the possibility of higher income tax rates to come. Charitable contributions are one way clients like you can lower your overall tax bill.
  • Interest rates for many sophisticated estate planning techniques remain low, but have risen and are expected to continue to rise. For those choosing to implement a CRT, higher rates are to your advantage.
  • One potential concern will be related to current rates of return, particularly for equities. Now, more than ever, the choice of investment after the sale is of paramount importance to ensure that the trustee of the CRT generates enough income to make payments to you, and does not have to make the payments to you of the underlying investments themselves.

Introduction to charitable remainder trusts

Beyond making contributions directly to charity or utilizing donor-advised funds or a private foundation, other options to benefit charity involve the use of so-called split-interest charitable gifts. One version of such a gift is the CRT. Working with your attorney, you create a trust for the ultimate benefit of one or more charities of your choosing. As the donor, you contribute assets to the trust and retain the right to receive a stream of payments, typically for a number of years. You also receive a charitable income tax deduction for the year in which you make the contribution. This is based upon the present value of the remainder interest that will pass to the charitable beneficiaries. The factors used in computing the present interest are the following:

  • The value of the asset contributed to the trust;
  • The term of the trust (how long the payments to you, the donor or other beneficiaries of your choosing);
  • The stated rate of the payout;
  • The section 7520 rate (the interest rate for predicting the growth of the assets); and
  • The timing or frequency of the payments to you (e.g., annually, quarterly, etc.)

During the period that you have the right to payments from the trust, the trustee is obligated to make those payments to you, typically from income generated by whatever assets the trust owns. This is where the decision of which assets to give to the trust is important. Among other factors to consider are the asset’s liquidity (because often the asset is sold by the CRT), ease of valuation, freedom from encumbrance, and income taxation.

Example of how a CRT works

Susan, age 60, establishes a CRT in November 2022 and makes a contribution of $1 million of publicly traded securities.  The Section 7520 rate for November 2022 is 4.8% (higher than either of the prior two months).  The CRT pays her $75,000 annually for 10 years.  The present value of Susan’s annuity stream is $584,797.50.  The present value of the charity’s interest (and Susan’s income tax charitable deduction) is $415,202.50 ($1 million less $584,797.50).

How does the sale of my business fit in?

In evaluating the options to sell your closely held business, taxes are likely a paramount concern. One opportunity may be to incorporate a CRT into your plan, to allow you to obtain a charitable income tax deduction and reduce the overall amount of tax you pay. Here’s how that typically works:

  • Working with your attorney, you establish a CRT.
  • You get a valuation report for your business from a valuation professional.
  • You contribute your closely held business to the CRT, retain an income stream and take a charitable income tax deduction for the amount ultimately passing to the charitable beneficiary.
  • The trustee of your CRT subsequently sells the business.
  • Because of the income-tax-free nature of the CRT, no taxes are paid at the time the trustee sells the business.
  • The trustee invests the proceeds from the sale in other investments and uses them to make the payments to you, the grantor, or others of your choosing (there are gift tax implications if others receive the payments).
  • The charity receives the remainder interest at the end of the term of the CRT.

Example: Comparison of net proceeds from sale versus sale with CRT

Let’s assume that you own a closely held business worth $10 million that you are looking to sell in the near future. You are interested in receiving payments over a period of time and are also charitably inclined. The business is a limited liability company (LLC) taxed as an S corporation, and you are the sole owner. Your basis in the LLC is $4 million. Should you opt to sell it directly to a third party, here is a basic calculation of what the income tax consequences could be with a lump sum sale (no installment election):

Should you, instead, decide to sell your business using a CRT, here is a look at the income tax consequences:

  • You contribute the LLC to a CRT, retaining the right to payments for 20 years.
  • Your charitable income tax deduction is $1,000,000.03 for the year of funding.
  • The trustee of the CRT will make annual payments of $709,986.35 to you for 20 years.
  • The trustee sells your business; given that the CRT is tax-exempt, there are no income taxes generated at the time of the sale.
  • The trustee invests the tax-free proceeds to generate income to be used to make the required annual payments to you.
  • While also dependent on what the trustee of the CRT invests in after the sale of your business, each payment to you of $709,986.35 is initially taxable as follows:
    – $6 million/$10 million (6/10), or $425,991.81, is long-term capital gain
    – $4 million/$10 million (4/10), or $283,994.54, is a tax-free return of basis

As can be seen in the above example, using the CRT allows you to obtain a charitable income tax deduction in the year you fund the CRT, retain an income stream and spread the payment of capital gains over a 20-year period.

The “prearranged sale” doctrine and how to avoid it

It is important that you evaluate the use of the CRT early enough in the process of selling your business. If you are too far along in identifying the purchaser of your business and are viewed as compelling the trustee of the CRT to sell to a particular buyer, the IRS will tax the sale of the business by the CRT immediately, undoing the tax benefits ordinarily associated with a CRT.

This is known as the “prearranged sale” doctrine. Although there are a variety of cases that have ruled on when a sale has in fact been prearranged, the application of this doctrine is based upon your particular circumstances, and you should work with your tax professionals to ensure you do not have a prearranged sale prior to moving along with plans to contribute your business to a CRT.

The impact of interest rates

The interest rates required to be used by the Internal Revenue Service for many planning techniques remained low for many years, but rose significantly in 2022. Though many sophisticated planning techniques generally benefit from low rates, the opposite is true with a CRT. With a CRT, you can choose the section 7520 rate for the month of the contribution to your CRT or the two previous months, whichever is highest. Here is chart reflecting recent rates as well as those for various periods historically:

Section 7520 rate table

Changes to current income tax rates

Although at the time of this article it appears that individual income tax rates are not likely to rise, higher rates remain a possibility, particularly for high-income earners. Developing a plan to help minimize your overall tax while selling your business is critical. Charitable planning can help you better achieve your goals, whether in conjunction with the sale of your business or apart from it.

Act now!

At Baker Tilly, we have consulted with thousands of closely held business owners like you. If you have questions about this particular technique, need help with how to move forward with the sale of your closely held business, or have questions about other aspects of your planning, please reach out to a Baker Tilly professional to get started today.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

William Grady
Construction project leader reviews plans
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