David T. Leibell & Daniel L. Daniels, in the Stamford, Conn., office of Wiggin and Dana LLP.

A new private letter ruling shows business owners a way to transfer their businesses to a family foundation, save estate taxes, and avoid big penalties under the private foundation excise tax rules.

In Private Letter Ruling 200927041, issued July 2, 2009, a business owner bequeathed an interest in business real estate to a private foundation, but gave family members an option to buy that real estate from the estate. Then, instead of the foundation receiving the real estate, it received the sale proceeds from the exercise of the option. The estate got a full charitable deduction, the family got control of the real estate immediately after the owner's death — and excise tax disaster was averted.

The federal estate tax poses an especially thorny problem for owners of closely held businesses. The business is often one of the single most valuable assets of the owner's estate and, as such, may result in a significant estate tax at the owner's death. At the same time, the estate may have no ready means to pay the tax due other than by selling the business to a buyer outside the family — a result that would have many a business owner spinning in his grave.

Faced with this dilemma, a lot of business owners want to leave their businesses to a private foundation that will be controlled by their families. The idea is seductive in that it seems to offer the business owner the best of all worlds: The business passes without an estate tax because the transfer of the business to a properly structured private foundation qualifies for the estate tax charitable deduction. Moreover — the owner might think — family members will be able to control the business through their positions as trustees of the private foundation.

But what sounds like a good idea can go terribly wrong and not only wind up costing the family, but also losing the family business to outsiders. That's because, if a private foundation owns an interest in a closely held business, the foundation may be subject to the unrelated business income tax, plus certain punitive taxes under the private foundation excise tax rules of Internal Revenue Code Sections 4940 through 4946. These excise taxes include the tax on excess business holdings and the tax on self-dealing between the foundation and certain inside parties; rates can run as high as 200 percent. One of the few ways around these onerous tax obstacles is to sell the business out of the foundation. But by then a sale of the business to a family member usually isn't possible because the sale violates Internal Revenue Service rules against self-dealing between the foundation and certain related parties.

Yet, despite these potential tax traps, it's still possible for business owners to successfully dance the “family business to private foundation” two step.

What this Family Did

PLR 200927041 shows us how:

The decedent (referred to in the ruling as “B”) died, leaving surviving her former spouse (S), and her children, a daughter (D) and a son (F).

S was the founder of a private foundation and of a closely held corporation. D and F are not only directors of the foundation, but also were appointed personal representatives of B's estate.

The closely held corporation was a holding company that conducts business through a number of wholly owned subsidiaries. F owns all shares of voting common stock in the corporation. B, S and the corporation all are substantial contributors to the foundation.

Upon B's death, she devised the residue of her estate to the foundation. The residue included the ownership of certain timber properties (the “business real estate”).

The business real estate was subject to an option agreement that granted the corporation the right to acquire the business real estate at any time up until B's estate terminated, at the then-current fair market value (FMV), as determined by an independent appraiser.

The corporation exercised the option through a third party intermediary acting as an assignee of the corporation. Pursuant to the option agreement:

  1. the corporation's assignee paid a price to B's estate that was above the business real estate's FMV (as determined by an independent appraiser); and
  2. B's estate received all cash.

The state attorney general didn't object to the estate selling the business real estate to the corporation. The probate court with jurisdiction over B's estate also approved the sale.

IRS Approval

Given these facts, the IRS ruled that the sale was not an act of self-dealing under IRC Section 4941 by any of the parties.

The Service relied on the “estate administration exception” to the self-dealing rules of IRC Section 4941. Under this section, an excise tax is imposed on each act of “self-dealing” between a private foundation and a “disqualified person.”

Self-dealing is defined as including a sale or exchange of property or the extension of credit between a foundation and a disqualified person whether done directly or indirectly. Under Section 4946, a “disqualified person” with respect to a private foundation includes a substantial contributor to the foundation, a foundation manager, and an owner of more than 20 percent of the total combined voting power of a corporation who is a substantial contributor to the foundation. It also includes a member of the family of any individual described here. And it includes a trust or estate in which persons described hold more then 35 percent of the beneficial interest.

In this case, the corporation, D and F are all disqualified persons. Therefore, if the foundation were to sell the business real estate to the corporation, it would be an act of self-dealing.

Why, then, is the estate's sale of the business real estate to the corporation, followed by a distribution of the option proceeds to the foundation, not an act of self-dealing? After all, the foundation and corporation end up in the same place economically as if the foundation itself had sold the business real estate to the corporation.

The Exception

The answer lies in an exception to the self-dealing rules contained in Treasury Regulations Section 5.4941(d)-1(b)(3), which provides that the term “indirect self-dealing” shall not include a transaction with respect to a private foundation's interest or expectancy in property held by an estate if five requirements are met:

  1. The executor either (a) has a power of sale with respect to the property; (b) has the power to reallocate the property to another beneficiary; or (c) is required to sell the property pursuant to a pre-existing option agreement.

  2. A court with jurisdiction over the estate or the private foundation approves the sale.

  3. The sale transaction occurs before the estate is considered terminated for federal income tax purposes.

  4. The estate receives an amount that equals or exceeds the FMV of the foundation's interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the property was acquired by the estate.

  5. The transaction (a) results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up, (b) results in the foundation receiving an asset related to its exempt functions, or (c) is required under the terms of any option that's binding on the estate.

How Requirements Were Met

The Service found that all five requirements of the estate administration exception were met.

B, during her lifetime, entered into an option agreement with the corporation to sell the property to the corporation in exchange for which B or her estate would receive FMV of the assets transferred, as determined by an independent appraiser.

Because the personal representatives of B's estate were required to sell the property under the terms of the option agreement, the transaction meets this first requirement.

The second and third requirements were easily met, as the transaction was approved by the relevant probate court and the sale occurred before the estate administration was terminated.

The fourth requirement was met because the option agreement specified that the purchase price would be the FMV as determined by an independent appraisal; and B's estate did receive an amount greater than the appraised amount and that amount was all in cash.

According to the ruling, the last requirement of the estate administration exception is that the transaction must result in the foundation receiving an interest or expectancy at least as liquid as the one it gave up, sometimes referred to as the “at least as liquid test.” Here, the estate (and thereby the foundation) gave up real property in exchange for all cash. Thus, the estate received an interest at least as liquid as the one it gave up.

A Few Planning Notes

The Service seems to have gone too far in reaching the question of whether the “at least as liquid” test was satisfied. There should be no reason to examine whether the foundation received consideration “at least as liquid” as the asset it gave up in a case in which the estate was required to sell the property pursuant to an option agreement. The “at least as liquid” test only applies when the sale occurs without an option agreement in place.

PLR 200927041 is welcome news for business owners who wish to leave the business to a family foundation at death. It follows a line of other private rulings that have approved similar transactions, specifically PLRs 200207029; 200124029; and 200024052.

Planners considering this strategy might consider including additional flexibility that may not have been necessary in the ruling. For example, the option described in the ruling was exercisable for cash. To provide flexibility for the family members buying the business interest, it's permissible for the consideration to be in the form of a promissory note with a fair interest rate rather than cash.

Also, to provide additional estate tax leverage, planners can consider replacing the private foundation in the ruling with a charitable lead annuity trust (CLAT) that benefits a private foundation. Economically speaking, a CLAT provides family members the opportunity to receive some of the economic returns of the private foundation in excess of the applicable interest rate under IRC Section 7520 at the end of the lead trust term, rather than have all of those benefits inure to the private foundation.

Obviously, it's a complicated exercise to create an estate plan that uses the estate administration exception described in this PLR. But clearly the benefits of doing it well can be substantial.