Gifts to charity are a common feature of estate planning for the wealthy. Although there are myriad advantages to making lifetime gifts, many clients prefer to retain the full use of their assets during life and, therefore, postpone some or all of their charitable giving until death by making one or more charities a beneficiary of their testamentary plan. Such gifts can range from a simple outright
Gifts to charity are a common feature of estate planning for the wealthy. Although there are myriad advantages to making lifetime gifts, many clients prefer to retain the full use of their assets during life and, therefore, postpone some or all of their charitable giving until death by making one or more charities a beneficiary of their testamentary plan. Such gifts can range from a simple outright bequest of a specified amount, to a percentage or all of the residue or even the use of split-interest trusts, such as charitable lead or charitable remainder trusts, to achieve sophisticated tax planning objectives. No matter how such testamentary gifts to charity are structured, however, they all implicate the so-called “private foundation rules” of Chapter 42 of the Internal Revenue Code. Furthermore, if a private foundation (PF) established by a decedent's family has a beneficial interest in the decedent's probate estate or (formerly) revocable trust, the PF rules apply self-dealing restrictions to the estate and trust that may come as a surprise to some fiduciaries and their advisors.
The PF rules are found in IRC Sections 4940 through 4948. The most familiar provisions are IRC Sections 4941 through 4945, which specify certain prohibited acts (and omissions) that will result in the imposition of excise taxes on the entity involved in the violation and, in some instances, on the entity's management. The prohibited acts include:
- Acts of self-dealing between a “disqualified person” (discussed below) and an entity subject to the PF rules (IRC Section 4941);
- Failure to make the minimum required distributions for charitable purposes (IRC Section 4942);
- Holding a significant equity interest in an operating business (IRC Section 4943);
- Investing in a manner that jeopardizes the entity's fulfillment of its charitable purposes (IRC Section 4944); and
- Making improper distributions or expenditures (IRC Section 4945).
For reasons discussed below, most of the PF rules don't apply during a “reasonable period of settlement.” We specifically focus on self-dealing issues that can arise, even during a reasonable period of settlement, when a PF has an interest in an estate or trust. Following the expiration of a reasonable period of settlement, the estate or trust itself will be considered a “split-interest trust” subject to most of the PF rules.
The term “private foundation” is defined in IRC Section 509 to mean, generally, an organization exempt from federal income tax under IRC Section 501(c)(3) that's not a publicly supported charity or closely affiliated with a publicly supported charity. However, it's important to understand that the PF rules don't apply only to “private foundations.” In fact, IRC Section 4947(a)(2) applies most of the PF rules to any estate or trust with a charitable beneficiary, if a charitable deduction is allowed with respect to the charity's interest for income, gift or estate tax purposes. Estates and trusts in which both charitable and non-charitable beneficiaries have an interest are often referred to as “split-interest trusts” and are potentially subject to the excise taxes described above for violating the PF rules.1
The Split-Interest Problem
Any revocable living trust (or will) containing a testamentary gift to charity that's deductible for tax purposes implicates the PF rules. Such a trust becomes a split-interest trust, subject to IRC Section 4947(a)(2), upon the grantor's death if either an estate or income tax charitable deduction is allowed for the charitable gift. For decedents' estates that are required to file a federal estate tax return, it would be unusual for the gift to be structured in a manner that doesn't qualify for the estate tax charitable deduction. However, if an estate tax charitable deduction isn't taken or the decedent's estate is too small to require the filing of a federal estate tax return, the trust would still claim an income tax charitable deduction under IRC Section 642(c) for the gift to charity in virtually all cases. Either deduction is sufficient to cause the trust to become a split-interest trust potentially subject to the PF rules. This holds true regardless of how the charitable gift is implemented, whether as a specific bequest of property, a pre-residuary gift of a dollar amount or percentage of the trust estate or as all or a portion of the residue.
So, why don't fiduciaries routinely confront the PF rules when administering trusts that contain a testamentary gift to charity? The main reason is that the Treasury regulations relieve revocable trusts and estates from complying with most of the PF rules for a “reasonable period of settlement” following the grantor's death. Specifically, the Treasury regulations provide:
Revocable trusts which become split-interest trusts. A revocable trust that becomes irrevocable upon the death of the decedent-grantor under the terms of the governing instrument of which the trustee is required to hold some or all of its net assets in trust after becoming irrevocable for both charitable and noncharitable beneficiaries is not considered a split-interest trust under section 4947(a)(2) for a reasonable period of settlement after becoming irrevocable except that section 4941 may apply if the requirements of § 53.4941(d)-1(b)(3) are not met. (Emphasis added).2
The regulations go on to define a “reasonable period of settlement” as:
… that period reasonably required (or if shorter, actually required) by the trustee to perform the ordinary duties of administration necessary for the settlement of the trust. These duties include, for example, the collection of assets, the payment of debts, taxes, and distributions, and the determination of rights of the subsequent beneficiaries.3
There's a similar regulatory exception for probate estates, which applies until an estate is considered terminated for income tax purposes, based on a standard that's virtually identical to the “reasonable period of settlement” concept.4 If administration of a trust or estate is prolonged beyond this period, then the trust or estate will be treated as a split-interest trust, and most of the PF rules will apply to the entity as though it were itself a PF.
Even during a reasonable period of settlement, the regulations provide that one of the PF rules, the self-dealing prohibition of IRC Section 4941, continues to apply, unless another regulatory exception under that statute is also met.5 Unfortunately, the self-dealing provisions are, arguably, the most burdensome and far reaching of the PF rules. Section 4941(d) sets forth a long list of transactions that constitute impermissible self-dealing if engaged in, directly or indirectly, with a “disqualified person.” These transactions include:
- Any purchase, sale, exchange or leasing of property to or from the disqualified person;
- Any loan or other extension of credit to or by the disqualified person (although there's an exception for interest-free loans to a PF); and
- Any transfer of property to or use of property by or for the benefit of a disqualified person.
In the case of an estate or revocable living trust following the grantor's death, any of the foregoing transactions between the trustee or executor and a disqualified person would constitute indirect self-dealing with the charitable beneficiary or beneficiaries of the trust or estate. The Tax Court has observed that Section 4941 and its regulations:
… clearly contemplat[e] that the interest of a private foundation in the property of an estate, as a beneficiary thereof, will be treated as an ‘asset’ of the private foundation … [T]ransactions affecting property of the [e]state are treated as affecting assets of the [f]oundation.6
The first step in determining whether a trust or estate faces self-dealing risks is to identify the disqualified persons, with respect to the charity, who have a beneficial interest in the trust or estate. This is a concept that applies only to PFs and not to public charities. Therefore, there can be no disqualified persons if the only charities having an interest in the estate or trust are public. If all beneficial interests are held by public charities, there's no potential self-dealing problem until a reasonable period of settlement has expired. After the expiration of that period, however, the trust or estate itself will be deemed to constitute a PF for purposes of Chapter 42, and prohibited transactions with any disqualified person in regard to the estate or trust will constitute direct self-dealing.
The following are disqualified persons in regard to a PF:
- Any “substantial contributor” to the PF (that is, anyone who has contributed more than 2 percent of the PF's total donations in the current or any previous year).7
- Any “foundation manager” (that is, an officer or director of the PF or any employee having responsibility for the transaction at issue).8
- Any person who owns 20 percent or more of a corporation, partnership, trust or other entity that's a substantial contributor to the PF.9
- Any corporation, partnership, trust or estate in which other disqualified persons own, in aggregate, more than a 35 percent interest.10
In addition, expansive attribution rules mean that a disqualified person's spouse, ancestors and descendants (and their spouses), down to the great-grandchild level, will also be treated as disqualified persons.11 Further, there's also attribution of corporate stock ownership,12 as well as ownership of partnership interests and beneficial interests in trusts,13 for determining whether a person owns more that 20 percent of an entity that's a substantial contributor and whether more than 35 percent of an entity is owned by disqualified persons.
Example 1: Consider the Family Foundation established by Mother and Father, whose board of directors consists of Mother, Father and their three adult children. Mother and Father also each own 50 percent of the family business and have established an irrevocable insurance trust for the benefit of their children, which owns an insurance policy on Father's life. Father has a revocable living trust, the primary asset of which is his interest in the family business. Upon Father's death, his revocable living trust provides for a gift of 10 percent of the trust estate to the Family Foundation, with the remainder passing in trust for Mother and the children. All of the individuals and entities mentioned are disqualified persons in regard to the Family Foundation for the following reasons:
- Mother, Father and all three children are disqualified persons by virtue of being foundation managers through their service as directors of the Family Foundation. Family attribution also results in the disqualification of all of their spouses, descendants and descendants' spouses down to great-grandchildren.
- Mother and Father are also likely to be substantial contributors to the Family Foundation, which disqualifies them regardless of their service as directors. In addition, all of their children, grandchildren and great-grandchildren will be disqualified under the family attribution rules, even if none are involved with management of the Family Foundation.
- The family business is a disqualified person as a result of Mother and Father collectively owning more than 35 percent of the company.
- The insurance trust is a disqualified person because the children, each of whom is a disqualified person for the reasons described above, collectively hold more than a 35 percent beneficial interest in the trust.
Accordingly, unless the five prong test under the “estate exception” is satisfied (see below), the trustee administering Father's revocable living trust after his death would be engaged in indirect self-dealing with the Family Foundation by taking any of the following actions:
- Borrowing cash from the insurance trust to pay taxes or administration expenses. Although the insurance trust could extend an interest-free loan without self-dealing concerns, it would be difficult to reconcile that approach with the fiduciary duties of its trustee.
- Selling an interest in the family business, or any other asset, to the insurance trust to raise cash. This would be particularly problematic if estate taxes are due upon Father's death, as the trust's primary asset is Father's interest in the family business.
- Exercising fiduciary discretion in funding gifts to the beneficiaries on a non pro-rata basis. Unless the trust, by its terms, allocates specific property to the PF's gift, the Family Foundation is deemed to have a 10 percent interest in the trust estate as a whole. If the trustee selects assets on a non-pro rata basis to fund the marital gift, for example, the trustee will have transferred property in which the Family Foundation has an interest to a disqualified person.
The Estate Exception
Treas. Regs. Section 4941 contains a limited exception for indirect self-dealing involving “a private foundation's interest or expectancy in property (whether or not encumbered) held by an estate (or revocable trust, including a trust which has become irrevocable on a grantor's death) …”14 Specifically, a transaction won't be treated as self-dealing if all five prongs of the following test are satisfied:
The fiduciary must either: (1) have the power to sell property in which the charity has an interest or to reallocate such property to other beneficiaries; or (2) be required to sell the property at issue pursuant to “any option subject to which the property was acquired by the estate (or revocable trust).”15
A court with jurisdiction over the probate estate, trust or PF at issue must approve the transaction that would otherwise constitute self-dealing.
The transaction must be completed within a reasonable period of settlement.
The trust or estate must receive at least the fair market value (FMV) of the PF's interest or expectancy in the property at issue at the time of the transaction. In making this determination, the effect of any option to which the property was subject at the time of the grantor's death on the property's FMV may be taken into account. We refer to this prong as the “market value test.”
The transaction must either: (1) be required pursuant to an option that's legally binding on the estate or trust; or (2) result in the PF receiving either an interest that's no less liquid than its interest prior to the transaction (or an asset related to implementation of its exempt purposes). We refer to this requirement as the “liquidity test.”
If any of these five requirements isn't satisfied, then the disqualified persons involved in the transaction will be subject to potentially severe excise taxes under Section 4941. Of the five requirements, the market value test and the liquidity test are the most likely to be problematic. Usually, a trustee or executor will have the fiduciary power to sell assets or reallocate them among beneficiaries under state law or the boilerplate language of the governing instrument. Further, the probate court, or other tribunal having jurisdiction over the fiduciary estate or PF involved, is likely to approve reasonable transactions to which there's no objection. In some jurisdictions, however, this will require notice of the proceeding to be served upon the Attorney General's office when that office has supervisory authority over charities operating within the state. Lastly, all transactions should, in the ordinary course, be completed within a reasonable period of settlement. As discussed above, failure to complete administration within this time would subject the fiduciary estate itself to all of the PF rules, which would raise problems of administration that go far beyond indirect self-dealing.
Routine and otherwise non-controversial actions in administering an estate or trust must satisfy the estate exception when a PF is beneficially interested in the estate. We discuss below how several common transactions can qualify under the market value and liquidity tests. It's likely that most clients will easily satisfy the other three requirements of the estate exception, assuming, of course, that the clients' advisors are aware of the issues. These transactions include the sale of property to a disqualified person, the borrowing of money from a disqualified person and the allocation of property among beneficiaries on a non-pro rata basis.
Sale to Disqualified Persons
In many cases, an executor or trustee will hold assets that must be sold to raise cash for the payment of taxes or expenses or to fund testamentary gifts. This is a frequent issue for owners of closely held businesses, whose estates often consist primarily of illiquid, non-marketable business interests. It may be difficult, or impossible in many instances, to sell these interests to anyone other than a family member or related trust by the time taxes must be paid or the estate settled. Even if taxes aren't an issue, it may be inappropriate to fund some testamentary gifts with closely held business interests, either because the decedent wouldn't want certain persons to become involved with the business, restrictions apply to who can own an equity interest in the business (as in the case of an S corporation) or in situations in which there aren't enough other assets to fully fund the testamentary gift to charity. Note that although the trust or estate is relieved of compliance with most of the PF rules for a reasonable period of settlement, a PF with an interest in the trust or estate remains subject to the rules at all times. Not only would a PF have little use for a closely held business interest, but also receipt of the interest could cause the PF to violate the rule against excess business holdings under IRC Section 4943 and/or give rise to unrelated business taxable income.
The best practice to avoid indirect self-dealing in this situation is to put an option or similar agreement into place during the client's lifetime that gives one or more disqualified persons the right to purchase closely held business interests or other property from the estate or trust following the client's death. Although the regulations refer only to an “option,” the Internal Revenue Service has issued at least one favorable private letter ruling that involved a mandatory redemption of stock upon a shareholder's death, rather than an option, under a buy-sell agreement.16 There's likewise no discernable reason why a mandatory purchase of property pursuant to an agreement should be treated differently from an option to acquire the property for purposes of the estate exception, and it's likely that any agreement conferring on a disqualified person the right or obligation to purchase property from the trust or estate is sufficient.
The market value test should be satisfied if a disqualified person purchases property pursuant to such an agreement, even if the purchase price is less than the property's FMV. Note that in this regard, the use of options that specify a purchase price for illiquid or difficult-to-value assets also permits the fiduciary to avoid potentially thorny valuation issues when transacting with disqualified persons. This is particularly true if the property to be sold has changed in value between the date of death (or alternate valuation date under IRC Section 2032) and the date of the transaction. The IRS may also revalue property on audit of the decedent's estate tax return, and the existence of an agreement setting a price that's binding on the estate or trust will prevent such revaluation from also disqualifying the sale under the estate exception.
Example 2: Continuing with the facts of Example 1, assume the insurance trust had an option to purchase stock in the family business from Father's estate, for $10 per share, pursuant to a buy-sell agreement. Even if the stock had a date-of-death FMV of $15 per share, without regard to the option, Father's estate would be deemed to have received the full FMV of the Family Foundation's interest at $10 per share, because the regulations permit the consideration of the terms of the option.17 No prospective buyer would pay more than $10 per share so long as the stock remains subject to the option and can be called by the insurance trust at this price. Accordingly, simply giving effect to the buy-sell agreement would satisfy the market value test.
The liquidity test typically won't pose a problem when the trust or estate seeks to sell an illiquid asset for cash, because the transaction will enhance the liquidity of all beneficiaries' interests. Furthermore, if a sale takes place pursuant to an option or similar agreement that's legally binding on the estate or trust, the liquidity test is deemed to be satisfied under the regulations.18
Absent an option or purchase agreement, the sale of property to a disqualified person must satisfy the substantive requirements of both the market value test and the liquidity test. While the liquidity test isn't often an obstacle in this context, it's extremely difficult to ensure compliance with the market value test if the property isn't readily marketable. Unless the property at issue has a very stable value, it won't be possible to base the transaction on the property's appraised value for estate tax purposes, unless the sale takes place on the decedent's date of death (or alternate valuation date), which may be difficult to arrange. Furthermore, there's always the risk that the IRS will disagree with the valuation, even if it's based on a quality independent appraisal. If the property's value is adjusted upwards on audit, then the IRS can easily assert that the sale failed to meet the market value test because the price was too low. In that event, the disqualified persons involved face excise taxes for indirect self-dealing with the PF having an interest in the trust or estate
Lending or Borrowing
Another common way to address an estate or trust's liquidity needs is for the fiduciary to borrow from the family or from a trust held for the benefit of the family. This approach is often desirable, as it avoids the delays, expenses and paperwork required to borrow from a financial institution, not to mention that such institutions will usually charge market interest rates that exceed the applicable federal rate, which is used for most loans between an estate or trust and a family. By the same token, some beneficiaries may request loans from the fiduciary estate to meet immediate needs or the decedent's business may have regularly borrowed working capital from the decedent and may expect to continue borrowing from the decedent's estate or trust following the decedent's death. All of these transactions will constitute indirect self-dealing by the disqualified persons involved unless the estate exception is satisfied.
When a beneficiary, business or other disqualified person borrows funds from the trust or estate, the market value and liquidity tests will be difficult, if not impossible, to satisfy. The trust or estate would presumably lend cash in exchange for a promissory note, which raises liquidity and valuation concerns. Is the borrower sufficiently creditworthy and the note secured or guaranteed such that it has an FMV equal to the sum loaned? If not, the transaction will fail the market value test. Further, it's at best unclear whether a promissory note, even if negotiable, is at least as liquid as the cash loaned by the estate or trust for purposes of the liquidity test. These are issues the careful fiduciary should best avoid. However, when a disqualified person purchases property, particularly closely held business interests, from the estate or trust pursuant to an option or buy-sell agreement, the agreement often allows the purchaser to pay some or all of the purchase price with a promissory note. As with the underlying sale transaction, the existence of an agreement binding on the estate or trust helps the associated loan transaction satisfy the market value and liquidity tests. To the extent that the trust or estate is obligated to extend such loan to the disqualified person under the agreement, the promissory note received should automatically meet both tests.
However, what if the promissory note received in such a transaction is subsequently distributed to a PF in satisfaction of the decedent's testamentary charitable gift? This would seem at first blush to be an extension of credit from the PF directly to the disqualified person and thus an act of direct self-dealing that isn't covered by the estate exception. Fortunately, the regulations under Section 4941 clarify that such a loan arrangement won't be treated as self-dealing “in the case of the receipt and holding of a note pursuant to a transaction described in Section 53.4941(d)-1(b)(3) [the estate exception] …”19 Additionally, the IRS has issued two PLRs on this matter, both concluding that a PF's holding of a promissory note from a disqualified person didn't constitute an ongoing act of self-dealing in the situation in which the note was received in a transaction that satisfied the estate exception.20
If the client's will or revocable trust requires the allocation of specific property or cash to a PF, the PF has an “interest or expectancy” only in that property, and the fiduciary is free to exercise funding discretion in allocating the remaining property among the other beneficiaries, because the PF's interest isn't affected. However, when the PF is entitled to a pecuniary amount, a percentage or fractional share of the estate, or a portion (or all) of the residue, the PF's interest in the fiduciary estate is affected whenever the executor or trustee exercises funding discretion. In the absence of a specific allocation of property to the PF, we believe that the IRS would consider the PF to have a pro rata interest in every asset subject to administration. Therefore, every time the fiduciary allocates or distributes property to a disqualified person, there's a transfer of the PF's pro rata interest in that property to the disqualified person, which will constitute indirect self-dealing unless the estate exception is satisfied. In such cases, the liquidity test will require special attention.
A non-pro rata distribution or allocation to a disqualified person will satisfy the liquidity test only if the PF's interest after the distribution or allocation is “at least as liquid as the one it gave up.” The fiduciary must, therefore, consider the liquidity of assets available for distribution to the PF both before and after each funding decision to ensure that the PF receives its share of the liquid assets. The regulations provide no guidance as to how to measure the liquidity of trust assets, although some guidelines should be clear. For example, a fiduciary shouldn't allocate cash and marketable securities to the decedent's family members while distributing private equity investments, hedge funds, personal property or other less marketable assets to the PF.
As with sales and loans, which can be facilitated through agreements that will be binding on the client's estate and revocable trust, proper drafting can head off funding problems that arise under the self-dealing rules. The client's will or revocable trust could allocate specific property or a sum of cash to the PF or limit the fiduciary's funding discretion by providing that the PF's gift must be funded from certain classes or types of property. Stated differently, it's not necessary for purposes of the liquidity test to analyze the liquidity of the fiduciary estate as a whole if the PF doesn't have an interest in the entire fiduciary estate. If the governing instrument restricts the PF's interest to certain classes or types of property, the liquidity test becomes much easier to meet.
Avoiding Violation of Rules
Although the PF rules can make a well-crafted estate plan significantly more complicated, there are certain steps that can be taken to avoid violating them. First, most of the PF rules don't apply to an estate or trust during the reasonable period of settlement. Therefore, a revocable trust can be administered without regard to most of the rules upon the grantor's death, as long as administration is completed within a reasonable time. Additionally, any transaction that may constitute self-dealing but meets the estate exception should occur during the settlement period. Proactive planning can also reduce the difficulties faced when dealing with these issues. By advising a client to take steps such as entering into option agreements or restricting the trustee's funding discretion, an estate planner can lessen the likelihood that an act of self-dealing will occur during the settlement period.
Once the reasonable period of settlement has ended, the PF rules against self-dealing, excess business holdings, jeopardizing investments and taxable expenditures will apply to the trust or estate, and violations of these rules will be penalized. Furthermore, the estate exception will no longer apply, so transactions that would have been permissible only because of the estate exception will now constitute self-dealing. Although proactive estate planning can avoid many of the complications faced by estates and trusts, in the absence of such planning, a fiduciary will need to have a firm understanding of the PF rules to successfully navigate the tricky waters of split-interest trust administration.
- Internal Revenue Code Section 4947(b)(3)(A), (B) provides that IRC Sections 4943 and 4944 (the private foundation rules against excess business holdings and jeopardizing investments) don't apply to charitable remainder trusts or charitable lead trusts, even though these are otherwise treated as split-interest trusts under the general rule.
- Treasury Regulations Section 53.4947-1(c)(6)(iii).
- Treas. Regs. Section 53.4947-1(c)(6)(ii)(A).
- This result is explicit in the regulations applicable to revocable living trusts that are quoted in the text. The regulations applicable to estates don't contain a similar reference to IRC Section 4941, but the Tax Court has held that the self-dealing rules also apply to estates during the period of administration. Estate of Reis v. Commissioner, 87 T.C. 1016 (1986).
- Ibid. at 1021-23.
- IRC Sections 4946(a)(1)(A), 507(d)(2).
- IRC Section 4946(a)(1)(B), (b).
- IRC Section 4946(a)(1)(C).
- IRC Section 4946(a)(1)(E)-(G).
- IRC Section 4946(a)(1)(D), (d).
- IRC Section 4946(a)(3).
- IRC Section 4946(a)(4).
- Treas. Regs. Section 53.4941(d)-1(b)(3).
- Treas. Regs. Section 53.4941(d)-1(b)(3)(i).
- Private Letter Ruling 200620030 (Feb. 23, 2006).
- Treas. Regs. Section 53.4941(d)-1(b)(3)(iv).
- Treas. Regs. Section 53.4941(d)-1(b)(3)(v).
- Treas. Regs. Section 53.4941-2(c)(1).
- PLR 9752071 (Oct. 1, 1997); PLR 9108024 (Nov. 26, 1990).
Michael Moyers is a partner and Gina Oderda is an associate at Winston & Strawn in Chicago