Royce, 72, was the sole owner of a successful 250-room hotel. He was proud that he and his son, George, 43, had built the companys value to $7.5 million without incurring a cent of debt. George had worked his way into the general managers job. The father, nearing retirement, wanted to transfer ownership to George but had gotten a late start on his estate planning. He was recently widowed when he came to me for help.
While trying to lower his estate-tax liability, Royce wanted to protect the hotels future cash flow. The debt-free balance sheet had always enabled him and his son to invest in renovations, and he didnt want to crimp Georges ability to make future upgrades. But Royce also had another important goal: He had long wanted to create a permanent method of supporting his favorite causes. He was adamant that any estate solution include a way to support local charities.
Our solution was what is called a support foundation. It allowed Royce to transfer more than half of the value of his business out of the estate, thereby reducing future estate taxes. At the same time, it enabled Royce to augment his charitable giving. And the technique had no adverse effect on the companys cash flow.
Royce considered three methods: a charitable remainder trust, a private foundation, or a support foundation. In a charitable trust, gifts are deferred until the donors death, clearly not Royces objective. Private and support foundations can donate immediately. The major plus of a private foundation is that you can place whomever you like on its board of directors. For a support foundation, a majority of board members must be from outside the family. However, a support foundation qualifies for many tax benefits and flexible financial arrangements not available to private foundations. For one thing, a private foundation is subject to excise taxes. A support foundation is not.
A support foundation is taxed as if it were a public charity. To qualify, it must establish a very close relationship with an existing public charity; its mission statement must support theirs and it must have one or more board members in common (see Tests of a Support Foundation, below). Most public charities are more than eager to cooperate.
Royce realized that when he died the IRS would want 55 percent of the value of the hotel and other assets for estate taxesalmost $5 million. That would force his son to take out a mortgage on the hotel, and the subsequent payments would surely cripple future operations.
He wanted to use his company stock to make his donation. With the support foundation, Royce could get a charitable deduction on his income tax equal to full fair-market value of the gift. With a private foundation, his deduction would be limited to his basis, the very low value he had paid for the stock when he formed the corporation.
Heres how it worked: Royce gifted 4 percent of the hotel stock, worth $135,000 after factoring in valuation discounts, to a trust for his grandchildren, using part of his unified credit (which allows $600,000 to be transferred free of gift and estate taxes). That left 96 percent of the shares in Royces name.
Royce then established his support foundation as a nonprofit corporation which was to support certain educational causes. To meet that charitable aim, the support foundation became affiliated with the local Community Foundation. Royce funded the foundation by contributing one-half of his remaining 96 percent interest in the hotel corporation.
An independent appraisal firm valued the donated shares at $1.6 million$7.5 million times 48 percent, minus a 55 percent discount allowed for the lack of marketability of closely held shares and the fact that the transferred stock represented a minority interest. The Community Fund agreed to allow the support foundation to provide an annuity to Royce. The foundation planned to convert the donation into an income-producing asset by selling the hotel stock and using the proceeds to provide Royces annuity and to fund current community causes. Royces son, George, offered to buy the stock at its appraised value, using an installment note. (This would not have been possible with a private foundation.)
The annuity retained by Royce reduced the income tax value of the 48 percent stock gift from $1.6 million to $1.25 million. Royce was able to claim the $1.25 million value as a charitable contribution deduction for income tax purposes.
George and his wife, Betsy, have their own S corporation that owns the hotels restaurant and gift shop. Using the S distributions from this corporation, they bought the shares for the appraised $1.6 million value on a 20-year installment note at an 8 percent interest rate.
The foundation used the annual principal and interest payments of $163,000 received on the installment note to pay the $75,000-a-year annuity to Royce. That left $88,000 a year for the foundation to distribute to charitable causes, which is more than Royce had been giving to charity each year.
If Royce dies before the note is paid, George must pay the balance due on the notes $1.6 million principal. George acquired life insurance on Royce; the proceeds will pay off the balance of the note. The support foundation will use those proceeds to create a permanent fund in the familys name, which will continue to support the community.
Also, Royce still had $465,000 of his $600,000 unified credit available, which he used to gift additional shares to George.
The bottom line: Royce now has an estate tax liability of $1.5 million. We reduced the estate tax bill by 70 percent, accomplished Royces goal of permanent support for his community, and transferred over half the hotel business to George.
Mike Cohn is president of The Cohn Financial Group Inc. in Phoenix, a consulting firm specializing in ownership succession and wealth transfer for family businesses.
A charitable organization may achieve public charity status and avoid private foundation classification even if it is not a church, school, medical institution, or government agency, and even if it has no public support. To do so, it must satisfy four basic requirements for becoming a support foundation:
Relationship Test: The organization must have a sufficiently close relationship with one or more public charities.
Organizational Test: Its bylaws and trust instrument or articles must limit its purposes and activities to the organizations it supports.
Operational Test: Its actual operations must conform to the limits set out in its organizational documentsit must do what it says it will do and not stray afield.
Control Test: It may not be controlled directly or indirectly by disqualified persons such as the donor and his or her family. The board of directors must have a majority of outsiders on it.
Of the four tests, the relationship test is the most important. The establishment of the close relationship with another public charity is basic to avoiding treatment as a private foundation. M.C.