CRUTS Can Sidestep Capital Gains Taxes
by John Scibek
While it may seem too good to be true, through careful charitable gift planning, an owner of a “C” corporation can sell her company, avoid paying capital gains tax on virtually all of the gain in her business’s stock, and receive income for life based on the full value of the stock.
How can this be accomplished? By first transferring the stock to a charitable remainder unitrust (CRUT), then selling the assets of the corporation, and finally, by making liquidating distributions from the corporation to the CRUT.
In a traditional asset sale the target corporation sells all of its assets to the buyer in return for the agreed upon purchase price. Gain on the sale of such assets is paid by the corporation. The corporation in turn makes a liquidating distribution of the net sales proceeds to its shareholders, who are then subject to a second tax on such sale proceeds at the individual level.
However, if the stock were in whole or part transferred to a CRUT prior to the asset sale and liquidating distribution, the taxable gain otherwise due upon sale at the individual level would be avoided. The full value of the stock is then available to be invested by the trustee of the CRUT in a diversified portfolio of equity and fixed income assets. At the corporate level, the gain on the sale of the assets cannot be avoided.
Here’s how a CRUT works: The owner transfers stock to a charitable remainder unitrust, which generates a charitable deduction based on the value of the assets, the payout rate, the age of the owner or fixed term of the trust and prevailing interest rates. The trustee sells the stock and invests the sale proceeds. The non-charitable beneficiary receives income from the trust based on the trust’s principal value as determined annually. Upon the death of the beneficiary or at the end of the trust term, the value of the remaining principal in the trust is transferred to one or more charities.
In a perfect world, the trustee may have a buyer waiting to purchase the stock. However, the business owner must be sure not to enter into a binding obligation to sell the stock before transferring it to the trust. Otherwise the owner may not be able to avoid paying the capital gains tax on the appreciation of the stock. The business owner should appoint an independent trustee for the CRUT through at least the stock redemption phase.
What if the business owner had contemplated eventually transferring the value of the corporation to loved ones through her estate plans? When the stock is transferred to the CRUT, the action is irrevocable and the value is locked up until the trust terminates and the remainder is transferred to charity.
There is a solution to this disinheritance of loved ones. That is a “Wealth Replacement Trust.” Using the cash equivalent of all or part of the charitable tax savings and ongoing payments that the trust will generate, an Irrevocable Life Insurance Trust (ILIT) may be established. With such a trust, life insurance is purchased to replace the assets transferred to the CRUT or to pay for estate taxes. Once the business owner/CRUT donor dies, the death benefit from the life insurance policy passes to family or friends without taxation to replace the assets that they otherwise would have received, but were instead used to fund the CRUT. When structured properly, the value of the trust is not includable in the estate of the donor.
There is an argument that the death benefit of the ILIT need not be the full value of the stock transferred to the CRUT. If the value of the corporate stock in the donor’s estate would have been reduced by estate tax, or if the business owner had sold the company and netted out an amount substantially reduced by taxes, then the insurance policy may be funded to produce what the estate beneficiaries would have received.
If a business owner wants to sell her company and is philanthropically inclined, a CRUT can help the owner avoid the pain of taxes and put the value of the company to work in generating income for a comfortable future and help a charity fulfill its mission.