Charitable planning in advance of the sale of a closely held business sounds like an effective way to minimize income taxes. The business owner donates stock to a charitable organization or to a charitable trust and receives a full fair market value (FMV) deduction against her income taxes, subject to certain adjusted gross income (AGI) limits.

Using a basic example, consider a 100% shareholder contemplating a charitable gift of stock in advance of a sale. The business is worth $100 million, and the stock gift to charity is worth $20 million. The business owner will have income of $80 million ($100 million less a $20 million charitable gift) as well as an offsetting charitable deduction of $20 million, resulting in $60 million of taxable income on the sale. Unfortunately, the reality isn’t that simple. The success or failure of a gift of closely held stock in advance of the sale of the business depends on the following two factors:

1. The nature of the asset (for example, whether it’s a C corporation (C corp), an S corporation (S corp), a limited liability company (LLC) or a partnership); and

2. The type of structure you want to use for the gift (for example, private foundation (PF), donor-advised fund (DAF) or charitable split-interest trust such as a charitable remainder trust (CRT)).

The reason for this uncertainty is that there are certain tax traps that can get in the way of a successful gift. Let’s identify some of these pitfalls and how they apply to particular types of assets and charitable structures.

Types of Entities

Closely held businesses are organized as C corps, S corps, partnerships or LLCs. The structure of the business can have a major impact on the viability of a particular charitable gift.

A C corp is initially taxed at the corporate level, which means that the corporation itself realizes the benefit or burden of any tax characteristics of its specific income and loss. If the C corp pays out dividends to the shareholders, the shareholders are taxed on this amount as a dividend, independent of the tax characteristics of the corporate income. The other options described above are all flow-through entities, meaning that all income, loss, deductions and credits pass through to the S corp shareholders, partners or LLC members. Because there’s no tax at the entity level, the owners, not the entity, realize the specific tax characteristics. While flow-through entities are popular structures for closely held businesses, they pose distinct problems in the context of charitable giving. The fact that a C corp is considered a separate taxpayer makes it the easiest of the closely held structures to give to charity. Flow-through entities, on the other hand, trigger some of the tax traps discussed below.

Charitable Recipients

Closely held business owners engaging in philanthropic planning have a range of charitable structures from which to choose when considering a charitable gift in advance of the sale of the business. In addition to outright gifts to traditional public charities (like churches, hospitals and universities), alternatives include PFs, DAFs and charitable split-interest trusts such as CRTs. The choice of strategy may be influenced not only by the type of business entity but also by the specific advantages and considerations of the potential charitable recipients.


A PF is a charitable organization to which a donor can make contributions that qualify for income, gift and estate tax charitable deductions. It can be structured either as a trust or a corporation. A PF commonly receives its funding from and is controlled by one or a few private sources (usually an individual, family or corporation). The principal activity of a PF tends to be making grants to public charities and awarding scholarships to individuals (although some PFs also run charitable programs). The general rule is that a PF must expend 5% of its net asset value for charitable purposes annually. PFs involve a fair amount of administrative complexity and are subject to burdensome rules, but offer the greatest amount of control of all the charitable vehicles.

If a donor funds a PF with cash or qualified appreciated stock (publicly traded securities), the donor’s income tax charitable deduction is based on the full FMV of the amount contributed; otherwise, the deduction is limited to the lesser of the FMV or the cost basis. As such, and for other reasons discussed below, lifetime gifts of closely held business interests to a PF aren’t particularly attractive. In addition, a donor may deduct cash gifts to a PF only up to 30% of her AGI for the year and 20% for gifts of long-term capital gains property. Deductions in excess of AGI limitations can be carried forward for five years.


A DAF acts much like a PF and is a much simpler philanthropic option in terms of administration when compared to a PF.

However, when using a DAF, the donor loses an element of control. Typically, a donor makes a gift to a sponsoring charitable organization (usually community foundations or commercial DAFs), which sets aside the gift in a separate account in the donor’s name, from which the donor suggests grants—typically to other public charities in which the donor has an interest. The donor doesn’t have legal control over grant-making decisions from the account—the sponsoring organization does, although legitimate grant recommendations are generally followed by the sponsoring charity. DAFs, at least with respect to the deductibility rules, are more attractive than PFs. As the organizations sponsoring DAFs are public charities, charitable contributions of closely held business interests held long term qualify for a full FMV charitable deduction. As a result of this tax advantage over PFs, DAFs are increasingly willing to accept contributions of closely held business interests, although because of the tax traps discussed below, such gifts may not always be tax efficient, and the sponsoring charity would typically look for a way to liquidate the assets in the short term (which shouldn’t be a problem if the business is being sold).

If a donor funds a DAF with cash, the donor may deduct the gift up to 60% of her AGI for the year and 30% for gifts of long-term capital gains property (like closely held business interests). Deductions in excess of AGI limitations can be carried forward for five years.


A CRT is one type of split-interest trust typically used when a donor wants to make a charitable gift in a tax-efficient manner but desires to continue to have an income stream on the contributed asset. A CRT is an irrevocable trust that provides for the payment of:

1. A specified distribution, at least annually;

2. To one or more individuals;

3. For life or for a term of years (not to exceed 20); and

4. With an irrevocable remainder interest to be paid to charity (a public charity or PF) at the end of the CRT term.

A CRT is a tax-exempt entity. There’s typically no capital gains incurred by the donor on the transfer of appreciated property to the trust or its subsequent sale by the CRT trustee. Note that if a CRT has any unrelated business taxable income (UBTI), it pays a 100% excise tax on such income. The donor of a CRT is entitled to an income tax charitable deduction equal to the present value of the charity’s remaining interest at the end of the CRT term, in some cases limited to cost basis (including transfers of property that aren’t cash or publicly traded securities), if a PF can be named as a remainder beneficiary. If the trust instrument provides that only public charities and DAFs can be named as remainder organizations, the deduction is based on the present value of the full FMV of the gift.

The minimum annual payout is 5% (but may be higher in certain circumstances). The payment can be a fixed amount annually (a charitable remainder annuity trust) or a percentage of the trust assets calculated annually (a charitable remainder unitrust). Although a CRT is a tax-exempt entity, distributions to the individual beneficiaries are subject to income tax (much like qualified retirement plan assets), based on a system of taxation unique to CRTs known as the “four tier system,” a “worst-in, first-out” method of taxation.

The Charitable Tax Traps

There are detailed and highly technical rules regarding a charitable entity’s investments and operations under the Internal Revenue Code. Many of these rules make various charitable contribution options involving closely held business interests difficult, undesirable or impossible. It’s important to be aware of these rules (the tax traps) before attempting a charitable gift of closely held business interests. Here are suggestions to help avoid the six most common of these tax traps.

1. Beware of S corps. Historically, charitable entities couldn’t be S corp shareholders. Transferring S corp shares to charity would terminate the S election. This changed in 1998, when legislation was enacted permitting certain charitable entities to be S corp shareholders. Unfortunately, for reasons discussed below, the provisions of the legislation weren’t attractive to donors or recipient charities.

When a charity owns shares of an S corp, all of the charity’s share of the S corp’s income and capital gains—and the capital gains on the sale of the S corp stock—will be considered UBTI and therefore taxable to the charity. In addition, a CRT isn’t a valid S corp shareholder. Therefore, a gift of S corp stock to a CRT will terminate the S corp’s status, causing it to convert to a C corp. Another potential problem for the donor is that if the S corp has inventory or accounts receivables (so-called “hot assets”), the donor’s deduction for the contribution of S corp stock will be reduced by the donor’s share of the hot assets, for which she won’t receive a deduction (similar rules apply for partnerships and LLCs).

Sometimes, when a charitable gift of S corp stock isn’t tax efficient, it may be possible for the S corp itself to make a gift of some of its assets to charity, with the charitable deduction flowing through to the shareholders.

2. Comply with onerous PF excise tax rules. Although these rules are referred to as the “private foundation excise tax rules,” they actually apply to PFs and to a limited extent to DAFs and CRTs. In general, if one of the excise tax rules is violated, a relatively modest excise tax is imposed initially, with the tax rate rising sharply if the prohibited act isn’t corrected within a certain period of time. The excise tax rules most relevant to charitable planning with closely held
business interests are the prohibitions against self-dealing (applicable to PFs and CRTs) and the prohibition against excess business holdings (applicable to PFs and DAFs):

• Self-dealing. The basic principle underlying the self-dealing rules is that all transactions between a PF and a CRT and a disqualified person should be prohibited, whether or not the transaction benefits the PF or the CRT. Disqualified persons include substantial contributors to the PF or CRT, as well as the officers, directors, trustees and certain employees of the PF or CRT. Subject to certain exceptions, the term “self-dealing” includes:

• A sale, exchange or leasing of property between a PF or a CRT and a disqualified person;

• Any lending of money or other extension of credit between a PF or CRT and a disqualified person. A disqualified person can make an interest-free loan to a PF if the proceeds are used entirely for charitable purposes;

• Any furnishing of goods, services or facilities between a PF or CRT and a disqualified person (with certain exceptions);

• Any payment of compensation by a PF or CRT to a disqualified person, except that payment to a disqualified person for personal services that are reasonable and necessary to carrying out the PF or CRT’s exempt purposes doesn’t constitute self-dealing if such payments aren’t excessive; or

• Any transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a PF or CRT.

Finally, if a disqualified person contributes closely held shares to a PF or CRT and retains some shares in her own name, every major decision by the business may need to be scrutinized to make sure that it doesn’t run afoul of the self-dealing rules.

As such, a PF or CRT should either sell the shares to a third party shortly after receipt, or the corporation should redeem the shares under the redemption exception to self-dealing to mitigate the self-dealing concerns.

• Excess business holdings. The IRC imposes an excise tax on a PF’s excess business holdings. A PF has excess business holdings when its holdings, together with those of disqualified persons, exceed 20% of the voting stock, profits, interest or capital interest in a corporation or partnership. Permitted aggregate business holdings are increased from 20% to 35% if it can be established that effective control of the corporation is in one or more persons who aren’t disqualified persons with respect to the PF. A PF has five years to dispose of excess business holdings acquired by a gift or bequest, and an extension of an additional five years can be requested (but isn’t guaranteed). During this time, the holdings aren’t subject to tax. DAFs are also subject to the excise tax on excess business holdings, but practically speaking, DAFs are likely to dispose of closely held stock before the 5-year grace period for excess business holdings ends. In the context of charitable gifts of closely held business interest in advance of a sale of the business, excess business holdings are rarely a problem because the business will typically be sold to a third party long before the end of the 5-year holding period.

3. Follow rules on UBTI. Although PFs, DAFs and CRTs generally aren’t subject to income taxation, an exception applies if the PF, DAF or CRT has UBTI. UBTI is income from an activity that constitutes a trade or business that’s regularly carried on and isn’t substantially related to the tax-exempt entity’s exempt purposes. UBTI is a particular problem for flow-through entities like S corps, partnerships and LLCs. As described above, any income or capital gains a charity receives from an S corp is deemed by statute to be UBTI and thus taxable. Partnerships and LLCs aren’t subject to UBTI by statute. An exempt organization can be taxed on its share of the income received from a partnership of which it’s a member, even though the partnership and not the exempt organization is the entity actively engaged in carrying on a trade or business. Most passive income received by the charitable entity, such as rents, royalties, dividends, interest and annuities, isn’t considered UBTI. Passive income will be considered UBTI to the extent leverage was used in connection with the investment.

UBTI is a particularly significant problem for CRTs because in any year that the trust has UBTI, there’s a 100% excise tax on that income. If a PF or DAF has UBTI, that income is subject to tax at regular corporate or trust income tax rates, depending on how the PF or DAF is organized.

4. Beware of characterization as a pre-arranged sale. In contrast to sales of publicly traded securities, sales of closely held business interests are privately negotiated. If a donor enters into an informal agreement or understanding to sell the appreciated property to a buyer prior to transferring it to a charity or CRT, and the property is actually sold to that buyer, the Internal Revenue Service may recharacterize the transaction as a sale by the donor personally rather than a sale by the charity or CRT. This means not only that the gain would be taxable, instead of being a tax-free sale by the charity or CRT, but also that the donor would have to pay the full capital gains tax out of her own pocket and can’t use any of the proceeds received by the charity or CRT to pay the tax.

5. Avoid reduction of value of charitable deduction due to minority interest discounts. If a closely held business owner transfers shares to family representing a minority interest in the business, she may be entitled to valuation discounts based on a qualified appraisal for lack of control and lack of marketability of those interests. These discounts may sometimes exceed 30%, depending on each business owner’s circumstances. Historically, the IRS and courts didn’t require significant discounts for minority interests in a closely held business gifted to charity or a CRT. In recent years, this has changed with both the IRS and the courts requiring that minority interest discounts be applied in determining the value of the charitable deduction for the gift. This reduces the value of the charitable deduction. There may be ways to mitigate the discount through the use of a “put right” (beyond the scope of this article) or by making the charitable contribution as close to the sale date as possible without triggering a pre-arranged sale and then obtaining a qualified appraisal after the sale is completed.

6. Avoid donating debt-financed property. Funding PFs, DAFs and CRTs with debt-financed property (including any underlying indebtedness of flow-through entities like partnerships or LLCs) is very difficult to accomplish in a tax-efficient manner for the following reasons:

• Debt-financed property can create a UBTI problem for the charity or CRT on income and gain from the sale of the business in proportion to the percentage of debt compared to the income or gain received. For example, if the flow-through business was 50% leveraged, then potentially 50% of all income or gain will be subject to UBTI.

• If the donor remains liable for the debt after gifting the property to a CRT, the CRT is treated as a grantor trust for income tax purposes. That means that it’s not a qualified CRT, and the donor loses the income and gift tax deductions, plus the trust loses its tax-exempt status. The donor will be liable for any capital gains taxes generated when an appreciated trust asset is sold.

• When a donor contributes debt-financed property to charity, the transaction is treated as a bargain sale for income tax purposes—that is, the donor is treated as having sold a portion of the property equal to the debt on the property and contributed the remainder to charity. This forces the donor to recognize gain on some portion or all of the outstanding indebtedness on the contributed asset value. The cost basis of the property is allocated between the sale and gift portions on a pro rata basis. This rule applies regardless of whether the underlying debt is recourse or non-recourse and regardless of whether the donor continues to pay the debt after the gift is made.

Planning After a Liquidity Event

If the facts and circumstances of contributing before the sale are problematic, charitable planning after a liquidity event can be a tax-efficient way to be philanthropic while offsetting some of the taxes in the year of the liquidity event. Unlike pre-liquidity charitable planning, post-liquidity charitable planning is fairly straightforward if the business owner receives cash in the transaction. Cash gifts to a public charity are deductible up to 60% of AGI in the year of the gift (with a 5-year carryforward for any excess contributions). All charitable vehicles are available post-sale, including outright gifts to public charities (including DAFs), gifts to PFs and gifts to CRTs.

David Thayne Leibell, Carrie J. Larson, Brian Schimpf – For Trusts & Estate Journal


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BKA Financial, LLC.

Phone: (607) 732-3050
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BKA Financial, LLC.