Now is the time of year when clients spend a lot of time thinking about taxes: how to pay them for last year and how to reduce the coming year’s tax bill. As part of their deliberations, some clients will be considering what, if any, assets to gift this year.
Gifting their limited liability company (LLC) or limited partnership units may seem appealing to these clients. After all, many of those entities are complex, and clients may wish to divest themselves of ownership of passive investment assets because of annual reporting delays, high compliance costs, and illiquidity and valuation issues.
However, many charitable organizations will not accept a gift of an LLC or limited partnership units because the entity’s business is not part of their charitable mission and they will be at risk for the liabilities of the entity. They will consider accepting the gift only if they can understand an exit strategy from the investment and how they can liquidate the interest for cash. Also, the entity a client wishes to gift an interest in may not want to have a charity as a co-owner and may not consent to the gift.
If a client insists on giving an LLC or limited partnership unit to charity, though, here are some issues that CPAs should help clients consider:
1. Whether it’s even possible to transfer or gift the interest. Review the LLC operating agreement or partnership agreement to determine if it is possible to transfer or gift the interest and, if so, whose consent is required for a member or partner to make a transfer or gift.
2. Is the entity taxed as a partnership? If the interest is in an LLC, determine whether it is taxed as a partnership or as a corporation. Under the check-the-box regulations (Regs. Secs. 301.7701-1 to -3), it is possible that an election was made to tax the entity as a corporation, not a partnership.
3. How much of a charitable deduction the client will realize. Generally, the taxpayer’s charitable deduction of property is the fair market value (FMV) of the gifted property less the amount that would be ordinary income or short-term capital gain if the property were sold at its FMV (unless the gift is to a private foundation, in which case the deduction is generally limited to the FMV of the property or the donor’s basis in the property) (Sec. 170(e)(1) and Regs. Sec. 1.170A-1(c)(1)).
In the context of a partnership interest, the FMV of a contributed partnership interest generally is the FMV of the donor’s share of the FMV of the partnership’s assets less the donor’s share of the partnership’s liabilities. However, because of the ordinary income rule, a partnership’s ordinary income assets, including Sec. 751 “hot assets” (i.e., unrealized receivables and inventory), may be included in the deduction only to the extent of the donor’s basis in the partnership.
In addition, the taxpayer must give the charity the entire partnership interest, or an undivided portion of the partnership interest, to obtain the tax deduction (Sec. 170(f)(3)).
4. Whether the entity has any liabilities that will lead to part gift/part deemed sale. If a partner contributes an interest with liabilities to a charity, the transaction is bifurcated into a charitable contribution and a deemed sale. The amount of the charitable contribution is equal to the amount by which the FMV of the partner’s share of the partnership assets exceeds the partner’s share of the liabilities (Rev. Rul. 75-194).
For the deemed sale, the partner’s share of the partnership liabilities on the gifted partnership interest is treated as the amount realized on the deemed sale of the partnership interest. The partner’s basis in the partnership interest is prorated between the portion that is deemed sold and the portion deemed contributed based on the FMV of each portion (see Sec. 1011(b), Regs. Sec. 1011-2). The donor must recognize, as gain, the difference between the amount realized and the basis prorated to the deemed sale (see Regs. Sec. 1.170A-3(d), Example (1), and Ebben, T.C. Memo. 1983-200). Ordinary income and capital gain on a bargain sale must be allocated to the sale and gift portion (Regs. Sec. 1.170A-4(c)(3)).
If it is a bargain sale to a private foundation, the self-dealing private foundation rules make it more complicated and apply no matter what the amount paid is (Regs. Sec. 53.4941(d)-2(a)(1)).
Charities considering accepting LLCs or limited partnership units should also take some key steps:
1. Look for phantom income. The unit owners of the LLC or partnership must pay income taxes regardless of whether cash is distributed to them to pay those income taxes. Most charitable donees will require that the LLC operating agreement or partnership agreement contain a provision that requires the entity to make distributions in an amount sufficient to pay any unrelated taxable business income the charity will incur so that they have the cash on hand to pay any tax that will be due on any phantom income.
2. Review the operating agreement to understand what the cash flow requirements are. Most LLC operating agreements and partnership agreements mandate that members in an LLC are liable for partnership debts and expenses only to the extent of their investment. The agreement can require members to make additional capital contributions or payments.
3. Undertake due diligence to make sure that there are no environmental issues. Charities should also be concerned about whether the underlying properties have any environmental issues such as lead paint, radon, asbestos, toxic mold, soil and groundwater contamination, or spilled oil. If the charity becomes an owner of property that has an environmental issue, then it, like the other owners, may be responsible for the often high cost of cleaning up the property.
Patricia M. Annino, J.D., LL.M., is a nationally recognized authority on estate planning and taxation, chairs the Estate Planning practice at Prince Lobel Tye LLP.