This article explores the merits of using philanthropy in estate planning as a practical tool for minimizing the government's tax bite, doing good and leaving the family in control of (if not owning) more of the family wealth. Specifically, the article examines the private operating foundation, a particularly useful and creative (if often overlooked) tool that family business owners can use-coupled with traditional planning-to keep younger generations at the helm of and still benefiting from the enterprise.
Succession Planning and Philanthropy
Families pursue charitable giving for various reasons. Some are noble and beneficent. The family just wants to do good. Others want to leave their mark in a community, such as through a scholarship, a teaching endowment or a named wing of a charitable hospital. Still others want to institutionalize family wealth and use it to teach younger generations to give something back. In a private family foundation or donor advised fund, younger family members can sit on the board, evaluate grant proposals and otherwise manage the foundation's activities. Many do so for tax and economic reasons, such as their desire to steward the highly appreciated stock portfolio or real estate tract conveyed to a charitable remainder trust that is later distributed to the foundation. For most, a combination of these factors motivates them.
The goals of an effective succession and estate plan include maximizing control and minimizing transfer costs. Most family business owners want to maintain maximum control and benefit of the estate for the family business owner and spouse during their lifetimes and after the death of the first to die, while at the same time addressing other family goals. On the death of the survivor of the family business owner and spouse, the goals include minimizing federal estate and income taxes, transferring the family business to children working in it in the most tax-advantageous manner, dividing the estate equally among the children and providing liquidity to pay federal estate and income taxes.
Given the proper circumstances, the private operating foundation can provide a unique and creative solution to enable a family business owner to achieve both charitable and noncharitable goals. The family owned business or aspects of it can be transferred to a private operating foundation during life (in which case, the owner will receive significant income and gift tax benefits) or at death (in which case, the owner's estate will receive significant estate tax relief). Doing so will also permit the owner or younger family members to keep operating the business, "hands on," without missing a beat. Most importantly, the younger family members continue to benefit economically from the fruits of the senior generation's labors in the process.
Code § 501(c)(3) provides for the creation and tax-exempt status of several types of charitable organizations. An organization is exempt from income tax under this section if it is organized and operated for an exempt purpose (religious, charitable, scientific testing for public safety, literary or educational purposes, or a purpose to foster national or international amateur sports competition or for the prevention of cruelty to children and animals); if no part of the organization's earnings inure to the benefit of any private person; if no substantial part of the organization's activities consists of lobbying; and if the organization does not participate in political campaigns.
A private foundation is any Code § 501(c)(3) organization that is not a public charity under Code § 509(a). Specifically, a private foundation is an organization that is not: a church, school, hospital, governmental unit or an organization supported by the general public or government, such as the Red Cross (Code § 509(a)(1)); an organization that receives more than one-third of its support from grants, gifts, membership fees and admissions and less than one-third of its support from investment income (Code § 509(a)(2)); an organization that supports a Code § 509(a)(1) public charity, social action group, agricultural or labor organization or trade association and is supervised, at least in part, by that entity (Code § 509(a)(3)); or an organization that is formed for the purpose of public safety testing (Code § 509 (a)(4)).
The Code regulates the behavior of those who manage private foundations through excise taxes on improper action. To obtain tax-exempt status, a private foundation must include in its governing instrument provisions that require or prohibit specified behaviors, as dictated by these "private foundation rules." Code § 508(e). To maintain its tax-exempt status, a private foundation must distribute a sufficient amount of income for exempt purposes (Code § 4942 defines the amount that a foundation must distribute each year to avoid a tax on undistributed income) and must refrain from engaging in any acts of self-dealing as defined in Code § 4941(d), from retaining any excess business holdings as defined in Code § 4943, from making investments in a manner that will subject the foundation to tax under Code § 4944 (which defines jeopardy investments) and from making any taxable expenditures as defined in Code § 4945(d).
Many private foundations, often called "family foundations," are created and funded by a small group of donors, frequently a family. This type of foundation does not directly operate any charitable activity. Instead, it is a passive or nonoperating entity that makes grants to other charitable organizations. Family members typically comprise the foundation's board of directors or trustees. There are many reasons why an individual, family or group of people might form a nonoperating private foundation; however, the underlying purpose is usually to provide a mechanism to fulfill and enhance charitable inclinations. A private foundation can serve as a permanent entity to facilitate lifetime and testamentary charitable giving by the founders and successive generations. Additional reasons for a private foundation include: instilling philanthropic values in the founders' children and succeeding generations; creating a perpetual fund in the donors' honor; providing flexibility in giving if interests or charities change; providing structure to charitable giving; providing control over how charitable funds are invested and distributed; serving the donor family's particular philanthropic objectives; and accumulating funds for future charitable projects while obtaining current income tax deductions.
In the case of a private operating foundation, charitable donors may wish to use the foundation's assets for more directed activities. For most purposes, a private operating foundation is treated as a nonoperating or family foundation and is subject to many of the Code's private foundation rules. A private operating foundation, however, has two major advantages over a private nonoperating foundation. A private operating foundation is exempt from the Code § 4942 minimum distribution requirements of a nonoperating private foundation, and contributions to the private operating foundation are deductible to the same extent as those made to a public charity. The interplay of these two advantages within a family business owner's succession planning process can produce dynamic results, as the case studies demonstrate.
Effective Planning for Family Businesses
Much has been written and said about the difficulties of estate and business planning for the entrepreneur or closely held business owner (referred to in this article as an "entrepreneur," "owner" or "client"). Much of the literature emphasizes statistics on the high rate of failure of business succession efforts and the difficulty in dealing with an entrepreneur's personality and with family dynamics. Owners and advisors have traditionally assumed that family business succession failures are primarily attributable to two causes: the impact of the federal estate tax scheme and poor (or in many cases no) decisions on transfer of control. The dominant advisor strategies have evolved in response to these assumptions. They have been designed to minimize income and transfer taxation (tax-driven succession strategies) or to produce effective transfers and delegations of control or authority (governance strategies). Transfer taxes are widely assailed as the primary cause of family business succession failures.
Traditional tax planning focuses on credit shelter trusts (whether contained in a will or a living trust) coupled with value dissipation techniques (such as annual exclusion giving and gifts of partial or full unified credit amounts) and value reduction techniques (such as family limited partnerships, residence trusts, GRATs, GRUTS, split ownership of title and minority interest discounts). Planners typically combine these planning techniques with a strategically placed second-to-die policy to fund estate taxes. Unfortunately, although fundamental and foundational, this traditional type of planning will not be sufficient in today's economy, even with the fully phased-in applicable exclusion amount at $1 million in 2006. If traditional planning is not sufficient, then advisors should evaluate other options.
Creative application of the charitable giving rules affords lawyers yet another arena in which to explore salvaging (if not saving) a lifetime of emotional and economic effort by the family business owner. In particular, where family owned businesses are concerned, the rules relating to private operating foundations give families another way to preserve, control and benefit from their wealth. The case studies in this article illustrate how the judicious application of these rules can come to the rescue with what may be called "hands-on philanthropy," when the angry seas of the federal estate tax system threaten to engulf a family business.
Family Dynamics and Issues
An important consideration in family planning, and especially in family business succession planning, is the family itself, its makeup, the number of individuals involved and not involved in the family business and personal as well as business issues with which family members may be grappling. Working with families and estate planning issues, and particularly when a family business is involved, is not for the uninformed or emotionally faint of heart. Aside from the critical and ethical issues of determining and documenting who is the client, there are the multiple agendas (hidden as well as direct) and road blocks that a planner must identify and address. In addition, there are many significant communication issues, often across multiple generational lines, that a planner must delicately handle. If some or all of the family members are not functional, are not willing to look at the issues, cannot deal well with change or cannot or will not communicate or participate in the process, the task of implementing an effective plan becomes almost impossible.
Family business owners are frequently reluctant to engage in the planning and implementation necessary to preserve their businesses. A variety of factors contribute to an owner's reluctance to plan. These include domineering personalities, lack of independent financial resources, a failure to appreciate aging, a failure to appreciate underlying problems and moods of resignation.
Overcoming a business owner's reluctance to plan can be as challenging as the planning process itself. Effective techniques generally fall under the heading of "disturb and motivate." This approach typically takes several forms. The advisor can use prior case histories in an attempt to motivate by example or can talk about what current research shows on the prevalence of succession breakdowns. The advisor may use estimated tax exposure projections with graphic, color flowcharts. This approach can be very effective.
Candid discussions about valuation principles, including how certain assets are valued, what is included in the gross estate and when and how the tax is paid, are useful. The advisor can also emphasize the importance of having both the patriarch and matriarch involved in designing succession solutions sooner rather than later. For example, the lawyer can ask the clients, "When is the best time to do this? Now, while the two of you are here and we have access to your knowledge, resources and leadership, or later when . . . ?" The lawyer can also play a role in facilitating discussions that include younger family members. Discussions that allow family members to talk about a shared vision and values for the family business typically empower children and facilitate transfer planning.
All of these techniques can be valuable in helping family members communicate with each other about succession planning. Getting the family to talk, one generation to the next, can provide a good opportunity to explore succession solutions and, in particular, those that encompass philanthropy. For example, a private operating foundation may actually be indicated as one planning solution where control is a concern or the owner is inseparable from his or her business and key family members want to retain control.
If the family business represents the majority of the family's wealth, philanthropic planning becomes more difficult. This is also the case when there is a great deal of psychological attachment to the business or interest to be given to a charitable entity. Clients may say that "this is all we have" or have childhood memories intertwined with a business or property that will be given away. Children may express a sentiment such as, "I'll never be able to take my children back to the family farm now that it's gone."
Families often have created stories around their businesses. These are stories that they tell and retell to themselves, family members and others about the origins, the "whys" and the "hows" of the family business. At any given time, these stories are a reflection of where the storytellers see themselves in relation to their business and family life cycle. These stories capture the mood, feeling and function of the family as a whole. Whether these stories are hopeful and expansive or are closed in nature and full of gloom and doom will depend, in large part, on who is doing the telling and who is doing the listening.
A family actively discussing business planning and succession issues fares better and is generally healthier than one that is reluctant to engage in the process. When these conversations take place in family meetings in a safe and appropriate way, the potential is greatly increased for these stories or narratives to be told and retold in different ways with new possibilities, different meanings and, in some cases, radically different outcomes, co-authored by those who will have to live with them. Ideally, all interested members will be present, engaged in candid conversation and dialogue as opposed to multiple monologues, will feel free to speak their minds and hearts, even about the really tough issues, and will listen actively and respectfully. When family members are engaged in this manner, consideration of succession planning issues and particularly "hands-on philanthropy" can have a salutary effect on the continuation and health of the family business. Without an environment of clear and open communication, attempting to engage a family on these issues can have an unfavorable and even disastrous effect.
Two case studies, one involving a family caves operation and the other a retired entrepreneur, demonstrate the use of a private operating foundation in family business succession planning. To preserve the privacy of the clients, their names and other identifying details have been changed.
Family Caves Operation
- Historic family operations. This case involved a difficult decision on behalf of the Smith family to implement a private operating foundation to preserve a beautiful natural stone bridge and series of interconnected caves that had been in the family for nearly 100 years. From the early part of the 20th century, Mrs. Smith's family operated the caves as a public attraction. In the 1950s, when Mr. Smith came into the picture, the two teamed up to expand the operation. Mr. Smith, a geologist by training who worked for an unrelated international firm, was struck by the natural beauty and the ancient rock formations in this Northeastern paradise. It was not long before the two committed to make this operation their livelihood. Over the years, Mr. and Mrs. Smith worked hard to publicize the attraction. Their economic investment grew as all spare cash went to add additional tracts of land to the initial cave operation, with the couple sometimes paying a premium to retrieve tracts that had been deeded out of the family. In time, the Smiths amassed more than 1,000 acres of breathtakingly beautiful wilderness. Each year the operation and revenue grew. The Smiths added a rock and gem shop, a gift shop, a small restaurant, a rock and gem cutting facility and other attractions.
Over these same years, the Smith children came regularly with their parents. Many a summer was spent with the entire family enjoying this natural paradise. As the years went by and the children grew, they, in turn, brought their families and children to the caves in the summer. The Smiths, now in their early 60s, with four grown children who had their own families, wanted to retire permanently to this paradise retreat; however, economic reality soon set in.
- Events precipitating change. Although financially strong on its face, a retirement buyout from Mr. Smith's principal employer (the unrelated international firm) would soon be decimated by income taxes. Most of the Smiths' income from this arrangement would be taxed at 39.6%. Planning to reduce income taxes became an urgent and critical issue. The Smiths had other retirement assets, but they were modest. Creating financial security in retirement was looming large as their biggest challenge. The balance of their wealth was tied up in the land encompassing and adjacent to the cave attraction. Much of the property essential to the operation was owned by their closely held corporation, and the balance was owned in their individual names.
Of the Smiths' now $3.5 million estate, nearly $2 million was tied up in real estate owned either directly or in entities associated with the cave attraction, which neither the Smiths nor their children had any intention of selling. The retirement dilemma became even more problematic because the net revenue from the cave operation was barely enough to support the Smiths.
Finding a way out this dilemma was not easy. Although a philanthropic solution seemed appropriate, every scenario initially conceived of required a sale of at least some assets, even if all of the real estate and operating assets were contributed to a regular private foundation. The income tax deductions for contributions to a regular private foundation were limited, and the requirement for ongoing distributions to other charitable organizations would require periodic sales of the real estate. Enter the private operating foundation.
- Private operating foundation. The private operating foundation solution for the Smiths made real sense for a number of reasons: (1) it left the family in control while providing asset protection (a major concern for the Smiths with more than 30,000 visitors a year to their property); (2) it provided a way to diminish the estate tax burden; and (3) the public charity contribution limits offered a way to provide significant immediate savings on their income taxes. The Smiths needed to grapple with whether to contribute the stock of the cave corporation (which owned some of the property), the real property itself or some combination of the two.
The timing of contributions was also important. It seemed obvious that the Smiths should make the largest contribution they could prior to year end (1998). That year, Mr. Smith would receive the largest amount of income from the payout of his retirement arrangement. The payout in the initial years was being characterized mostly as deferred compensation.
This fact made the private foundation an ideal solution for the Smiths' tax problems, but, in their case, not for the reasons that they and their advisors initially thought. Mr. Smith, it seems, had been operating under some erroneous but understandable assumptions. Because both he and the children did not want the cave property and operation to leave the family, he and Mrs. Smith assumed one or more of the children would carry on the operation. They also mistakenly assumed that the self-dealing rules were more flexible than they are and that family members could, for example, continue to use the properties and facilities for personal use in ways that would not also be available to the public at large.
When it finally came down to contributing the stock of the cave company and title to real estate to the private operating foundation, the family balked. It became obvious that the family members had not fully communicated about everything that they needed to talk through, including how emotionally painful it was for various members to let go of their cherished summer retreat. As a consequence, Mr. Smith made a non-tax driven decision to forego implementing the foundation to give the family a better opportunity to fully air all thoughts and feelings about how to proceed and to discuss who would take over the operation. As a result, Mr. Smith ended up paying a large income tax bill for 1998. The family, however, has come to a much more balanced approach to their estate plan that assures Mr. and Mrs. Smith's economic future, eliminates taxes through a gifting and discounting program over time and finally incorporates the use of the foundation for future family plans and to act as remainder beneficiary in the event of the premature deaths of Mr. and Mrs. Smith in close succession.
New operation. This case presented itself as retirement planning for an entrepreneur in the transportation business, whose closely-held C corporation held about $500,000 of cash that it had slowly accumulated over the years and that the client did not need for his retirement. The entrepreneur would be receiving a large amount of cash in the current year under separate contracts with those for whom he did direct consulting. His initial concern was how to shelter this ordinary income from tax, and he came to a lawyer to discuss creating a private foundation. The client thought that by contributing the closely held stock to a private foundation, he could produce a tax deduction large enough to shelter his major shot of income in the final year of his biggest contract. The concern, of course, was that a gift of closely held stock to a nonoperating private foundation would produce only a basis deduction. Thus, there were two potential options: (1) a contribution to a community foundation, donor advised fund or other public charity that would deliver the fair market value deduction but provide little control for the donor; and (2) a private operating foundation. To help make the decision between the two options, the client was asked a few follow-up questions.
- The decision-making process. In response to an inquiry about what he wanted the foundation to do, the client expressed an interest in helping the homeless and poor residents of the rural area to which he had moved in the closing years of his career. When asked why he had chosen housing as the purpose he wanted to promote, he responded that he had been an avid student of carpentry all his life and believed that nothing gave a person a greater sense of security and pride than owning his or her own home. In fact, he had inculcated his son with his love of carpentry. The two of them had worked together to build a vacation home and had compared their carpentry projects over the years. Part of the reason he had moved to this remote area was the fact that his son had a home there and worked as a consultant, telecommuting.
The next question was whether he had any interest in being directly and personally involved in the construction or renovation of the housing, given that there are public charities such as Habitat for Humanity and Christmas in April that are doing a marvelous job of this kind of work. He said that he had spoken with these organizations, which would be happy to receive a contribution from him but could offer him no more in return than an opportunity to participate as a volunteer under their direction. Because of his independent nature, this alternative did not please him. He felt it would be better to have a private foundation, the funds of which he could spend for those charitable activities that he and his family chose. It was a clear example of a client not wanting to let go of control over his charitable largess.
By this point, it was evident that he was a candidate for a private operating foundation-not a huge organization, but one that would help meet both his personal and family needs as well as serve the community. Although the same tax benefits would have been available from a gift to a community foundation, a donor-advised fund or a support foundation, the desire for control was important to him. He was asked whether he and his family would be interested in becoming directly and actively involved in building and renovating housing for the poor and homeless in his area. That question took him aback for a moment, because he had not thought about this possibility before. After explaining that it could provide him with both more favorable tax treatment and allow him to retain control, he agreed to think it over.
The client called the very next day, saying that he had discussed it with his wife and son and that they wanted to know what was involved in running a private operating foundation. The lawyer spent a good deal of time carefully describing how it could work and noting several important points. As the lawyer explained, private operating foundations are subject to the same inflexible rules against self-dealing, excess business holdings, jeopardizing investments and taxable expenditures as private nonoperating foundations. The vast majority of expenses must be for the direct, active conduct of charitable activities by staff and volunteers for the private operating foundation. Further, as with all private foundation gifts, a good deal of administrative detail and paperwork is necessary to prove that funds have been properly spent in furtherance of charitable goals.
The client decided to hold a family meeting, which his lawyer would attend by phone to go over these important points before they made a decision. In preparation for this meeting, his lawyer created a handbook setting out in writing the points he would make by phone and sent a copy to each of the three of them. They were instructed to read it, cover to cover (about 25 pages), before the meeting. When the meeting was held, each family member raised points he or she wanted clarified. At the end of the meeting, the family met privately, and the next day the client called with approval to proceed.
- Implementing the plan. The client contacted the local Habitat for Humanity organization to see if it would assist the private operating foundation in selecting projects, and it was happy to do this. The private operating foundation was created, the TIN obtained, the Form 1023 completed and filed and a favorable determination letter received in due course. Habitat's agreement to cooperate undoubtedly helped obtain credibility with and approval from the IRS. A strong working relationship with Habitat has developed, and it is pleased to have an added source of funding and labor in the community. Note that the IRS raised questions about the family's abilityto carry out this plan. In response,the advisors and the client agreed to obtain the services of a construction supervisor for building all houses and for making all structural repairs. That satisfied the IRS and worked well in practice.
Immediately after receiving the favorable determination letter, the client contributed the stock in the C corporation to the private operating foundation, which liquidated it and distributed the cash to itself. Eighteen months into the project, the client is happy, renovation of several houses is underway and plans to build a new house with contributed supplies are in the works. The private operating foundation has become a family affair (father, mother and son joined by volunteers) that benefits the community-a winner all the way round.
Although private operating foundations are not a solution for every family business owner faced with estate planning issues, for those who wish to use active philanthropy to bridge intergenerational family gaps and to convey values to their children and grandchildren, planners should evaluate this tool for its ability to meet those needs.