future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills.
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arcticpineapplecorp.
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future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by arcticpineapplecorp. »

Hi all,

I've read through the following posts on CRUTS and still some questions remain (hoping B.Steiner can weigh in here!):
https://www.google.com/search?sitesearc ... org&q=crut
https://www.kkwc.com/wp-content/uploads ... 4_2020.pdf
viewtopic.php?p=2288365#p2288365
viewtopic.php?t=357913
https://www.bogleheads.org/wiki/Charita ... nder_trust

I'm asking for a friend. I have done his taxes for the past few years and wanted to give him some information. Here's the situation and some quetisons: (feel free to correct any terms and/or assumptions I have made) and I thank you all in advance:

my friend, who lives in PA, has worked as a CTO for decades for a private company.
The CEO may be looking to sell the business in a few years (he's approaching retirement age).
I'm not sure how the company is structured (C-Corp or S-Corp) if that matters (it's incorporated though so assumed not LLC).
I don't know if stock has been issued to the owner and/or board members when founded/incorporated (if that matters).

The owner is drafting paperwork to give my friend 10% of the company now (at no cost. There's no buyin required. CEO is trying to determine if this would be a gifting issue or what and fall under lifetime exemption? not sure if that even applies to businesses/gifts of share of ownership in a business?).

the owner is thinking he will sell the business for $10 million in the near future. (I don't know what it's worth now. I thought I read somewhere they maybe do $3 million in annual revenue, but don't know what the profit is).

So my friend's stake (equity?) would be $1 million (at time of sale). This is what he expects he would receive if a sale for business goes according to plan, for $10 million in a few years.

questions:
1. Forget about whether or not friend should have negotiated the amount of the percentage of ownership rather than just accept 10% offer, should he have a lawyer review the contract offered him before signing to make sure everything's kosher (and no stone unturned)?

2. If my friend just takes the payout from sale (doesn't go CRUT route), I'm assuming it's all cap gains. His boss said he'd look into if there was a way to reduce taxes. Boss told him he'd be paying 40% in taxes, but I assume the boss is thinking the proceeds would be taxed as ordinary income rather than cap gains. Since my friend hasn't yet seen the contract, could Boss actually structure it in a way that the boss could wind up paying my friend a percentage of the sale but listing it as income on a w-2 (in which case friend would be paying much more in taxes, right?)

If not, or under best case scenario it's a cap gain and not ordinary income, i would assume he'd need to know the cost basis of his 10% in order to determine what the amount of gain is when sale takes place, right? If so, does he need to get a valuation of the company to know what his 10% represents at time his interest is acquired rather than just counting the entire amount received as gain (assuming a $0 cost basis because he paid $0 to acquire his 10% share)?

3. From the posts above and what I could find, it seems like a way to reduce paying the cap gains which looks like it would be 20% long term + PA state capital gain tax 3.07% + NIIT 3.8? and 0.9% medicare too? could be to put the proceeds into a CRUT and have some questions about that not answered from the posts above:

a. I read up on CRUT vs CRAT and it seems like CRUT is preferable for various reasons but I'm trying to understand does my friend need to transfer his proceeds from sale directly into the CRUT to avoid the cap gains? I assume if he goes this route an estate attorney can advise him of the details to eliminate immediate taxation of the proceeds?

b. In addition to non immediate taxability of funds placed in CRUT, my understanding is he'd get a tax deduction if itemizing (due to the contribution amount)? If he doesn't itemize, would this be irrelevant or could it still be used if the donation to CRUT is greater than the standard deduction for MFJ? Is there a limit to the amount able to itemize here? Is it 60% of AGI as a max charitable contribution for deduction purposes? Looks like the case for cash into CRUT or 30% of AGI if donating appreciated assets or can spread that deduction over 5 years? source: https://www.schwabcharitable.org/maximi ... nder-trust

c. It looks like the CRUT has either a lifetime payout or 20 years? He's about 45 years old. I understand there has to be 10% that goes to the charity at the end, so $100,000. Does this mean he would draw on the remaining $900k plus growth on that over his lifetime? Does this mean he'd get payments for potentially 50 years or so? Can payments increase over time to cover inflation or are they fixed? Looks like it could be 5% but the value of the account based on investments would vary each year and that 5% then could be more or less than prior year? Looked like many payments are 5% a year (up to 50%?) so would he be getting around roughly $50,000 a year in income from the CRUT for life?

d. seemed like in early years mostly income is received from the trust and then after any cap gains, other tax exempt income and return of principal, so assuming the tax could vary depending on the type of income paid from the trust each year?

e. I saw I think B.Steiner might have written about in some cases it being a close call between which is better just paying the cap gains on the proceeds or paying the taxes on the income/cap gains from a CRUT (and major benefit in stretching these taxes over a long time) rather than paying cap gains all at once in the beginning. Since the CRUT is irrevocable I was wondering if there's a calculation to run to see how much he might get from just paying the cap gains and utilizing the remainder over lifetime vs. getting payouts from CRUT? Obviously how he invests the after tax amount would matter (and could differ vastly from how money would be invested in the CRUT).

f. I saw B.Steiner talked about the larger the trust the better (>$1 mil) but that he's done them for as small as $500k. Assuming this situation could fall into an amount of assets that might be warranted for CRUT use ($1 million)?

g. how much in fees should he be paying (max) for someone to manage the trust? Does this include trust tax returns completed or is that generally separate?

h. does he have the manager of the trust or that firm complete the trust tax returns?

i. I've seen use of CRUT along with donor advised fund (as a way to save money?). Is the CRUT put in the donor advised fund or do the proceeds for charity go into the donor advised fund after death of receipient (or beneficiary) and/or after exhausting an established time period (like the 20 years previously mentioned) or when there's only $100k left in the account in this case, which would need to go to charity at that time?

if he decides not to go CRUT, obviously I'll advise him to file quarterly estimated taxes when he receives his payout.

thank you again. If I think of any other questions, I'll add them.
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Joey Jo Jo Jr
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by Joey Jo Jo Jr »

It sounds like your friend really ought to consult a quality tax attorney or CPA, but here are few things to try to help:

-to defer gain on a business sale, the business interest has to be transferred to the CRT before the sale is agreed to. Transferring the proceeds, or even the business after the sale is agreed to, won’t work.

-transfer of S corp stock to a CRT will blow the S election. However, the S Corp itself can set up a CRT and transfer assets or stock of a C corp sub

-the CRT period (if not based on one or two lives) can be up to 20 years; it doesn’t have to be exactly 20 years.

-the minimum 10% charitable payout is just and actuarial projection and may ultimate be more or less than that

-a DAF can be a beneficiary but may result in tax deduction limitations. Not 100% sure off the top of my head.

-donor can also be trustee of the CRT. Use a CPA to do the returns unless trustee feels comfortable doing them directly.

-the receipt of stock from the corporation I’m pretty sure would be taxed as ordinary income and provide a basis equal to FMV.

-receipt directly from the owner may or may not be respected as a gift depending on the circumstances, but if so then recipient gets a carryover basis

-it might not even be stock at all. Sometimes corporations issue “phantom stock” which are rights to participate in subsequent appreciation during a liquidation event, and are ordinary income at that time.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by bsteiner »

Joey Jo Jo made some excellent points.

The charitable remainder trust would probably be a unitrust, and would probably run for lifetime.

A lawyer in a firm with a good trusts and estates group would be the one to consult. He/she will have done it at least a few times and would be able to do it.

You'll need an accountant who's familar with the returns for charitable remainder trusts. Any of the medium size accounting firms should be able to do them. Some sole practitioners and small firm accountants are also able to do them.

You are correct that it's often a close call from the client's standpoint, but some people like it since it may give charity a substantial benefit at the government's expense. Also, under present tax law, depending on your other income in future years, it may move some capital gain from the 20% rate to the 15% rate; and it may avoid the 3.8% net investment income tax.

While charitable remainder trusts are exempt from Federal income tax, you'll have to check whether they're exempt from Pennsylvania income tax. If not, you'll need a trustee outside Pennsylvania, at least in the initial year, to avoid this tax.

One of the tradeoffs with a charitable remainder trust is the loss of flexibility. That's less of a concern if it's a small enough portion of your assets.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by arcticpineapplecorp. »

Joey Jo Jo Jr wrote: Mon May 29, 2023 4:48 am It sounds like your friend really ought to consult a quality tax attorney or CPA, but here are few things to try to help:

-to defer gain on a business sale, the business interest has to be transferred to the CRT before the sale is agreed to. Transferring the proceeds, or even the business after the sale is agreed to, won’t work.

-transfer of S corp stock to a CRT will blow the S election. However, the S Corp itself can set up a CRT and transfer assets or stock of a C corp sub

-the CRT period (if not based on one or two lives) can be up to 20 years; it doesn’t have to be exactly 20 years.

-the minimum 10% charitable payout is just and actuarial projection and may ultimate be more or less than that

-a DAF can be a beneficiary but may result in tax deduction limitations. Not 100% sure off the top of my head.

-donor can also be trustee of the CRT. Use a CPA to do the returns unless trustee feels comfortable doing them directly.

-the receipt of stock from the corporation I’m pretty sure would be taxed as ordinary income and provide a basis equal to FMV.

-receipt directly from the owner may or may not be respected as a gift depending on the circumstances, but if so then recipient gets a carryover basis

-it might not even be stock at all. Sometimes corporations issue “phantom stock” which are rights to participate in subsequent appreciation during a liquidation event, and are ordinary income at that time.
thank you very much for your information. Just a couple follow-ups.

I knew i badly worded what I intended to say regarding the transfer of the asset into the CRUT (before or after liquidation) but thanks for clearly spelling out that distinction.

Like I said I'm not even sure how the company is structured but assume it's not LLC since it's an "inc." at the end of it's name. And I think it's a family or self owned (sole proprietor) business with employees.

Just a few follow up questions:

1. Sounds like before he accepts the contract/transfer of 10% of the business he should consult a professional from a tax perspective of how this is to be treated now, not just after sale of business years from now. If the business is worth $5 million now and he gets a "value" of 10% which is taxable as $500k more income now, that will present some problems for him (because while he will get the 10% equity, he will not have the cash to pay the taxes at ordinary income rates) so he probably needs to know the tax impact of this transfer now, not just later when business is sold, right? Maybe if he's getting the "phantom stock" that doesn't impact him now, but later during the liquidation event? The contract should make that clear?

2. what do you mean by carryover basis if the transfer is treated as a gift?

thank you for your time and effort explaining it.
Last edited by arcticpineapplecorp. on Mon May 29, 2023 12:22 pm, edited 2 times in total.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by arcticpineapplecorp. »

bsteiner wrote: Mon May 29, 2023 11:34 am Joey Jo Jo made some excellent points.

The charitable remainder trust would probably be a unitrust, and would probably run for lifetime.

A lawyer in a firm with a good trusts and estates group would be the one to consult. He/she will have done it at least a few times and would be able to do it.

You'll need an accountant who's familar with the returns for charitable remainder trusts. Any of the medium size accounting firms should be able to do them. Some sole practitioners and small firm accountants are also able to do them.

You are correct that it's often a close call from the client's standpoint, but some people like it since it may give charity a substantial benefit at the government's expense. Also, under present tax law, depending on your other income in future years, it may move some capital gain from the 20% rate to the 15% rate; and it may avoid the 3.8% net investment income tax.

While charitable remainder trusts are exempt from Federal income tax, you'll have to check whether they're exempt from Pennsylvania income tax. If not, you'll need a trustee outside Pennsylvania, at least in the initial year, to avoid this tax.

One of the tradeoffs with a charitable remainder trust is the loss of flexibility. That's less of a concern if it's a small enough portion of your assets.
thanks very much for your response. your expertise in this area is highly valued.

I thought about (but failed to mention) if he's in a lower bracket later there's an advantage to the CRUT.

Yes, I thought I read something not only about the cap gains at the PA state level (if receive distribution/cash and not use CRUT) but also possible tax to PA from income distributed from the CRUT (if CRUT is used instead of receiving distribution/cash). Two questions:

1. If the trust is not exempt from PA tax, why would he need a trustee outside PA just for the initial year? Is there a difference in the income received from the trust in the first year, but thereafter it's distributed to my friend (via k-1) and falls thereafter on the individual taxpayer?

2. if he would need a trustee outside PA to avoid this tax, is there any downside to just keeping the trustee outside PA thereafter?

I saw the loss of flexibility (presumably because it's irrevocable). It would be a substantial part of his assets though, so that might change the equation.

Thanks for your help and if you could add insight to my questions above I'd appreciate it.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by bsteiner »

arcticpineapplecorp. wrote: Mon May 29, 2023 12:20 pm ...
Yes, I thought I read something not only about the cap gains at the PA state level (if receive distribution/cash and not use CRUT) but also possible tax to PA from income distributed from the CRUT (if CRUT is used instead of receiving distribution/cash). Two questions:

1. If the trust is not exempt from PA tax, why would he need a trustee outside PA just for the initial year? Is there a difference in the income received from the trust in the first year, but thereafter it's distributed to my friend (via k-1) and falls thereafter on the individual taxpayer?

2. if he would need a trustee outside PA to avoid this tax, is there any downside to just keeping the trustee outside PA thereafter?
...
I seem to recall (but you should check to confirm) that Pennsylvania doesn't follow the Federal treatment of charitable remainder trusts as tax-exempt.

However, under McNeil v. Commonwealth, https://scholar.google.com/scholar_case ... _sdt=4,229, the Commonwealth Court held that if there's no trustee in Pennsylvania, no real or tangible property in Pennsylvania, and no Pennsylvania source income, Pennsylvania can't tax a trust.

To be safe, since the court recited that the trust wasn't governed by Pennsylvania law, you might want to have it governed by the law of the trustee's home state.

It would be simpler to keep the trustees outside Pennsylvania in subsequent years though the stakes are much smaller than in the year of the sale. In the year of the sale, the trust will have a large capital gain from the sale of the shares. After that, the trust will have modest amounts of investment income and gains. So even if the trust is taxable in Pennsylvania, it would probably only be taxed on capital gains in subsequent years.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by arcticpineapplecorp. »

bsteiner wrote: Mon May 29, 2023 12:41 pm
arcticpineapplecorp. wrote: Mon May 29, 2023 12:20 pm ...
Yes, I thought I read something not only about the cap gains at the PA state level (if receive distribution/cash and not use CRUT) but also possible tax to PA from income distributed from the CRUT (if CRUT is used instead of receiving distribution/cash). Two questions:

1. If the trust is not exempt from PA tax, why would he need a trustee outside PA just for the initial year? Is there a difference in the income received from the trust in the first year, but thereafter it's distributed to my friend (via k-1) and falls thereafter on the individual taxpayer?

2. if he would need a trustee outside PA to avoid this tax, is there any downside to just keeping the trustee outside PA thereafter?
...
I seem to recall (but you should check to confirm) that Pennsylvania doesn't follow the Federal treatment of charitable remainder trusts as tax-exempt.

However, under McNeil v. Commonwealth, https://scholar.google.com/scholar_case ... _sdt=4,229, the Commonwealth Court held that if there's no trustee in Pennsylvania, no real or tangible property in Pennsylvania, and no Pennsylvania source income, Pennsylvania can't tax a trust.

To be safe, since the court recited that the trust wasn't governed by Pennsylvania law, you might want to have it governed by the law of the trustee's home state.

It would be simpler to keep the trustees outside Pennsylvania in subsequent years though the stakes are much smaller than in the year of the sale. In the year of the sale, the trust will have a large capital gain from the sale of the shares. After that, the trust will have modest amounts of investment income and gains. So even if the trust is taxable in Pennsylvania, it would probably only be taxed on capital gains in subsequent years.
Thank you very much. That makes a lot of sense. And thanks for the reference to the commonwealth case. I'll review that.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by Joey Jo Jo Jr »

arcticpineapplecorp. wrote: Mon May 29, 2023 12:11 pm
Joey Jo Jo Jr wrote: Mon May 29, 2023 4:48 am It sounds like your friend really ought to consult a quality tax attorney or CPA, but here are few things to try to help:

-to defer gain on a business sale, the business interest has to be transferred to the CRT before the sale is agreed to. Transferring the proceeds, or even the business after the sale is agreed to, won’t work.

-transfer of S corp stock to a CRT will blow the S election. However, the S Corp itself can set up a CRT and transfer assets or stock of a C corp sub

-the CRT period (if not based on one or two lives) can be up to 20 years; it doesn’t have to be exactly 20 years.

-the minimum 10% charitable payout is just and actuarial projection and may ultimate be more or less than that

-a DAF can be a beneficiary but may result in tax deduction limitations. Not 100% sure off the top of my head.

-donor can also be trustee of the CRT. Use a CPA to do the returns unless trustee feels comfortable doing them directly.

-the receipt of stock from the corporation I’m pretty sure would be taxed as ordinary income and provide a basis equal to FMV.

-receipt directly from the owner may or may not be respected as a gift depending on the circumstances, but if so then recipient gets a carryover basis

-it might not even be stock at all. Sometimes corporations issue “phantom stock” which are rights to participate in subsequent appreciation during a liquidation event, and are ordinary income at that time.
thank you very much for your information. Just a couple follow-ups.

I knew i badly worded what I intended to say regarding the transfer of the asset into the CRUT (before or after liquidation) but thanks for clearly spelling out that distinction.

Like I said I'm not even sure how the company is structured but assume it's not LLC since it's an "inc." at the end of it's name. And I think it's a family or self owned (sole proprietor) business with employees.

Just a few follow up questions:

1. Sounds like before he accepts the contract/transfer of 10% of the business he should consult a professional from a tax perspective of how this is to be treated now, not just after sale of business years from now. If the business is worth $5 million now and he gets a "value" of 10% which is taxable as $500k more income now, that will present some problems for him (because while he will get the 10% equity, he will not have the cash to pay the taxes at ordinary income rates) so he probably needs to know the tax impact of this transfer now, not just later when business is sold, right? Maybe if he's getting the "phantom stock" that doesn't impact him now, but later during the liquidation event? The contract should make that clear?

2. what do you mean by carryover basis if the transfer is treated as a gift?

thank you for your time and effort explaining it.
Yeah he should have someone review the proposed documentation and explain the ramifications. Better yet, get the biz owner to explain the transaction and expected tax consequences as the owner understands it, and THEN get someone independent to verify that is correct, as it’s quite possible the owner doesn’t necessarily have a correct understanding.

But the 3 possible consequences as I see it are 1) the corporation is issuing new shares that will be 10# of the total shares when issued, which will be taxed as ordinary income equal to FMV of that 10% (which likely should be discounted for lack of control and marketability) and with a tax basis equal to such FMV. 2) the owner truly is gifting the shares without any associated agreements or quid pro quo, in which case the owner reports it as a taxable gift and friend gets a tax basis equal to the owner’s tax basis in the gifted shares (i.e., the carryover basis). Or 3) this is a deferred comp interest, such as phantom stock, that is not a gift or result in immediate income, but gets taxed later as ordinary income at the relevant triggering event.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by LFS1234 »

You need to know what kind of entity this is. If it is a C-corporation, it’s easy – no reporting or record-keeping requirements aside from your basis, your dividends, and your proceeds upon eventual sale. Worst case scenario is that the stock becomes worthless.

If it is a sub-S corporation, you have to deal with K-1s and pay your share of the corporation’s income taxes regardless of whether or not the corporation distributes anything to you. Worst case scenario is that you end up with large flow-through tax liabilities and no way to pay them. You probably don’t want to own shares in an S-Corp without a sensible shareholder agreement in place.

You need to know who the shareholders are. If there is more than one shareholder, then the company and controlling shareholder/CEO have responsibilities those shareholders. If new stock is issued, there are legal records to be kept, and often IRS or state filings to be made.

If the controlling shareholder merely wants to transfer some of his own stock, that’s easy. Unless there is a shareholder agreement restricting this, he can gift or sell his shares to whomever he pleases.

The current value of a 10% minority interest in a closely held company has very little to do with the valuation that the controlling shareholder hopes to obtain for 100% of the company somewhere down the road. Especially in small companies, money is easily dissipated to family and friends or for quality-of-life enhancements, and some such companies are essentially “zeroed out” – managed so that they don’t have any profits. Often, very low valuations can be justified for minority interests in closely held companies. Often, it can make sense for someone in your friend’s position just to buy the stock at a very low price - particularly if the stock dividends/distributions are very attractive compared to the price paid for the stock.

Regarding the prospective sale of the whole company: nobody can know for sure that such a sale will occur until it actually happens. Depending on the nature of the company, sometimes a deal calls for the sale price to be paid in two installments – the first one being a fixed amount, and the second one some years later depending on the subsequent performance of the company. Sometimes that second payment ends up being zero, if the business post-sale doesn’t end up performing as hoped for. Your friend’s calculations will have to take into account the possibility that his boss’ expectations don’t come to pass.

Regarding fancy tax maneuvers: often these don’t make sense. They can be complicated and expensive to implement. The certainty of a specific price and a specific tax obligation can be replaced with an expensive muddle that ties your hands for decades and creates huge opportunity costs. I have bought and sold many interests in private corporations. So far, I’ve never regretted just making clean sales and writing the appropriate checks to the IRS. I’m sure that there are some times when the fancy tax maneuvers do make sense, but if it’s a close call on paper, then it would be an obvious “no” for me.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by arcticpineapplecorp. »

Joey Jo Jo Jr wrote: Mon May 29, 2023 10:12 pm
arcticpineapplecorp. wrote: Mon May 29, 2023 12:11 pm
Joey Jo Jo Jr wrote: Mon May 29, 2023 4:48 am It sounds like your friend really ought to consult a quality tax attorney or CPA, but here are few things to try to help:

-to defer gain on a business sale, the business interest has to be transferred to the CRT before the sale is agreed to. Transferring the proceeds, or even the business after the sale is agreed to, won’t work.

-transfer of S corp stock to a CRT will blow the S election. However, the S Corp itself can set up a CRT and transfer assets or stock of a C corp sub

-the CRT period (if not based on one or two lives) can be up to 20 years; it doesn’t have to be exactly 20 years.

-the minimum 10% charitable payout is just and actuarial projection and may ultimate be more or less than that

-a DAF can be a beneficiary but may result in tax deduction limitations. Not 100% sure off the top of my head.

-donor can also be trustee of the CRT. Use a CPA to do the returns unless trustee feels comfortable doing them directly.

-the receipt of stock from the corporation I’m pretty sure would be taxed as ordinary income and provide a basis equal to FMV.

-receipt directly from the owner may or may not be respected as a gift depending on the circumstances, but if so then recipient gets a carryover basis

-it might not even be stock at all. Sometimes corporations issue “phantom stock” which are rights to participate in subsequent appreciation during a liquidation event, and are ordinary income at that time.
thank you very much for your information. Just a couple follow-ups.

I knew i badly worded what I intended to say regarding the transfer of the asset into the CRUT (before or after liquidation) but thanks for clearly spelling out that distinction.

Like I said I'm not even sure how the company is structured but assume it's not LLC since it's an "inc." at the end of it's name. And I think it's a family or self owned (sole proprietor) business with employees.

Just a few follow up questions:

1. Sounds like before he accepts the contract/transfer of 10% of the business he should consult a professional from a tax perspective of how this is to be treated now, not just after sale of business years from now. If the business is worth $5 million now and he gets a "value" of 10% which is taxable as $500k more income now, that will present some problems for him (because while he will get the 10% equity, he will not have the cash to pay the taxes at ordinary income rates) so he probably needs to know the tax impact of this transfer now, not just later when business is sold, right? Maybe if he's getting the "phantom stock" that doesn't impact him now, but later during the liquidation event? The contract should make that clear?

2. what do you mean by carryover basis if the transfer is treated as a gift?

thank you for your time and effort explaining it.
Yeah he should have someone review the proposed documentation and explain the ramifications. Better yet, get the biz owner to explain the transaction and expected tax consequences as the owner understands it, and THEN get someone independent to verify that is correct, as it’s quite possible the owner doesn’t necessarily have a correct understanding.

But the 3 possible consequences as I see it are 1) the corporation is issuing new shares that will be 10# of the total shares when issued, which will be taxed as ordinary income equal to FMV of that 10% (which likely should be discounted for lack of control and marketability) and with a tax basis equal to such FMV. 2) the owner truly is gifting the shares without any associated agreements or quid pro quo, in which case the owner reports it as a taxable gift and friend gets a tax basis equal to the owner’s tax basis in the gifted shares (i.e., the carryover basis). Or 3) this is a deferred comp interest, such as phantom stock, that is not a gift or result in immediate income, but gets taxed later as ordinary income at the relevant triggering event.
thank you very much for breaking it down like that. Makes sense. And don't worry about explaining the carryover basis, I understand that now.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by arcticpineapplecorp. »

LFS1234 wrote: Tue May 30, 2023 6:09 am You need to know what kind of entity this is. If it is a C-corporation, it’s easy – no reporting or record-keeping requirements aside from your basis, your dividends, and your proceeds upon eventual sale. Worst case scenario is that the stock becomes worthless.

If it is a sub-S corporation, you have to deal with K-1s and pay your share of the corporation’s income taxes regardless of whether or not the corporation distributes anything to you. Worst case scenario is that you end up with large flow-through tax liabilities and no way to pay them. You probably don’t want to own shares in an S-Corp without a sensible shareholder agreement in place.

You need to know who the shareholders are. If there is more than one shareholder, then the company and controlling shareholder/CEO have responsibilities those shareholders. If new stock is issued, there are legal records to be kept, and often IRS or state filings to be made.

If the controlling shareholder merely wants to transfer some of his own stock, that’s easy. Unless there is a shareholder agreement restricting this, he can gift or sell his shares to whomever he pleases.

The current value of a 10% minority interest in a closely held company has very little to do with the valuation that the controlling shareholder hopes to obtain for 100% of the company somewhere down the road. Especially in small companies, money is easily dissipated to family and friends or for quality-of-life enhancements, and some such companies are essentially “zeroed out” – managed so that they don’t have any profits. Often, very low valuations can be justified for minority interests in closely held companies. Often, it can make sense for someone in your friend’s position just to buy the stock at a very low price - particularly if the stock dividends/distributions are very attractive compared to the price paid for the stock.

Regarding the prospective sale of the whole company: nobody can know for sure that such a sale will occur until it actually happens. Depending on the nature of the company, sometimes a deal calls for the sale price to be paid in two installments – the first one being a fixed amount, and the second one some years later depending on the subsequent performance of the company. Sometimes that second payment ends up being zero, if the business post-sale doesn’t end up performing as hoped for. Your friend’s calculations will have to take into account the possibility that his boss’ expectations don’t come to pass.

Regarding fancy tax maneuvers: often these don’t make sense. They can be complicated and expensive to implement. The certainty of a specific price and a specific tax obligation can be replaced with an expensive muddle that ties your hands for decades and creates huge opportunity costs. I have bought and sold many interests in private corporations. So far, I’ve never regretted just making clean sales and writing the appropriate checks to the IRS. I’m sure that there are some times when the fancy tax maneuvers do make sense, but if it’s a close call on paper, then it would be an obvious “no” for me.
excellent points. gives me more to think about as I explain this to him. great explanation. taking notes on everything that was written so far. great info.
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arcticpineapplecorp.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by arcticpineapplecorp. »

LFS1234 wrote: Tue May 30, 2023 6:09 am You need to know what kind of entity this is. If it is a C-corporation, it’s easy – no reporting or record-keeping requirements aside from your basis, your dividends, and your proceeds upon eventual sale. Worst case scenario is that the stock becomes worthless.

If it is a sub-S corporation, you have to deal with K-1s and pay your share of the corporation’s income taxes regardless of whether or not the corporation distributes anything to you. Worst case scenario is that you end up with large flow-through tax liabilities and no way to pay them. You probably don’t want to own shares in an S-Corp without a sensible shareholder agreement in place.

You need to know who the shareholders are. If there is more than one shareholder, then the company and controlling shareholder/CEO have responsibilities those shareholders. If new stock is issued, there are legal records to be kept, and often IRS or state filings to be made.

If the controlling shareholder merely wants to transfer some of his own stock, that’s easy. Unless there is a shareholder agreement restricting this, he can gift or sell his shares to whomever he pleases.

The current value of a 10% minority interest in a closely held company has very little to do with the valuation that the controlling shareholder hopes to obtain for 100% of the company somewhere down the road. Especially in small companies, money is easily dissipated to family and friends or for quality-of-life enhancements, and some such companies are essentially “zeroed out” – managed so that they don’t have any profits. Often, very low valuations can be justified for minority interests in closely held companies. Often, it can make sense for someone in your friend’s position just to buy the stock at a very low price - particularly if the stock dividends/distributions are very attractive compared to the price paid for the stock.
Joey Jo Jo Jr wrote: Mon May 29, 2023 10:12 pm Yeah he should have someone review the proposed documentation and explain the ramifications. Better yet, get the biz owner to explain the transaction and expected tax consequences as the owner understands it, and THEN get someone independent to verify that is correct, as it’s quite possible the owner doesn’t necessarily have a correct understanding.

But the 3 possible consequences as I see it are 1) the corporation is issuing new shares that will be 10# of the total shares when issued, which will be taxed as ordinary income equal to FMV of that 10% (which likely should be discounted for lack of control and marketability) and with a tax basis equal to such FMV. 2) the owner truly is gifting the shares without any associated agreements or quid pro quo, in which case the owner reports it as a taxable gift and friend gets a tax basis equal to the owner’s tax basis in the gifted shares (i.e., the carryover basis). Or 3) this is a deferred comp interest, such as phantom stock, that is not a gift or result in immediate income, but gets taxed later as ordinary income at the relevant triggering event.
Ok, so I found out that this company is an S corp. Here are my follow-up questions and thank you so much, you've been very helpful and I'm learning a lot here:

1. my friend's asking "Do the tax liability risks apply to phantom stock as well?" This was what I found on the internet:
there are actually 2 types:
""Appreciation only" plans do not include the value of the actual underlying shares themselves, and may only pay out the value of any increase in the company stock price over a certain period of time that begins on the date the plan is granted.

"Full value" plans pay both the value of the underlying stock as well as any appreciation."
source: https://www.investopedia.com/terms/p/phantomstock.asp

from the link above couple other things to know about phantom stock:

"Phantom stock may be hypothetical, however, it still can pay out dividends and it experiences price changes just like its real counterpart. After a period of time, the cash value of the phantom stock is distributed to the participating employees.

Phantom stock, also known as synthetic equity, has no inherent requirements or restrictions regarding its use, allowing the organization to use it however it chooses. Phantom stock can also be changed at the leadership's discretion."
is one better than the other (appreciation only vs full value)? what are the pros and cons of each, and anything else to know here?

2. I looked up Sub S-Corp because you mentioned it earlier and I hadn't heard the term. I don't understand how a sub s-corp is different from an s-corp so maybe if you can say if/how they're different (he didn't say his company was sub s corp, he just said it was s corp). Looked like either way the concerns are:
At the end of each year, all S corporation profits are allocated to the corporation's shareholders. Even if you and your fellow shareholders choose to leave some or all of the profits in the corporation, taking nothing as distributions or salaries, you will still be required to pay tax on those profits. In technical lingo, an S corporation is not permitted to have any retained earnings. This is different from a regular corporation, which can retain—and pay taxes on—its earnings.

However, S corporation shareholders may be able to deduct 20% of their business income with the pass-through deduction established under the Tax Cuts and Jobs Act. See The 20% Pass-Through Tax Deduction for Business Owners for more information."

source: https://www.law.cornell.edu/wex/subchap ... orporation
3. I'm not sure what a "sensible shareholder agreement" means. I found regarding the shareholder agreement:
"the shareholder agreement of an S corporation will have in it an indemnity clause that necessitates a holder to pay a change in tax status cost if the consequences result in automatic termination" (source: https://www.upcounsel.com/sample-shareh ... ent-s-corp).

sources:
https://www.upcounsel.com/s-corp-shareholder-agreement
https://www.upcounsel.com/sample-shareh ... ent-s-corp
what does a "sensible shareholder agreement" mean and is there any way he would not have to pay taxes each year regardless of whether the s-corp distributes income? I think that's a concern of his.

i'm confused on the indemnity clause. does this indemnity clause protect him and if so how?

It seemed like the main thing I found was that a shareholder agreement have this indemnity clause, but I didn't find any other advise regarding what should/shouldn't be in there to protect his interests.

4. looks like he'd get a k-1 (form 1120S) and have at least a schedule E and possibly Schedule D (cap gains if any) to file in addition for his tax return.

Does he have any control over whether or not dividends and/or cap gains are distributed?

What other questions should he be asking when he meets with a tax attorney or CPA?

Thanks a million.
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hachiko
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by hachiko »

He needs an attorney with experience in closely held businesses. This is not a situation where you can "wing it" by searching Google for specific information.

There's a lot going on here, and the fact that it's an S Corp only complicates matters. The first step is the attorney. The attorney should be able to bring in a tax person to assist with the tax side. If they don't have any recommendations for tax professionals, find another attorney.

My advice to you is that you steer clear of *any sort* of advising on this transaction, but still join the discussions so you know what's going on for when you're helping with his tax returns in the future and so you can answer questions and provide additional information to the attorney and specialized tax pro that he may not know himself.
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by arcticpineapplecorp. »

hachiko wrote: Fri Jun 02, 2023 1:08 pm He needs an attorney with experience in closely held businesses. This is not a situation where you can "wing it" by searching Google for specific information.

There's a lot going on here, and the fact that it's an S Corp only complicates matters. The first step is the attorney. The attorney should be able to bring in a tax person to assist with the tax side. If they don't have any recommendations for tax professionals, find another attorney.

My advice to you is that you steer clear of *any sort* of advising on this transaction, but still join the discussions so you know what's going on for when you're helping with his tax returns in the future and so you can answer questions and provide additional information to the attorney and specialized tax pro that he may not know himself.
excellent advice. I will pass that on to him. I have told him to contact a tax lawyer and/or a CPA before signing anything and to understand what's being offered and the implications therein. I thought having an S corp complicated things from what I could tell. Good to know.
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Joey Jo Jo Jr
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Re: future sale of business proceeds, read posts on CRUTS, questions not answered on other posts read

Post by Joey Jo Jo Jr »

Definitely agree with hatchiko about not advising the friend, especially as it seems rather uncertain what is even being considered by the owner at this point.

But given the question about pass through taxation, reading some general articles about S corps would probably help the friend. But in brief, the net income of the S corp gets allocated to the owners in proportion to their ownership, but without any certainty of distributions of cash to pay for the resulting tax obligation (though usually the owners vote to distribute available cash periodically or that might be automatic under the shareholder agreement).

I had mentioned the S corp possibility having a C Corp sub for purposes of funding a CRUT (since S corp shares can’t go to the CRUT), but it sounds like the CRUT may not be relevant to this transaction after all.

And I’ve only dealt with phantom stock that provided rights to future appreciation, as the point is to incentivize future work of key employees rather than something that has already been accomplished. Also, providing rights to existing value may result in ordinary income even if it’s phantom stock.
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