Estate planning for political contributions
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Estate Planning for Political Contributions. Eric Reis Thompson & Knight LLP 214.969.1118 [email protected] Introduction: Political Giving.

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Estate Planning for Political Contributions

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Estate planning for political contributions

Estate Planningfor Political Contributions

Eric Reis

Thompson & Knight LLP

214.969.1118

[email protected]


Introduction political giving

Introduction: Political Giving

  • Harold Simmons has contributed over $17 million and Houston homebuilder Bob Perry has contributed over $11 million to GOP-friendly SuperPACs in the 2012 election cycle

  • Contributions to Democratic-friendly SuperPACs have been lower this cycle, but include 7-figure contributions from Morgan Freeman, Bill Maher, and Jeffrey Katzenberg

  • Contributions to Democratic-friendly groups were higher before Citizens United; in 2004, George Soros contributed more than $22 million to such groups


Introduction political giving1

Introduction: Political Giving

  • Some donors have long-term political objectives extending beyond a single election

  • However, current federal estate and gift tax provisions assume that donors do not have long-term political interests and will not attempt to make deferred gifts and bequests for political causes


Introduction political giving2

Introduction: Political Giving

  • There are also significant inconsistencies in the treatment of political gifts for estate and gift tax purposes

    • Bequests to political organizations are subject to the federal estate tax

    • Lifetime gifts to political organizations are excluded from the federal gift tax


Introduction political giving3

Introduction: Political Giving

  • Planning opportunities exist for donors with long-term political interests to make large nonpolitical transfers to family members

  • To understand the current opportunities, it is helpful to review the past estate and gift tax planning strategies on which these new strategies are based


Past strategies partial interest gifts to charity

Past Strategies: Partial Interest Gifts to Charity

  • Prior to the Tax Reform Act of 1969, partial interest gifts to charities were deductible for gift tax purposes

  • Donors made partial interest gifts to charities with the remainder to family members

  • Actuarial tables were used to maximize the value of the partial interest to charity and depress the value of the remainder interest


Past strategies partial interest gifts to charity1

Past Strategies:Partial Interest Gifts to Charity

  • Hipp v. United States – upheld the use of the actuarial tables as a reasonable method for valuing a partial income interest gift to charity (actual yield 0.62%, assumed yield 3.5%)

  • Hamm v. Commissioner – denied any gift tax deduction for an income interest in common stock contributed to trust for a charity when the corporation had not paid dividends in 16 years and owed $3.7 million delinquent preferred dividends

  • Revenue Ruling 77-195 – the IRS conceded the use of the actuarial tables to value partial interest gifts in all but the most extreme circumstances


Legislative response tax reform act of 1969

Legislative Response: Tax Reform Act of 1969

  • Disallowed gift, estate, or income tax charitable deduction for partial interest gifts to charity unless structured in a form prescribed by statute

    • A deduction for a term interest in trust is allowed if it is an annuity interest or a unitrust interest

    • A deduction for a remainder interest in trust is allowed if it follows an annuity or unitrust interest


Legislative response tax reform act of 19691

Legislative Response: Tax Reform Act of 1969

  • Self-dealing rules impose penalties for self-dealing between private foundations and disqualified persons and between split interest trusts and disqualified persons

  • Congress later enacted excise taxes for “excess benefit transactions” between disqualified persons and charities other than private foundations


Past strategies retained interests

Past Strategies: Retained Interests

  • Preferred or Lapsing Rights in Business Entities

    • Taxpayers transferred business entity interests to family members, retained preferred or lapsing interests for themselves, and maximized the value of their retained interests with conversion, redemption, or dissolution rights


Past strategies retained interests1

Past Strategies: Retained Interests

  • Snyder v. Comm’r—

    • The taxpayer formed a corporation and contributed assets worth $2.6 million

    • The taxpayer transferred common stock in the corporation to her great-grandchildren and retained preferred stock for herself

    • The stock held by the corporation appreciated to $5.3 million, inuring almost entirely to the benefit of the great-grandchildren

    • The Tax Court concluded the value of the common stock transferred to the great-grandchildren was only $1,000 due to the crowding out of the preferred stock


Legislative response revenue reconciliation act of 1990

Legislative Response:Revenue Reconciliation Act of 1990

  • Added Chapter 14 to the Internal Revenue Code

    • If a taxpayer transfers a business interest to family members, any interest retained by the taxpayer is valued at zero unless structured in a form prescribed by statute

    • Any special rights or powers retained by the taxpayer in the transfer of a family business interest are deemed exercised, or not exercised, in a manner that will maximize the gift value


Legislative response revenue reconciliation act of 19901

Legislative Response:Revenue Reconciliation Act of 1990

  • Chapter 14 (continued)

    • If a taxpayer retains a right in a business interest that lapses, the lapse may be treated as an additional gift or bequest

    • Any interest retained in a trust for the benefit of family members is valued at zero unless structured in statutorily-prescribed form


Legislative response revenue reconciliation act of 19902

Legislative Response:Revenue Reconciliation Act of 1990

  • Chapter 14 applies only if a taxpayer, or members of the taxpayer’s family, retain an interest in the property or business entity at issue

  • Chapter 14 can be avoided by donating the retained interest to a political organization


The gift tax exclusion for political contributions

The Gift Tax Exclusion for Political Contributions

  • Section 2501(a)(4)—transfers of money or other property to a “political organization” (within the meaning of Section 527(e)(1)) for the use of such organization are excluded from the federal gift tax (need not be reported on Form 709)

  • No corresponding exclusion or deduction for federal estate tax purposes


The gift tax exclusion for political contributions1

The Gift Tax Exclusion for Political Contributions

  • Uncertainty exists regarding meaning of “to a political organization for the use of such organization”

  • Treasury Regulations clarify that contributions of income interests are “for the use of” charitable organizations and contributions of remainder interests are “to” charitable organizations

  • If the same is true for contributions to political organizations, gifts of remainder interests (even if made in trust) should qualify for the Section 2501(a)(4) exclusion


The gift tax exclusion for political contributions2

The Gift Tax Exclusion for Political Contributions

  • A “political organization” described in Section 527(e)(1) is “a party, committee, association, fund or other organization (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function”


The gift tax exclusion for political contributions3

The Gift Tax Exclusion for Political Contributions

  • Examples of Political Organizations:

    • Democratic and Republican parties

    • Campaign committees for individual candidates

    • Independent political groups operated primarily for political purposes

  • Independent political groups are most appealing for gift tax planning due to less stringent limitations under campaign finance law


Campaign finance law

Campaign Finance Law

  • There are strict limits on the amount of contributions to individual candidates

  • Bipartisan Campaign Reform Act of 2002—imposes limits on the amount of any contribution to a national political party or congressional campaign committee


Campaign finance law1

Campaign Finance Law

  • No limitations on “soft money” contributions to independent political organizations

  • Thus, a donor seeking an unlimited gift tax exclusion for political contributions can contribute to an “independent” Section 527(e)(1) organization


Estate planning for political contributions

How can the gift tax exclusion rules for political contributions be used for family transfer planning?


Snyder revisited preferred or lapsing rights in business entities

Snyder Revisited: Preferred or Lapsing Rights in Business Entities

The following example illustrates how the strategy used in the Snyder case can be adapted to take advantage of the Section 2501(a)(4) exclusion without triggering the restrictions of Chapter 14


Snyder revisited preferred or lapsing rights in business entities1

Snyder Revisited: Preferred or Lapsing Rights in Business Entities

  • Step 1—A taxpayer forms a corporation and contributes assets with a value of $2.6 million in return for 990 shares of nonvoting preferred stock and 10 shares of voting common stock

    • The preferred stock is entitled to a 10% noncumulative annual dividend

    • The common stock is not entitled to a dividend in a given year unless the preferred dividend has first been paid

    • Upon liquidation, the preferred shareholders will receive their original capital and the common shareholders will receive the balance of the assets


Snyder revisited preferred or lapsing rights in business entities2

Snyder Revisited: Preferred or Lapsing Rights in Business Entities

  • Step 2—The taxpayer transfers the preferred stock to an independent Section 527(e)(1) political organization and the common stock to his children (no child receives a controlling interest)

    • Chapter 14 does not apply because the taxpayer has retained no interest

    • The gift to the political organization is exempt from gift tax and need not be reported on Form 709

    • The gifts to the children are valued under normal gift tax principles based on the price a disinterested third party will pay

      • The value of each child’s interest is reduced due to: (i) the preferred shareholders’ right to receive dividends first and (ii) lack of a controlling interest


Snyder revisited preferred or lapsing rights in business entities3

Snyder Revisited: Preferred or Lapsing Rights in Business Entities

  • Step 3—The directors choose to reinvest the earnings of the corporation rather than declaring dividends on the preferred stock

    • If the corporation reinvests an annual 10% return, $260,000 will pass to the children tax-free each year in the form of accumulated corporate assets for distribution on liquidation


Snyder revisited preferred or lapsing rights in business entities4

Snyder Revisited: Preferred or Lapsing Rights in Business Entities

  • Step 4—The children buy the political organization’s stock at a discount resulting in additional value passing tax-free to the children

    • The children’s stock purchase is not reported as a political contribution because the political organization is merely converting an asset to cash

    • Alternatively, the corporation could redeem the political organization’s stock at a discount


Snyder revisited preferred or lapsing rights in business entities5

Snyder Revisited: Preferred or Lapsing Rights in Business Entities

  • Potential IRS Challenges:

    • Substance over form—IRS might argue that there is an implied agreement that the political organization will not assert its rights or that the directors acted improperly, but case law does not support this argument

    • Re-characterization of preferred interests to income interests in trust (there is no precedent for such re-characterization)

    • Valuation challenge—these challenges are labor- and resource-intensive for the IRS


Snyder revisited preferred or lapsing rights in business entities6

Snyder Revisited: Preferred or Lapsing Rights in Business Entities

  • Other risks/drawbacks:

    • Taxpayer must be willing to make a significant contribution to the political organization

    • The political organization may complain if the directors withhold distributions, but the business judgment rule provides some protection for the directors


Snyder inverted political contributions of remainder interests in trust

Snyder Inverted: Political Contributions of Remainder Interests in Trust

The following example illustrates how the strategies used in Snyder and Hipp can be reversed by giving an income interest to a taxpayer’s children and a residual interest to a political organization


Snyder inverted political contributions of remainder interests in trust1

Snyder Inverted: Political Contributions of Remainder Interests in Trust

  • Step 1—A taxpayer creates a trust with all of the income to the taxpayer’s children for a term of years and the remainder to an independent political organization described in Section 527(e)(1)


Snyder inverted political contributions of remainder interests in trust2

Snyder Inverted: Political Contributions of Remainder Interests in Trust

  • Step 2—The taxpayer contributes high-yield assets to the trust:

    • “Junk” bond portfolio

    • Wasting assets such as mineral assets (the trustee should allocate between income and principal in accordance with the law of a state without a generous reserve for depletion)

    • Stock in a family corporation expected to pay dividends in full each year


Snyder inverted political contributions of remainder interests in trust3

Snyder Inverted: Political Contributions of Remainder Interests in Trust

  • Step 3—The income and remainder trust interests are valued using the actuarial tables

    • The assumed yield for September 2012 is 1.0%

    • Assume the taxpayer contributes a royalty interest expected to be exhausted over the 10-year term of the trust

    • Royalty interests are generally valued between 3 and 5 times annual receipts

    • Assuming an average annual royalty of $200,000, the interest will be valued between $600,000 and $1 million


Snyder inverted political contributions of remainder interests in trust4

Snyder Inverted: Political Contributions of Remainder Interests in Trust

  • Step 3 (continued)

    • Assuming a value of $800,000 (the midpoint), the actuarial table calculation results in an assumed yield of $8,000 per year

    • If the trust is established under Oklahoma law, the statute provides that 85% of each royalty is allocated to income

    • Thus, $170,000 (85% of $200,000) is classified as income for distribution, resulting in an actual yield of 21.25% (rather than 1.0%)

    • The actuarial factor for a 10-year term income interest at a 1.0% rate is .094713


Snyder inverted political contributions of remainder interests in trust5

Snyder Inverted: Political Contributions of Remainder Interests in Trust

  • Step 3 (continued)

    • The value of the gift to the children for gift tax purposes is .094713 times $800,000 = $76,000

    • The children will actually receive $1.7 million over the 10-year trust term ($170,000 per year), and $30,000 will be set aside for the political organization each year (for $300,000 total)

    • The children will also receive the interest income generated by the principal set aside for the political organization


Snyder inverted political contributions of remainder interests in trust6

Snyder Inverted: Political Contributions of Remainder Interests in Trust

  • Potential IRS Challenges:

    • This strategy will be difficult for the IRS to challenge because case law supports (and the IRS has conceded to) the use of the standard actuarial tables to value income interests, even when the actual income substantially differs from the assumed income


Conclusion

Conclusion

  • Political giving has exploded in the past quarter-century and will likely continue to rise

  • Although campaign finance law addresses the substantive regulation of political contributions, the tax laws relating to political contributions have not been addressed

  • Beneficial planning opportunities exist for taxpayers willing to make political contributions


Circular 230 disclaimer

Circular 230 Disclaimer

As required by United States Treasury Regulations, this communication is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under United States federal tax laws.


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