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The Uses and Abuses of Charitable LLCs

Jul 7, 2020 | Podcasts

“The Uses and Abuses of Charitable LLCs,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Travis Hayes, ACTEC Fellow from Naples, Florida. How are people using charitable LLCs and how are people abusing them? To learn more about this topic, you will be hearing today from ACTEC Fellow, Justin Miller of San Francisco, California. Welcome Justin.

Alright. Thank you very much. Happy to be here. Today I am going to talk a little bit about charitable LLCs. How are people using them and how are they potentially abusing them? So, I’ll start with, when we talk about charitable LLCs, what we are really talking about is a vehicle or a structure for giving.

Charitable LLC Overview

Now, most people at this point should be familiar with public charities, Donor Advised Funds (DAF), private foundations, charitable trusts. Those are your typical structures or vehicles. The problem is that those types of structures, they have a lot of rules – a lot of rules, and the beauty of a charitable LLC is it’s a way to avoid all of those really strict rules. For instance, there are no mandatory distribution requirements. If you have a private foundation, you have to give or spend at least 5 percent every single year. There are none of those self-dealing rules, excess business holding rules, jeopardy investments, taxable expenditures. You just don’t have to deal with any of that if you have a charitable LLC.

If you have got a charitable entity — these other types of entities — depending on your state, you very likely have Attorney General oversight. Guess what? Not if you have got a charitable LLC. What about confidentiality, privacy? If you have got any kind of public charity private foundation, very likely you are filing either a 990 or a 990-PF. Guess what that means? It means everybody knows your business. It means that you can just go on the web and download those 990s or 990-PFs, those IRS forms, and not just find out the tax information about public charities and private foundations; you can find addresses, you can find people’s names, family members. You can find out what people are paying different employees. You can find out what organizations that those entities are giving to. Charitable LLCs, you avoid all of that.

The other thing, the great part about charitable LLCs is you are not limited in what you can do. Sure, if you want, you can give it to charity. But it’s a charitable LLC, meaning if you want, you can invest in for-profit opportunities. It doesn’t have to be impact-related or socially responsible. If you want to open up a massage parlor, tanning salon, liquor store, you can do that with a charitable LLC. So, it really gives you the ultimate in flexibility.

Issues with Charitable LLCs

So at first, it sounds like charitable LLCs are amazing. Why would you ever use anything but a charitable LLC for charitable giving? And, there are two reasons why you would use those other vehicles or structures and there are two things. So, number one, an LLC is not tax-exempt. Those other structures are exempt from federal income tax. An LLC, on the other hand, is typically a pass-through type of entity, meaning whatever money that that LLC makes, whatever type of tax consequences, they will flow through to the LLC owners. Typically you would call them members. So, first issue is that a charitable LLC is not tax-exempt.

The second big issue is that you don’t get an income tax deduction when you set it up. If you are doing a private foundation, donor advised fund, anything like that, you are going to get a deduction when you set it up. In LLC, you don’t get that same tax benefit. Now, if that charitable LLC ever turns around and actually gives anything to charity, there will be a charitable deduction at that time; and at that time, it will flow through — the benefit of that deduction — will flow through to the LLC’s owners.

Background of Charitable LLCs

So where did this all come from? Why all the buzz if you have heard it all about charitable LLCs? Now, as a planning tool, they have been around for decades. People have been using charitable LLCs for decades, but it really kind of became a hotter topic at the beginning of December 2015 when Mark Zuckerberg, the founder of Facebook, announced publicly that he was going – with his wife, was going to actually transfer a bulk of his fortune to this Chan Zuckerberg Initiative. So, there was a lot of publicity around it. All of the news media got a hold of this and there were a lot of things being said. They said, ‘wow, is this going to be the new form of giving? Are people going to abandon private foundations and public charities?’ Then a lot of people started looking into it and saying, ‘is this just a PR stunt? It’s an LLC. It’s not really a charitable entity; you are just calling it a charitable LLC.’

There was a lot written about that, sort of at the end of 2015, beginning of 2016. And so, what did all those articles get right and what did they miss? What did they get wrong? How are people potentially abusing this structure? Now, don’t get me wrong. Chan Zuckerberg Initiative LLC has done some amazing projects; we are not talking about anything specific to that entity. But how are other people potentially using and abusing the structure? So why don’t I walk you through sort of four steps about how they are legitimately used and how people might be pushing it too far.

Legitimate Uses and Possible Abuses of Charitable LLCs

So, step number one. If you are creating a charitable LLC, all you are doing is really transferring money to a for-profit entity, an LLC; most of the time, it’s a disregarded entity. That means for tax purposes, it’s a tax-nothing. Everything just automatically flows through to the owners; and let’s just say you have got a client who contributes $20 million to a charitable LLC. They don’t need the deduction right up front and they want ultimate flexibility. Maybe eventually they want those dollars to go to charities; maybe they want to invest in windmills or solar power or whatever they want, but they want complete privacy. They don’t need the deduction right now. A charitable LLC could be the perfect vehicle. Now, that first step is absolutely above board, nobody has an issue with it. It’s a really, really great planning structure.

But let’s move on to step two. What could you do next? Well, let’s say the client set up their charitable LLC, they own a 100 percent of it and it has got $20 million dollars in it and then they decide that they are going to gift 1 percent over to a trust for their kids and grandkids. Nothing wrong with that. We deal with that all the time in planning. If you own a partnership or LLC, you certainly can transfer a percentage to a trust for kids and grandkids. It’s a great planning technique. There should be some discounting for lack of marketability and lack of control. But a 1 percent interest in a $20 million partnership — will it be worth $200-grand, let’s say without discounting? If you take a 20 percent discount, the gift is worth $160,000. Right now, every individual has an $11.4 million exemption, $22.8 million per couple, and that means it’s not like they are going to pay any gift taxes on it, and if they haven’t used up their full exemption, but they would likely file a tax return Form 709 to show that they have made that gift. Once again, step two, nothing wrong with gifting a percentage of your charitable LLC to a trust for your kids and grandkids.

Now, step three is where things get a little questionable, and that is, you turn around and say, ‘wait a minute. I have got this charitable LLC, the money may or may not benefit charity now or in the future, but I want a deduction.’ And what you can do is gift a percentage in that LLC to a charity. Not actually the money, but an interest in the LLC. Now, there is nothing wrong with that. You absolutely are entitled, if you have any kind of LLC or partnership or entity, you can absolutely donate that interest to a charity and get a tax deduction. The IRS has said they are actually not going to rule on partnerships or LLCs whether it qualifies for the 170 or the deduction under Section 170 but there is nothing to stop you from donating your LLC to charity.

Now, if it’s a private foundation, there could be some self-dealing issues you want to look out for, but let’s say it’s a public charity. What public charity at this point in time, if the Chan Zuckerberg Initiative went around the country and said, ‘hey, we want to donate 98 percent.’  There are very few public charities that wouldn’t say, ‘great, we are happy to take your donation.’ And the same thing can be said for anyone’s charitable LLC; and let’s say the client turns around and gifts 98 percent of their charitable LLC to a public charity. They get a big deduction. Now, once again, they will have to be discounting, there will have to be discounting. Lack of marketability, lack of control, but a 98 percent interest in that charitable LLC; even with discounting, maybe you will get with a 20 percent discount, a $15.7 million deduction.

Now, what did the public charity actually get? They didn’t get any cash. All they got was this non-voting 98 percent interest in someone else’s LLC that someone else controls, but it’s a huge deduction. But once again, technically nothing wrong with that. So, what about step four? Where are people pushing it a little too far? Well, the clients for step four can actually turn around and borrow the money out of the LLC. They take the $20 million. Now they are going to have to pay some interest back, but we are in a low interest environment. Maybe they only pay less than 2 percent back to the partnership – 98 percent of that interest goes to the charity — but the clients can turn around and use that $20 million, and all of the appreciation on that, they can keep for themselves. Not only do they get the benefit of investing that $20 million, remember, they also got a $15.7 million deduction. But I am going to add one more step. And this is where people really may have pushed it too far. So, this is the step five that potentially could be abusive.

Step five is when the client goes to the charity and says, ‘you know what? I know I got a $15.7 million deduction when I gave you this interest. You are not really getting much benefit out of it. Why don’t we agree in in my own charitable LLC or even better, that trust I set up for my kids and grandkids, I am going to have that trust buy the interest from you.’ Now, it’s not going to sell for $15.7 million. What’s the public charity going to sell it for — $4 million, $5 million? Maybe the public charity would be happy. All they are getting is some small interest every year. They might say, ‘great, you are willing to pay me $4 million to $5 million. Absolutely. I will sell our interest to your kids’ trust.’ And what have we just done? We have just had a client that set up this charitable LLC and very little money has actually gone into a real charity, but they have got 99 percent of the shares of the membership units over to their kids’ trust. They have got a $15.7 million deduction and they only ended up paying the charity maybe $4 million, $5 million, whatever an arm’s length fair market value was at that time for the interest. That may be pushing it too far.

Just to warn you, there are a couple rulings and cases that do deal with this issue. There is a Notice 2004-30 that the IRS released. It really dealt with S corporations, but if there is any kind of pre-arranged legally binding plan or option that requires the charity or gives the charity the ability to sell, then it might fall under Notice 2004-30. The other thing to look out for is there was a recent case, US v. Michael Meyer. So, that’s not the Michael Myers from Halloween movies and that’s not the Michael Myers, the famous comedian from Canada. No, this is Michael Meyer and what actually happened is the DOJ, the tax division did go after someone who was selling these very aggressive structures and actually did succeed in Florida in getting an injunction.

So, we do need to be careful if clients are pushing this. What could be a great charitable LLC idea, if they push it too far, they might get into some trouble afterwards. And with that, thank you for giving me this time, Travis. I hope you enjoy the rest of the day.

Thank you, Justin, for providing us with information on the uses and abuses of charitable LLCs.

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