estate planning for political contributions eric reis thompson & knight llp...

Estate PlanningEstate Planningfor Political Contributionsfor Political Contributions

Eric ReisEric ReisThompson & Knight LLPThompson & Knight LLP

214.969.1118214.969.1118

[email protected]@tklaw.com

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Introduction: Political GivingIntroduction: Political Giving Harold Simmons has contributed over $17 million and Harold Simmons has contributed over $17 million and

Houston homebuilder Bob Perry has contributed over $11 Houston homebuilder Bob Perry has contributed over $11 million to GOP-friendly SuperPACs in the 2012 election cyclemillion to GOP-friendly SuperPACs in the 2012 election cycle

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

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

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Introduction: Political GivingIntroduction: Political Giving

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

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

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Introduction: Political GivingIntroduction: Political Giving

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

► Bequests to political organizations are subject to the Bequests to political organizations are subject to the federal estate taxfederal estate tax

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

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Introduction: Political GivingIntroduction: Political Giving Planning opportunities exist for donors with long-Planning opportunities exist for donors with long-

term political interests to make large nonpolitical term political interests to make large nonpolitical transfers to family memberstransfers to family members

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

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Past Strategies: Past Strategies: Partial Interest Gifts to CharityPartial Interest Gifts to Charity

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

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

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

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Past Strategies:Past Strategies:Partial Interest Gifts to CharityPartial Interest Gifts to Charity

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

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

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

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Legislative Response: Legislative Response: Tax Reform Act of 1969Tax Reform Act of 1969

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

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

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

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Legislative Response: Legislative Response: Tax Reform Act of 1969Tax Reform Act of 1969

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

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

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Past Strategies: Past Strategies: Retained InterestsRetained Interests

Preferred or Lapsing Rights in Business EntitiesPreferred or Lapsing Rights in Business Entities

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

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Past Strategies: Past Strategies: Retained InterestsRetained Interests

► Snyder v. Comm’rSnyder v. Comm’r——

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

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

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

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

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Legislative Response:Legislative Response:Revenue Reconciliation Act of 1990Revenue Reconciliation Act of 1990

Added Chapter 14 to the Internal Revenue CodeAdded Chapter 14 to the Internal Revenue Code

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

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

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Chapter 14 (continued)Chapter 14 (continued)

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

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

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

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

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The Gift Tax Exclusion The Gift Tax Exclusion for Political Contributionsfor Political Contributions

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

No corresponding exclusion or deduction for No corresponding exclusion or deduction for federal estate tax purposesfederal estate tax purposes

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Uncertainty exists regarding meaning of “Uncertainty exists regarding meaning of “toto a political a political organization organization for the use offor the use of such organization” such organization”

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

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

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

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Examples of Political Organizations:Examples of Political Organizations:► Democratic and Republican partiesDemocratic and Republican parties► Campaign committees for individual candidatesCampaign committees for individual candidates► Independent political groups operated primarily for Independent political groups operated primarily for

political purposespolitical purposes

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

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Campaign Finance LawCampaign Finance Law

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

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

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Campaign Finance LawCampaign Finance Law

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

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

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How can the gift tax exclusion rules for How can the gift tax exclusion rules for political contributions be used for political contributions be used for

family transfer planning? family transfer planning?

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SnyderSnyder Revisited: Preferred or Lapsing Revisited: Preferred or Lapsing Rights in Business EntitiesRights in Business Entities

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

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Step 1—A taxpayer forms a corporation and Step 1—A taxpayer forms a corporation and contributes assets with a value of $2.6 million in contributes assets with a value of $2.6 million in return for 990 shares of nonvoting preferred stock return for 990 shares of nonvoting preferred stock and 10 shares of voting common stockand 10 shares of voting common stock► The preferred stock is entitled to a 10% noncumulative The preferred stock is entitled to a 10% noncumulative

annual dividendannual dividend

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

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

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

► Chapter 14 does not apply because the taxpayer has retained no Chapter 14 does not apply because the taxpayer has retained no interestinterest

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

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

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

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

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

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

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

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

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Potential IRS Challenges:Potential IRS Challenges:

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

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

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

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Other risks/drawbacks:Other risks/drawbacks:

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

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

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SnyderSnyder Inverted: Political Contributions of Inverted: Political Contributions of Remainder Interests in TrustRemainder Interests in Trust

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

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Step 1—A taxpayer creates a trust with all of the Step 1—A taxpayer creates a trust with all of the

income to the taxpayer’s children for a term of income to the taxpayer’s children for a term of

years and the remainder to an independent years and the remainder to an independent

political organization described in Section 527(e)political organization described in Section 527(e)

(1)(1)

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

► ““Junk” bond portfolioJunk” bond portfolio

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

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

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

► The assumed yield for September 2012 is 1.0%The assumed yield for September 2012 is 1.0%

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

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

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

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Step 3 (continued)Step 3 (continued)

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

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

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

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

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SnyderSnyder Inverted: Political Contributions Inverted: Political Contributions of Remainder Interests in Trustof Remainder Interests in Trust

Step 3 (continued)Step 3 (continued)

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

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

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

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SnyderSnyder Inverted: Political Contributions Inverted: Political Contributions of Remainder Interests in Trustof Remainder Interests in Trust

Potential IRS Challenges:Potential IRS Challenges:

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

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ConclusionConclusion

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

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

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

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Circular 230 DisclaimerCircular 230 Disclaimer

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

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