A recent Private Letter Ruling (PLR133620-18 (released Sept. 11, 2020)) confirms that a charitable lead trust (CLT) that otherwise would have run afoul of the self-dealing rules (by owning a note created by an irrevocable trust of which the grantor of the CLT was also a grantor) can hold non-voting interests in a well-organized limited liability company (LLC) without violating those rules.
Although the PLR was requested by the CLT in an estate administration context, estate planning practitioners can apply the principles in numerous other situations.
Thoughtful Estate Planning Illuminates the Path
This PLR arose out of circumstances that should be familiar to many. The taxpayer owned shares in a corporation and sold the shares to an irrevocable trust in exchange for a note. This wealth transfer technique “freezes” the taxpayer’s estate, allowing future expected appreciation to pass to beneficiaries free of transfer tax.
The taxpayer’s estate plan included a will and revocable trust. On her death, the note receivable, as part her residuary estate, passed to her revocable trust. The revocable trust allocated some percentage of the residue to a charitable lead unitrust (CLUT), with the grantor’s descendants as the remainder beneficiaries.
Although the PLR didn’t specify this, the note may have comprised the majority of the decedent’s estate, necessitating, as a practical matter, transfer of at least part of the note to the CLUT.
Self-Dealing Rules Cast a Shadow
Even if the estate had other assets available, the note was a logical asset to allocate from the revocable trust to the CLUT. The note payments owed, ultimately, from the irrevocable trust to the CLUT would be a reliable income stream to provide at least some funds for the annual distributions from the CLUT to the beneficiaries during the unitrust period. Self-dealing rules, however, make such a relatively direct disposition inadvisable.
CLTs are treated as private foundations (PFs) under Internal Revenue Code Section 4947(a)(2). As stipulated in this ruling request, the irrevocable trust is a disqualified person with respect to the CLUT because the trusts share beneficiaries. Lending between PFs and disqualified persons is one definition of self-dealing, so the revocable trust’s distributing the note receivable to the CLUT – an act would make the CLUT a creditor of the irrevocable trust – wasn’t a viable option.
Creative Approach Shines a Ray of Light
The solution to the self-dealing problem would have the revocable trust contribute cash and the note to an LLC in exchange for 100% of the LLC membership interests: 99% non-voting interests and 1% voting interests. The revocable trust would then distribute a portion of non-voting LLC interest to the CLUT to satisfy its percentage allocation under the terms of the revocable trust. The remaining non-voting interests and the 1% voting interest would be distributed to the other revocable trust beneficiaries, along with remaining assets in the revocable trust.
The LLC would hold the note and receive payments of principal and interest from the irrevocable trust. The LLC’s sole source of income would be the note payments. The LLC would distribute note payments pro rata to its members, including the CLUT, which would engage only in passive investment activities.
A necessary condition for the success of this approach is that the CLUT held a sufficient percentage (at least 65%) of the non-voting LLC membership interests and that the non-charitable beneficiaries (who are disqualified persons) collectively held less than the threshold 35% of the LLC interests, so the LLC wouldn’t be a disqualified person under IRC Section 4946(a)(1).
There’s also the practical matter of selecting the manager of the LLC, who must not be a disqualified person. The ruling didn’t emphasize this requirement nor did it reveal the identity of the manager. Identifying an independent person to manage the LLC may present a planning challenge, but is necessary to the technical efficacy of this approach.
Ruling Confirms Sunny Forecast
The IRS ruled that the CLT may hold non-voting interests in the LLC and receive proportionate distributions from the LLC without violating the self-dealing rules under IRC Section 4941. The ruling went on to confirm the receipt and continued ownership of the LLC interests wouldn’t constitute excess business holdings under IRC Section 4943.
The terms of the LLC operating agreement proved critical to the self-dealing analysis. Under Treasury Regulations Section 53.4941(d)-1(b)(4), a transaction between a PF (here, the CLUT) and an organization doesn’t result in self-dealing if the organization isn’t controlled by the PF, nor has a disqualified person owning at least a 35% beneficial interest in the organization. The operating agreement provided that the LLC would be managed by a single manager who’s selected by members holding the voting interests. The members holding non-voting interests had neither management rights nor rights to vote on appointment or removal of the manager. A non-voting member had power only to approve: (1) amendments to the operating agreement, or (2) dissolution of the LLC.
As the note receivable would be the LLC’s sole asset, the LLC wouldn’t be considered a business enterprise for the purpose of Section 4943(d)(3), because at least 95% of its gross income would be derived from passive sources. The ruling concludes that the CLUT’s receipt and continued ownership of the non-voting interests would not result in its having “excess business holdings.”
Sophisticated estate planners know that an “LLC wrapper” doesn’t solve every tax problem. Here, the estate administration challenge was allocating a specific asset (the note) and a given disposition to a CLT. In this case, the LLC offered an elegant solution, with its non-voting interests and an independent manager. This PLR may guide planners seeking to use a carefully constructed LLC to avoid impermissible self-dealing when funding a CLT.
Of course, a private letter ruling isn’t precedential for any client other than the taxpayer requesting the ruling. This ruling suggests, however, that with careful planning, interests in an LLC holding a note can fund a CLT.