An inversion occurs when there is a merger between a U. S. domestic corporation and a foreign corporation and the resulting corporation is a foreign corporation. One motivation for an inversion is the opportunity for the former U. S. corporation to avoid being taxed in the United States on income that was derived from sales outside of the United States.
An unintended consequence of an inversion is that the shareholders of the U. S. corporation are deemed to have sold their shares in the corporation for fair market value on the date of the merger. Depending how long a shareholder has held the stock, a deemed sale can result in a substantial capital gains tax.
If the shareholder is charitably inclined, a charitable remainder trust may help soften the blow of an inversion. A charitable remainder trust pays out a predetermined percentage to the person making the trust and/or to other persons designated by him, either for life or for a term of years. When the measuring life passes away, or the term of years ends, the remainder of the trust passes to a designated charity.
The income of the charitable remainder trust is taxed to the beneficiary to the extent of distributions. The income that is carried out in a distribution is tiered. To the extent that the trust has ordinary income (such as dividend or interest income), that ordinary income is carried out first, then capital gains, tax free income and, finally, the balance of the distribution is a return of capital. Undistributed income is not taxed to the trust but is accumulated and taxed to the beneficiary when it is distributed.
The annual payout from a charitable remainder trust must be between 5% and 50%. A charitable remainder trust can either be a unitrust or an annuity trust. If the charitable remainder trust is a unitrust, the minimum payment is 5% of the value of the trust as revalued annually. If the charitable remainder trust is an annuity trust, the minimum payment is 5% of the initial fair market value of the trust.
Let’s look at an example: Assume that a shareholder has stock with a fair market value of $5,000,000 and a tax basis of $0. Shareholder contributes the stock to a 5% charitable remainder annuity trust. The shareholder is the lifetime beneficiary of the trust. The trust will pay the shareholder $250,000 per year for remainder of her life. If there is an inversion after the stock is contributed to the trust, the trust will have a capital gain of $5,000,000. Remember, the trust is not a taxpayer (at least for federal tax purposes) – it will not have to pay federal capital gains tax. When the annual $250,000 is distributed to the shareholder, a portion of that distribution will be dividend income and the remainder will be capital gain.
Depending on the shareholder’s cash flow needs the deferral of tax on the capital gains can be deferred indefinitely by using an income only charitable remainder unitrust in place of a charitable remainder annuity trust. The distributions from an income only charitable remainder unitrust are limited to the income earned in the trust. Capital gains do not generally count as income in such a trust. Additional variations are possible by using a charitable remainder unitrust that converts from income only to a regular unitrust when a predetermined event occurs.
Contributing stock, that is subsequently the subject of an inversion, to a charitable remainder trust defers the recognition of the capital gain. If the measuring life, or the term of years ends before all of the capital gains are distributed, a portion of the capital gain will not be taxed.