For ultra-high net worth (UNHW) individuals looking to transfer assets in a tax-efficient manner while maintaining some degree of control and accomplishing socially responsible objectives, the answer may lie in combining a gift to a trust with a Section 501(c)(4) social welfare organization.
Contributions to a tax-exempt public charity are deductible for income, estate, and gift tax purposes. Likewise, income earned by a public charity is generally exempt from income taxation. Section 501(c)(3) of the Internal Revenue Code (Code) is responsible for this tax exemption.
However, Section 501(c) of the Code also lists 28 other types of tax-exempt organizations. One of them is a social welfare organization, outlined in Section 501(c)(4) of the Code. Broadly defined as an organization primarily engaged in promoting the common good and general welfare of the community, social welfare organizations seek to provide a community benefit. So, how does it differ from a public charity?
While they appear to be similar on the surface, a Section 501(c)(3) public charity and a Section 501(c)(4) social welfare organization are different because the former can attract tax deductible gifts, but it cannot be politically active. However, a social welfare organization can be politically active, but it cannot attract tax deductible gifts despite being exempt from federal income tax. More specifically, a donation to a tax-exempt public charity is tax deductible for income, estate, and gift tax purposes; however, it can only engage in insubstantial lobbying and is prohibited from participating in political campaigning, otherwise known as “electioneering.” On the other hand, lobbying for legislation relevant to an organization’s programs is a permissible way for a social welfare organization to pursue its agenda.
As a result, a social welfare organization can—and usually does—lobby more than insubstantially. It can also electioneer as long as that is not its primary activity (thought to be less than 50% of activities). However, contributions to a social welfare organization are not deductible for income tax purposes.
The method that Patagonia-founder Yvon Chouinard and his family used to transfer the company’s ownership epitomizes how to use a social welfare organization to transfer a business interest in a tax-efficient manner. Chouinard facilitated the transaction through voting and non-voting shares of stock. In a two-phase process, he transferred the company’s voting stock to a trust and its non-voting stock to a social welfare organization.
During the first phase of the transaction, which entailed transferring all of Patagonia’s voting stock (2% of the company’s total value) to a trust, the transfer constituted a taxable gift for gift tax purposes. After valuing the stock and presumably taking a valuation discount, Mr. Chouinard incurred a gift tax in the amount of $17.5 million. Because family members and trusted advisors are the presumed trustees of the trust, and the trust obtained all of the company’s voting shares, the trust can control the operations of Patagonia and carry out Mr. Chouinard’s mission of stewarding a socially responsible business. The company distributes excess profits to Holdfast Collective, a social welfare organization.
The second phase involved transferring Patagonia’s non-voting stock (98% of the company’s value) to the Holdfast Collective, which qualifies as a tax-exempt organization due to its 501(c)(4) status. Unless it classifies its proceeds as unrelated business taxable income (UBTI), Holdfast Collective pays no tax on income or incurred capital gains. Because it is a social welfare organization, it can lobby and engage in insubstantial political activity to achieve its socially responsible goals, unlike a public charity.
Prior to 2015, the IRS took the position that contributions to social welfare organizations constitute a taxable gift for gift tax purposes. Afterward, legislation enacted in 2015 clarified that contributions to social welfare organizations are not a taxable gift for gift tax purposes. However, the same rule does not apply for estate tax purposes. Therefore, transferring Patagonia’s non-voting stock to Holdfast Collective did not constitute a taxable gift. Unlike a private non-operating foundation, which may only hold up to 20% of stock in a business, a social welfare organization has no such limits.
The structure of the Patagonia transaction is illustrated below:
The combination of using a trust to hold voting stock and a social welfare organization to hold non-voting stock allowed Mr. Chouinard to transfer stock (believed to worth $3 billion) out of his estate at the cost of $17.5 million in gift tax. This structure also allowed him to retain control of the company’s operations and engage in lobbying as well as other political activity to ensure his socially responsible goals are met. While the Internal Revenue Service could still challenge the voting stock’s valuation in the future, this structure allowed Mr. Chouinard to transfer the company in a tax-efficient manner while enabling the family to control its operations and socially responsible direction.
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The information in this paper is as of March 2023 and is based on sources believed to be reliable but content accuracy is not guaranteed. WM-357413-2023-03-07