Thursday June 1, 2023
Case of the Week
Lucky Lucy Lindstrom's "Lucky Penny LLC"
Case:Lucky Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucky Lucy was so successful in these markets that she now only manages her own large personal portfolio.
Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market.
Lucy had invested $1,000,000 in stock in a "penny stock" company that sells consumer electronics. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy was delighted with her gain and decided to give $5,000,000 to a supporting organization (SO) with a favorite charity.
For the first two years, the SO distributed grants for charitable purposes. By year three, Lucy was so committed to her favorite charity that she wanted to increase the annual grants. As a creative investor, Lucy suggested that the SO start a limited liability company (LLC) and jointly invest with Lucy and others in the penny stock. She calls the new project "Lucky Penny LLC."
Lucy is hopeful that the price of the penny stock will increase more and has several friends who are eager to participate. Lucy and the SO will each contribute $1 million to Lucky Penny LLC. Total funding will be $10 million. With this amount, Lucky Penny LLC will become a partner in the penny stock company. As Lucy says, "The sky is the limit! Profits will soon be gushing forth!"
Question:Will this plan work? Can the supporting organization be a member in the LLC?
Solution:Lucy has good intentions, but there are several major problems with this plan. If Lucy moves forward, the SO would be participating in an active business – selling electronics. If a charity earns income from a trade or business that regularly conducts and that trade or business is not substantially related to its charitable purpose, the income is subject to income tax. A charity regularly conducts an activity if the "frequency, continuity and manner" of the activity is similar to that of a for-profit company that conducts the same type of activity. Any activity carried on for the production of income from the sale of goods or performance of services is a trade or business for purposes of applying unrelated business income tax (UBIT). Since the LLC is treated as a partnership for taxation purposes, the SO is an active participant in the sale of consumer electronics under Sec. 512(c).
While there are exceptions to the unrelated business taxable income rules, the Lucky Penny LLC does not fall within these exceptions. The sale of consumer electronics is a regular, active business and not related to the SO's exempt purpose. Therefore, any income from the LLC will be unrelated business income (UBI) to the SO. In addition, if the sale profits become the major source of income, it is possible that the IRS may question the charitable purpose of the SO and even the charitable purpose of Lucy's favorite charity.
After thinking through these risks to the SO and her favorite charity, Lucy decided to set up the LLC herself. She and her friends did invest in the penny stock company. With the substantial profits from the LLC, Lucy continues to make gifts to the SO. Her favorite charity is delighted to cash those checks and sends Lucy a warm thank you note.
Published February 3, 2023
Lucky Lucy Lindstrom's "Personal Loan" Charity
Lucky Lucy Lindstrom's "Cousins' Scholarship" Plan
Lead to Remainder Double Charitable Trust
Lucky Lucy Lindstrom's Long Shot Unitrust