The double foundation - Tax-optimised transfers of assets and benefits (Part 1: Fundamental principles and establishment)
The transfer of assets to the next generation is frequently associated with inheritance disputes, the fragmentation of assets, tax charges as well as the risk of an undesired sale by the succeeding generation. In this respect, many companies and consultants are already familiar with family foundations and public benefit foundations along with their pros and cons. By contrast, the largely unknown double foundation combines the advantages and, in particular for family enterprises, it can constitute an effective instrument for business succession and asset protection in the long term while permanently retaining control over the business. In this edition of our PKF magazine, we discuss the fundamental principles of the double foundation and the tax treatment of its establishment. In the next edition, a tax-optimised structuring will be presented on the basis of a practical case study.
1. Introduction - Issue and initial question
The single 60-year-old business owner ‘A’ is the sole shareholder of A GmbH (German limited liability company) and has property rented out to third parties, an equity portfolio and a personal use property in Germany. A GmbH was built by A on his own and he therefore wishes for the business to continue to exist as a family-owned company, even after his death. As A’s two children are pursuing their own goals and currently showing no interest in managing A GmbH and continuing to operate the business, A has already arranged for an external managing director and created rules of procedure. Despite his children's lack of interest in the company, A would nevertheless like to provide financial security for his children and himself. Furthermore, A would also like his future profits to be used for public benefit purposes.
A, the company owner, is wondering if and to what extent a foundation - and here, in particular, a so-called double foundation - would be appropriate for his estate planning requirements.
2. Conceptual fundamentals in the context of the establishment of foundations
Foundations are legally independent pools of assets that, through the founder’s intent, are permanently dedicated to a specific purpose. Unlike corporations or partnerships, foundations thus have no shareholders. The purpose of a foundation is set out in the foundation’s statutes. Depending on the structuring of the purpose and the statutes, it is possible to create different types of foundations.
A foundation pursues its purpose through the use of the foundation’s assets or the income from the assets. If a foundation is set up in perpetuity, then it is necessary to observe the principle of capital preservation. According to this, the so-called endowment capital must be preserved in full. Solely the income from the endowment capital may be used to pursue the purpose.
The beneficiaries of a foundation are referred to, in German, as Destinatäre [beneficiaries]. These are the persons or groups of persons to whom, in accordance with the foundation’s statutes, benefits are to be paid out of the foundation's assets or its income. A foundation is represented by a management board. If a foundation is established during the founder’s lifetime then, to begin with, the founder can also be the sole member of the board.
A distinction is made between foundations with legal capacity and those without legal capacity.
- According to Section 80(1) of the Civil Code (Bürgerliches Gesetzbuch, BGB), a foundation with legal capacity is a legal entity under private law with no members, which itself holds the foundation's assets. It is recognised by the foundation authority, it has been entered into the Foundation Register (Stiftungsregister) and is liable for corporation tax (Section 1(1) no. 4 of the Corporation Tax Act [Körperschaftsteuergesetz, KStG]).
- However, a foundation without legal capacity (also referred to as a trust foundation) does not have a separate legal personality. Its assets are held and managed by a legal entity in accordance with the foundation’s purpose. The foundation without legal capacity is likewise liable for corporation tax (Section 1(1) no. 5 KStG).
Irrespective of the classification under German civil law, depending on their purpose, foundations can be structured to be, in particular, for private benefit or for public benefit.
3. Types of foundations
3.1 The family foundation
The family foundation is a private benefit foundation whose primary purpose is to support and provide for one or more families. The purpose of such a foundation is normally the long-term preservation of the family’s wealth as well as financial security for future generations. The beneficiary of a family foundation can also be the founder themself. This would be on condition that the founder is included in the group of beneficiaries in the foundation’s statutes. Given that in the case of a foundation there are no natural persons who are heirs and thus no normal succession cases arise across generations, under inheritance tax law an asset transfer is simulated every 30 years.
3.2 The public benefit foundation
A foundation is for public benefit if it exclusively and directly pursues tax-privileged purposes. The principles of the non-profit legislation under Section 51 ff. of the German Fiscal Code are applicable. Unlike family foundations, the primary focus must be on the promotion of the public good. Public benefit foundations enjoy extensive tax privileges. These include, in particular, exemptions from corporation tax and trade tax as well as inheritance tax.
Allocations by a public benefit foundation to its founder and their family members are only possible within tight limits and in compliance with the requirements for public benefit status; moreover, they may only be made to the general public in accordance with the tax-privileged purposes set out in the statutes. Otherwise, there is a risk of withdrawal of the public benefit status and the forfeiture of the tax privileges.
3.3 Double foundation as a combined structuring model
The double foundation is a structuring model that is based on the combination of two different foundations with legal capacity. Here, the founder’s assets are allocated in part to a private benefit family foundation and in part to a public benefit foundation. The aim is, on the one hand, to ensure that the family members are provided for via a family foundation and, on the other hand, to profit from the tax privileges for public benefit corporations.
The voting rights and the share of the founder’s assets of a family foundation as well as of a public benefit foundation can be individually structured. Traditionally, a family foundation is set up with a low share of the assets and a high percentage of voting rights, while in the case of the public benefit foundation there is a high share of the assets and few voting rights. It can thus be ensured that the family or the management board of the family foundation is able to continue to make decisions regarding the assets.
4. Income tax treatment of establishment
The transfer of a holding in a corporation for no consideration to a foundation does not result in the realisation of hidden reserves and thus also an income tax charge for the founder or the foundation. Even the transfer for no consideration of securities, properties rented out to third parties or other assets held as private assets to a foundation would not give rise to any income tax liability.
A, the company owner from the above practical case study, would therefore not have to expect any income tax charges to arise from the transfer to the foundation(s) of 100% of his holding in A GmbH, the properties rented out to third parties and the equity portfolio.
5. Income tax anomaly when transferring business assets
The transfer of business assets to a foundation basically constitutes a withdrawal that results in the realisation of hidden reserves and thus an income tax charge. Only in cases where a qualifying aggregate of assets - i.e., a business, a business unit or an entire partnership interest (including special business assets) - is transferred is it possible to do so at the carrying amounts and thus with no income tax charge arising from the realisation of hidden reserves.
Moreover, for a public benefit foundation a financial interest in a partnership that operates commercially normally constitutes a commercial business operation so that it would not be possible to benefit from current tax exemptions (more on this in Part II of this report in the next edition of our magazine).
6. Inheritance tax treatment of establishment
The transfer of assets to a domestic (German) foundation - in the case of both an acquisition due to death as well as by way of a gift - is generally subject to inheritance tax on the assets as well as personal inheritance tax. For the sake of simplicity, the following section refers merely to inheritance tax. The inheritance tax charge will depend on
- the valuation of the transferred assets,
- the tax exemptions claimed,
- the applicable tax class, and
- the applicable tax rate.
Under Section 13(1) no. 16(b) of the Inheritance and Gift Tax Act (Erbschaft- und Schenkungsteuergesetz, ErbStG), allocations to public benefit foundations are wholly exempt from inheritance tax - irrespective of the type of assets transferred. This tax exemption provision cannot be applied to family foundations due to their lack of public benefit status. Although there are other exemption provisions that would be possible for transfers to a family foundation, namely,
- the tax exemption for the transfer of domestic (German) business assets and shares in corporations under Section 13a ff. ErbStG, as well as the needs assessment in order to obtain a tax-exemption under Section 28a ErbStG, and
- the tax exemption for property that is rented out for residential purposes under Section 13d ErbStG.
According to the so-called tax class privilege, in the case of a transfer of assets to a family foundation, the tax class is determined on the basis of the relationship of the beneficiary who is most distantly related to the founder. In the event of the establishment of a family foundation for A with his children, tax class I would be applied, which would mean a tax-free allowance €400,000.
With appropriate structuring for the establishment of a double foundation, the tax exemption provisions and the inheritance tax-free allowances can be combined to achieve a transfer of the foundation assets that is as tax-efficient as possible.
