CGNA: S Corporations - Advanced, Part 1 of 3

CGNA: S Corporations - Advanced, Part 1 of 3

Article posted in General on 31 January 2018| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 2 February 2018
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Summary

We begin a deep dive into charitable gifts of S Corporations, a complex but important asset and subject.

This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

By Christopher Hoyt2
 
Below is an in-depth examination on S corporation gifts. S corporation topics are based on Christo- pher Hoyt’s “Charitable Gifts by S Corporations and Their Shareholders: Two Worlds of Law Collide,” and “Charitable Gifts by S Corporations: Opportunities and Challenges.” For quick take-aways on S corporation gifts, see S Corporation Quick Take-Aways. For a review based on the articles, see S Cor- porations Intermediate. For an in-depth examination adapted and excerpted from the articles, see S Corporations Advanced. For further details, see S Corporations Additional Resources.
 

If donors and charities do not properly plan a transaction, more tax can be paid when a tax-exempt charity owns and sells S corporation stock than if the contributing donor owns and sells it. This counterintuitive result frustrates Congressional policies of encouraging charitable gifts and having charities devote resources to charitable purposes. With over four million S corporations and over seven million shareholders, the transactions could affect many parties.

Two Ways Corporations Are Taxed: Subchapter C and Subchapter S

The tax laws provide two alternative ways of taxing corporations. The general rule is that a corporation is subject to the corporate income tax under Subchapter C of the Internal Revenue Code (C Corporation).3 There is another option available to a corporation that has fewer than 100 shareholders: it can file an election with the IRS to be taxed under Subchapter S of the Internal Revenue Code (S corporation), provided that it meets the eligibility criteria.4

Except for three unusual situations, an S corporation does not pay income tax. Instead, the IRS taxes corporate income directly to the shareholders.5 The principal advantage of this tax treatment is that a shareholder can avoid the double taxation of income that often occurs with a C corporation (the IRS taxes corporation income first, and then shareholder dividends). After the Tax Reform Act of 1986 made the taxation of S corporations more attractive than that of C corporations, small businesses embraced S corporations.

Charitable Gifts of Stock: The Charity's Perspective on Gifts of Stock

Most charities prefer to sell donor-contributed stock rather than hold it. First, they want to apply the proceeds—or with an endowment, apply the investment income— to charitable purposes. Second, a large block of donated stock will usually not conform to the charity's investment policy. The charity prefers to diversify, and put the proceeds in its investment pool.

The charity can easily accomplish this with a gift of publicly traded stock which it can sell on the stock market. By comparison, stock of closely held businesses have an extremely limited market. The potential purchasers are usually only the corporation, the shareholders, or a possible purchaser of the entire business. A common strategy has been for the shareholder to contribute closely held stock with an informal under- standing that the corporation will redeem the stock in the future. As long as the agreement does not compel the charity to sell the stock to the corporation at the time of the gift, the IRS is agreeable with this arrangement.6

This arrangement had great appeal to shareholders. First, the shareholder was able to claim a charitable income tax deduction on his or her personal return for the gift of stock. Second, it was the corporation's cash that went to the charity to redeem the stock. This was a much better tax arrangement than if the corporation paid a taxable dividend to the shareholder and the shareholder gave the cash to the charity. As a result, this redemption-after-gift arrangement was a popular way for small business owners to make large charitable gifts.

Charitable Gifts of Stock: Why Legislation Was Needed

What changed this paradigm of redemption-after-gift was the decline in the number of closely held C corporations, many owners of which converted to S corporations. Between 1986 and 1993, the number of C corporations experienced an average annual decline of 3.2 percent whereas the number of S corporations grew at an annual rate of 13 percent. Even today, over 90,000 C corporations convert to Subchapter S status every year.7

This trend posed a challenge to charities, since the tax law prohibited them from owning stock of an S corporation. Until Congress changed the law, only individuals, estates and certain trusts were eligible to be shareholders. If an ineligible shareholder, such as a charity, ever acquired stock of an S corporation, the corporation lost its S corporation tax status and converted into a taxpaying Subchapter C corporation. Char- ities witnessed a major source of charitable gifts drying up as small business owners converted their corporations to Subchapter S status. They and others lobbied Congress to add charities to the list of eligible shareholders and it granted their wish: beginning in 1998, charities could own stock of S corporations.8

Charitable Gifts of Stock: A Charity Can Be A Shareholder, But A Charitable Remainder Trust Cannot

With so many technical rules, it is easy to make a mistake that can have serious tax consequences. For example, whereas some forms of charitable lead trusts can own S corporation stock,9 a charitable remainder trust cannot.10 When an ineligible share- holder acquires S corporation stock, the corporation loses its Subchapter S status and becomes a Subchapter C corporation.11 The IRS has been very generous to forgive inadvertent mistakes and allow shareholders to undo such transactions,12 but obvi- ously all parties would have been better served if the parties had never made the mistake in the first place.

Charitable Gifts of Stock: Charity's Mistake—To Structure S Corp Gifts Like the C Corp Gifts

Once Congress enacted the law, many charities approached small business owners ready to make the same redemption-after-gift transaction that had been popular with closely held C corporations. What many people were not aware of was that they could often accomplish better results by structuring the gift in a manner that the law had always permitted: have the S corporation contribute some of its appreciated assets rather than have the shareholder contribute some of his or her stock.

Recall that the advantage of the redemption-after-gift strategy with a C corporation was that the shareholder obtained a charitable income tax deduction for the gift of stock even though the corporation ultimately made the cash payment to the charity. This two-step process of redemption-after-gift is not necessary for S corporation share- holders. Unlike a C corporation, an S corporation's financial transactions flow through to the shareholder's tax return. Thus, if an S corporation makes a simple cash gift to a charity, the shareholder will claim the charitable income tax deduction on the individ- ual's tax return.

As a result of this tax treatment, there is no need for the shareholder to contribute stock to obtain a charitable tax deduction. The S corporation's gifts can produce these tax benefits to the shareholder, often at less cost since there is no need to pay for an appraisal of the stock's value. The charity also benefits from a corporate gift, since it will not have to pay UBIT. By comparison, when a shareholder of the S corporation contributes stock, a charity has a UBIT liability for the income attributable to the days and/or years that it was a shareholder of an S corporation as well as a UBIT liability for the gain on the ultimate sale of the stock.

Three Bad Things Happen When S Corp Stock Is Donated to a Charity

By way of background, normally the best way to structure a large charitable gift is to contribute appreciated stock or real estate to a public charity. The donor gets the double tax benefit of an income tax deduction for the appreciated value of the prop- erty, and also avoids recognizing the taxable gain that would have occurred on sale of the property. Donors are aware of this and often make large gifts shortly before the sale of their corporation or real estate. However, the tax laws provide that three bad things happen when a donor contributes appreciated S corporation stock to a charity:

First Bad Thing: The Donor's Tax Deduction Is Usually Less Than the Appraised Value of the Stock

Congress made the tax deduction for a gift of S corporation stock comparable to a gift of a partnership interest rather than a gift of Subchapter C corporation stock. Conse- quently, the law requires a donor to reduce the deduction by the amount of ordinary income that the donor would recognize if the S corporation liquidated its assets (that is, the portion of a hypothetical gain from selling inventory, assets subject to depreci- ation recapture, and other ordinary income assets). For most donors, this adjustment does not significantly affect the amount of the charitable tax deduction.

The last sentence of Section 170(e)(1) (relating to income tax charitable deductions for contributions of ordinary income and capital gain property) states, “For pur- poses of applying this paragraph in the case of a charitable contribution of stock in an S corporation, rules similar to the rules of Section 751 shall apply in determining whether gain on such stock would have been long-term capital gain if such stock were sold by the taxpayer.” Congress therefore imported the “hot asset” rules, which determine the amount of ordinary income versus capital gain that partners have when they sell their partnership interests, to charitable gifts of S corporation stock. By comparison, when a shareholder sells S corporation stock instead of contributing it to a charity, the partnership hot asset rules that apply to the sale of a partnership interest do not apply to the sale of stock. Instead, the IRS classifies all of the gain as capital gain. The partnership hot asset rules only apply to a charitable donation of S corporation stock and not a sale.

This may cause the corporation to pay more money to redeem the stock than the shareholder was able to deduct. For example, assume that a shareholder owns 100 percent of an S corporation and that the shareholder makes a charitable gift of stock that appraisers value at $100,000. Also assume that the corporation holds $5,000 of ordinary income assets attributable to the stock, so that the IRS reduces the charitable tax deduction for the stock gift to $95,000. If the S corporation redeems the stock from the charity in an arm's-length transaction, the corporation would have to write a check for the entire value of $100,000. The charity should not sell the stock for anything less than its value.

From a tax perspective, it would have been much better for the example S corporation to have simply made a cash gift of $100,000 to the charity. The full $100,000 charitable tax deduction would flow through to the shareholder's return, rather than just $95,000, and the parties would have avoided the costs of a qualified appraisal. Of course, if the shareholder's basis in the stock is very low—for example, less than $100,000—then the corporate gift could produce less tax benefit to the donor than would a gift of stock.

Second Bad Thing: For Every Day That the Charity Owns the Stock, the Charity Must Report Its Share of the Corporation's Income as Unrelated Business Taxable Income (UBTI) and Must Pay the Unrelated Business Income Tax (UBIT)

The tax treatment is worse than a comparable gift of a partnership interest. A charity does not pay UBIT on its share of a partnership's passive investment income, such as interest or capital gains, but it will have to pay UBIT on such income earned by an S corporation. In 2003, nearly 20 percent of all S corporation income was from such investment sources.

Third Bad Thing: Whereas Normally a Charity Does Not Have UBTI When It Sells Stock from Its Investment Portfolio for a Profit, a Sale of Appreciated S Corporation Stock Will Trigger a UBIT Liability

Normally an exempt organization excludes from the computation of UBTI any capital gains earned from the sale of corporate stock.13 However, with regard to the sale of S corporation stock, Section 512(e)(1)(B)(ii) overrides this exemption: “notwithstanding any other provision of this part... any gain or loss on the disposition of the stock in the S corporation shall be taken into account in computing the unrelated business taxable income of such organization.”

In fact, the tax liability incurred by a charity can often be greater than the tax liability that the donor would have incurred had the donor sold the stock. Whereas individuals are subject to a maximum federal tax rate of only 15 percent on their long-term capital gains, incorporated charities receive no tax break for long-term capital gains and pay UBIT at ordinary corporate rates, which can be as high as 35 percent. Thus, if there is a $100,000 gain, the shareholder would have paid only $15,000 federal tax on the sale but the charity that receives the stock as a gift must pay a tax as high as $35,000! By comparison, a charity that is a trust rather than a corporation can pay the same low 15 percent rate as the donor.

  • 2. 1. FREE DOWNLOADS OF COMPREHENSIVE ARTICLES: This outline is an abbreviated version of two comprehensive articles that go into great detail about the laws governing charitable gifts made by S Corporations and by S corporation shareholders. You can locate and download .pdf copies of these two articles with a simple Google search: SSRN S corporation charity. The articles are as follows: #1 - Charitable Gifts of S Corporation Stock: Charitable Gifts by S Corporations and Their Shareholders: Two Worlds of Law Collide; —ACTEC Law Journal, Vol. 36, pp. 693-768, Spring 2011, http://ssrn.com/abstract=1926693. #2 - Charitable Gifts Made by S Corporations: Charitable Gifts by S Corporations: Opportunities and Challenges—ACTEC Law Journal, Vol. 36, pp. 477-515, Fall 2010, http://ssrn.com/abstract=1926717.
  • 3. IRC § 11.
  • 4. IRC §§ 1361 and 1362.
  • 5. IRC § 1366.
  • 6. Rev. Rul. 78-197.
  • 7. Luttrell, Kelly, “S Corporation Returns, 2003”, IRS Statistics of Income Bulletin, Spring, 2006, pp. 91-165, computed from Table 1 at p. 105.
  • 8. IRC § 1361(c)(6).
  • 9. A charitable lead trust that is not a grantor trust can elect to be an Electing Small Business Trust (ESBT). Treas. Reg. § 1.641(c)-1(k), Example (4).
  • 10. A charitable remainder trust is not listed as an eligible shareholder in IRC §§ 1361(b)(1), 1361(c)(2) or 1361(c)(6), and, unlike a charitable lead trust, it is specifically prohibited from qualifying as an Electing Small Business Trust (ESBT). IRC § 1361(e)(1)(B)(iii). The Service also concluded in a revenue ruling that a charitable remainder trust could not qualify as a Qualified Subchapter S Trust (QSST) under § 1361(d). Rev. Rul. 92-48, 1992-26 I.R.B. 7.
  • 11. IRC § 1362(d)(2)(A).
  • 12. Section 1362(f ) provides that if the Secretary determines that there was an inadvertent termination of an S corporation, and if all affected parties work to restore S corporation status and make adjustments to income as if the corporation had never terminated, then, notwithstanding the terminating event, the corporation shall be treated as never having lost its S corporation status. The legislative history instructs the IRS to be liberal in granting waivers. S. Rep. No. 640, 97th Cong., 2d Sess. 12-13 (1982), 1982-2 C.B. 718, 723-24; H.R. Rep. No. 826, 97th Cong., 2d Sess. 12 (1982), 1982-2 C.B. 730, 735. As can be seen from the many waivers for transferring S corporation stock to IRAs, the IRS has been very generous in granting inadvertent termination relief.
  • 13. IRC § 512(b)(6).

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