CGNA: S Corporations - Intermediate

CGNA: S Corporations - Intermediate

Article posted in General on 16 January 2018| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 18 January 2018
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Summary

Bryan Clontz continues the exploration of gifts of S Corp stock, probing a little deeper into the nuances and challenges of such gifts.

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.

Below is a review on S corporation gifts. S corporation topics are based on Christopher Hoyt’s “Char- itable 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 Corporations Inter- mediate. For an in-depth examination adapted and excerpted from the articles, see S Corporations Advanced. For further details, see S Corporations Additional Resources.

This review of charitable gifts of S corporation stock has six parts, beginning with an overview. The second part discusses the three bad things that happen when S corporation stock is donated to charity. Next is the best way to structure a charitable gift of S corporation stock. Following this is a brief update on recent statutory changes. Obstacles for corporate gifts are examined next, before concluding with a point-by- point discussion of other issues to consider.

Without proper planning, gifted S corporation stock can lead to greater tax liability for a charity than if the donor had sold it and donated the proceeds. Unlike C corpo- rations, S corporations that meet IRS eligibility requirements will not pay income tax at the corporate level. This avoids the classic C corporation double taxation, on both the entity and on dividends. As a result of this favorable tax treatment, it has become a popular form of business entity. Over four million S corporations exist, with over seven million shareholders.

Review Part 1: Overview

Generally, charities prefer to sell contributed stock rather than holding it. Two reasons for this are 1) the desire to liquidate the asset and use the proceeds, and 2) held stock usually will not conform with the charity’s existing investment profile and policy. Unfortunately, S corporation stock is often difficult to sell. Typically, the possible buyers are the corporation itself, other shareholders, or a third-party acquiring the entire business. Often, there is an informal understanding that the corporation will redeem the donated stock. This is appealing for shareholders, since they get a deduction.

Donations of S corporation stock were not allowed until 1998, when Congress allowed tax-exempt charities to own such shares. This means that two sets of laws apply— those governing tax-exempt status, and those governing S corporation status. With so many technical rules, it is easy to make a mistake that can have serious tax conse- quences. For example, some charitable lead trusts can own S corporation stock, but charitable remainder trusts cannot. Ineligible shareholders can cause the corporation to lose its Subchapter S status, although these transactions can often be undone.

Since S corporation financial transactions flow through to shareholders, the S corporation itself can make the donation, meaning the charitable income tax deduc- tion will be claimed on the shareholder's tax return. There is no need for the share- holder to contribute stock to obtain a charitable tax deduction when the corporation's gifts can produce these tax benefits to the shareholder, often at less cost since there is no need to have the stock's value appraised. This also helps the charity avoid unrelated business income tax (UBIT) liability on income from the S corporation stock or gain from sale of that stock.

Review Part 2: Three Bad Things Happen When S Corp Stock Is Donated to a Charity

Tax law provides that three bad things happen when a donor gives appreciated S corporation stock to a charity:

  1. The donor’s tax deduction is usually less than the appraised value of the stock.

    The tax deduction for S corporation stock is more like a donated partner- ship interest than a gift of C corporation stock. This means that donors are subject to “hot asset” rules, which determine the amount of ordinary income versus capital gain that partners have when they sell their interests. As a result, the corporation may pay more money to redeem the stock than the shareholder was able to deduct.
  2. For every day that the charity owns the stock, the charity must report its share of income as unrelated business taxable income (UBTI).

    The charity is taxed on its portion of that S corporation income, including passive investment income the S corporation generates, such as interest or capital gains. This attributable income is reflected on the K-1 return and is taxable whether it is distributed or not.
  3. 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.

    In fact, the tax liability for a charity can often be greater than the donor would have incurred had the donor sold the stock—individuals are subject to a 20 percent maximum rate on long-term capital gains, but corporate charities pay UBIT at ordinary rates of up to 35 percent.

Review Part 3: The Best Way to Structure a Charitable Gift

Despite the adverse tax treatment described above, there are still unique ways to structure charitable gifts from S corporations and their shareholders. This is because in most cases, only one or two shareholders own an S corporation. They dominate every aspect of the business' operations, and therefore, can select the best asset to donate— either the donor's stock or specific corporate assets.

In most cases, both the donor and the charity will usually benefit if the corporation contributes assets, rather than if the shareholder contributes stock. The shareholder claims the tax benefit with either type of gift. General advantages of a gift by the S corporation itself follow:

  • The lack of marketability problem does not apply to gifts of corporate property, unlike stock. Essentially, fair market value is higher for both the donor’s deduction and the charity’s sale.
  • Other assets the S corporation owns will not reduce the value of donated property.
  • Charitable gifts of property can avoid the “built-in gains tax” (for C corpo- rations that convert to S corporations). Although appreciated property which the corporation sells or distributes is subject to the tax, property that it donates outright is not.
  • Charities are not subject to UBIT on income from contributed property (unless debt-financed or active business interests) or on gain from sale, unlike with S corporation stock.
  • Charitable remainder trusts (CRTs) can receive and hold S corporation assets, but not stock. Asset gifts are good for both corporate donors and shareholders. The tax deduction flows to the latter, and the IRS does not tax the charity on gains from sale of the property, meaning more cash in the CRT.

Review Part 4: Recent Statutory Changes

S corporation donations of appreciated property used to have tax disadvantages compared to those of partnerships or LLCs. The 2015 PATH Act made permanent a tax provision that encourages S corporations to donate appreciated assets. The share- holder can claim a charitable income tax deduction for the full value of the property by the S corporation, even if that value exceeds the shareholder’s basis in stock. The Tax Committee Report gives a good example:

“Thus, for example, assume an S corporation with one individual shareholder makes a charitable contribution of stock with a basis of $200 and a fair market value of $500. The shareholder will be treated as having made a $500 charitable contribution ... and will reduce the basis of the S corporation stock by $200. This example assumes that basis of the S corporation stock (before reduction) is at least $200.”1

Review Part 5: Obstacles for Corporate Charitable Gifts

Complications may prevent either an S corporation from making a gift of assets or a shareholder from claiming a charitable income tax deduction. These are as follows:

  • If any other shareholders oppose the charitable gift, it may be difficult to donate corporate assets. One possible solution is to establish a corporate donor-advised fund, which would allow shareholders to recommend grants to different public charities.
  • The S corporation’s assets may not be useful or valuable to charity, for example, inventory or equipment.
  • The charitable income tax deduction might be limited for shareholders with a low basis. This is a common outcome, since nearly one third of S corporations report operating losses.
  • The IRS treats donations of “substantially all” of S corporation assets as a liquidation. This triggers an income tax liability as if the corporation sold its assets to an unrelated buyer. The definition of “substantially all” is unclear, but 80 percent of assets usually qualifies. In these cases, the S corporation recognizes a gain as if on sale.
  • Accrual-method C corporations can deduct charitable pledges in that year as long as it pays the pledge within the first 2½ months of the next year. Cash-method shareholders of S corporations cannot deduct an S corpora- tion's charitable gifts until it actually makes the gift.

Review Part 6: Other Issues to Consider

Other factors that the charity, all advisors, and the donor(s) should consider follow:

A. When are cash and property distributions taxed as UBIT?

B. Low basis of S corporation stock can cause problems.

C. Tax issues for S corporation with losses.

D. Is municipal bond interest subject to UBIT?

E. Can an S corporation's charitable contributions reduce UBIT?

F. Does S corporation income keep or lose its character for UBIT?

G. What if the charity and S corporation have different fiscal years?

H. Tax issues if S corporation was once a C corporation.

I. Private foundation as an S corporation shareholder.

J. Inadvertent termination of S corporation status.

K. What if an S corporation becomes a C corp, or vice versa, while the charity owns stock?

L. Does the installment sales method apply when a charity sells its S corporation stock in exchange for the buyer's promissory note?

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