Charitable Gifts By Subchapter S Corporations And By Shareholders Of S Corporation Stock

Transcription

1 Charitable Gifts By Subchapter S Corporations And By Shareholders Of S Corporation Stock Christopher R. Hoyt A. The Big Picture There Are Usually Two Potential Donors: The Corporation And The Shareholder 1. Introduction a. Most closely held corporations are Subchapter S corporations (hereafter S corporations ). They usually have very few shareholders who tend to control and dominate every aspect of the corporation s business. Consequently, most charitable gifts that involve an S corporation have two potential donors: (1) the S corporation, which can contribute some of its assets, and (2) the shareholder, who can make a charitable contribution of S corporation stock. The donor and the charity should identify which donor and which asset will produce the best results. 2. An S Corporation Can Contribute Some Of Its Assets a. Overview Christopher R. Hoyt is Professor of Law at the University of Missouri-Kansas City School of Law. Christopher R. Hoyt All Rights Reserved. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA by calling CLE-NEWS and asking for customer service. (Have the order code CK088 handy). Or order online at 5

2 6 ALI-ABA Estate Planning Course Materials Journal April 2006 i. When an S corporation makes a charitable contribution, the charitable income tax deduction is reported on the corporation s income tax return and then flows through to the shareholder s individual income tax return. Because corporate charitable gifts can avoid many of the problems that can occur when a shareholder contributes stock of an S corporation (described below) and because the shareholder will be the beneficiary of the income tax benefits in either case, shareholders will often be better off having the corporation make a charitable gift of its assets than having the shareholder give stock. ii. Example: Assume that an S corporation has one shareholder and that the corporation is contemplating a sale of appreciated real estate that is worth $100,000 and has a tax basis of only $20,000. The shareholder has a basis in the S corporation stock of $300,000 and the stock is worth $1 million. If the shareholder intends to make a major charitable gift, there are basically three options: (1) the S corporation could contribute the real estate; (2) the S corporation could distribute the real estate to the shareholder who could give the real estate to a charity; or (3) the shareholder could contribute $100,000 of S corporation stock that the corporation might later redeem. iii. The tax consequences are: (1) The corporation would report a charitable contribution deduction of $100,000, which would flow through to the shareholder s return as if the shareholder had personally made the gift. The shareholder would reduce his basis in the stock by the full $100,000. Internal Revenue Code ( Code ) 1367(a)(2)(B); Pvt. Letter Rul (Oct. 26, 1999). (All section references are to the Code unless otherwise indicated.) (2) The corporation must report a taxable gain of $80,000 as if it had sold the real estate, which will have to be reported on the S corporation shareholder s return. 1371(a) and 311(b). The shareholder s gift produces an offsetting charitable deduction of $100,000. The charity has no unrelated business income tax ( UBIT ) while it holds the real estate or when it sells the real estate. (3) The shareholder can claim an income tax deduction for the gift of $100,000 of stock, but the tax law will likely require the deduction to be less than the appraised value of $100,000. The last sentence of sec-

3 S Corporation Charitable Gifts 7 tion 170(e)(1) (relating to income tax charitable deductions for contributions of ordinary income and capital gain property) states: For purposes 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. The charity will have a UBIT liability both while it holds the S corporation stock and again when it sells the stock. b. Advantages Of Corporate Gifts Over Shareholder Gifts i. A charitable deduction for a gift of corporate property (e.g., real estate) would not be reduced by a lack of marketability discount as a shareholder s gift of stock would be. That is, the real estate could be valued at its full worth, but the stock of any closely held business will often be appraised at less than the value of the corporation s underlying assets because of the difficulty of selling a minority interest in a closely held business. ii. The charitable income tax deduction for a gift of corporate property is not reduced by the value of any other assets that the S corporation owns, whereas the income tax deduction for a charitable gift of S corporation stock will usually be less than the appraised value to reflect any ordinary income assets that the S corporation might have. Id. (See above and below.) For example, assume that the appraised value of donated S corporation stock is $100,000 but the corporation holds $5,000 of ordinary income assets attributable to the stock. The charitable tax deduction for the stock gift would be reduced 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 full appraised value of $100,000. From a tax perspective, it would have been much better for the 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. iii. A charity is not subject to UBIT on the income of the contributed property such as real estate (unless it was debt-financed ) or on the gain from its sale, whereas a charity will have to pay those taxes when it holds and sells stock of a profitable S corporation (see below); and

4 8 ALI-ABA Estate Planning Course Materials Journal April 2006 iv. Although a charitable remainder trust ( CRT ) cannot receive or hold S corporation stock, it can receive and hold real estate. Such a CRT is usually for a term of years (e.g., 20 years) rather than the life of an individual. Both the corporation and shareholder could benefit by having the corporation contribute real estate to a CRT and then having the CRT sell the real estate. First, the charitable income tax deduction from the gift of real estate would flow through to the shareholder s individual returns. Second, because a CRT is tax-exempt, it will not pay any tax on the gain from the sale. It can thereby retain greater cash that can be invested to produce greater annual cash flow to benefit the S corporation, which the S corporation can then distribute to the shareholder. c. Obstacles For Corporate Charitable Gifts. There are several complications that could prevent a corporation from making a charitable gift of its assets or prevent a shareholder from claiming income tax deductions for the gift. In that case, a shareholder s gift of stock might be the primary charitable giving opportunity. These obstacles include: i. If there are other shareholders who do not want to make a charitable gift of corporate assets, the charitably inclined shareholder might be limited to giving her or his stock. Similarly, the S corporation might not have any assets that are attractive to the charity (e.g., the only assets are equipment and inventory) so that stock will be the main option. ii. The charitable income tax deduction could be limited for shareholders who have a low basis in their S corporation stock. For example, if an S corporation informs a shareholder that her deduction for the corporation s charitable gifts is $20,000, but the shareholder only has stock with a basis of $12,000, the shareholder will be limited to a $12,000 deduction that year. If a shareholder has a very low basis in his or her stock, then a gift of the stock may be the only way for the shareholder to get a charitable tax benefit. iii. If the S corporation makes a charitable contribution of appreciated property, the shareholder s basis in her or his stock is probably reduced by the amount of the charitable deduction rather than by the cost basis of the property that was given to the charity. For example, assume that an S corporation with only one shareholder made a charitable contribution of appreciated real estate with a cost basis of $20,000 but a value of $100,000. The shareholder could deduct $100,000, but probably has to reduce the

5 S Corporation Charitable Gifts 9 basis in her stock by the full $100,000. With a lower basis, the shareholder will have a larger gain when the stock is ultimately sold or when the company liquidates. By comparison, if a partnership or a limited liability company made the same gift, the owner s basis in the partnership interest or LLC interest would be reduced only by the $20,000 cost basis. iv. Although an accrual-method corporation can usually deduct a charitable pledge in the year it makes the pledge as long as it pays the pledge within the first months of the next year, cash-method shareholders of S corporations will not be able to deduct an S corporation s charitable gifts until the corporation actually makes the gift. d. Charitable Gifts By Subchapter S Corporations Cases And Rulings i. Timing Of Gifts (1) Even if an S corporation uses the accrual method of accounting, shareholders may only claim deductions in years in which the corporation actually made the charitable gift (i.e., the cash method). Rev. Rul , C.B. 333; Tech. Advice Mem (September 30, 1998). (2) A gift by an S corporation to a charity where the corporation retained an option to acquire the property back at a nominal price was not a completed gift until the option expired. Tech Advice Memo (March 9, 1998). ii. General Gifts By A Corporation (1) Gifts of appreciated real estate to a governmental entity qualify for charitable deduction equal to the full value of the property. The IRS ruled that the corporation would not have to recognize the built-in gains tax under section 1374 (the tax that applies if an S corporation sells appreciated property that it held at the time of conversion from Subchapter C status to Subchapter S status). Pvt. Letter Rul (Oct. 26, 1999). (2) The IRS approved a gift of a conservation easement (a timber company contributed a perpetual conservation easement on property that the company would continue to own and use for timber operations). Pvt. Letter Rul (June 20, 1995).