CGNA: S Corporations - Advanced, Part 3 of 3

CGNA: S Corporations - Advanced, Part 3 of 3

Article posted in General on 14 February 2018| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 15 February 2018
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Summary

Continuing with S Corp stock, we move to the advanced planning aspects.

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.

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 corporation's gift. In that case a shareholder's gift of stock might be the primary charitable giving opportunity. These obstacles are as follows:

1. If there are other shareholders who do not want to make a charitable gift to a particular charity, this lack of consensus may limit the shareholder who is advocating a charitable gift to giving her or his stock. One solution when there are shareholders with diverse charitable interests is for the corporation to establish a corporate donor-advised fund. A donor-advised fund is a grant-making account at a community foundation, Jewish federation, national donor-advised fund, or other sponsoring organization where donors recommend grants from the fund to other public charities. The corporation can divide its donor-advised fund into subaccounts that will allow each shareholder to recommend grants to the public charities that each shareholder wants to support.

2. 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.

3. The charitable income tax deduction could be limited for shareholders who have a low tax 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. With nearly one third of S corporations reporting operating losses, it is very common for a shareholder to have a low basis.

4. If an S Corporation donates “substantially all” of its assets to a charity, the corporation will be treated as if it had liquidated. This will trigger an income tax liability as if the corporation had sold its assets to an unrelated buyer.

The definition of what constitutes “substantially all” is not clear. Contributing 80 percent or more of its assets to charity will probably trigger the liability. Some are concerned that contributing just a majority of the assets (over 50 percent) may be enough to cause problems. Consequently, the most generous gift that a shareholder can make—a gift or bequest of the entire corporation—poses serious tax challenges to a charity. When the S corporation distributes assets to the charitable parent corporation—even assets that could be considered charitable, such as a valuable painting for display to the public—the S corporation will recognize a taxable gain on the distribution as if the asset had been sold to a buyer and there will be no offsetting charitable income tax deduction.20

5. 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 2½ 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.

Alternate Donation Opportunities

A donor-advised fund (DAF) is a separately named fund that is held by a larger charity where a donor may recommend grants from the fund to eligible charitable recipients.21 The governing body can accept or reject each recommendation, although they usually follow the donor’s recommendation whenever the proposed recipient is an eligible public charity.

Although classified as public charities, DAFs are subject to private foundation excess business holdings tax, and must dispose of any donated S corporation stock within five years (or ten years with an extension).22 Also, self-dealing rules for DAFs prohibit paying a donor/substantial contributor (or a related person)23 for services,24 but a property sale with a donor is permissible for cash (but not a loan) if it meets the general excess benefit standards for public charities.25

A DAF holding S corporation stock is still subject to UBTI rules. However, if the DAF is organized as a trust, it will be taxed at trust rates rather than corporate rates.26 As a result, it can mitigate the UBTI burden when holding donated S corporation stock. Although the taxable income threshold for the highest marginal tax rate is much lower for trusts (only $8,350), long-term capital gains are taxed at only 20 percent.27 This capital gains advantage is very appealing for highly appreciated S corporation stock. Further still, if the DAF makes charitable grants to other public charities, any capital gains tax would be reduced by half given the 990T UBIT return allows for a full deduction for charitable contributions limited to 50 percent of AGI. So the net long term federal capital gains tax would be just 10 percent. Similarly, any recognized ordinary income would be at half the maximum rate as well (currently, 19.8 percent vs. 39.6 percent).

Another option is funding a charitable gift annuity with S corporation stock. Ideally using the trust form again for the favorable capital gains treatment, a CGA can be used in lieu of an ineligible remainder trust.28 As with other CGA agreements, the donor (or their named beneficiary) gets an income interest and a deduction for the charitable portion of the gift. Since UBTI rules still apply, the trust should liquidate the S corporation at its soonest convenience.

Checklist for a Charity When it Is Offered a Gift of S Corp Stock

A. Charitable Purpose. If donor intends to make a restricted gift (e.g., scholarships only, endowment only), are the donor's charitable purposes acceptable?

B. Stock as an Investment

1. What is the nature of the business and its prospects for profitability?

2. What is the stock worth?

3. When will the charity likely sell it?

4. During the time that the charity will own the stock, what is the expected after-tax cash flow from the stock? The after-tax cash flow will be the cash distributions from the S corporation minus the UBIT.

C. Should Donor's Recognition or Benefits Be Adjusted for Anticipated UBIT?

1. Should donor get credit in a major campaign for the full appraised value of the stock or only for the anticipated net amount after UBIT?

2. If a charitable gift annuity will be issued, should the payments be reduced since there will be less cash after the stock's sale because of the UBIT?

D. State Law Issues

1. Can charity own stock under state law?

2. Is there a state UBIT?

E. UBIT Concerns

1. Will gift be made to a charitable trust or an incorporated charity? If a charity has a choice, determine which type of entity will pay the least amount of UBIT.

2. What is donor's adjusted tax basis in the stock? If donor does not know, looking at the balance sheet of the corporation's income tax return may be a way to estimate the basis. Donor's tax basis is important because of the following reasons:

a. It affects the gain or loss upon the sale of stock.

b. It affects whether cash distributions from S corporation are taxable or tax free.

c. It affects whether an S corporation's losses will be deductible or not.

3. What is the projected taxable income or losses of the corporation? How much UBIT will the charity have to pay while it holds the stock? Examine the Schedule K-1 that the donor received from the S corporation.

4. What are the projected cash and property distributions to the charity? See Line 20 of Schedule K-1.

a. Cash distributions?

b. Expected Amounts?

c. Sufficient to pay UBIT?

d. Any extra for charitable purposes?

5. Distributions taxable or tax free?

6. Timing of distributions to meet quarterly UBIT payments when due?

7. Property distributions?

8. A distribution of appreciated property could trigger tax. Are any such distributions planned in the near future?

a. Will the charity have to file UBIT Form 990-T return (required if gross UBTI is over $1,000)?

b. Will the charity have to make quarterly UBIT estimated tax payments (required if tax due for any year over $500)?

F. Administrative Requirements if Gift Is Accepted

1. Charity must sign donor's Form 8283 (qualified appraisal) to acknowledge receipt of gift of stock. The donor should know that unlike gifts of other kinds of stock, the tax deduction for donated S corporation stock is often less than the appraised value.

2. Charity should send donor a “contemporaneous written acknowledgment” that contains the language necessary for the donor to claim a charitable income tax deduction.

G. Sale of Stock

1. Obtain evidence of the sale of the stock for its fair value (e.g., a recent appraisal).

2. Send Form 8282 to the IRS and the donor if property is sold within three years.

3. Charity must pay UBIT on the gain from the sale of S corporation stock.

 

S Corporations  Additional Resources

Below are further details on S corporation gifts. S corporation topics are based on Christopher 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 Corporations Intermediate. For an in-depth examination adapted and excerpted from the articles, see S Corpora- tions Advanced. For further details, see S Corporations Additional Resources.

For a discussion on the possible pitfalls of donated S corporation stock, see Zaragoza, D. (February 28, 2012), “Charities, S Corporations and UBIT: Why a Charitable Gift of S Corporation Stock May Not Be the Best Option,” LexisNexis, https://www.lexisnexis.com/legalnewsroom/estate-elder/b/ estate-elder-blog/archive/2012/02/28/morrison-foerster-llp-charities-s- corporations-and-ubit-why-a-charitable-gift-of-s-corporation-stock-may- not-be-the-best-option.aspx?Redirected=true.

For a discussion of how nonprofits should hold S corporation stock, see Peebles, L. (1999), “Tax Saving Opportunities for Charities Owning Subchapter S Stock,” Planned Giving Design Center, http://www.pgdc.com/pgdc/article/1999/10/ tax-savingopportunities-charities-owning-subchapter-s-stock.

For analysis of an IRS ruling on S corporation gifts, see Hoyt, C. (March 3, 2008), “Service Issues Favorable Guidance Regarding Gifts of Appreciated Property by S-Corporations,” Planned Giving Design Center, http://www. pgdc.com/pgdc/service-issues-favorable-guidance-regarding-gifts-appre- ciated-property-s-corporations.

For examples and analysis of S corporation charitable transaction, see Newman, D.W. (2011), “Gifts of S Corporation Assets,” Partnership for Philanthropic Planning, http://my.pppnet.org/library/60433/1/NCPP11_New- man%28rev%29.pdf.

For analysis of IRS positions on S corporation donations, see Joseph P. Toce, Jr. et al, Tax Economics of Charitable Giving 10-13 – 10-16 (2003).

IRC § 1367(a) (adjusted basis rules for contributions by the S corporation)

IRC § 512(e) (unrelated business taxable income rules relevant to S corporation interests)

IRC § 170(e)(1) (donors recognize “hot asset” gain on contributed S corporation stock)

Rev. Rul. 92-48, 1992-1 C.B. 301 (CRTs not allowed to own S corporation stock)

Rev. Rul. 08-16, 2008-11 I.R.B. 585 (example and analysis of an S corporation making a gift)

IRS Notice 2004-30, 2004-17 I.R.B. 1 (donations of nonvoting S corporation stock)

Private Letter Ruling 200326039 (donation of S corporation assets with multiple entities)

Private Letter Ruling 200644013 (June 21, 2006) (donation of built-in gain property to a CRT)

Alli v. Comm’r, TC Memo, 2014-15 (January 27, 2014) (S corporation donation with appraisal problems)

  • 20. § 1371(a) provides that an S corporation is subject to the same tax laws as a C corporation unless there is a specific S corporation law that is in conflict. Generally, a C corporation that distributes appreciated property to shareholder must recognize a taxable gain as if the property was sold, whether the distribution is made by an ongoing corporation (§ 311(b)(1)) or in liquidation (§ 336(a)).
  • 21. IRC § 4966(d)(2)(A).
  • 22. IRC § 4943(e).
  • 23. The prohibition against a payment for services generally applies to any donor to any DAF. IRC §§ 4958(c)(2), 4958(f )(7) and 4966(d)(2)(A)(ii).
  • 24. IRC § 4958(c)(2)(A).
  • 25. The special rules contained in IRC § 4958(c)(2) (c)(3) for donor-advised funds supporting organizations only apply to a “grant, loan, compensation, or other similar payment.” See, for example, Private Letter Ruling 200821024 (May 23, 2008), which involved a donation of closely held stock to a DAF that the parties expected would be redeemed by the corporation in a manner similar to that described in Rev. Rul. 78-197, 1978-1 C.B. 83. The Service did not expressly address potential excess benefits tax issues under IRC § 4958.
  • 26. Horwood, R.M. (2012), “Unlocking Your Donors’ Noncash Treasure Chests,” Partnership for Philanthropic Planning, http://my.pppnet.org/library/75955/1/NCPP12_Horwood.pdf.
  • 27. Id.
  • 28. Id.

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