Tax-Saving Opportunities for Charities Owning Subchapter S Stock

Tax-Saving Opportunities for Charities Owning Subchapter S Stock

Article posted in Privately Held Business Interests on 21 October 1999| comments
audience: National Publication | last updated: 18 May 2011
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Summary

Since January 1, 1998, charities have been able to own Subchapter S stock. But how should they own it? In this edition of Gift Planner's Digest, Laura Peebles, tax director at the national office of Deloitte & Touche, challenges the conventional wisdom of corporate ownership and presents tax saving alternatives for recipient organizations.

by Laura H. Peebles, CPA, PFS

Current Situation

Since January 1, 1998, charities have been able to own Subchapter S stock. This change in the law represents a significant opportunity for charities to share in some of the wealth created by America's small businesses. However, without careful planning, the ownership of Subchapter S (hereafter Sub S) stock by an exempt organization may be either an unexpected tax burden, or worse yet, a liability rather than an asset.

In general, Sub S companies do not pay income taxes. The income is taxed to the shareholders whether or not it is distributed in cash. Charitable shareholders are not exempt from this provision. The way Congress chose to implement this provision was to treat a charity's share of the Sub S's income as unrelated business taxable income (UBTI). The same treatment also applies if the charity sells the stock: the gain will be subject to tax.

Depending on the actual distributions received from the corporation, the charity may find itself with little cash left over after tax payments to use for charitable purposes. Worse yet, if the corporation does not distribute enough cash to pay the taxes, the tax must be paid from the charity's other assets. This is not likely to happen, as the other shareholders that control the company need to pay their taxes, too, and therefore are likely to distribute at least enough to pay the tax.

Many commentators have discussed the "best" way for a charity to hold the Sub S stock. Their discussion usually focuses on how to lower the effective tax rate paid by the charity on its share of the income. If the charity is a corporation, the tax is paid at corporate rates.

Generally, the top corporate tax rate is effectively 34%. For corporations, capital gains are taxed at the same rate as ordinary income. On the other hand, if a charity was set up as a trust, it uses the trust tax rates. The top trust rate is the same as for individuals: 39.6%, but a trust receives the benefit of the capital gains rates (currently 20% on most assets).

The conventional wisdom is that if a charity expects to hold a gift of Sub S stock for a relatively long period of time before selling it, holding it in corporate form is better since the tax rate is lower. Also, if the gift of stock is relatively small, the graduated corporate rates could be beneficial. Corporate income under $100,000 is taxed at rates below 34%, but trust income is taxed at the highest rate beginning at less than $10,000. If the stock is expected to be sold promptly, then the availability of the capital gains rate may make the trust form more attractive.

The purpose of this article is to challenge the conventional wisdom. There is a charitable deduction available that can reduce the above tax rates. This requires considering additional factors before making a decision on using a corporation or a trust to hold Sub S stock on behalf of a charitable organization. (For purposes of discussion, the graduated tax rates have been ignored, and the trust rate is assumed to be 40%, and state taxes are ignored.)

The Opportunity

First consider the provisions applying to exempt organizations organized as corporations. IRC §512(b)(10) provides:

In the case of any organization described in section 511(a), the deduction allowed by section 170 (relating to charitable etc. contributions and gifts) shall be allowed (whether or not directly connected with the carrying on of the trade or business), but shall not exceed 10 percent of the unrelated business taxable income computed without the benefit of this paragraph.

The regulations under this section (Treas. Regs. §1.512(b)-1(g)(3)) read:

The contribution, whether made by a trust or other exempt organization, must be paid to another organization to be allowable. For example, a university described in section 501(c)(3) which is exempt from tax and which operates as [sic] unrelated business, shall be allowed a deduction, not in excess of 5 percent of its unrelated business taxable income, for gifts or contributions to another university described in section 501(c)(3) for educational work but shall not be allowed any deduction for amounts expended in administering its own educational program.

[Note: These regulations predate the change in the limitation on corporate deductions from 5% to 10%.]

In English, this means that a charity set up as a corporation is entitled to a deduction for grants made to another charity--up to 10% of its taxable income. Monies expended in fulfilling the charity's own mission are not deductible for this purpose. This would reduce the effective tax rate by approximately ten percent from 34% to 31%. If an operating charity has (or establishes) a supporting organization, it should be able to deduct the distributions made in support of its "charitable parent" or another charity.

Now consider the same provisions as they apply to trusts. §512(b)(11) provides:

In the case of any trust described in section 511(b), the deduction allowed by section 170 (relating to charitable etc. contributions and gifts) shall be allowed (whether or not directly connected with the carrying on of the trade or business), and for such purpose a distribution made by the trust to a beneficiary described in section 170 shall be considered as a gift or contribution. The deduction allowed by this paragraph shall be allowed with the limitation prescribed in section 170(b)(1)(A) and (B) determined with reference to the unrelated business taxable income computed without the benefit of this paragraph (in lieu of with reference to adjusted gross income).

In English, this means that charities established as trusts are entitled to the same deduction limits as individuals. In general, the individual limitations allow a deduction of up to 50% of adjusted gross income for donations of cash to a public charity (30% for donations to a private foundation).

If a trust-type supporting organization holding Sub S stock receives sufficient cash from the S Corporation to distribute at least 50% of its taxable income to its "supported organization," it can effectively cut its tax rate in half from 40% to 20%. (The 50% reduction would apply to capital gains as well as ordinary income: the effective rate would be 10% instead of 20%.) This is 35% less tax than the best possible results obtainable under the corporate rules. Also, the Internal Revenue Code and Regulations make it clearer that distributions to the beneficiary of a trust are allowable as deductions in computing taxable income. The provisions for corporations are not quite as clear.

Not So Fast

After reading the above, some organization's first reaction might be that all charities that are offered a donation of Sub S stock should immediately establish a supporting organization in the form of a trust. Or, perhaps they should have the donor establish the trust. It does seem certain that there is no downside (other than administrative costs) to establishing a supporting organization rather than holding the Sub S stock directly, where no charitable deduction would be available unless grants were made to other charities.

Unfortunately, it's not that easy. Sub S Corporations are almost always ongoing businesses. They usually distribute their earnings to their owners in two forms: salary to the owner-employees, and just enough cash in the form of dividends to pay the tax on the remaining income. The remainder is retained for debt service, expansion, and other business needs. As an almost assuredly minority shareholder, the charity will not be in a position to influence the payment of dividends. (Indeed, the donors may give the charity non-voting stock.) Assuming the exempt organization will not be receiving any salary or other deductible distributions, it will be dependent on the cash dividends to pay its income tax. If there is any cash left over, it can be distributed to the "supported" charity.

Although it may seem awkward to ask these questions up front, the necessary information would usually be included in any appraisal of the company. Any owner of Subchapter S stock is going to understand a potential owner's concerns regarding distributions to pay taxes. Once the potential donor understands that the charity will also be taxed on corporate income whether distributed or not, they should understand the charity's need to make an informed decision about how the stock is to be owned (or even whether the donation can be accepted).

The "right" answer for how a charity should hold Sub S stock depends significantly on the expected annual cash distributions as a percent of taxable income. Take two extremes: the first business distributes 40% of taxable income, just enough for the owners to pay their individual income taxes. The second, a mature business with fewer cash needs, distributes 70% of its taxable income. In each case, the charity's share of annual taxable income is $500,000.

A corporate charity holding stock of the first business would receive $200,000 in cash. Their tentative tax would be 34% of $500,000 or $170,000. However, they can deduct any contributions to their supported charity. Using a circular formula, we calculate that the taxable income would be $454,545, the tax would be $154,545, and the charity would receive the difference, $45,455. If they had been organized as a trust, the entire 40% distribution would be remitted for taxes, leaving nothing for charitable disbursements.

A corporate charity holding stock in the second business would be better off, receiving $350,000 in cash distributions. Their tax would be $153,000, ($500,000 Sub S income, less $50,000 charitable deduction, times 34%). Their supported charity would receive the net of $197,000. Here, however, the trust form produces clearly better financial results. Again, a circular formula is used to calculate tax of $100,000 and a distribution to charity of $250,000 out of the $350,000 distribution. This is the minimum possible tax rate of 20%.

All other things being equal, if the S Corporation will be distributing exactly 54% of its income, the effective tax rate will be 31% whether the charity is a corporation or a trust. The net cash available for charitable use will be about $117,000 (after tax of about $153,000). The charity's other unrelated business income or loss and the potential availability of the lower brackets will change the "break-even" point.

A word of caution: Even if the Sub S corporation does not distribute sufficient cash to pay the tax, it is still due and must be paid from other assets or borrowings. This is the hazard of owning an interest in a pass-through entity such as an S corporation, limited liability company, or partnership interest that generates taxable income (of course, this problem is not limited to charitable organizations!).

What happens to the rest of the taxable income? After all, the shareholders, including the charity, have paid tax on more income than the cash they actually received. This undistributed income is added to the shareholder's basis in the stock. When (if) the stock is sold or redeemed by the S corporation, this additional basis will decrease the taxable gain.

In a year in which Subchapter S stock is sold, distributing cash to the supported organization can also reduce the tax. Using the same calculations as above, the tax on a sale by a corporation would be an effective 31% rate, but the trust form would produce a tax rate as low as 10% (20% capital gains rate less 50% charitable deduction). In the year of the sale, we would assume there would be sufficient cash to maximize the deduction. Obviously, there are other considerations besides tax costs when choosing between organizing as a corporation or trust.

Corporations are easier to amend than trusts. State laws may impose a higher standard of care on trust fiduciaries than on corporate officers. Some of these issues may be less important if the only function of the organization is as a supporting organization rather than an operating charity.

Summary

Taxes should never be the only consideration when negotiating with a potential donor. However, before accepting a gift of Subchapter S stock, taxes must be given serious consideration. Once the charity knows as much as possible about the company and its distribution policy and history, it can then consider the structure of the organization to hold the donation. To do otherwise is to miss the opportunity to maximize the value of the donation and minimize the tax consequences.

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