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