Many entrepreneurs and investors have accumulated substantial net worth related to their business and investment holdings. For years, these individuals have focused their efforts and attention on building their businesses or accumulating wealth. Many times, however, they may have allowed the years to slip by without formulating a successful business exit plan. After taking a small initial investment and building that into something of considerable value, these entrepreneurs and investors tend to have a very low cost basis in their business interests. If it is sold, there will be undesirable tax consequences to the owner.
A business owner may find that adding a charitable component to his or her business exit plan will help achieve many of his or her goals. Accordingly, developing the appropriate exit strategy may depend on the type of assets the owner holds as well as the owner's personal objectives and goals for the future of the business. This article is the second in a three-part series. Part I covered charitable gifts of C-corp stock. Part II will discuss giving options for S-corp owners. Part III will cover charitable gifts for owners of partnership interests.
Charitable Solutions for S-Corp Stock
Nearly 90% of all businesses in America are organized as closely held businesses. Oftentimes, the majority owner of the business is the founder of what has become a family business. Corporations may be organized under either Subchapter C or Subchapter S of the U.S. tax code. C corporations (C-corps) and S corporations (S-corps) each have their own benefits and drawbacks for shareholders.
Many small business owners organized their businesses under Subchapter S. The owner of S-corp stock has many of the same concerns as the C-corp owner when it relates to the sale of stock. Closely held corporate stock can be difficult to sell. If it is sold, it may produce a high capital gains tax bill for the seller.
Prior to 1998, charities were not permissible S-corp shareholders. Any transfer of S-corp stock to a charitable organization prior to that time resulted in the corporation's conversion to a C-corp. Under current law, however, charitable organizations are eligible to own S-corp stock. While charitable ownership of S-corp stock is permissible, it comes with consequences that may make ownership undesirable for the charity.
When a charity owns S-corp shares, the charity's entire share of income or loss from the corporation is unrelated business income ("UBI"), which is taxable to the charity. This is the case even if the income would not be taxable had the charity earned it directly. Similarly, the sale of S-corp stock will result in UBI tax. Sec. 512(e). The potential for taxation in connection with the gift will cause many charities to be waryif not outright unwillingto accept a gift of S-corp stock.
Charitable transfers of S-corp stock are limited by the same prearranged sale rules applicable to C-corp stock. If a binding obligation to sell the stock exists prior to the charitable transfer, the donor will realize capital gain in the year of the gift. Therefore, the donor and charity should exercise caution when seeking potential purchasers for S-corp stock. For a full discussion of prearranged sales and corporate stock, see Part I of this article.
The charitable income tax deduction for a donation of S-corp stock is determined differently than for C-corp stock. Generally, C-corp stock held for more than one year is deductible at fair market value. When a shareholder contributes S-corp stock held for more than one year, the deduction will be based on fair market value but will be reduced by any ordinary income component of the corporation. Sec. 170(e)(1).
Gifts of S-corp stock valued at more than $500 require completion of Form 8283. If the gift is valued at more than $5,000, Section B of Form 8283 must be completed. If the gifted stock is valued at more than $10,000, a qualified appraisal is required along with Form 8283.
Roger started a successful business 20 years ago manufacturing and selling sweaters. He and his business partner Daniel own all of the shares in the business, which is organized as an S-corp and valued at $3,000,000. Roger is approaching retirement age and is looking for a way to transfer his $2,000,000 interest to Daniel and also offset the taxable income from the sale with a charitable income tax deduction.
He asks his professional advisor about the possibility of selling $1,250,000 of his stock to Daniel and donating the remaining stock to his favorite charity. Roger's advisor warns him that the transfer of $750,000 in S-corp stock to charity will not produce a full $750,000 charitable deduction, but will be reduced by the ordinary income of the corporation. Roger learns that if the corporation were to sell its inventory 15% of the amount realized would be ordinary income. Therefore, Roger's deduction would be reduced by 15% from the $750,000 fair market value to $637,500.
The transfer of S-corp stock to a charitable remainder trust (CRT) raises potential issues as well. While a charity is a permissible S-corp shareholder, a charitable remainder trust is not. Sec. 1361(e). If a CRT receives S-corp stock, either through donation or purchase, the S-corp will be reclassified as a C-corp. This will cause the corporation to lose its pass-through taxation status and its income will be subject to double taxation, likely to the chagrin of the remaining shareholders.
If, after considering all potential alternatives, the owner of S-corp stock would still prefer to donate the stock to a CRT, the shareholders should plan ahead, discussing the tax implications of converting the S-corp to a C-corp. The corporation's accountant and legal counsel should be prepared to discuss the consequences of such a conversion, including the double taxation associated with C-corps.
One potentially attractive alternative to transferring S-corp stock to charity or to a CRT is for the corporation to donate assets to charity instead. It is usually much easier to find a willing buyer to purchase corporate assets than S-corp stock. As with a transfer of S-corp stock, when an S-corp contributes its assets to a charity, the charity may have UBI if the income generated by those assets is not passive income. The S corporation will receive a charitable deduction for the gift, which flows through to the S-corp shareholders.
Gifts of S-corp assets to a public charity may be deducted up to fair market value. It is important to note that when calculating the deduction for charitable gifts from S-corps, the shareholder's basis is taken into account. Whereas the shareholder's basis is not factored into the charitable income tax deduction for gifts from C-corps, the deduction for a gift from an S-corp requires knowledge of both inside basis and outside basis. The S-corp's basis in its assets is known as inside basis. The shareholder's basis in the S-corp stock is known as outside basis.
Each S-corp shareholder is only able to use the deduction to the extent of his or her outside basis. Sec. 1366(d)(1). A charitable gift of an S-corp's appreciated property generates a charitable income tax deduction that flows through to the shareholders. The deduction will cause each shareholder to adjust his or her outside basis. Sec. 1367(a)(2). Prior to 2006, the shareholder's outside basis would be reduced by the value of the deduction. Since 2006, however, and made permanent with the passage of the PATH Act in 2015, the shareholder's outside basis is reduced by the adjusted basis in the gifted property.
Michael is the sole shareholder in an S-corp he purchased 20 years ago from the founder, who was retiring. Michael's current adjusted basis in the stock is $150,000. The S-corp, which operates a hardware store in town, purchased a plot of land for $70,000 10 years ago with the intent to build an additional store, but those plans never materialized. Michael is now ready to sell his shares to a third party but would like to offset the capital gains from the sale with a charitable income tax deduction.
Michael donates the plot of land, now valued at $150,000, to the local community college, which has its main campus adjacent to the property. Michael takes an income tax deduction of $150,000 for the charitable gift. While under prior law, Michael's outside basis would also be reduced by $150,000, current law only requires him to reduce his outside basis by $70,000. Thus, Michael ends up with an adjusted basis of $80,000.
Later in the same year, Michael finds an entrepreneur ready to operate the local hardware store who purchases all of Michael's S-corp shares for $300,000. Michael realizes $220,000 of gain on the sale, part of which is offset by his $150,000 charitable income tax deduction.
This asset transfer strategy does not come without its share of difficulty. First, the transfer of assets will likely be a better fit for S-corps with few shareholders. An S-corp with the maximum 100 shareholders will have difficulty reaching a consensus regarding a substantial charitable gift of corporate assets. An S-corp with two shareholders, on the other hand, is much more likely to be amenable to the idea of a charitable gift of corporate assets, as a greater percentage of the deduction will flow through to each shareholder.
An additional potential roadblock is that a transfer of all, or substantially all, S-corp assets to charity will trigger the recognition of gain or loss as if the corporation had sold the assets at fair market value. Reg. 1.337(d)-4. This recognition of gain would undermine the donor's purpose in donating the assets to charity. Thus, the S-corp owner is not able to transfer all of the corporation's assets into a CRT and avoid gain on the sale of the assets.
There is no bright line test for determining how much of a corporation's assets constitute "substantially all" assets for the purpose of this rule. However, the IRS has generally held that the "substantially all" requirement is satisfied when (1) assets representing at least 90% of the value of the corporation's net assets are transferred or (2) the assets transferred represent at least 70% of the value of gross assets prior to transfer. Sec 368(a)(1).
George and his son Hal have owned and operated a small chain of bicycle repair shops for the last 21 years. When George first started his business, he formed a corporation and made an "S election" for the corporation to be treated as an S-corp. Over time, the corporation expanded its footprint to three locations.
George is ready to retire and hand over the business to Hal. They meet with the company's attorney to determine the best exit strategy for George. George would ideally like to reduce his interest in the company in exchange for some extra retirement cash. Hal is on board with the plan but he does not have the means to buy his father's shares. George has heard of other small business owners using charitable solutions to achieve their goals, so he asks the attorney if there are any charitable gift vehicles that will help him and Hal.
The attorney explains that charities may be wary of accepting a gift of S-corp stock, since there will likely be a heavy tax bill attached before the stock can be sold and that a CRT cannot be funded with S-corp stock. George is intrigued, however, when the attorney mentions that the assets of an S-corp may be used to fund a CRT.
George and Hal decide to consolidate their bicycle repair operation by closing the smallest and lowest revenue producing shops of their three locations. They redistribute the newly closed location's inventory and equipment between the two remaining locations. The corporation then establishes a 20-year term charitable remainder unitrust funded with the real estate that formerly housed the repair shop that they closed. Even though the store was small, the real estate was very valuable. In fact, the real property represents roughly one-third of the value of the corporation's total assets. With this arrangement, George and Hal are able to steer clear of any danger of recognized gain.
It is important to note that a CRT funded with S-corp assets should be limited in duration to a term of years rather than for the life or lives of an individual or individuals. In Private Letter Ruling (PLR) 200203034, the Internal Revenue Service (the Service) ruled that a CRT funded by an S-corp that included individuals as successor beneficiaries did not qualify as a trust for federal income tax purposes and thus was not a qualified CRT. The Service based this decision in part on Reg. 1.671-2(e)(4), which treats the corporation as the grantor of the trust if the transfer is for a business purpose. However, if the transfer to the CRT is for personal purposes, the transfer will be treated as a constructive distribution to the shareholders, who will be treated as the grantors of the trust.
While a PLR is not binding precedent, it is useful to understand the rationale the Service follows. Therefore, the safest way for the S-corp to contribute assets to a CRT is through a term of years CRT that will make payments to the corporation. The tax benefits and CRT payouts will flow through to the S-corp shareholders.
Regardless of the type of business interest the owner holds, his or her attorney should take time to examine its articles of incorporation, operating agreement, partnership agreement or other foundational documents. These documents mayunbeknownst to the ownerimpose restrictions on the transfer of an ownership interest. Often such restrictions may be removed prior to the charitable transfer, but usually require additional legal legwork upfront before the gift can be made.
Business owners preparing to exit their businesses may have any number of reasons for doing so. It is imperative that the professional advisor work with the owner to try to best determine the owner's goals and how best to meet those goals. There are many circumstances in which a charitable gift may be the best way to serve the owner's interest. However, the potential for missteps along the way requires business owners to work with advisors who can guide them to the most effective solution for their circumstances.