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Friday, September 16, 2011

Hoyt: Charitable Gifts by S Corporations and Their Shareholders

This article examines the tax opportunities and tax hazards when a subchapter S corporation makes a charitable gift. The article demonstrates that usually the shareholders of an S corporation and the charity are both better off when an S corporation makes a charitable gift compared to having a shareholder make a charitable gift of S corporation stock. Either way, the income tax benefit will be on the S corporation shareholder’s personal income tax return. By having the S corporation make the gift, the parties avoid the “three bad things” that happen when a shareholder donates S corporation stock. The problems and solutions for a charitable gift of S corporation stock are analyzed in the companion article: Charitable Gifts by Subchapter S Corporations and Their Shareholders: Two Worlds of Law Collide, 36 ACTEC L.J. 693 (Spring 2011).

The opportunities include the ability to donate corporate property to a charitable remainder trust (CRT), a temporary enhanced income tax deduction for a gift of appreciated property (such as a conservation easement), the ability to avoid the Section 1374 built-in gains tax (even with a gift to a CRT), and the avoidance of the unrelated business income tax (UBIT).

The article also identifies hazards and ways to solve them. For example, an S corporation should avoid making a charitable gift to a charity while the charity is also a shareholder. It could be a prohibited “second class of stock.” Even a charitable gift to an unrelated charity can be a problem: a gift of a substantial portion of the corporation’s assets could be treated as a taxable corporate liquidation. Professor Hoyt identifies ways to reduce or even eliminate the potential tax liability triggered by such a large gift.

This comprehensive article analyzes the rules that apply to, and the tax planning strategies for, a charitable gift of S corporation stock. It describes the interaction of the laws governing S corporations and tax-exempt organizations and describes the best ways to solve the challenges posed by each set of laws. The article also addresses additional challenges that can occur when specific types of tax-exempt organizations own S corporation stock, notably private foundations, donor advised funds, supporting organizations and ESOPs.

From the perspective of both the donor and the charity, three “bad things" happen when S corporation stock is contributed to a charity: (1) the donor's income tax deduction is usually less than the stock’s appraised value; (2) the charity must pay the unrelated business income tax (UBIT) on its share of S corporation income; and (3) the charity must pay UBIT on its gain when it sells the stock. This is much harsher tax treatment than if the charity had received and sold an ownership interest in an identical closely-held business that had been organized as a C corporation, a limited liability company or a partnership. Professor Hoyt suggests specific legal reforms to make the tax treatment more consistent.

The article also identifies the best ways to structure a charitable gift under the existing laws, such as a donation to an intermediary charitable trust. In most cases, though, both the donor and the charity will be better off if the S corporation makes a charitable contribution of some of its assets compared to having a shareholder contribute S corporation stock.

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