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Even if an asset is very common, it doesn’t necessarily mean it will be easy to donate. In fact, sometimes the most common assets are more difficult to dedicate toward charitable purposes. This is particularly true for gifts of subchapter S corporations – even if the companies are successful and very valuable.
There are often liquidity and marketability problems. S corporations are also significantly regulated, which may make ownership and transfer challenging. Nonetheless, there are options for donors who wish to give these assets to charity. Even a planned giving vehicle which typically requires significant liquidity, such as a charitable gift annuity, will work with some ingenuity and additional creativity.
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Do Your Homework A brief discussion of the definitions, risks, and structure of these planned giving transactions may be useful. S corporations are the largest type of privately-held business entity. In fact, there are more S corps than C corps and LLCs combined. S corps usually have a very low adjusted tax basis in the shares, but also may have low cost basis assets (such as real estate) inside the entity which can also provide charitable giving opportunities. Since the S corp can appreciate significantly in value over time, it is an appealing donation for the charity and donor alike. The charity, of course, receives a valuable gift. The donor both avoids realizing capital gain and receives a charitable deduction.
For historical context, S corporations are closely-held businesses which meet certain IRS requirements, and in doing so, qualify for pass-through treatment. Beginning in 1998, Congress allowed charities to own interests in S corporations, whereas previously only individuals, estates, and certain trusts were permitted. This is particularly helpful since, as of 2018, over 4.8 million S corporations exist, with a proportionately small pool of owners – in 2016, less than eight million.
Gift Planning Options Charitable gift annuities (“CGAs”) are the primary planned giving vehicle this article focuses on. Unlike charitable trusts, CGAs are a contract between the donor and the charity, wherein the donor transfers some consideration (cash or otherwise) to the charity in exchange for an annuity. However, that CGA contract can be arranged in many ways. It can pay either a single person or couple for life, it can begin payments immediately or defer them until some future start date. These considerations all affect the value of the annuity, which in turn affects the allowable deduction.
Charitable remainder trusts (“CRTs”) are a common planned giving vehicle. They are a form of charitable trust where the donor-grantor transfers some asset into the trust. The trustee administers the CRT for the income beneficiary (usually the donor) and the remainder beneficiary (the charity). Once the income interest expires, usually after either a pre-determined term of years or the donor’s death, the charity receives the remaining trust assets.
S corporations offer some appealing options for planned giving, particularly considering their nature as closely-held businesses, usually having only one or two owners. This section outlines the risks, standard charitable mitigation tactics, and special techniques which merit consideration.
Charities holding S corporation interests can trigger UBTI (unrelated business taxable income) regulations in more than one way. First, they must report their share of income as UBTI for every day they own the interest, including passive investment income. Worse still, this income is taxable whether distributed to the charity or not. This all means that planned giving vehicles should usually liquidate their interests as soon as possible.
Additionally, when the charity sells appreciated S corporation stock, there is UBTI on all capital gain above the donor’s adjusted tax basis, and is taxed at corporate or trust rates. Remember that the charity will take the donor’s basis in the donated interest, and for S corporations, that is very often close to zero, meaning the value of the donated asset is entirely taxable for the charity!
Current laws do not even allow CRTs to hold S corporation stock. Further, “even if a charitable remainder trust could be an eligible shareholder, the UBIT from the S corporation could revoke the tax-exempt status of the trust.” 1 And this is in addition to there being a 100% tax on all UBIT within a CRT – it can receive donated S corporation assets, however. A serious practical concern with S corporation inter
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ests is marketability. The simple fact is that S corporations are always closely held, typically with not more than a few owners (they are legally limited to 100 shareholders). This means that the pool of potential buyers is often limited to an entity acquiring the entire business, the few other owners, or the S corporation itself (a redemption). Without a buyer, the charity will be holding an interest which literally may generate taxable income on a daily basis. For this reason, charities often will not accept S corporation gifts without a clear path to liquidity.
S corporations have exploded in popularity over the last twenty years. This means that there are many successful companies in S corporation form. Since appreciated stock is a great asset to contribute, S corporation shareholders should consider utilizing their appreciated stock for charitable giving. Although there are some limitations, it is nonetheless an excellent asset to give. A little bit of advance charitable and tax planning can yield a meaningful gift funded with S corporation stock, and significant tax benefits.
1 Hoyt, Christopher, “Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems,” Planned Giving Design Center, http://www.pgdc.com/pgdc/charitable-gifts-subchapter-s-stock-how-solve-practical-legal-problems.