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Introduction

Individuals who want to start a business have several options for structuring their enterprise. As individuals explore the various possibilities, they often weigh factors like tax implications, liability protection and potential for business growth. S corporations, for instance, offer distinct tax benefits with passthrough taxation as well as asset protection of a shareholder's personal assets from creditors seeking payment for business debts. With these financial benefits, many business owners choose to form an S corporation.

In this article series, we will discuss considerations for charitably-minded S corporation shareholders. The first installment will explore S corporation taxation, charitable gifts involving S corporations and transferring S corporation stock to supporting organizations. The next installment will examine the complexities of using a charitable remainder trust (CRT) with S corporation stock or assets. By gaining insight into the various options and tax consequences of using S corporations for charitable giving, advisors will be better equipped to guide their clients through the gifting process and help fulfill their goals and objectives.

S Corporation Taxation

An S corporation is a business structure that is commonly used by small businesses. An S corporation is limited to less than 100 shareholders. Sec. 1361. An S corporation is similar to C corporations, except that S corporations are taxed differently. If a business elects S corporation status, it does not pay tax at the corporate level like a C corporation. Instead, the shareholders of an S corporation must report their share of the S corporation's income, deductions and credits on the shareholders' personal income tax returns. As such, the taxation is passed through to the shareholders as the S corporation "passes" its income, deductions and credits "through" to its shareholders.

To have passthrough taxation, the shareholders of an S corporation may elect at the outset to have corporate income, losses, deductions and credits flow through to them using IRS Form 2553. As a separate entity, an S corporation will need to file an information return, IRS Form 1120-S, to report its income, gains, losses, deductions and credits. However, while the business owners must pay tax on their share of the S corporation's income (even if nothing is distributed to them), the benefit of making an S corporation election is that S corporations do not pay federal taxes at the corporate level. Because S corporations avoid double-taxation, many small businesses benefit from operating as an S corporation since the shareholders report the flow-through income and losses on their personal tax returns and will only be taxed once at their individual income tax rates.

Inside and Outside Basis

Normally, an individual's cost basis in an asset is equal to his or her investment in that asset. Essentially, the cost basis is the amount a person paid for an asset. With S corporations, there are two types of cost basis that must be accounted for by a shareholder. The first is the S corporation's basis in its asset which is often referred to as "inside basis." The second is the shareholder's basis in his or her S corporation stock which is referred to as "outside basis." The importance of basis has to do with the limitations on benefiting from a charitable gift. An S corporation shareholder can only use a charitable deduction up to the amount of outside basis in the S corporation. Sec. 1366(d)(1).

When an S corporation disposes of an asset, the gain or loss on the sale to the corporation is determined by the difference between the sales price and the inside basis in the asset, which is recognized by the shareholders. Similarly, when a shareholder disposes of S corporation stock, the gain or loss to the shareholder is determined by the difference between the sales price and the shareholder's outside basis in the stock.

It may be beneficial for an S corporation to make charitable contributions due to the passthrough nature of the charitable deduction and basis limitation rules. The S corporation as a donor can contribute assets, while an S corporation shareholder can only contribute S corporation shares to charity. The charitable deduction generated from the S corporation acting as the donor will adjust the shareholder's outside basis. Sec. 1367(a)(2). The outside basis adjustment will be reduced by the adjusted basis in the contributed property, rather than the value of the charitable deduction.

Charitable Gifts Involving S Corporations

There are charitable giving options available for S corporations and its shareholders. The first are gifts of corporate assets by the S corporation. Due to S corporations being passthrough entities, any deductions from charitable gifts will also flow through to the shareholders in proportion to their ownership interest. Another option available is for outright charitable gifts of S corporation stock by the shareholders. For a stock gift, the charitable deduction will be based on the fair market value of the stock but will be reduced if there is any ordinary income element attributable to the S corporation itself. Sec. 170(e)(1).

The IRS applies substantiation requirements which vary depending on the size of the gift. For example, gifts of noncash assets 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 noncash asset is valued at more than $5,000 a qualified appraisal is required. If the asset is a gift of closely held stock, then the value threshold for an appraisal increases to more than $10,000.

Example

Barry started a successful business 20 years ago that manufactures and sells running shoes. He and his business partner Allen own all the shares in the business, which is organized as an S corporation and valued at $3,000,000. Barry is approaching retirement age and is looking for a way to transfer his $2,000,000 interest to Allen and offset the taxable income from the sale with a charitable income tax deduction.

Barry contacted his professional advisor and asked about the possibility of selling $1,250,000 of his stock to Allen and donating the remaining stock to his favorite charity. Barry's advisor warned him that the transfer of $750,000 in S corporation stock to charity will not produce a full $750,000 charitable deduction but will be reduced by the ordinary income of the corporation. Barry learned that if the corporation were to sell its inventory, 15% of the amount realized would be ordinary income. Therefore, Barry's deduction would be reduced by 15% from the $750,000 fair market value to $637,500. Barry will also be limited in his ability to take the charitable deduction, up to his outside basis in the S corporation.

Charity as a S Corporation Shareholder

Tax exempt organizations under section 501(c)(3) are permitted to own stock of an S corporation. Sec. 1361(c)(6). However, ownership of S corporation stock does have its drawbacks. For example, a charity's entire share of income or loss from an S corporation is considered unrelated business income (UBI) that is subject to taxation to the charity. The UBI tax applies even if the income would not be taxable if the charity had earned it directly through rents or royalties. Similarly, when a charity disposes of its S corporation stock, the gain or loss on the sale is UBI subject to taxation. Sec. 512(e).

To help avoid these UBI issues, a charity has a few options available. The donor could explore a voluntary conversion of the S corporation into a C corporation prior to the gift of stock so that the stock would be subject to the rules governing C corporations. In general, a charity is not going to retain ownership of the stock following the gift. Instead, the charity will want to sell the stock which typically is sold to either a third party or back to the S corporation in a redemption transaction.

If an S corporation converts to a C corporation, a shareholder can contribute their resulting C corporation stock to a charity or CRT and receive a fair market value deduction for the value of the charitable gift. While conversion from an S corporation to a C corporation may facilitate stock gifts to CRTs, a C corporation faces its own challenges such as the income of C corporation being taxed twice. In addition, if after the conversion, the C corporation contributes assets outright to charity or to a CRT, any deduction generated is limited to 10% of the C corporation's taxable income. The C corporation conversion may not be a favorable option if there are other shareholders in the S corporation.

Since S corporations have a very limited market to sell the stock, an extended period of time may pass before a sale or redemption is possible. Given the limitation on marketability, it is vital that a donor does not enter into any binding agreement for the sale or redemption of the S corporation stock prior to the gift. If a binding obligation to sell the stock exists prior to the gift, prearranged sale rules prevent the donor from bypassing any gain on the gift and, instead, the donor will realize capital gain. As such, the donor and the charity should exercise caution when seeking potential buyers for the S corporation stock. The marketability and minority ownership issues will also impact the fair market value of the S corporation stock, which may be discounted significantly at the time of the qualified appraisal.

Subchapter S Stock to a Type I Supporting Organizations

There are three types of supporting organizations (SOs). Reg. 1.509(a)-4(i)(2). Type I affords the supported organization with the most control over the SO, while Type III offers the least. As such, Type III SOs are more heavily regulated.

A Type I SO has a "parent/subsidiary" relationship with the charity it supports. This relationship is established where the supported organization exercises a substantial degree of direction and control over the policies, programs and activities of the SO. Generally, this occurs where the supported organization elects or appoints the majority of the SO's officers, directors or trustees. Reg. 1.509(a)-4(g).

If a donor owns stock in a S corporation, they may plan to retire and sell the S corporation to a new buyer. The new buyer prefers an asset sale. The corporation has had a sub "S" election in effect for its entire existence. The donor plans to give 30% of the S corporation stock to a donor advised fund. The solution is to transfer 30% of the donor's stock to a charity prior to signing a binding agreement for sale. However, when the charity receives the stock and sells to a new buyer, there will be unrelated business taxable income. Sec. 512(e)(1).

At least four nonprofits have created Type I SOs to receive gifts of S corporation stock and reduce the UBI tax upon sale of the stock. The SO is usually a Nevada trust that is a Type I SO of a public charity. Because it is a charitable trust, it is not subject to the 3.8% net investment tax and Nevada has no state income tax on trusts. In addition, the Type I SO may have substantial charitable carryforwards that will offset 60% (50% after 2025) of the taxable gain on the asset sale. Therefore, the normal 20% federal capital gains tax for a trust is reduced to 8% (10% after 2025).

Conclusion

There are several charitable strategies that can be used when selling a business or transferring a business on to the next generation. Using outright gifts or CRUTs, S corporations and shareholders can align their objectives for exiting their business with their philanthropic efforts, all while realizing tax savings. By understanding the tax implications that come with S corporations and the tax benefits offered by charitable gift strategies, professional advisors will be well equipped to guide and support business owners through their wind-down process.