S Corporations and Charities

S Corporations and Charities

S corporations and charities lie at the cross roads of advanced estate planning.  Most new wealth is generated through corporate structures.  Most corporations are S corporations.  Most advanced planning for the people who own such corporations will include a charitable component. The net effect is that working with both an S corporation and charitable planning is a common issue in high-end estate planning. The purpose of this article is to consider some of the typical issues that arise with S corporations and charities in the planning process.

Summary:  Can a person gift stock in an S corporation to Charity?  Generally yes, but there will be tax and accounting consequences for the charity.  To a Donor Advised Fund?  Such gifts are permitted by statute, but may or may not be acceptable to the charity because of the tax and accounting issues.  To a Charitable Remainder Trust?  No.  Can an S corporation make charitable gifts?  Yes.  Can an S corporation create a charitable trust?  Yes.

S Corporations

An S corporation is a “flow through” entity.  It does not pay taxes. Rather, the tax consequences of its business activities flow through to its shareholders.  The shareholders of an S corporation are limited in number and in type or kind.  In general, according to the IRS, to qualify as an S corporation, an entity must make an election using Form 2553 and meet the following criteria:

• Be a domestic corporation
• Have only allowable shareholders
  • May be individuals, certain trusts, and estates and
  • May not be partnerships, corporations or non-resident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

So what about charitable entities?

Charitable Remainder Trusts

A classic move to avoid capital gains tax when selling a highly appreciated business is to gift all or part of the business to a Charitable Remainder Trust (“CRT”).  The concept is relatively simple.  The incentives are significant.

• Lower Taxes.  A CRT may lower your taxes in 3 ways:
  • Charitable Deduction.  When you transfer an asset to a Charitable Remainder Trust, you are making a gift of the future remainder interest to Charity.  You get a charitable tax deduction for this gift.
  • Capital Gains Relief.  A Charitable Remainder Trust is a tax exempt trust.  It does not pay taxes.  So if the CRT is the seller of the highly appreciated asset, there is no capital gains.
  • Estate Tax Exclusion.  The CRT is excluded from your taxable estate at death because the remainder goes to Charity, not your heirs.
• More Income.  Under the Charitable Remainder Trust, the Grantor typically has a retained income interest.  In other words, they get the income.  This can be for a specific term or years, or for life.  Because of the tax savings (particularly the present deduction and the capital gains avoidance), money that would otherwise go to taxes is put to work generating income.  For example, if you sell an asset and pay 25% of its value in taxes, only 75% of its value is available to be invested to produce an income.  But if you sell the same asset and there are no taxes on the transaction, 100% of the value is available to generate income through investment.
• Support Charitable Intent.  When the Grantor dies, the remainder goes to charity.  You can name any qualified charity.  Many such organizations are willing and anxious to assist you in setting up a CRT naming them as the ultimate beneficiary.  My preference is to use a “Family Foundation” or Donor Advised Fund for the charitable beneficiary.  This gives the family an ongoing role in selecting ultimate charitable beneficiaries and in holding charities accountable.
• Leave a Legacy.  If you have no natural heirs (because there are no children, etc.), your Legacy will be in fulfilling your charitable mission.  What about when there are heirs?  If the CRT goes to charity at death, are the heirs short changed?  I have seen several approaches to this issue.  It ultimately comes down to the “how much is enough” question.  In very large estates, it may be that with lifetime and annual gift exclusions there is enough to provide for the heirs without anything further.  In other instances, this makes life insurance an attractive option to provide a guaranteed tax free benefit for the heirs.  This will typically be structured through an ILIT or an Irrevocable Dynasty Trust.

All this sounds great until the business being sold is an S corporation.  Then it gets complicated.

Tax Treatment of S Corporations owned by a Charity

Only certain types of entities qualify as shareholders of an S corporation.  If there is a disqualified shareholder, it terminates the S election.  Obviously, this can have significant tax consequences.

In the “good old days” (pre-1998), charities were simply not permitted as shareholders of an S corporation.  Transferring the shares of an S corporation to a tax exempt entity had the effect of terminating the S election with many unhappy tax consequences.  Under Section 1316 of the Small Business Job Protection Act of 1996, as of January 1, 1998, charities were permitted to own stock in an S corporation without terminating the election.  This means that under the law as it is today, the typical tax exempt charity under 501(c)3 of the tax code may own shares in an S corporation.

The ownership, however, is generally not going to be “tax free”.  S corporations generally don’t pay taxes.  The income and losses from an S corporation flow through to the shareholders.  When the shareholder is a charity, such income and losses flow through to the charity.  Assuming the business activity of the S corporation is not related to the charitable mission of the charity, the income will be treated as unrelated business income.  The “tax exempt” charity will pay taxes.  Consequently, although permitted, charitable ownership of shares in an S corporation may or may not be an attractive option for the charity.

In certain instances, using a Qualified Sub-Chapter S Trust (“QSST”) as an intermediary to pay the taxes and then make the gift to charity may result in reducing the UBIT so that less goes to taxes and more goes to the charity.

Tax Treatment of S Corporations Owned by a Charitable Remainder Trust

Charitable Remainder Trusts are NOT permitted shareholders of an S corporation.  [Rev. Ruling 92-48]  Transferring shares of an S corporation to a CRT terminates the S election.  Don’t do this.

Gifts of S Corporation Distributions to Charity

The shareholder in an S corporation may contribute any distributions from the S corporation to a CRT.  An S corporation can also make charitable contributions.  These do NOT avoid capital gain on the sale of an appreciated asset, but there is still an offsetting deduction against the income.

Gifts by an S Corporation to a Charitable Remainder Trust

While a CRT cannot own shares in an S corporation, an S corporation may be the Grantor and Beneficiary of a Charitable Remainder Trust.  It is important to note that the extent of the corporation’s assets gifted to the CRT has an impact on how the IRS will view the transaction.  If an S corporation conveys substantially all of its assets to such a CRT, it may have to recognize the fair market value gain or loss on the transfer as if the assets were sold prior to the transfer.