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. This installment will examine the complexities of using a charitable remainder trust (CRT) with S corporation stock or assets, unrelated business taxable income, prearranged sales and disqualified person rules. 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.

CRTs Funded with S Corporation Stock

Even though charities are permissible S corporation shareholders, split interest trusts, like a charitable remainder trust, are not. Sec. 1361(e). If a CRT is funded with S corporation stock, the S corporation will be disqualified and reclassified as a C corporation. An important aspect of S corporations is the single level of flow-through taxation. If the S corporation is reclassified as a C corporation, the corporation's income will now be taxed twice, once at the corporate level and once at the shareholder level.

If after weighing all options, the owner of an S corporation still prefers to donate the stock to a CRT, the shareholders would need to prepare themselves by discussing the tax implications of converting the S corporation into a C corporation. The corporation's financial advisor and legal counsel should be consulted to explain the consequences of the conversion, including the double taxation associated with C corporations.

Example

Diana creates a CRT and contributes her stock in Widgets Unlimited, an S corporation, to the CRT. As a result of her contribution of Widgets Unlimited stock to the CRT, Widgets Unlimited was disqualified as an S corporation and converted to a C corporation. The other shareholders of Widgets Unlimited are extremely unhappy with Diana for causing the S corporation to now be reclassified as a C corporation. As a result, the other shareholders of Widgets Unlimited will be taxed twice on the corporation's income.

S Corporation as Donor

S corporations can make charitable contributions as donors, with the charitable deduction passing through to the shareholders. S corporations can engage in outright gifts, bargain sales, charitable remainder trusts and charitable lead trusts.

From the donor and nonprofit's perspective, a gift of S corporate assets is typically favored. If the S corporation is the donor of corporate assets, the underlying asset will likely not be subject to discounting in the qualified appraisal. If the asset is a capital gain type asset, its value will not be impacted by other ordinary income assets that are retained by the S corporation.

CRTs Funded with S Corporation Assets

While S corporation stock cannot be used to fund a CRT, the assets of the S corporation may be transferred. With this strategy, instead of having a shareholder transfer S corporation stock to charity to fund a CRT, the S corporation itself contributes assets to a term of years CRT. The S corporation is entitled to a charitable deduction and because of the S corporation's passthrough nature, the deduction flows through to the shareholders.

While the deduction flows through to the shareholders, each shareholder is only able to use the deduction up to the extent of the outside cost basis in the S corporation shares. Sec. 1366(d)(1). As discussed earlier, S corporations have both an outside basis in the stock by the shareholders, as well as an inside basis in corporate assets. When appreciated assets are gifted by an S corporation, the deduction will flow through to the shareholders at fair market value. However, there is an adjustment in the shareholder's outside basis. Sec. 1367(a)(2). As such, the deduction will flow through, but the decrease in the shareholder's cost basis is equal to the adjusted basis of the gifted property to the S corporation.

CRTs and UBI Considerations

When an S corporation contributes assets to a CRT, there may be UBI if the income generated by the contributed assets is not considered passive income. If the contributed asset generates income that is not substantially related to the exercise of the charity's exempt purpose, then the charity will be subject to UBI. Newhall v. Commissioner; No. 95-70501 (9th Cir. 1997). Among the various exceptions to UBI are the receipt of fixed payouts of rent from real property and the fixed payment of royalties and lease returns. If payments are dependent on earnings and profits, then the trust income would be subject to UBI. Sec. 512(c).

In addition, an S corporation should not contribute substantially all its assets to a CRT. If an S corporation transfers all or substantially all its assets, then it must recognize gain or loss immediately before the transfer as if the corporation had sold the assets. Reg. 1.337(d)(4). In this case, there will be no bypass of capital gain and the recognition of the capital gain will occur.

What is considered "substantially all" is determined based on facts and circumstances. However, the IRS has generally held that the "substantially all" requirement is satisfied when assets representing at least 80% of the value of the corporation's net assets are transferred or the assets transferred represent at least 70% of the value of gross assets prior to transfer. Reg. 1.337(d)-4(a)(1). Advisors may feel comfortable with a limit on asset transfers from S corporations to between 50% and 60% of total S corporation asset value to help avoid the application of the "substantially all" rule.

Lease Options to Avoid UBI

When an S corporation creates a CRT with the entity's assets, there may be UBI generated. If the assets are used in a trade or business, UBI may be an issue that can be avoided with a fixed lease to a third party prior to making a charitable contribution of the asset. With a fixed rent lease in place prior to the charitable gift, all income received is deemed as passive income rather than active. Sec. 512(c). This will allow an S corporation to place the assets in a CRT and avoid UBI.

Example

Willy's Widgets, Inc. is an S corporation that uses its assets to conduct an active trade or business. Willy's Widgets, Inc. wants to contribute 20% of its assets to a CRT. To avoid the CRT's income from being considered UBI, Willy's Widgets, Inc. enters into a short-term net lease with Greg Gadgets whereby Greg Gadgets leases the assets that will be contributed to the CRT. When Willy's Widgets, Inc. contributes the assets to the CRT, the CRT's only income is fixed lease payments received from Greg Gadgets, which would be considered passive income instead of UBI.

Disqualified Persons and Self-Dealing Considerations

A CRT is prohibited from conducting business with any disqualified person. Sec. 4941. As such, if an S corporation decides to lease its assets and subsequently contributes its assets to a CRT, except for the incidental exception to Sec. 4941, the CRT should not receive lease payments from a disqualified person. Disqualified persons are determined by the facts and circumstances but will typically include the S corporation itself, anyone with more than 20% ownership of the S corporation, the CRT trustee or a family member of a disqualified person. Sec. 4946. As such, it is common to see a key employee of the S corporation, one who is not an officer or director of the S corporation or otherwise disqualified, as the person to lease assets from the S corporation.

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.