Post a Comment On: CPA at Law

Public charities have been permitted shareholders of S-Corporations since 1998. Since that time, charitably-inclined business owners have sought to donate shares of their closely-held business stock to charitable organizations. Normally, donating long-term capital gain property to a charity is highly tax efficient because (1) the donor receives a deduction for the fair market value of the donated asset, (2) the donor avoids paying tax on the asset's built-in gain, and (3) the charity, being tax-exempt, also avoids paying tax on any gain from the sale of the asset. In a previous post, I addressed some situations where the charity may some tax.

In the case of S-Corp stock, however, charities pay a lot of tax. Section 512(e)(1)(B)(ii) of the Internal Revenue Code requires that "any gain or loss on the disposition of the stock in the S corporation" is included in unrelated business taxable income (UBTI). Unlike the gain on "virtually every other asset that a charity might own," only the gain on the sale of S-Corp stock is includible in UBTI. See Christopher R. Hoyt, Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems. This is a significant issue because charities typically seek to sell closely-held business interests as quickly as possible, especially stock in S-Corporations.

However, different charities pay different rates of tax on sales of S-Corp stock. Specifically, charities that are trusts pay less tax on gains included in UBTI than do charities that are corporations. This is because trusts are taxed at trust rates, which impose a 20% rate on long-term capital gains, whereas all corporate income, including long-term capital gains, is taxed at corporate rates of around 35%. Moreover, a trust is able to deduct up to 50% of its adjusted gross income for donations to other charities, while corporations are limited to 10%.

This is what makes a Donor Advised Fund at a charity that (1) is a trust and (2) maximizes contributions to other charities, such as Fidelity Charitable, an attractive target for a gift of S-Corp stock. The legal structure of the charity reduces the tax erosion of the gift, while the donor still has the right to advise what organization will ultimately receive the proceeds from the stock sale. Below is a comparison of the post-tax benefits that a corporate charity and trust charity would enjoy from the donation and immediate sale of S-Corporation stock:

 Corporation   Trust   Gain from S-Corp. Shares   1,000,000   1,000,000   Maximum Charitable Deduction   (100,000)   (500,000)   Net Unrelated Business Taxable Income   900,000   500,000   Estimated Tax Rate   35%   20%   Unrelated Business Income Tax   315,000   100,000   Effective Tax Rate   31.5%   10%