Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems

Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems

Article posted in Privately Held Business Interests on 13 July 1999| comments
audience: Partnership for Philanthropic Planning, National Publication | last updated: 15 September 2012
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Summary

Nearly half of the nation's corporations are classified as Subchapter S corporations. Prior to 1996, charitable organizations were not permitted to be shareholders of S corporation stock. However, with the enactment of The Small Business Job Protection Act of 1996, new opportunities have been created for small business owners to make gifts of what in many cases may be the most valuable asset they own.

by Christopher R. Hoyt

Introduction

Nearly half of the nation's corporations are classified as Subchapter S corporations under the tax laws.1 Until 1998, the tax laws prohibited a charity from owning any stock of an S corporation; thereby prohibiting charities from owning any part of the most common form of closely-held business in the nation. If a charity ever became a shareholder, the corporation immediately lost its S corporation status and was subject to many of the disadvantageous provisions of the general corporate income tax laws.

However, in 1996, Congress enacted The Small Business Job Protection Act Of 19962 and permitted a charity (but NOT a charitable remainder trust) to be an eligible shareholder of an S corporation beginning January 1, 1998. The good news is that this gives charities access to gifts of stock of many closely-held businesses that they couldn't previously own. It also provides an opportunity for many business owners to make charitable gifts of such stock. S corporation stock is frequently the most valuable asset owned and it is often the only asset that they can use for a major charitable gift.

The bad news from a charity's perspective is that every penny of a charity's income attributable to S corporation stock will be subject to the unrelated business income tax (UBIT). Even the gain from the sale of the S corporation stock will be subject to UBIT.

The primary tax concerns that both the donor and the charity should be aware of before a gift of S corporation stock is made are:

  • The donor's tax deduction will likely be less than the appraised value of the stock.3
  • The charity will be subject to UBIT on its portion of the S corporation's accounting income for every day that it owns the S corporation stock. If the business is profitable, the charity will need cash to pay the UBIT. The most likely source will be distributions from the S corporation.4
  • Unlike virtually every other asset that a charity might own, the gain from the sale of S corporation stock will be subject to UBIT.5
  • A charity that is a trust under state law will generally pay more UBIT on an S corporation's ordinary income than a charity that is a corporation. However, a charitable trust will generally pay less UBIT on a large long-term capital gain, such as from the sale of S corporation stock than a charitable corporation. To the extent that a charity consists of a combination of trusts and corporations (for example, a community foundation or a university with several supporting organizations), the charity should adopt a policy that S corporation stock will be contributed to the type of charitable organization that will pay the least amount of UBIT based on the anticipated income that will be generated from the S corporation stock.6

This article outlines the basic considerations that a donor and a charity should contemplate for a gift of S corporation stock. There will, of course, be additional nuances that could require further research of the law of S corporations or UBIT.7 The IRS might also issue guidance to answer some of the questions that are raised in this article, such as whether municipal bond interest is subject to UBIT and whether the "passive loss limitation" applies to charities. In the meantime, this article provides estate and charitable gift planners with a helpful analysis to assess gifts of S corporation stock in the brave new world introduced by the 1996 tax legislation.

What Is An S Corporation?

S Corporation Compared To C Corporation

The tax laws provide two alternative ways for taxing corporations. The general rule is that a corporation is subject to the corporate income tax under Subchapter C of the Internal Revenue Code (C corporation.)8 There is another option available to a corporation that has fewer than 76 shareholders: It can file an election with the IRS to be taxed under Subchapter S of the Internal Revenue Code (S corporation) provided that it meets the eligibility criteria.9

Except for three unusual situations, an S corporation does not pay income tax.10 Instead, the corporation's income is taxed directly to the shareholders.11 The principal advantage is that a shareholder can avoid the double taxation of income that often occurs with a C corporation.12

After the Tax Reform Act of 1986 made the tax treatment of S corporations more attractive than that of C corporations, small businesses embraced S corporations. Between 1986 and 1993, the annual growth rate of S corporations was 13% whereas the average annual decline of C corporations was 3.2%.13 The proliferation of S corporations has been so dramatic that they now constitute nearly 50% of all the corporations in the United States, an increase from just 24% in 1986.14

Despite the dramatic increase in the number of S corporations, they remain the domain of small business and therefore have only a small fraction of the assets and taxable income of the nation's corporations. Thus, despite constituting nearly 50% of the nation's corporations, they only earn 13.3% of all corporate income.15 Some interesting statistics are in Exhibit A.

EXHIBIT A
Statistics from 1993 S Corporation Income Tax Returns

Number of S Corporations and Shareholders Corporations 1,901,505 (48% of all U.S. corporations) Shareholders 4,500,309 Profits and Losses of S Corporations

Business Operations Net
Profits
Net
Losses
Total
       
Percentage of S corporations 59% 41% 100%
Dollar Amounts (in billions) $86.7 ($32.6) $54.1
 
Investment Income (in billions of dollars)
Interest
$5.2
Dividends
0.7
Net Capital Gains/Losses
4.0
Other general investments
0.4
 
Real Estate Rental
1.2
Other Rental
0.6
 
Total Investment Income
12.1
 
TOTALS CORPORATION INCOME $66.2


Assets of S Corporations Based on Number of Shareholders

Number of
Shareholders
S corporations
Number
Percent Average Assets
Per corporation
(your mileage may vary)
$457,960
(Average Net Worth:$130,910)
 
All Corps 1,901,505 100%
 
 
1 939,079 50% $ 287,330
2 578,793 31% $ 359,780
3 142,792 8% $ 679,130
4 to 10 180,827 10% $1,174,150
11 to 20 16,794 0.8% $2,874,670
Over 20 7,764 0.2% $7,764,400


SOURCE: "S corporation Returns," IRS Statistics of Income Bulletin, Amy Gill and Susan Wittmen, Spring, 1996, pp. 27-63, especially Table 1 (p.35), Table 3 (p. 53) and Table 4 (p. 62).



Legal Requirement To Be An S Corporation

A U.S. corporation can be treated as an S corporation if:
1) the corporation files an election to be classified as an S corporation with the IRS on Form 2553 that has been signed by every shareholder and
2) the corporation and each of its shareholders meet the eligibility criteria.16

Most U.S. corporations with 75 or fewer shareholders are eligible to be S corporations. A few are prohibited because of technical matters concerning the corporation's operations or its history that make it ineligible.17 The most common reason that a corporation might not qualify as an S corporation is if it has a shareholder that is not eligible to own S corporation stock. This is what prevented charities from owning such stock until 1998 and continues to prevent charitable remainder trusts and pooled income funds from becoming S corporation shareholders.

Charities, But Not CRTs, Are Eligible Shareholders

The statutes list the types of shareholders that are eligible to own stock of an S corporation.18 If an ineligible shareholder ever becomes a shareholder, then the S corporation loses its tax status on that day and becomes a C corporation.19 For example, a corporation will lose its S corporation tax status on the date that a corporation, partnership, or a charitable remainder trust becomes a shareholder because none of them is eligible to be a shareholder.20

The 1996 tax legislation added Section 501(c)(3) charities21 to the list of eligible shareholders.22 On its face this includes both public charities and private foundations. However, as a practical matter, private foundations will be prohibited from owning stock of most S corporations because of the Section 4943 excess business holdings tax. A solution for a donor who would like to have a private foundation hold the stock is to establish a Section 509(a)(3) supporting organization instead.23

By comparison, the 1996 tax legislation did not add charitable remainder trusts24 or pooled income funds25 to the list of eligible shareholders. An S corporation will lose its tax status on the date that such a trust becomes a shareholder and the corporation will thereafter be taxed under Subchapter C of the Internal Revenue Code.26 The only conventional form of deferred charitable giving that S corporation stock can be used for is a charitable gift annuity, since the charity (an eligible shareholder) will be the owner of the stock. 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.27

There is one type of relatively obscure trust that can own S corporation stock and can have a charity as a beneficiary: an "electing small business trust" (ESBT).28 A charitable remainder trust will not qualify as an ESBT29 even if it has lost its tax-exempt status.30 An ESBT has poor income tax treatment and charities probably should not recommend them to donors for the sole purpose of making a charitable gift.31

If a donor makes a mistake and transfers S corporation stock to a charitable remainder trust or a pooled income fund, it may be possible for the parties to reverse the transaction so that the corporation will be treated as never having lost its S corporation status. The parties should apply to the IRS for permission to ignore the error as an "inadvertent termination" and have the transaction retroactively undone.32

What Is UBIT? History And Policy

Although charities are generally exempt from paying income tax on revenue from their exempt function33 or from their investments,34 they must pay the unrelated business income tax on "unrelated business taxable income" (UBTI).35 The principal purpose of the UBIT is to put a tax-exempt organization on the same footing as a taxable organization when a profitable activity is not directly related to its charitable function. Congress was concerned that there might otherwise be unfair competition.36

Consequently, the first type of UBTI is from a regularly conducted trade or business that is not substantially related to a charitable organization's exempt purpose. For example, when a tax-exempt organization raises money by selling greeting cards, it could have a competitive advantage over a for-profit corporation that sells the same cards but has to pay income taxes on its profits.37

A second form of UBTI is from "debt-financed" income.38 Although charities generally do not pay tax on rental income, interest and dividends,39 these sources of income may be taxable if they are attributable to "debt-financed property": property that has an underlying mortgage or debt.40

UBIT Tax Rates: Corporate Versus Trust Tax Rates

The amount of UBIT that a charity pays depends on whether it is a trust or a corporation under state law.41 A charitable trust is subject to the worst income tax rates in the nation. Ordinary income is subject to the highest 39.6% marginal income tax rate once UBTI reaches just $8,350.42 By comparison, a trust's long-term capital gains are generally subject to only a 20% tax rate.43 All other charities, including state universities and the corporations they control are subject to the income tax rates imposed on for-profit C corporations.44 They are subject to lower tax rates than trusts. Income is not subject to the highest 39% marginal rate until UBTI reaches $100,000 and then the rate falls to 34% when UBTI exceeds $335,000.45 However, corporations do not get the benefit of paying a lower tax rate on long-term capital gains.46

A charity that consists of a combination of trusts and corporations (for example, a community foundation or a university with several supporting organizations) should adopt a policy that S corporation stock should be contributed to the type of charitable organization that will pay the least amount of UBIT based on the anticipated income that will be generated from the S corporation stock. If, for example, it appears likely that the charity will hold the stock for many years, a charitable corporation appears to be the better choice in order to pay less UBIT on the ordinary income. On the other hand, if it appears likely that the S corporation stock will be sold shortly after its contribution so that virtually all of the income attributable to the stock will be long-term capital gain then a trust may be the better choice.47 If a charity expects numerous gifts of S corporation stock, it might consider establishing a charitable trust or corporation (whichever is appropriate) to serve as a Section 509(a)(3) "supporting organization" to help reduce the UBIT tax.

From a tax policy perspective, although there may be reasons in the taxpaying sector of the economy for trusts to pay higher marginal income tax rates than corporations,48 there is no policy reason for charitable trusts to have to pay significantly more UBIT than charitable corporations. Section 511 should be reformed to establish a single set of tax rates for tax-exempt organizations. Those rates should be the same as the tax rates paid by corporations, since the purpose of UBIT is to put tax-exempt organizations on the same level playing field (and no worse) as their taxpaying business counterparts, who are generally corporations. However, an argument can be made that charities should be allowed to pay a reduced tax on the long-term capital gain from the sale of S corporation stock that would correspond to the amount that the government would have collected if other shareholders of the S corporation (usually individuals and definitely not corporations) had sold the stock.49

Application To Partnerships, Limited Partnerships And Limited Liability Companies

Although a charity might view an investment in a partnership as similar to any other kind of investment, the income tax laws view the investment as a charity's indirect participation in an unrelated commercial enterprise: the partnership's underlying business activities.50 Although the statute does not directly address Limited Liability Companies (LLCs), the same rules apply to LLCs that are treated for tax purposes as partnerships.51

Only the charity's share of the income attributable to partnership's or LLCs' unrelated commercial activities is subject to UBIT. A charity does not pay any tax on its share of partnership income from passive investments, such as interest, dividends and capital gains.52

UBIT Imposed On Tax Income From S Corporations

The tax laws treat a charity's share of income from an S corporation very differently from a partnership or an LLC. The 1996 tax legislation makes a charity subject to UBIT on its share of all income attributable to an S corporation, including sources that are traditionally tax-exempt to charities, such as interest, dividends, rents and capital gains.53 Even the gain from the charity's sale of the S corporation stock is taxable.54 Congress concluded that this treatment was appropriate in light of the history of granting S corporations exemption from the conventional corporation income tax.55

A charity will be taxed on its share of an S corporation's accounting income rather than the corporation's cash distributions. Exhibit B contains an illustration of how a charity reports a different amount of income from an S corporation than from a comparable partnership as well as how a charitable trust pays a different amount of UBIT than a charitable corporation. The technical rules are described in detail later in this article.

Exhibit B

Example of how income from an S corporation is treated differently from comparable income from a partnership; how charitable trusts pay more UBIT than charitable corporations.

Example: Public Charity received a bequest of 100% ownership of "Business Enterprise" on January 1. During the year the organization had $150,000 profits from operating a hardware store, $10,000 of interest income and $10,000 of long-term capital gain. During the year it distributed $80,000 cash to its owner: Public Charity.

The following amounts of income tax will be paid to the IRS by either Business Enterprise or by Public Charity depending upon whether Business Enterprise is either a C corporation, an S corporation, or an LLC/limited partnership/general partnership:

Tax Paid by Business
  C corporation S corporation LLC/Partnership[1]
Taxable Income
to Business Enterp.
$170,000 $170,000 $170,000
Business Enterp's Tax
(only if a C Corp)
$50,000 None None
 
Tax Paid by Charity
UBTI to
Public Charity
C corporation S corporation LLC/Partnership
None[2] $170,000 $150,000[3]
 
UBIT tax varies;
depends upon whether
Public Charity is a:
Corporation None $50,000 $42,000
Trust None $65,000[4] $58,5004
 
Total Tax Paid by Business and Charity
  C corporation S corporation LLC/Partnership
Business Enterprise
Public Charity:
Corporation
$50,000 None None
  None $50,000 $42,000
Trust None $65,000 $58,500
TOTAL $50,000 $50,000 $42,000
    or
$65,000
or
$58,500
1 Technically, there must be at least two owners for a business or LLC to be treated as a partnership for income tax purposes. See Reg. Section 1.7701-1 to 3 (as amended to January 1, 1997 by T.D. 8697, 61 F.R. 66584 [Dec. 18, 1996].

However, for purposes of comparing partnership and S corporation tax treatment, this example assumes that all of the partnership's or LLC's income is allocated to the charity.

2 Dividends that a tax-exempt organization receives from a C corporation are exempt from UBIT. Section 512(b)(1). Cash distributions that a tax-exempt organization receives from an S corporation or an LLC/partnership are also generally exempt from UBIT because the owner has already paid tax on its share of the organization's accounting income. Section 731(a).

3 Only the unrelated business activities of a partnership are subject to UBIT. A charity's share of a partnership's investment income is generally not subject to UBIT since it is not an unrelated activity (the principal exception is debt-financed investment income). Section 512(c); Reg. Section 1.512(c)-1. By comparison, all of the income attributable to an S corporation is subject to UBIT, including the S corporation's investment income. Section 512(e)(1)(B)(i).

4 Trusts are subject to the highest marginal tax rate of 39.6% on most income except for long-term capital gains that are subject to a 20% tax rate. See supra n. 42. By comparison, corporations pay lower marginal tax rates on ordinary income but do not pay a different tax rate on long-term capital gains. See supra n. 45. There is an issue as to whether a charitable trust's share of an S corporation's long-term capital gain will qualify for the 20% tax rate or not. See supra n.110.



Donor's Perspective: Making A Gift Of S Corporation Stock

A donor must first determine whether he or she is willing to give S corporation stock to a charity. The donor will go through many of the same considerations that he or she would have for a gift of an ownership interest in any type of closely-held business. For example, will the donor be comfortable with a charity having the legal rights of a minority shareholder of a corporation? Is the stock subject to a transfer restriction that prevents the charity from selling or giving the stock to another party without the shareholder's approval?56

In order to receive an income tax deduction, the donor will need to receive a "contemporaneous written acknowledgment" from the charity that contains the language necessary to sustain a charitable tax deduction.57 In addition, if the stock is worth more than $10,000, the donor must obtain a "qualified appraisal" and file IRS Form 8283 with his or her income tax return.58 If the charity sells or disposes of the stock within two years of receipt, it is required to notify both the IRS and the donor of the sales price on Form 8282.59

The donor needs to be aware that the income tax deduction will usually be less than the appraised value. By way of background, the income tax deduction for a gift of appreciated property must generally be reduced by the amount of "ordinary income" that the donor would have had if the donor had sold the property.60 The rule generally does not apply to assets that, if sold, would produce a long-term capital gain.61 That is why wealthy donors generally favor gifts of appreciated stock and real estate: They can deduct the full appreciated value without recognizing any taxable income from the growth in value over time.62 If a gift consists of both long-term capital gain and ordinary income property then the deduction is only partially reduced to reflect the ordinary income component (Exhibit C).

Since the profitable sale of S corporation stock usually produces a 100% long-term capital gain,63 most donors would assume that they can deduct the entire appraised value of the stock. However, the tax laws provide that the income tax deduction for a charitable gift of S corporation stock should be reduced under rules that are analogous to charitable gifts of partnership interests.64 Thus, if the rental property in Exhibit C was owned by an S corporation, the donor who gave the S corporation stock to a charity would have to reduce his or her income tax deduction by the proportion of the gain that would be treated as ordinary income if the underlying assets of the corporation had been sold.

This reduction only applies to income tax deductions. By comparison, if the same stock is left to a charity as a bequest at death, the donor could deduct the full fair market value of the stock as an estate tax charitable deduction.65

It may be possible to avoid a reduced deduction by having the donor terminate the S corporation status shortly before making the gift of stock. For example, a donor who owns an S corporation might be negotiating to sell the business to a large corporation. In the past, the usual strategy was for the donor to make a gift of the stock before the sales negotiations were complete and then for the charity and the donor to sell their stock to the buyer. Normally this is a desirable tactic to avoid having the gain from the sale of the charity's stock taxed to the donor.66 If this is done with S corporation stock, then 1) the donor will receive a reduced income tax deduction because the gift is S corporation stock,67 and 2) the charity must pay UBIT on the gain from the sale.68

Is there a better approach? Yes. The large corporation that will buy the stock is not eligible to be an S corporation shareholder. The sale will therefore cause the corporation to lose its S corporation status.69 If the donor is reasonably certain that the corporation will be sold in the near future, the donor and the charity would both be better off if the corporation terminated its S corporation status and became a C corporation before the charitable gift is made.70 The donor could then deduct the full appraised value of the stock and the charity would not have any UBIT upon its sale. Would the IRS attempt to apply the "step transaction" doctrine to prevent this result?71 It probably depends upon the facts.

EXHIBIT C

The income tax deduction for charitable gifts of appreciated stock or real estate is reduced for the "ordinary income" component of the charitable gift but not for the "long-term capital gain" portion. Example: Assume that a donor acquired rental property 10 years ago for $200,000 and claimed straight-line depreciation on the building and equipment. The property currently has the following tax basis and appraised values (all numbers are in thousands):
  TAX BASIS   APPRAISED
VALUE
GAIN
IF SOLD
  Original
Cost
Tax
Depreciation
Basis    
Land 70 -0- 70 141 71(Long-term CG)
Building 120 (40) 80 150 70 (Long-term CG)
Equipment 10 ( 8) 2 9 7 (Depreciation Recapture)
Total $200 $(48) $152 $300 $148
The donor's tax deduction would be $293,000 ($300,000 market value reduced by the $7,000 of depreciation recapture that would have been treated as ordinary income if the property had been sold).72


Charity's Perspective: Accepting A Gift Of S Corporation Stock Nontax Issues: The Underlying Economics

Whereas charities readily accept gifts of marketable stock, they will likely treat offers of S corporation stock similarly to how they deal with offers of real estate. Just as each parcel of real estate is unique, each S corporation is a separate business whose success or failure depends primarily upon the management skills of the corporation's directors and shareholders. Although owning S corporation stock does not pose the maintenance responsibilities of real estate, a charity could have additional bookkeeping and UBIT burdens from owning and selling the stock.

The crucial issue is whether the stock looks like an attractive investment in light of the potential burdens that owning the stock could impose. How soon can the stock be sold and converted into productive marketable investments? If the stock will be held for a period of time, will it produce net cash flow (after paying applicable UBIT) that can be used for charitable purposes? The UBIT consequences, although important, will generally be secondary to the basic economics of the transaction. The fundamental tax and nontax issues are outlined in Exhibit D.

As a general rule, charities prefer to sell interests in closely-held businesses that have been contributed to them. These assets do not conform to a charity's overall investment philosophy. Stock of an S corporation will not be an exception to this basic policy; a charity will usually want to sell it. The imposition of UBIT is likely to make a charity even more eager to sell S corporation stock.

However, many donors may expect the charity to hold the stock for a long period of time. A charity has a very restricted market for selling the contributed stock. The potential buyers usually consist of only the corporation, existing shareholders or purchasers who have been pre-approved by the existing shareholders. Since a charity will usually be a minority shareholder--an outsider--it will have to rely on the controlling shareholders to treat it fairly.

Consequently, a charity should not accept S corporation stock unless it is reasonably satisfied that there will not be any material financial problems from holding the stock. Usually a charity has no liability for the underlying business liabilities of a corporation since shareholders cannot be held personally liable for a corporation's debts.73 Instead, the largest potential source of problems comes from the UBIT that may be generated from the S corporation's income while the charity holds the stock and from the gain when it sells the stock.

A charity should, therefore, be assured that the S corporation will distribute cash at such times and in sufficient amounts to pay the quarterly UBIT tax installments as they become due. The charity should also satisfy itself that the controlling shareholder-employees will not engage in practices that could hurt the minority-shareholder charity.74 If the stock will be sold several years after the contribution, the charity should be assured that it is receiving a fair price for the stock through, for example, an appraisal at the time of the sale.

If the S corporation stock will be accepted, another important determination is whether the donor will receive reduced credit for the gift since S corporation stock carries a UBIT burden that most other gifts do not. For example, assume that a donor will contribute stock that has been appraised at $100,000 but will trigger a UBIT liability upon sale of $20,000, leaving the charity with $80,000 of after-tax proceeds. If the donor is contributing the stock for a major campaign, should the donor receive credit for a $100,000 gift or an $80,000 gift? Of much greater significance is if the donor will receive a charitable gift annuity in exchange for the stock. Should the annuity be based on the $100,000 appraised value or the $80,000 of after-tax proceeds? Since only $80,000 will be left to pay the annuity, the after-tax amount is probably the wiser choice.75

Before accepting its first gift of S corporation stock, a charity should also examine whether there will be any problems under state law with owning such stock. In most states there should not be any difficulty, but the issue is worth investigating. The Pennsylvania legislature, for example, had to amend its statutes in 1997 so that charities could own stock of Pennsylvania S corporations in 1998.76

Exhibit D

Checklist for a charity when it is offered a gift of S corporation stock A. Charitable Purpose. If donor intends to make a restricted gift (e.g., scholarships only, endowment only), are the donor's charitable purposes acceptable? B. Stock as an Investment.
1. What is the nature of the business and its prospects for profitability?

2. What is the stock worth?

3. When will the charity likely sell it?

4. During the time that the charity will own the stock, what is the expected after-tax cash flow from the stock? The after-tax cash flow will be the cash distributions from the S corporation minus the UBIT.
C. Should Donor's Recognition or Benefits be Adjusted for Anticipated UBIT?
1. Should donor get credit in a major campaign for the full-appraised value of the stock or only for the anticipated net amount after UBIT?

2. If a charitable gift annuity will be issued, should the payments be reduced since there will be less cash after the stock's sale because of the UBIT?
D. State Law Issues.
1. Can charity own stock under state law?

2. Is there a state UBIT?
E. UBIT Concerns.
1. Will the gift be made to a charitable trust or an incorporated charity? If a charity has a choice, determine which type of entity will pay the least amount of UBIT.
2. What is donor's adjusted tax basis in the stock? If donor does not know, the basis might be estimated by looking at the balance sheet of the corporation's income tax return.
Donor's tax basis is important because it:
  • Affects the gain or loss upon the sale of stock.
  • Affects whether cash distributions from S corporation are taxable or tax-free.
  • Affects whether an S corporation's losses will be deductible or not.
3. What is the projected taxable income or losses of the corporation? How much UBIT will the charity have to pay while it holds the stock? Examine the Schedule K-1 that the donor received from the S corporation. 4. What are the projected cash and property distributions to the charity? See Line 20 of Schedule K-1.
  • Expected Amounts?
    Sufficient to pay UBIT?
    Any extra for charitable purposes?
  • Distributions taxable or tax-free?
  • Timing of distributions to meet quarterly UBIT payments when due?
  • Property distributions? A distribution of appreciated property could trigger tax. Are any such distributions planned in the near future?
5. Will charity have to file UBIT Form 990-T return (required if gross UBTI is over $1,000)? 6. Will charity have to make quarterly UBIT estimated tax payments (required if tax due for any year over $500)?
F. Administrative Requirements If Gift Is Accepted.
1. Charity must sign donor's Form 8283 ("qualified appraisal") to acknowledge receipt of gift of stock. The donor should be aware that unlike gifts of other kinds of stock, the tax deduction for a gift of S corporation will often be less than the appraised value of the stock. 2. Charity should send donor a "contemporaneous written acknowledgment" that contains the language necessary for the donor to claim a charitable income tax deduction.
G. Sale of Stock.
1. Obtain evidence that the stock is being sold for its fair value (e.g., a recent appraisal). 2. Send Form 8282 to the IRS and to the donor if property is sold within two years of receipt. 3. Charity must pay UBIT on the gain from the sale of S corporation stock.

UBIT Issues

Accepting The Stock: The greatest potential burden that owning and selling S corporation stock poses to a charity is paying UBIT. Except for UBIT, there are generally no liabilities or risks associated with owning S corporation stock.

Will There Be UBIT Returns Or Payments?: A charity should first determine whether it will have to file a UBIT return (Form 990-T) and whether it will have to pay quarterly estimates (Form 990-W). If the income from the corporation is minimal or negative, there may not be a problem. Generally, no return is needed if gross UBTI is under $1,00077 and estimates are not required if the total UBIT liability for the year is less than $500.78 A charity can usually make this determination by asking questions of the donor and by examining the Schedules K-1 that the S corporation issued to the donor over the past few years. If UBIT is due, a charity must make quarterly estimates or it will be subject to penalties.79

What Is The Tax Basis Of The Stock?: If the gift will be accepted, the charity should learn the donor's adjusted basis of the stock since it will affect the amount of the taxable gain that the charity will have upon the stock's sale.80 If the donor does not currently know the amount, the basis might be estimated by looking at the balance sheet of the corporation's income tax return.81 A low tax basis could lead to complications.82

Administrative Requirements: The charity will have to send a contemporary written acknowledgment to the donor in order to sustain a charitable income tax deduction. The donor will need to have an appraisal if the stock is worth $10,000 or more and the charity will have to sign the appraisal to acknowledge receipt of the property.83 If the property is sold within two years of receipt, the charity will have to notify the IRS and the donor of the details on IRS Form 8282.84

Holding The Stock

Generally the income of an S corporation is allocated to each shareholder in proportion to the number of shares owned by that shareholder.85 If a shareholder acquires or disposes of S corporation stock during the year then the shareholder will be taxed on a fraction of the year's income based on the number of days that the shareholder owned the stock that year.86

UBIT consists of the charity's share of the accounting income that is shown on the shareholder's Schedule K-1 that the corporation attaches to its income tax return (Form 1120-S). The accounting income is rarely the same as the cash distributions that the charity receives from the S corporation. For example, the Schedule K-1 could show UBTI of $60,400 but cash distributions of only $39,250.87 It is very common for an S corporation to retain part of its profits to reinvest in a growing business. With rare exception, the cash distributions that the charity receives from the S corporation will be tax exempt since the tax is levied on the accounting income instead.88

To the extent that UBIT cannot be avoided,89 a charity's primary concern is that there be sufficient cash available to pay the tax as it comes due, usually in quarterly estimated tax payments. A charity should examine the Schedule K-1s that the donor received for the past few years to match the taxable accounting income with the amount of cash distributions reported on Line 20 of that schedule. Even though most S corporations distribute sufficient cash to their shareholders for them to pay their income tax liabilities attributable to the income, a charity should specifically address this issue before it accepts a gift of S corporation stock. A charity should avoid accepting stock of an S corporation that is like a "burned out" partnership tax shelter with lots of accounting income and few cash distributions to pay the UBIT.

Selling The Stock

When the stock is sold, the charity will want adequate assurance that it is selling the stock for a fair price. Sales near the time of the gift can usually be done for at or near the appraised value of the stock. If the sale will be years in the future, the original appraisal will be out of date and the charity will need some other assurance that the price is adequate.

Unlike most other assets, the gain from the sale of S corporation stock is subject to UBIT to a charity.90 The good news is that the amount of the gain from the sale of S corporation stock is usually much less than that from comparable C corporation stock. This is because the basis of S corporation stock is usually increased by the amount of corporate profits that were retained by the S corporation.91

Example: Ten years ago Mr. C paid $100,000 to purchase all of the stock of C corporation and Ms. S paid $100,000 to purchase all of the stock of S corporation. C corporation was taxed under Subchapter C of the Internal Revenue Code and S corporation was taxed under Subchapter S.

Over the past 10 years each corporation had $1,000,000 of profits. C corporation paid $300,000 of corporate income tax and kept the remaining $700,000. Similarly, S corporation kept $700,000 and distributed $300,000 to shareholder S so she could pay the income tax attributable to the $1,000,000 of S corporation income that was taxed on her individual income tax return.

Each shareholder is about to sell each corporation for $900,000. Mr. C will have a taxable gain of $800,000 ($900,000 sale price minus $100,000 original cost). Ms. S, by comparison, will have a taxable gain of only $100,000 since she was able to increase her basis in her stock by $700,000 (the $1,000,000 taxed to her reduced by the $300,000 that was distributed to her).92

Specific Situations: When Are Cash And Property Distributions Taxed As UBTI?

With only a few exceptions, a shareholder--including a charity--does not pay any income tax on the distributions that it receives from an S corporation.93 A good analogy is a conventional savings account. A person pays income tax only on the interest that is added to the account. There is no income tax on cash withdrawn from the account since a person is only receiving amounts that had already been taxed. Similarly with an S corporation, partnership or an LLC, a shareholder or partner--including a charity--is generally taxed only on his, her, or its share of the business' income. Distributions of cash and property are generally tax free.

There are, however, three situations where a distribution from an S corporation could be taxable. First, if a distribution is greater than the basis of the stock, then the excess is taxable as a capital gain.94 Second, if the S corporation had ever been a C corporation, a distribution of accumulated profits attributable to the C corporation years could be a taxable dividend to taxpaying shareholders but it is probably not taxable as UBTI to a tax-exempt shareholder in the year paid.95 However, a tax-exempt shareholder that purchased S corporation stock may have to ultimately pay tax on such a distribution in the year the stock is sold since the distribution reduces the basis of the stock.96

The third and most serious situation is if the S corporation distributes appreciated property, such as real estate, to its shareholders. Such a distribution can trigger taxable income, regardless of whether it is distributed as an ongoing distribution or upon liquidation.97 This could pose a burden to all shareholders, including charities, since they will have to spend cash to pay the tax when all that they might have received is illiquid property.

For example, assume that an S corporation purchased real estate 10 years ago for $100,000. It is now worth $300,000. If it distributes the property to its shareholders, the S corporation must recognize a $200,000 gain as if it had sold the property.98 Each shareholder will have to recognize a proportionate share of the S corporation's gain as taxable income and will have to use cash from other sources to pay the income tax or UBIT.

Low Basis Of S Corporation Stock Can Cause Problems

If a donor has a low basis in his or her S corporation stock, it increases the likelihood of two potential problems. The first is that a distribution from the corporation might be taxable since distributions in excess of basis are taxable.99 The second is that if the S corporation has losses instead of profits, the charity might not be able to deduct the entire amount of the losses. The loss deduction is limited to the charity's basis in the stock and any unused loss is carried forward to future years.100 This could be a problem if the charity owns interests in other S corporations or partnerships that generate UBTI and the charity would like to apply the losses against its UBTI to reduce the UBIT liability. Finally, a low basis means a potentially higher gain from the sale of the S corporation stock that will trigger a larger amount of UBIT.

Tax Issues For S Corporation With Losses

If the S corporation has losses, the first complication is whether all of the losses can be deducted (please see the previous paragraph). The second issue is whether the "passive loss limitation"101 applies to prevent a charity from deducting an S corporation's operating losses against the corporation's interest, dividend and other "portfolio income."102 There is an argument that the passive loss limitation does not apply to UBIT, but it would be helpful if the IRS would clarify the situation.103

Is Municipal Bond Interest Subject To UBIT?

Since interest paid on state and local government bonds is normally tax-exempt to individuals on their federal income tax returns,104 many partnerships and S corporations invest in such bonds. However, since UBIT is computed without reference to regular income tax statutes105 and since the UBIT statute requires a tax-exempt organization to treat all income attributable to an S corporation as UBTI,106 an S corporation's municipal bond interest might be subject to UBIT.

Can An S Corporation's Charitable Contributions Reduce UBIT?

When a charity directly engages in an unrelated business that generates UBTI (for example, selling calendars), it can claim a charitable deduction on Line 20 of Form 990-T if the profits are given to an unrelated charity. The deduction is subject to different rules depending upon whether the charity is a trust or a corporation.107

Will an S corporation's charitable gifts be deducted in the same manner?108 In addition, is there any reduction in the benefit of the charitable gifts if the S corporation makes a gift to the charity that owns some of its stock? There probably is a problem if the S corporation is a subsidiary of the charity,109 but what happens if the charity owns, for example, less than 10% of the stock? Guidance from the IRS would be helpful.

Does S Corporation Income Keep Or Lose Its Character For UBIT?

The three preceding issues are related to an important issue: does S corporation income keep or lose its character for UBIT? The issue is most important for charitable trusts since they might be able to pay only a 20% tax rate on long-term capital gains instead of a 39.6% tax rate if an S corporation's long-term capital gains keep their character and rather than being reclassified as ordinary income.110

By way of background, Section 1366(b) provides that the character of a shareholder's pro rata share of income of an S corporation under Section 1366(a) shall be determined as if the shareholder had directly engaged in the transaction. This means that the characteristics of different forms of income pass through to the shareholder. For example, an individual will report the profits from the S corporation's business operations on Schedule E, the corporation's interest on Schedule B, the long-term capital gain on Schedule D, the charitable deductions on Schedule A and so on. The individual therefore obtains the benefit of lower long-term capital gains rates from the corporation's capital gains. Similarly, the individual's ability to deduct the corporation's charitable deductions may be restricted based on the taxpayer's own charitable gifts.111

The law is not clear whether these principles carry over to a charity that owns S corporation stock. The complication arises from the fact that the S corporation UBIT statute only refers to Section 1366(a).112 Does the statute's omission of any reference to Section 1366(b) mean that the character of the income does not pass through? The problem can best be illustrated with an example from Schedule K-1.

The following reflects amounts of income, deductions and credits on a sample Schedule K-1:

Line Description Amount
1 Ordinary income--business operations $53,550
4a Interest 1,800
4b Dividends 7,200
4e Long-term capital gain $10,000
7 Charitable contributions (10,800)
11a Interest expense on investment debts ( 1,350)
  Net Accounting Income  
  (excluding municipal bond interest113) $60,400
  Other Information  
13 Credits $ 2,700
17 Municipal bond interest income 2,250
19 Nondeductible business expenses114 (7,358)
20 Cash distributions to shareholder $39,250


When the charity fills out its Form 990-T, does it simply put the figure of $60,400 as a single entry on the tax return to reflect its total net income from the S corporation? This appears similar to the current treatment for partnerships where a single figure is entered on line 5 of the Form 990-T. Or instead, will the charity break down the S corporation information into its components? For example, will it report the S corporation's charitable contribution deduction of $10,800 on line 20, the long-term capital gain of $10,000 on line 4 and the remaining net income of $61,200 on the line for S corporation income? Guidance from the IRS is extremely important since charitable trusts will pay a different amount of UBIT depending upon whether the S corporation's long-term capital gain keeps its character or is instead treated as ordinary income.

The closest comparable law is that of partnerships and it is of little help. The instructions to Form 990-T suggest that all partnership UBTI is condensed to a single line reflecting net partnership income. This may not have posed much of a problem in the past since charities only paid UBIT on the portion of a partnership's income that came from an unrelated commercial activity. A partnership's investment income is exempt from UBIT.115 The consequences can be different for income from an S corporation because its investment income is subject to UBIT.

What If Charity And S Corporation Have Different Fiscal Years?

Most S corporations are required to use the calendar year to coincide with the tax years of their shareholders, which are usually individuals.116 What happens if the charity has a different fiscal year-end, such as January 31? Until there is guidance for S corporations, probably the safest strategy is to conform to the rules that tax-exempt organizations use for reporting income from a partnership that has a different fiscal year. They include in income the amount shown on the partnership's Schedule K-1 that is dated within their own fiscal year.117

Example: Public Charity has owned 10% of S corporation stock since the beginning of 1998. Public Charity received a Schedule K-1 dated Dec. 31, 1998 showing $12,000 of income earned during calendar year 1998 and another Schedule K-1 dated Dec. 31, 1999 showing $24,000 of income earned during calendar year 1999. Public Charity has a fiscal year-end of June 30. On its UBIT return for June 30, 1999, Public Charity should report $12,000 of UBTI, since that is the amount shown on the only Schedule K-1 that was dated between July 1, 1998 and June 30, 1999. It should not attempt to allocate the profits to the months that the corporation earned them in 1998 and 1999.

Tax Issues If S Corporation Was Once A C Corporation

Since an eligible C corporation with fewer than 76 shareholders can easily convert to an S corporation by filing an election, Congress enacted a series of special rules to prevent converted C corporations from completely escaping some of the taxes that would otherwise have applied to them. Problems can therefore arise if an S corporation that was once a C corporation: 1) sells property that it owned at the time of the switch within 10 years of the conversion,118 2) invests large portions of its assets in passive investments, such as real estate and stocks,119 3) had LIFO inventories at the time of the conversion,120 or 4) distributes dividends attributable to its C corporation years.121

Private Foundation As An S Corporation Shareholder

Although the S corporation statutes permit a private foundation to own S corporation stock,122 most will be discouraged from owning such stock because of the private foundation excise tax on excess business holdings.123 To the extent that a private foundation can hold such stock, it will not be liable for the 2% private foundation excise tax on investment income since the S corporation income is subject to UBIT instead.

A solution for a donor who would like to have a private foundation hold the stock is to establish a Section 509(a)(3) "supporting organization." The IRS has been fairly generous in letting donors establish supporting organizations for the express purpose of avoiding the excess business holdings tax.124

Inadvertent Termination Of S Corporation Status

Since S corporations were designed for small business, Congress recognized that some taxpayers might make mistakes with some of the technical requirements. Congress instructed the IRS to forgive "inadvertent terminations" and "invalid elections" of S corporation status if the IRS found that there were innocent mistakes.125 The IRS has been fairly lenient and forgiving.126

To qualify for inadvertent termination relief, the disqualifying transaction should be undone and the taxpayers returned to their original position. Inadvertent termination treatment might be an appropriate remedy if, for example, S corporation stock was mistakenly contributed to a charity's pooled income fund, which is an ineligible S corporation shareholder.127 Otherwise, the general rule is that a corporation that has lost its S corporation status is ineligible to re-elect S corporation status for at least five years after the status was terminated.128

What Happens If, While A Charity Owns Stock, An S Corporation Switches To Become A C Corporation Or Vice-Versa?

A corporation can have its S corporation status voluntarily or involuntarily revoked.129 What happens to a charity if this occurs while it owns such stock? Presumably it would have to report as UBTI its share of the S corporation's income until the date of revocation. The converse should be true if it owned stock of a C corporation that converted into an S corporation: The charity would begin to recognize UBTI on the first date of S corporation status. If a charity is a shareholder at the time of the conversion, a C corporation will not be able to switch to an S corporation unless the charity gives its consent by signing the election on Form 2553.

The much more complicated issue concerns what happens to the gain on the sale of the stock. For example, suppose a donor contributed S corporation stock to a charity in the year 1998, the corporation switched to C corporation status in the year 2000 and the charity sells the stock in the year 2004. Is some, none, or all of the gain subject to UBIT? There is, of course, no guidance at this time. Does the installment sales method apply when a charity sells its S corporation stock in exchange for the buyer's promissory note?130

Other S Corporation And UBIT Issues

There are many other legal issues that exist when a charity owns S corporation stock. Legal advisors can find answers to some of the questions in publications pertaining to S corporations and UBIT.131 However, the interaction of the laws of S corporations and UBIT pose many unique and unanswered legal issues that will be best resolved when the IRS issues guidance that is directly on point.

Conclusion

The ability of charities to own S corporation stock opens the door to letting charities participate in the most common form of small business. Charities and donors should first focus on the fundamental economics of a possible gift before they wrestle with the UBIT issues. If the transaction does not benefit the charity, the gift should not be accepted.

Although many transactions will not pose any legal difficulty, the interaction of the UBIT laws with the S corporation laws raises many potentially complex issues. With nearly 4.5 million potential donors of S corporation stock, the nation's charities and taxpayers will be well served if Congress and the IRS provide guidance to answer the many unanswered questions.

Reprinted from The Journal of Gift Planning, a quarterly publication of the National Committee on Planned Giving.

The Journal is available to members of an NCPG affiliated council for $22.50 per year -- $45 for nonmembers.

The publication is intended to facilitate and encourage the education and training of the many different professionals in the planned giving community.

For subscription information, contact NCPG at its website: www.ncpg.org


Footnotes

A) If a C corporation elects to switch to an S corporation, then the sale of assets that the corporation owned at the time of conversion triggers the "built-in gains" tax. Section 1374.

B) If: 1) a C corporation elects to switch to an S corporation and 2) the corporation used the LIFO method of accounting for inventories at the time of conversion, then it must pay the LIFO recapture tax in the year of conversion. The tax is computed based on the difference between the lower LIFO value and the higher FIFO value. Section 1363(d).

C) If: 1) a C corporation with accumulated profits elects to switch to be an S corporation and 2) its passive investment income (interest, dividends, etc.) exceeds 25% of its total receipts, the "excess net passive income" is taxed at the highest corporate marginal tax rate. Section 1375.

A) The corporation can have no more than 75 shareholders. The limit had been 35 shareholders until the law was amended in 1996. Section 1361(b)(1)(A) of SBJPA. A husband and a wife count as a single shareholder for purposes of the 75-person limit. Section 1361(c)(1). In the case of an "electing small business trust" with multiple beneficiaries, each current beneficiary is counted toward the 75-person limit. (Contingent and deferred beneficiaries are not counted) Section 1361(c)(2)(B)(v). See infra n. 28.

B) Each shareholder must be an eligible shareholder. See infra n. 22 and the accompanying text.

C) The corporation must be incorporated in the United States. Section 1361(b)(1).

D) The corporation may only have one class of stock (e.g., common stock, but not both common and preferred stock). Section 1361(b)(1)(D). However, an S corporation can issue both voting and nonvoting common stock without violating this requirement. Reg. Section 1.1361-1(l)(1).

E) The corporation cannot be a bank, insurance company, DISC or Section 936 Puerto Rico corporation. Section 1361(b)(2).

F) If a corporation was at some point in its history a C corporation, it must have less than 25% of its gross receipts from passive sources (interest, dividends, etc.) to keep its S corporation status. Section 1362(d)(3). Even during the years that it keeps its S corporation status, such investment income can be subject to a special tax. If: 1) a C corporation with accumulated profits elects to switch to be an S corporation and 2) its passive investment income (interest, dividends, etc.) exceeds 25% of its total receipts, the "excess net passive income" is taxed at the highest corporate marginal tax rate. Section 1375.

G) An S corporation that has lost its tax status is generally ineligible to elect S corporation status for at least five years after the status was terminated. Section 1362(g). An important exception is if there was an "inadvertent termination." See infra n. 126 and the accompanying text.

A) An individual (i.e., a human being), except that an S corporation cannot have a person who is a nonresident alien as a shareholder. Section 1361(b)(1)(B) & (C).

B) The estate of a deceased individual. Section 1361(b)(1)(B).

C) Beginning in 1998, a Section 501(c)(3) charity. Section 1361(c)(7).

D) Beginning in 1998, a Section 401(a) retirement plan. Section 401(a) retirement plans include traditional company pension, profit sharing and stock bonus plans. However, there is likely to be great confusion on this issue since Section 401(a) does NOT include other common types of retirement plans, most notably IRAs (Section 408), SIMPLE IRAs [Section 408(m)] and tax-sheltered annuities and custodial accounts [Section 403(7) and (10)].

E) A trust that meets any one of the following criteria:

i) A "living trust" for a single beneficiary. Section 1361(c)(2)(A)(i).

ii) For up to two years after a shareholder's death, a trust that received S corporation stock upon the decedent's death. Section 1361(c)(2)(A)(iii), as amended by SBJPA Section 1303. A living trust that held S corporation stock at the time of the shareholder's death will also qualify for the two years following the shareholder's death, even if the trust has multiple beneficiaries. Section 1361(c)(2)(A)(ii).

iii) A qualified Subchapter S Trust (QSST) that benefits only a single individual. Section 1361(d).

iv) An "Electing Small Business Trust" (ESBT). Section 1361(c)(2)(A)(v) and 1361(e). See infra n. 28 and the accompanying text.

Under certain circumstances a charity can be a beneficiary of an ESBT. Section 1361(e)(1)(A)(i). There are also a few other organizations that can be beneficiaries of an ESBT. The other types of organizations that qualify for charitable income tax deductions are: veterans' organizations, cemetery companies and certain fraternal societies. Section 170(c)(3)-(5). Although contributions to these types of organizations qualify for charitable income tax deductions, they generally do not qualify for charitable estate tax deductions. Rev. Rul. 77-385, 1977-2 C.B. 331 and Child v. U.S., 540 F.2d 579 (2d Cir. 1976). By comparison, gifts to Section 501(c)(3) charities qualify for both income and estate tax deductions. Section 170(c)(2) and 2055.

For example, if an ESBT has $100,000 of ordinary income and distributes $100,000 to its income beneficiaries, the trust must pay a tax of $39,600. The beneficiaries will not have any income tax liability for the distributions from the trust. By comparison, a traditional trust would be able to deduct the $100,000 distribution and each beneficiary would include a portion of the distribution on his or her tax return and pay income tax based on his or her own marginal income tax rate. The only parties likely to use an ESBT are very wealthy families who feel it is important to give a trustee the discretion to change the allocation of S corporation dividends among various family members as their economic circumstances change.

If Taxable Income Is: The Tax Is:

Under $1,700 15% of taxable income

$1,700 - $4,000 $255 plus 28%

$4,000 - $6,100 $899 plus 31%

$6,100 - $8,350 $1,550 plus 36%

Over $8,350 $2,360 plus 39.6% of

the excess over $8,350

If Taxable Income Is: The Tax Is:

Under $50,000 15% of taxable income

$50,000 - $75,000 $7,500 plus 25%

$75,000 - $100,000 $13,750 plus 34%

$100,000 - $335,000 $22,250 plus 39%

$335,000 - $10,000,000 $113,900 plus 34%

$10,000,000 - $15,000,000 $3,400,000 plus 35%

$15,000,000 - $18,333,333 $5,150,000 plus 38%

Over $18,333,333 $6,416,667 plus 35%

No Exception for Corporate Long-Term Capital Gains; they are taxed at the same marginal rate as ordinary income.

Special rules applicable to partnerships--If a trade or business regularly carried on by a partnership of which an organization is a member is an unrelated trade or business with respect to such organization, such organization in computing its unrelated business taxable income shall ... include its share (whether or not distributed) of the gross income of the partnership from such unrelated trade or business and its share of the partnership deductions directly connected with such gross income.

See also Service Bolt & Nut Co. Profit Sharing Trust v. Commissioner, 724 F.2d 519 (6th Cir. 1983) (retirement plan's 90% ownership interest in limited partnership that distributed fasteners was taxable, even though plan physically did no work) Rev. Rul. 79-222, 1979-2 C.B. 273, Section 512(c), Reg. Section 1.512(c)-1.

1) IN GENERAL--If an organization described in Section 1361(c)(7) [a charity or a Section 401(a) retirement plan] holds stock in an S corporation--

a) such interest shall be treated as an interest in an unrelated trade or business; and

b) notwithstanding any other provision of this part--

i) all items of income, loss, or deduction taken into account under Section 1366(a) and

ii) any gain or loss on the disposition of the stock in the S corporation shall be taken into account in computing the unrelated business taxable income of such organization.

Reasons for Change

The Congress believed that the present-law prohibition of certain tax-exempt organizations being S corporation shareholders may have inhibited employee ownership of closely-held businesses, frustrated estate planning, discouraged charitable giving and restricted sources of capital for closely-held businesses. The Congress sought to lift these barriers by allowing certain tax-exempt organizations to be shareholders in S corporations. However, the provisions of Subchapter S were enacted in 1958 and substantially modified in 1982 on the premise that all income of the S corporation (including all gains on the sale of the stock) would be subject to a shareholder-level income tax. This underlying premise allows the rules governing S corporations to be relatively simple (in contrast, for example, to the partnership rules of Subchapter K) because of the lack of concern about "transferring" income to non-taxpaying persons. Consistent with this underlying premise of Subchapter S, the provision treats all the income flowing through to a tax-exempt shareholder and gains and losses from the disposition of the stock, as unrelated business taxable income.

Explanation of Provision

Tax-exempt organizations described in Code Section 401(a) and 501(c)(3) ("qualified tax-exempt shareholders") are allowed to be shareholders in S corporations. For purposes of determining the number of shareholders of an S corporation, a qualified tax-exempt shareholder will count as one shareholder. An individual retirement account is not a qualified tax-exempt shareholder.

Items of income or loss of an S corporation will flow-through to qualified tax-exempt shareholders as UBTI, regardless of the source or nature of such income (e.g., passive income of an S corporation will flow through to the qualified tax-exempt shareholders as UBTI.) In addition, gain or loss on the sale or other disposition of stock of an S corporation by a qualified tax-exempt shareholder will be treated as UBTI. A distribution of stock to a qualified plan participant or beneficiary will be considered to be a taxable disposition.

To qualify as a CWA, the charity's thank you letter, receipt, ticket or other form of acknowledgement must contain certain information and must be received by the donor within the applicable time requirement. The acknowledgement should state:

1) the amount of cash and a description (but not necessarily the value) of any property given and

2) whether the charity provided any goods or services in exchange for the property (if so, then it must give a description and state the value of the goods and services). Section 170(f)(8)(B).

The taxpayer should receive the acknowledgment on or before the earlier of: 1) the date on which the taxpayer files a return for the taxable year in which the contribution was made, or 2) the due date (including extensions) for filing the return. Section 170(f)(8)(C).

The appraisal summary must be attached to the donor's income tax return on IRS Form 8283. A charitable organization that receives such property must sign a copy of Form 8283 that should then be attached to the donor's income tax return. Signing the report does not mean that the charity agrees that the value is correct. Rather, it is more of an acknowledgement that the property was in fact received. Reg. Section 1.170A-13(c)(4)(iii). It also puts the charity on notice that it must notify the IRS if it disposes of the property within two years of receipt (please see the next endnote).

To qualify as a qualified appraisal, a qualified appraiser must perform the appraisal no more than 60 days before the gift and no later than the due date for filing the donor's income tax return (including extensions). Reg. Section 1.170A-13(c)(3)(i). A qualified appraiser is someone who publicly holds himself or herself out as an appraiser and who is qualified to appraise the particular property. Reg. Section 1.170A-13(c)(5)(i). The donor and the charity, as well as employees and related parties to the donor and charity, are also prohibited from acting as appraisers even if they would otherwise be qualified. Reg. Section 1.170A-13(c)(5)(iv).

The IRS has taken a hard-line approach in several court cases and has attempted to disallow any deduction unless every requirement for a qualified appraisal has been satisfied. Although the courts have generally agreed with the IRS when the appraisals fell well below the minimum standards for a qualified appraisal, they have been forgiving for minor omissions. See, for example, Bond v. Commissioner, 100 T.C. 32 (1993) and D'Arcangelo v. Commissioner, T.C. Memo. 1994-572.

The appraisal requirements are contained in Reg. Section 1.170A-13, Section 6050L and Reg. Section 1.6050L-1. For further information concerning the appraisal requirements, consult IRS Publications 561, "Determining the Value of Donated Property" and 526 "Charitable Contributions."

1) "unrealized receivables" (uncollected bills of a cash method business),

2) "substantially appreciated inventory" (inventory whose market value is more than 120% greater than its cost),

3) "depreciation recapture" under Section 1245 or 1250 and

4) a laundry list of other assets that produce ordinary income rather than long-term capital gain when sold.

If time is of the essence, another way to quickly terminate S corporation status is to intentionally make the corporation ineligible for S corporation status. The easiest way to do this is to transfer a few shares of stock to an ineligible shareholder, such as a corporation or a pooled income fund. See supra n. 17, 22 and the accompanying text. The revocation becomes effective on the date that the ineligible shareholder acquires the stock. Section 1362(d)(1); Reg. Section 1362-2(b)(2).

This method will not always work. For example, if the corporation had once been a C corporation--a very common occurrence--or if the donor purchased the stock from an existing shareholder, then the basis could be very different.

1) the donor's adjusted basis at the time of the gift [Section 1223(2)],

2) increased by the amount of taxable and tax-exempt income (or decreased by the amount of losses) reported to the charity on the Schedule K-1 [Section 1367(a)] and

3) reduced by the amount of distributions the charity received from the corporation [Section 1367(b)].

There are other adjustments that are described in greater detail in Section 1367. A special rule that applies only to tax-exempt shareholders is that if the charity purchased the stock, rather than received the stock as a gift, then any "dividends" attributable to the corporation's years as a C corporation will reduce the basis of the stock. Section 512(e)(2). See infra n. 95 and the accompanying text.

This type of dividend is probably not subject to UBIT to a tax-exempt shareholder. Section 512(e)(1)(B)(i) provides that a charity that owns S corporation stock shall be taxed on "all items of income, loss, or deduction taken into account under Section 1366(a)." Under that statute, a charity will be taxed on its share of the dividend income that an S corporation received from the S corporation's stock investments. However, the type of dividend described in the preceding paragraph is from the S corporation's own business activities and is taxed to shareholders under Section 1368 rather than Section 1366. Consequently, the general exemption those dividends receive from UBIT under Section 512(b)(1) should apply to a Section 1368 dividend distribution. Guidance from the IRS on this issue would be helpful.

The other situations where passive investment income of a tax-exempt organization has been subject to UBIT are: a) unrelated debt-financed income under Section 514 (see, particularly, Section 514(c)(9)(B)(vi) for how debt-financed income of a partnership passes through to a tax-exempt partner) and b) rent and interest that controlled subsidiaries pay to parent-charities under Section 512(b)(13). Until 1994, passive income from publicly traded partnerships was also subject to UBIT. See former Section 512(c) before it was repealed by the Revenue Reconciliation Act of 1993, P.L. 103-66.

Another argument is that the statutes that exempt charities from the conventional income tax preempt the passive loss limitation. Section 501(a) states that a tax-exempt organization "shall be exempt from taxation under this subtitle," which refers to Subtitle A (Income Taxes) of Title 26 of the U.S. Code (Internal Revenue Code). Thus, the argument is that none of the taxes and none the rules mentioned in Subtitle A, including the passive loss limitation, apply to a tax-exempt charity. The only taxes that apply to tax-exempt organizations are those taxes that are specifically levied on them, such as UBIT and the private foundation excise taxes. Section 511(a)(2) and 4940-4945, respectively. The argument is, therefore, that the Section 469 passive loss limitation does not apply to a tax-exempt organization because it is preempted by Section 501(a) and it is not expressly referred to in the UBIT statutes of Section 511 through 515.

The excess business holdings tax is triggered if the combined ownership interest of a private foundation with that of all "disqualified persons" (DPs) is more than 20% [or sometimes 35%--see Section 4943(c)(2)(B)] of a corporation's voting stock. For example, if all DPs own 15% of a corporation, then the most that a private foundation can own is 5%. Section 4943(a)-(c)(2). A DP is anyone who donated more than 2% of the private foundation's total contributions. Family members and businesses in which the donor has substantial ownership interests are usually considered DPs. The definition also includes other private foundations to which the donor (or the donor's family) made contributions. Section 4946(a)(1).

Since 89% of S corporations have three or fewer shareholders, it will be very difficult for a private foundation to own stock of a typical S corporation. One strategy that may work in a few situations is if DPs own 20% or less of an S corporation, then a private foundation can own an unlimited amount of nonvoting stock. Reg. Section 53.4943-3(b)(2). An S corporation can issue nonvoting stock without violating the "one class of stock" requirement. Reg. Section 1.1361-1(l)(1).

The IRS has issued a series of very generous rulings concerning supporting organizations. Several rulings concluded that supporting organizations are exempt from this tax. See G.C.M. 36600 (1976) and Private Letter Ruling 9308045. The IRS even permitted private foundations to convert to supporting organization status for the express purpose of avoiding the tax. See Private Letter Rulings 9407029 (Jan. 13, 1994) (which expands on Private Letter Ruling 9308046 and involves a supporting organization "operated in connection with" another public charity) and 8617119 (Jan. 31, 1986). The IRS even authorized one private foundation to make a charitable grant to a supporting organization of sufficient stock to bring the private foundation's holdings below the authorized limit. Private Letter Ruling 9415011 (April 15, 1994). The IRS also concluded that a fund in a community foundation could hold such stock for more than five years without triggering the tax. Private Letter Ruling 9439015 (July 6, 1994).

applications in Announcement 97-4, 1997-3 I.R.B. 1 and in Rev. Proc. 97-1, 1997-1 I.R.B. 11.


  1. In 1993 the IRS estimated that there were 1,901,505 S corporations (48% of all U.S. corporations) with 4,500,309 shareholders. "S corporation Returns," IRS Statistics of Income Bulletin, Amy Gill and Susan Wittmen, Spring, 1996, pp. 27-63.back

  2. Public Law 104-188; signed into law on August 20, 1996 (SBJPA).back

  3. See infra n. 64 and the accompanying text.back

  4. See infra n. 89 and the accompanying text.back

  5. See infra n. 90 and the accompanying text.back

  6. See infra n. 42 and the accompanying text.back

  7. See infra n. 132 and the accompanying text.back

  8. Section 11.back

  9. See infra n. 17 and the accompanying text.back

  10. Section 1363. The exceptions when an S corporation can pay income tax are:back

  11. Section 1366.back

  12. A C corporation's income is often taxed twice. It is first taxed in the year it is earned by the corporation under the corporate income tax. Then, when the corporation distributes amounts that remain after these taxes to its shareholders as a dividend, the shareholders pay income tax on the dividend income.back

  13. "S corporation Returns," IRS Statistics of Income Bulletin, Amy Gill and Susan Wittmen, Spring, 1996, pp. 27-63. In 1993 the number of S corporations grew only by 6.5% which may be partially attributable to the introduction of a new business form that many people find more attractive than a corporation: the Limited Liability Company (LLC).back

  14. Id.back

  15. Id.back

  16. See infra n. 17 & 22 and the accompanying text.back

  17. If a corporation fails any of the following provisions it is no longer eligible to be an S corporation:back

  18. Eligible shareholders are listed at infra n. 22.back

  19. Section 1362(d)(2); Reg. Section 1362-2(b).back

  20. See Private Letter Ruling 8922014 (Feb. 28, 1989) where a taxpayer attempted to contribute S corporation stock to a charitable remainder unitrust.back

  21. Section 1361(b)(1)(B) and 1361(c)(7), as added by SBJPA Section 1316(a).back

  22. The only people or entities that are eligible to own stock of an S corporation are:back

  23. See infra n. 123 and the accompanying text.back

  24. Section 664.back

  25. Section 642(c)(3) and 642(c)(5).back

  26. Section 1362(d)(2); Reg. Section 1362-2(b). Private Letter Ruling 8922014 (Feb. 28, 1989).back

  27. A charitable remainder trust will lose its tax-exempt status if it has any unrelated business taxable income. Reg. Section 1.664-1(c); Leila G. Newhall Unitrust v. Commissioner, 104 T.C. No. 10 (March, 1995), affirmed 105 F. 3rd 482 (9th Cir. 1997).back

  28. An ESBT is a "sprinkling" or "spray" trust that gives the trustee the ability to give more or less income to various beneficiaries based on their changing needs and economic circumstances. Section 1361(c)(2)(A)(v) and 1361(e).back

  29. A tax-exempt trust is not eligible to be an ESBT [Section 1361(e)(1)(B)(ii)] and a charitable remainder trust is tax-exempt under Section 664(d).back

  30. Some commentators concluded that it might be possible for a charitable remainder trust that lost its tax-exempt status to qualify as an ESBT. The IRS announced its intention to clarify that this is not the case. "Technical Corrections Bill Likely To Include S Corporation Provisions," 97 Tax Notes Today 14-6 (Jan. 22, 1997).back

  31. An ESBT is subject to the highest income tax rate imposed on trusts (39.6% for ordinary income and 20% or 28% for long-term capital gains) and is not allowed to claim a deduction for distributions to beneficiaries. Section 641(d)(2)(A).back

  32. See infra n. 126 and the accompanying text.back

  33. For example, a symphony pays no income tax on its ticket sales. Section 501(a) and 501(c)(3).back

  34. Interest, dividends, rents and the gain from the sale of non-S corporation stock are exempt from UBIT. Section 512(b)(1) and (5) and 1.512(b)-1.back

  35. Section 511-514.back

  36. For the legislative history of the first UBIT legislation, see S. Rep. No. 2375, 81st Cong., 2d Sess., reprinted in 1950-2 CB 483, 504.back

  37. Veterans of Foreign Wars, Department of Michigan v. Commissioner, 89 T.C. 7 (1987) Christmas card sales were subject to UBIT.back

  38. Congress concluded in 1969 that tax-exempt organizations were able to use borrowed funds to acquire rental and other investment property at a competitive advantage over taxable organizations because a charity's investment income was normally tax-free. Until the debt-financed UBIT legislation was enacted, this had occurred with some frequency with sale-leaseback transactions. S. Rep. 91-552, reprinted in 1969-3 CB 423, 464.back

  39. Section 512(b)(1) and (3) exclude passive investment income from UBIT.back

  40. Section 512(b)(4) and 514.back

  41. Compare Section 511(a) and 511(b).back

  42. Section 511(b) and 1(e); Reg. Section 1.511-1. Except for long-term capital gains described in the next endnote, the marginal tax rates for trusts in 1998 are:back

  43. Long-term capital gains of a trust are taxed at the same rates that individuals pay. The Taxpayer Relief Act of 1997 lowered the maximum rate to 20% (10% for taxpayers in the 15% marginal income tax bracket) for capital gain assets that have been held for over 18 months. For assets held between 12 and 18 months, the maximum marginal rate is 28%. Section 1(h), as amended by Section 311 of the Taxpayer Relief Act of 1997; Section 511(b) and 1(e) & 1(h); Reg. Section 1.511-1.back

  44. Section 511(a).back

  45. Section 511(a) and 11. The marginal tax rates for corporations in 1998 are:back

  46. Section 1201.back

  47. Although the charity might not have held the stock for the requisite 18 months, recipients of gifts can usually add the donor's holding period to their own for purposes of the 18 month holding period requirements. Section 1(h) and 1223(2).back

  48. The high trust tax rates were enacted to prevent wealthy people from shifting income at low tax rates to family members.back

  49. Such treatment could conform to the logic expressed in the legislative history at infra n. 55.back

  50. The rules are contained in Section 512(c), which states in part:back

  51. "Edited Transcript Of The Sessions Of The May 19, 1995 ABA EO Committee Meeting In Washington: Attachment C: Limited Liability Companies: Discussion For General Practitioners, Creditors And Non-tax Specialists," 12 Exempt Org. Tax Rev. 77 (May 1995).back

  52. For example, if a tax-exempt charitable organization is a partner in a partnership that operates a factory, it must treat as UBTI its share of the gross income and deductions from the operation of the factory. However, the dividend and interest income of the partnership is usually not unrelated business income; only the profit from the business operation is. Reg. Section 1.512(c)-1; S. Rep. No. 1402, 85th Cong., 2d Sess. 2 (1958), reprinted at 1958-1 C.B. 656, 657.back

  53. Section 512(e) states: Special Rules Applicable to S corporations:back

  54. Id.back

  55. See "Explanation of Tax Legislation from the 104th Congress" (The "Blue Book"), Joint Committee On Taxation, Part Four(I)(C): "Provisions Relating To S corporations" which states:back

  56. Usually a valid transfer restriction requires a buy-sell agreement and the restriction should be boldly printed on the stock certificate.back

  57. In 1993, Congress enacted a law that disallows a charitable income tax deduction to any donor who gave $250 or more to any charity unless the donor received a special type of receipt from the charity. The receipt must qualify as a "contemporaneous written acknowledgement" (CWA). The donor's cancelled check or any other type of receipt will NOT suffice. In the absence of a CWA, the donor's income tax deduction for the gift will be lost. Section 170(f)(8); Reg. Section 1.170A-9(e)(13).back

  58. Congress instituted a requirement that donors who contribute property (other than publicly traded securities) valued at more than $5,000 in any year must substantiate the value with "qualified appraisals" from "qualified appraisers." Section 155(a) of The Tax Reform Act of 1984, Pub. L. 98-369. The $5,000 threshold is increased to $10,000 for non-publicly traded stock, such as S corporation stock. Reg. Section 1.170A-13(c)(2)(ii).back

  59. If a charity disposes of property listed on IRS Form 8283 through a sale or some other non-charitable disposition within two years of receipt, it must file a separate report within 125 days with IRS on Form 8282 (Donee Information Return) and disclose facts about the disposition. Section 6050L and Reg. Section 1.6050L-1; IRS Ann. 90-25. It must also send a copy to the donor. Failure to file the form could trigger a penalty of $50 per disposition and there is a penalty of $5 if there is missing information. Section 6721 and Ann. 90-25. The penalties are greater for intentional violations.back

  60. Section 170(e)(1)(A); Reg. Section 1.170A-4(a). EXAMPLE: Assume a business contributes to a charity inventory that has a value of $10 but was purchased for $6. The $10 tax deduction is reduced by the amount of ordinary income that would have been recognized had the property been sold ($4) so that the net deduction is limited to the taxpayer's basis in the property ($6). The other major source of ordinary income is depreciation recapture under Section 1245 or 1250.back

  61. Section 170(b)(1)(C)(iv). Usually the greatest benefits come from gifts of appreciated stock and real estate. The tax laws restrict the benefits from gifts of tangible personal property (paintings, books, etc,) unless the charity physically uses the property for its exempt purpose, then the donor can deduct the full fair market value. Section 170(e)(1)(B)(i); Reg. Section 1.170A-4(b)(3)(ii). In addition, the deduction can be reduced if appreciated capital gain property is contributed to a private non-operating foundation, with publicly traded stock being the principal exception. Section 170(e)(1)(B)(ii) and 170(e)(5).back

  62. Id.back

  63. See, for example, Private Letter Ruling 9224036 (March 16, 1992).back

  64. The last sentence of Section 170(e)(1) (relating to income tax charitable deductions for contributions of ordinary income and capital gain property) states: "For purposes of applying this paragraph in the case of a charitable contribution of stock in an S corporation, rules similar to the rules of Section 751 shall apply in determining whether gain on such stock would have been long-term capital gain if such stock were sold by the taxpayer." The Section 751 "Hot Assets" rules that apply to partnerships treat certain assets as "ordinary income" property, including:back

  65. Section 170 only applies to income tax deductions; Section 2055 applies to estate tax deductions. The provision in the preceding endnote only applies to charitable income tax deductions.back

  66. The gain could be taxed to the donor under the "assignment of income" theory. See Rev. Rul. 78-197, 1978-1 C.B. 83, which interprets Palmer v. Commissioner, 62 T.C. 684 (1974), aff'd on another issue, 523 F.2d 1308 (8th Cir. 1975) where the IRS stated that it will treat the proceeds of a redemption of stock as income to the donor only if the charitable organization is legally bound, or can be compelled by the corporation, to surrender the shares for redemption. The IRS has also approved similar transactions through letter rulings issued to donors who contemplated gifts of stock followed by redemptions. See, for example, Private Letter Rulings 9452020 (Sep. 30, 1994), 8810009 (Sep. 25, 1987), 8701029 (Oct. 7, 1986), 8532027 (May 10, 1985). See, however, the recent case of Ferguson V. Commissioner, 108 T.C. No. 14 (April 28, 1997) where the Court concluded that the gain on the sale of stock should be taxed to the donors even though an important contingency of a stock tender offer had not been met at the time of the gift. The tender offer was conditioned on the purchaser acquiring at least 85% of the stock, the court held that once 50% of the stock had been tendered, the purchaser had majority control and could have forced the merger to be completed.back

  67. See supra n. 64 and the accompanying text.back

  68. Section 512(e)(1)(B)(ii).back

  69. Section 1362(d)(2); see also supra n. 17.back

  70. Having the owners of over half of the stock file a revocation with the IRS can terminate S corporation status. Generally the revocation becomes effective on the first day of the next taxable year (usually January 1). If, however, the revocation is filed within two-1/2 months of the beginning of the corporation's taxable year (i.e., usually by March 15), the revocation is retroactive to the beginning of the taxable year unless the revocation specifies a prospective date. Section 1362(d)(1); Reg. Section 1362-6(a).back

  71. When the Courts and the IRS identify a series of artificial steps as part of a tax-avoidance plan, they sometimes invoke the step transaction doctrine to ignore some of the intermediate steps and treat all transactions as one. For example, if a donor gave a few shares of stock to a pooled income fund solely to terminate S corporation status and the next day gave considerable stock to a charity, the courts might ignore the gift to the pooled income fund and apply the S corporation rules even though technically the corporation was not an S corporation at the time of the gift. Although the IRS might have success if the transactions are just a day apart, it would have much greater difficulty if months or years separate the transactions.back

  72. See supra n. 64 and the accompanying text. Under Section 1245, the depreciation recapture for personal property is treated as ordinary income. However, for real property, such as a building, Section 1250 provides that only the excess of accelerated depreciation deductions over straight-line deductions is treated as ordinary income. Since this taxpayer used the straight-line method for the real property, none of the $40,000 of depreciation deductions that would have been recaptured upon a sale would be treated as ordinary income; it would all be long-term capital gain. Although the Tax Relief Act of 1997 levied a tax rate on such capital gains of 25% instead of the usual 20%, such gains nevertheless remain capital gains rather than ordinary income.back

  73. Shareholders generally have "limited liability" for corporate debts unless they personally used the corporation to commit fraud or injustice. See "Stockholder's Personal Conduct of Operations or Management of Assets As Factor Justifying Disregard of Corporate Entity," 46 A.L.R.3d 428; "Liability of Corporation for Contracts of Subsidiary," 38 A.L.R.3d 1102; and "Liability of Corporation For Torts of Subsidiary," 7 A.L.R.3d 1343.back

  74. For example, it is common for S corporation shareholders that work for the business to have fairly low salaries. They do not mind since they receive all of the business income either in the form of salaries or profits of the business. If an S corporation is a family business and if a non-family member becomes a shareholder (e.g., a charity), will the shareholder-employees increase their salaries to reduce the profits allocable to the non-family shareholder?back

  75. Section 514(c)(5) requires only that the value of a charitable gift annuity be less than 90% of the value of the property contributed by the donor. A charity is therefore free to issue a charitable gift annuity based on a lower amount than the appraised value of the property.back

  76. 1997 Pa. House Bill No. 134, which amended the Pennsylvania S corporation laws.back

  77. See Reg. Section 1.6102-2(e) for charitable corporations and Reg. Section 1.6102-3(a)(5) for charitable trusts.back

  78. Section 6655(g)(3). A tax-exempt organization will be subject to an estimated tax penalty if insufficient payments are made through estimates. Generally, to avoid the penalty the amount of estimated tax payments must be 100% of the current tax year's liability.back

  79. Reg. Section 1.511-3(a).back

  80. The donor's basis will carryover to the charity. Section 1223(2). The charity will then adjust the basis over time to reflect its share of the corporation's income and distributions. See infra n. 91 and the accompanying text.back

  81. If the corporation has always been an S corporation, the basis in the stock will often be the donor's share of the sum of the issue price for the stock plus the corporation's retained profits. For example, the Balance Sheet indicates that the stock was issued for $200,000 and it has accumulated profits of $309,270 (line raqheargh??). The book value of all of the stock would then be $509,270 and the owner's 45% interest would have a basis of $229,172.back

  82. A low tax basis could cause normally tax-exempt cash distributions to be taxable and could prevent the charity from deducting the business operating losses. See infra n. 99 and the accompanying text.back

  83. See supra n. 57 and the accompanying text.back

  84. See supra n. 59.back

  85. Section 1366(b).back

  86. Section 1377(a)(1).back

  87. The computations are shown at infra n. 113.back

  88. See infra n. 93 and the accompanying text.back

  89. For example, a charity may own interests in several S corporations and partnerships, some of which generate profits and others which generate losses. If the losses exceed the profits, then no UBIT is due on the net loss. See infra n. 102 and the accompanying text.back

  90. Section 512(e)(1)(B)(ii) takes precedence over the general exemption Section 512(b)(5) affords to capital gains.back

  91. A charity's adjusted tax basis in S corporation stock will generally be:back

  92. Id.back

  93. Section 1368.back

  94. Section 1368(b)(2) and (c)(3). For example, if an S corporation distributes $30,000 cash to a shareholder who only has a basis in the stock of $20,000, the extra $10,000 is taxed as a capital gain.back

  95. If an S corporation had ever been a C corporation, then Section 1368(c)(2) provides that after an S corporation has distributed all of the profits that it had accumulated from the years that it had been an S corporation, the remaining part of any distribution will be treated as an ordinary dividend income to the extent the corporation had accumulated profits from years when it was a C corporation. For most taxpayers, it means that the distribution is taxable as ordinary dividend income. Section 301.back

  96. See supra n. 91 and the accompanying text.back

  97. See Section 311(b), which applies to both C corporations and S corporations by virtue of Section 1371(a)(1). By comparison, an identical distribution of appreciated property from a partnership or LLC would not trigger taxable income to the partners or members. The principal tax effect from a distribution of property to a partner is that the partners reduce their "tax basis" in their partnership interest by the amount of the tax basis of the appreciated property that was distributed. Section 731(a)(1) and 732(a)(1). For this reason, a partnership or an LLC is considered a better form of business organization to own property that is likely to appreciate in value than is an S corporation.back

  98. Id.back

  99. See supra n. 94 and the accompanying text.back

  100. Section 1366(d), Section 1367(2)(B) (for stock) and 1367(b)(2) (for debt). For example, assume a charity has $50,000 of profits from S corporation "A" and $40,000 of losses from S corporation "B," and that the charity's basis in the S corporation "B" stock is only $30,000. The charity can only use $30,000 of the $40,000 loss to deduct against the $50,000 of profits, since the loss deduction is limited to the basis of its S corporation stock and debt. The unused $10,000 is carried forward and can be deducted in a future year when S corporation "B" has taxable income.back

  101. The passive loss limitation prevents taxpayers from deducting losses from passive partnership and S corporation investments against their wages and other investment income. For example, assume an individual owns stock of an S corporation where she does not work. Her share of the S corporation's income consisted of loss from business operations of $10,000, dividends of $8,000 and capital gain of $7,000. She must pay income tax on the full $15,000 of investment income. The passive loss limitation prevents her from deducting the $10,000 loss from business operations against the S corporation's investment income. Section 469(a),(e)(1) and (h)(1). The $10,000 loss is carried forward and is deducted in the year that the corporation's business operations produce a profit or when she sells her stock, whichever occurs first. Section 469(b) and (g).back

  102. The issue has not been addressed before, since with only a few exceptions, investment income of tax-exempt organizations has generally been exempt from UBIT. Section 512(b)(1). However, since over 40% of S corporations report operating losses (Exhibit A) the passive loss issue is likely to arise very soon.back

  103. The first argument is that charitable trusts and corporations might not be included in the list of taxpayers that are subject to the passive loss limitation. For example, publicly traded corporations are exempt from the rules. Section 469(a)(2) provides that the only taxpayers who are subject to the passive loss limitation are: "A) any individual, estate or trust, B) any closely-held C corporation and C) any personal service corporation." One issue is whether a tax-exempt charitable trust is subject to the limitation because it is a trust. In addition, since a nonprofit corporation usually has no shareholders, is it a "closely-held C corporation?" One can argue that neither are subject to the rules, but the instructions to the Form 990-T concerning a charity's UBIT from partnership income make a quick and confusing reference to Section 469 "for limitations on losses for certain activities."back

  104. Section 103.back

  105. See the second paragraph of supra n. 103.back

  106. Section 512(e)(1)(B) states: "notwithstanding any other provision of this part ... ALL ITEMS OF INCOME, loss, or deduction taken into account under Section 1366(a)... shall be taken into account in computing the unrelated business taxable income [of a tax-exempt organization]."back

  107. Charitable corporations have the same annual deduction limitation of 10% of income as for-profit corporations. Section 512(b)(10). Charitable trusts have the 50/30% limits that usually apply to individuals. Section 512(b)(11). Disallowed amounts can be carried forward for five years.back

  108. Section 512(e)(1)(B)(i) states: "All items of income, loss, or DEDUCTION taken into account under Section 1366(a)... shall be taken into account in computing the unrelated business taxable income [of a tax-exempt organization]."back

  109. The IRS and Tax Court have taken the position payments from a subsidiary from a tax-exempt charitable parent are dividends rather than charitable contributions. Dave Inv. Co. v. Commissioner, 462 F.2d 1373 (1972), aff'g 29 TCM (CCH) 1345 (1970); Crosby Valve & Gage Co.v. Commissioner, 380 F.2d 146 (1967), aff'g 46 T.C. 641 (1966); Rev. Rul. 68-296, 1968-1 C.B. 105.back

  110. See supra n. 42 and the accompanying text.back

  111. For example, an individual cannot deduct any charitable contributions, including his or her share of an S corporation's charitable contributions, unless the taxpayer itemizes tax deductions on Schedule A of Form 1040. Even if the taxpayer itemizes, a person cannot deduct an S corporation's charitable contributions if his or her own gifts for the year exceed the annual deduction limitation of 50% of the person's own adjusted gross income. Section 170(b)(1)(A) and (C).back

  112. Section 512(e)(1)(B)(i).back

  113. The issue of whether municipal bond interest is subject to UBIT was introduced at supra n. 105. For purposes of this example, we will assume that it is not subject to UBIT.back

  114. The provisions that disallow certain business deductions, such as the limitation that only 50% of business meals expenses are deductible [Section 274(n)], will apply to the computation of UBIT. Section 512(a)(1) permits UBIT deductions for business expenses that are "allowed by this chapter that are directly connected with the carrying on of such trade or business." The word chapter refers to Chapter 1 (Income Tax), which includes Section 1 through 1399 and all of the limitations on deducting business expenses.back

  115. Section 512(c), Reg. Section 1.512(c)-1. See supra n. 50 and the accompanying text.back

  116. Section 1378.back

  117. Section 512(c)(2); Reg. Section 1.512(c)-1.back

  118. If a C corporation elects to switch to an S corporation, then the sale of assets that the corporation owned at the time of conversion triggers the "built-in gains" tax. Section 1374.back

  119. If: 1) a C corporation with accumulated profits elects to switch to be an S corporation and 2) its passive investment income (interest, dividends, etc.) exceeds 25% of its total receipts, the "excess net passive income" is taxed at the highest corporate marginal tax rate. Section 1375. If the corporation has three consecutive years with more than 25% of its gross receipts from passive sources (interest, dividends, etc), it will lose its S corporation status. Section 1362(d)(3).back

  120. If: 1) a C corporation elects to switch to an S corporation and 2) the corporation used the LIFO method of accounting for inventories at the time of conversion, then it must pay the LIFO recapture tax in the year of conversion. The tax is computed based on the difference between the lower LIFO value and the higher FIFO value. Section 1363(d).back

  121. See supra n. 96.back

  122. Section 1361(b)(1)(B) and 1361(c)(7) permit any Section 501(c)(3) charity to be an eligible shareholder.back

  123. The main problem for a private foundation to own S corporation stock is the Section 4943 excess business holdings tax. If a private foundation has excess business holdings, then there is an initial tax of 5% on the value of the excess business holdings. If the private foundation does not dispose of the excess by the end of the taxable year, it is subject to a punitive 200% tax on the excess value. If a private foundation receives the stock by gift or bequest, the tax is not imposed until five years (10 years with an IRS extension) after it received the stock.back

  124. Because public charities are not subject to private foundation excise taxes, they and their supporting organizations are an attractive source of gifts of closely-held stock. They can hold such stock for more than five years, which gives a business more time to redeem the stock, which can ease the cash-flow crunch.back

  125. Section 1362(f). The IRS explained its procedures for inadvertent terminationback

  126. Private Letter Ruling 9730017 (April 24, 1997) (transfer of stock to a trust that failed QSST requirements), Private Letter Ruling 9728022 (April 11, 1997) (transfer of stock to an Individual Retirement Account). See also Rev. Rul. 92-73, 1992-2 C.B. 224 concerning an IRA receiving S corporation stock.back

  127. See supra n. 26 and the accompanying text.back

  128. Section 1362(g).back

  129. See supra n. 70 and the accompanying text.back

  130. Section 453 permits a seller of closely-held stock to recognize capital gain from the sale as he or she collects cash payments from the buyer. This is an exception to the general rule that the entire gain is taxable in the year that the seller exchanges the stock for the buyer's promissory note. An issue exists whether a charity that sells its S corporation stock in exchange for a buyer's promissory note can use the installment method or whether the installment method does not apply to UBIT. See the analysis in the second paragraph of supra n. 103.back

  131. See, for example, the Bureau of National Affairs "Tax Management Portfolios": Starr, 730 T.M., S corporations: Formation and Termination, Starr, 730 T.M., S corporations: Operations, Neeley, 874 T.M., Unrelated Business Income Tax.back

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