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Senate Investigating Questionable Charitable Tax Shelter
Senator Carl Levin, of the Senate Permanent Subcommittee on Investigations, yesterday released a statement that outlines charitable giving plan being promoted by KPMG that takes advantage of the tax-exempt status of a willing charitable organization and its unrelated business income losses to secure income tax charitable deductions and shelter corporate income for S-corporation shareholders.
Senator Carl Levin, of the Senate Permanent Subcommittee on Investigations, yesterday released a statement that outlines a charitable giving plan being promoted by KPMG that takes advantage of the tax-exempt status of a willing charitable organization and its unrelated business income losses to secure income tax charitable deductions and shelter corporate income for S-corporation shareholders.
The plan is not new. San Francisco attorney Erik Dryburgh, of Silk, Adler & Colvin, drafted a white paper condemning the transaction that was published by the National Committee on Planned Giving several years ago.
The IRS is investigating the transaction.
SC2: PHONY CHARITABLE DONATION
1) The Income. Individual owns 100% of S-corporation which earns net income (e.g., $3 million annually).
2) The Sales Pitch. Individual is approached by KPMG with a "charitable donation strategy" to shelter a significant portion (often 90%) of the S-corporation's income from taxation by "allocating," with little or no distribution, the income to a charitable organization. Individual is told that, for a fee, KPMG will arrange a temporary "donation" of corporate non-voting stock to the charity and will provide an opinion letter stating it is "more likely than not" that nonpayment of tax on the income "allocated" to the charity while it "owns" the stock will withstand an IRS challenge, even if the allocated income is not actually distributed to the charity and the individual regains control of the income. The individual is told he can also take a personal tax deduction for the "donation."
3) Setting Up The Transaction. The S-corporation issues non-voting shares of stock that, typically, equal 9 times the total number of outstanding shares (e.g., corporation with 100 voting shares issues 900 nonvoting shares). Corporation gives the non-voting shares to the existing individual-shareholder. Corporation also issues to the individual-shareholder warrants to purchase a substantial number of company shares (e.g., 7,000 warrants). Corporation issues a resolution limiting or suspending income distributions to all shareholders for a specified period of time (e.g., generally the period of time in which the charity is intended to be a shareholder, typically 2 or 3 years). Prior to issuing this resolution, corporation may distribute cash to the existing individual-shareholder.
4) The Charity. A "qualifying" charity (one which is exempt from federal tax on unrelated business income) agrees to accept S-corporation stock donation. KPMG actively seeks out qualified charities and identifies them for the individual.
5) The "Donation." S-corporation employs an independent valuation firm to analyze and provide a valuation of non-voting shares. Due to the non-voting character of the shares and the existence of a large number of warrants, the non-voting shares have a very low fair market value (e.g., $100,000). Individual "donates" non-voting shares to the selected charity, making the charity the temporary owner of 90% of the corporation's shares. Individual claims a charitable deduction for this "donation." At the same time, the corporation and charity enter into a redemption agreement allowing the charity, after a specified period of time (generally 2-3 years), to require the corporation to buy back the shares at fair market value. The individual also pledges to donate an additional amount to the charity to ensure it obtains the shares' original fair market value in the event that the shares' value decreases. The charity does not receive any cash payment at this time.
6) The "Allocation." During the period in which the charity owns the non-voting shares, the S-corporation "allocates" its annual net income to the charity and original individual- shareholder in proportion to the percentage of overall shares each holds (e.g., 90:10 ratio). However, pursuant to the corporate resolution adopted before the non-voting shares were issued and donated to the charity, little or no income "allocated" to the charity is actually distributed. The corporation retains or reinvests the nondistributed income.
7) The Redemption. After the specified period in the redemption agreement, the charity sells back the non-voting shares to the S-corporation for fair market value (e.g., $100,000). The charity obtains a cash payment from the corporation for the shares at this time. Should the charity not resell the stock, the individual- shareholder can exercise the warrants, obtain additional corporate shares, and substantially dilute the value of the charity's shares. Once the non-voting shares are repurchased by the corporation, the corporation distributes to the individual-shareholder, who now owns 100% of the corporation's outstanding shares, all of the undistributed cash from previously earned income.
8) Taxpayer's Claim. Due to its tax exempt status, the charity pays no tax on the corporate income "allocated" or distributed to it. According to the KPMG opinion letter, for tax purposes, the individual can claim a charitable deduction for the "donated" shares in the year in which the "donation" took place. During the years in which the charity "owned" most of the corporate shares, individual will pay taxes on only that portion of the corporate income that was "allocated" to him or her. KPMG also advised that all income "allocated" to the charity is then treated as previously taxed, even after the corporation buys back the non-voting stock and the individual regains control of the corporation. KPMG also advised the individual that, when the previously "allocated" income was later distributed to the individual, the individual could treat it as long-term capital gains rather than ordinary income, taxable at the lower capital gains rate. The end result is that the individual owner of the S-corporation was told by KPMG that he or she could defer and reduce the rate of the taxes paid on income earned by the S-corporation.
9) IRS Action. This transaction is under review by the IRS.
Prepared by U.S. Senate Permanent Subcommittee on Investigations, Subcommittee staff of Senator Carl Levin, November 2003
Prepared by U.S. Senate Permanent
Subcommittee on Investigations,
Subcommittee Staff of Senator Carl Levin,
Until Monday, November 17, 2003
S-Corp. Creates and Transfers to the Shareholder an Additional 900
Voting Shares and 7,000 Warrants Shareholder "Donates" Non-Voting
Stock to a Charitable Entity
2-3 Year Period When Charity is Shareholder in S-Corporation