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The “S” Corporation

By The Children’s Home Society of Florida Foundation

The most common type of corporation is a traditional “C” corporation. All companies whose stock is publicly traded are C corporations. C corporations pay tax on net income at the corporate level. When that income is distributed to shareholders in the form of dividends, the shareholders also pay tax. The result is that C corporation income is taxed twice – once at the corporate level and once at the shareholder level.

“S” Election

“S” corporations resemble C corporations except that they elect to be taxed differently. Not all corporations are eligible to make this election. To make the election, a corporation must have only one class of stock and less than 75 shareholders who are all individuals, estates and certain types of trusts and charities. IRC Sec. 1361. Charitable remainder trusts are not permissible holders of Subchapter S stock.

“Pass-Through” Taxation

An S corporation does not pay tax at the corporate level. Instead, the shareholders of an S corporation must include their share of the S corporation’s income, deductions and credits on the shareholder’s personal tax return – even if that income isn’t actually distributed. This is called “pass-through” taxation because the S corporation “passes” its income, deductions and credits “through” to its shareholders.

Inside and Outside Basis

The concept of tax basis appears regularly in the context of charitable giving. A person’s tax basis in an asset is generally equal to his or her investment in that asset. Often, tax basis is the amount a person paid for an asset (i.e. the asset’s “cost” to the owner). When the fair market value of an asset is more than its tax basis, the asset is appreciated and, if sold, will result in taxable gain to the owner. Charitable giving often allows the owner of an appreciated asset to bypass gain or defer part of the gain.

When working with S corporations, the concept of basis can be confusing. This is because there are two types of basis at issue. The first is the S corporation’s basis in its assets — this is often referred to as inside basis. The second is the shareholder’s basis in his or her S corporation stock – this is often referred to as outside basis.

When a shareholder sells his S corporation stock, the gain or loss on the sale is determined by the difference between the sale price and the outside basis. In the same way, when an S corporation disposes of an asset, the gain or loss to the S corporation is determined by the difference between the sale price and the S corporation’s inside basis in the asset.

Gifts of S Corporation Stock – Issues Relating to the Donor

Certain tax-exempt organizations are permissible shareholders of Subchapter S stock. Sec. 1361(c)(6). Therefore, an owner of S corporation stock can make a gift of the stock to a charitable organization and receive an income tax deduction. There are a few issues the donor needs to be aware of, however, before making a gift of Sub S stock to charity.

First, the donor’s ability to use the charitable deduction from the gift of the Sub S stock will be limited to the donor’s cost basis in his or her S corporation stock. Sec. 1366(d)(1) limits the amount of deductions and losses to the donor’s basis in stock and debt of the Sub S corporation. Often the donor of Sub S stock is also the person who established the business. Generally, the business was started with very little capital. Because of this, it is likely that the donor’s cost basis will be very low. If the donor’s basis in his or her stock is very low, the donor will only have a small charitable deduction.

The second issue for the donor to be aware of is minority discount. Generally, when a donor makes a gift of stock, the amount transferred to the charity represents a minority interest in the corporation. When a minority interest is given, it is very likely that the qualified appraiser will apply a discount to the value of the stock.

Finally, the donor of S corporation stock must be aware that there cannot be a binding agreement with the charity to repurchase the stock. If there is a binding agreement, the donor will have to recognize the income from the redemption of the stock and will not receive the benefit of a bypass of capital gain. Because S corporations are closely-held entities, there generally is not a large market for the sale of the stock. Therefore, it is very likely that the corporation will repurchase the stock. The repurchase is permissible, but a binding agreement before the gift is prohibited. Rev. Rul. 78-197.

Gifts of S Corporation Stock – Issues Relating to the Charity

While it is allowable for a charity to own Subchapter S stock, the tax benefits are not as advantageous as the ownership of C corporation stock. With C corporation stock, the charity is not taxable on any stock dividends, nor is it taxable on the gain when it sells the stock. This is not true with S corporation stock. Any income received by the charity for its ownership of Sub S stock is taxable to the charity as unrelated business taxable income. Sec. 512(e). In addition, when the charity sells the stock the gain from the sale is also taxable to the charity as unrelated business taxable income. Sec. 512(e)(1)(B)(ii). Because a charity is often established as a corporation itself, the tax on the gain will be taxed at corporate income tax rates. (corporations do not have a lower, favorable capital gains rate like individual taxpayers).

It is also important for a charity not to enter into a binding agreement with the donor for the sale of the stock. While there are no adverse tax consequences to the charity if such an agreement is made, there are adverse tax consequences to the donor as discussed above. If the charity is aware of the unfavorable tax consequences to the donor from having a binding agreement, it can prevent having an unhappy donor.

The S Corporation Unitrust

A charitable remainder unitrust or CRUT is not a permissible owner of Subchapter S stock. Therefore, if an S corporation shareholder were to transfer even one share of his or her S stock into a CRT, the S corporation election would be terminated and the corporation would become a C corporation the day after the transfer. This would mean that the corporation would be subject to two layers of tax: one at the corporate level and one at the shareholder level.

It is permissible, however, for the S corporation itself to establish a CRUT. Because the S corporation does not have a life expectancy, the CRUT must be established for a term of years not to exceed 20. The S corporation would fund the CRUT with some of its assets. However, it must be careful not to fund the CRUT with substantially all of its assets as discussed below. Because the S corporation is funding the CRUT, it would receive the charitable deduction and also would be the income beneficiary of the CRUT.

Even though the S corporation is entitled to the income tax deduction, because of its pass-through taxation the charitable deduction will flow through to the S corporation shareholders. As mentioned above, however, the deduction to the shareholders will be limited to the shareholders’ cost basis in their Sub S stock.

Potential Reg. 1.337(d)-4 Gain Recognition

When a corporation is liquidated, there is potential tax payable at the corporate level. If it were permissible for a corporation to distribute all of its assets to charity or to a charitable trust, then this tax could be avoided. In order to limit this type of transaction, Reg. 1.337(d)-4 requires recognition of gain at the corporate level if “substantially all” the assets are given to charity or to a charitable remainder trust.

Even though an S corporation is not subject to tax like a C corporation, if an S corporation liquidates the corporation must recognize gain as if the assets were sold. The S corporation does not pay taxes on the gain, but the gain passes through to the shareholders who must report the taxable gain.

The phrase “substantially all” is not defined in Sec. 337(b)(2) or in Reg. 1.337(d)-4. However, there are several other places in the Code in which the phrase “substantially all” is interpreted to mean 85%. Reg. 1.514(b)-1(b)(1)(ii). Reg. 53.4942(b)-1(c). Reg. 53.4946-1(b)(2). Reg. 1.401(k)-1(d)(1)(ii). While these regulations cover a variety of tax issues, it is significant that they uniformly interpret the phrase “substantially all” to mean 85%.

Since the exception under Sec. 337 refers to “an 80%” subsidiary, some counsel have also expressed the belief that “substantially all” could be interpreted to be 80%. Regardless, it is apparent that a transfer of perhaps 65% of assets to charity or to a charitable trust would be permissible under Sec. 337(b)(2). Cautious counsel would be prudent in remaining at or below that level with transfers to charity.

Financial Planning Strategies

While the use of a CRT is more limited with an S corporation then with a C corporation, there is still the possibility of utilizing a CRT when selling a business. For example, Tom and Suzie started a business years ago creating designer clothing for dogs. Tom and Suzie liked the idea of have a corporation to protect them from potential liabilities, but they did not like the idea of the double tax system. Therefore, they established their business as an S corporation. Tom and Suzie are the sole shareholders and are now planning to retire. Over the years they have supported a number of charities that assist in the prevention of cruelty to animals. Tom and Suzie are hoping to use some of the money they receive from the sale of the business to continue to support such charities.

Recently Tom and Suzie have had a number of inquires for the sale of their business. It seems that designer clothing and accessories for dogs has become a booming business. Tom and Suzie met with the gift planner from their favorite charity and like the idea of a CRUT that would pay them an income stream over their two lives. However, they discovered that because they have an S corporation they cannot transfer the stock to a CRT without losing their S election status. Tom and Suzie do not want to convert their business to a C corporation. Tom and Suzie can, however, have the S corporation use some of its assets to fund a CRUT that would pay for 20 years. However, they must take steps to ensure that the CRT is not disqualified.

First, Tom and Suzie have to carefully choose which assets the S corporation will use to fund the CRUT. The value of those assets cannot be substantially all of the value of the corporation. Further, they have to ensure that there is not any unrelated business taxable income while the assets are in the CRUT. Even $1 of unrelated business taxable income will disqualify the tax-exempt status of the CRUT. If Tom and Suzie decide to use any of the corporation’s equipment or inventory, the deduction of the CRUT will be limited to the corporation’s cost basis in those assets, which is very low. The S corporation does own the building and land on which it operates and the value of the land and building represents about 50% of the S corporation assets.

To make sure that the CRUT will work, Tom and Suzie enter into lease agreements with two of their key employees. Under the first lease, the employees will lease the operating assets of the S corporation. Under the second lease, the two employees will lease the building and land. Both leases are fixed payment leases. By establishing the leases, the S corporation can transfer some of its assets into the CRUT and avoid the unrelated business income tax problem.
Once the leases are established, the S corporation will transfer title of the real estate to the CRUT. To avoid potential self-dealing issues, Tom and Suzie decide to select their local bank to serve as trustee of the CRUT. Once the land is transferred to the CRUT, the trustee, along with Tom and Suzie, will negotiate for the sale of the assets and the land and building. After the sale is completed, the CRUT will receive the proceeds from the sale of the real estate and the S corporation will receive the proceeds from the sale of the operating assets.

The sale of the operating assets will trigger gain for the S corporation that will flow through to Tom and Suzie as the shareholders. It is important for Tom and Suzie to leave this cash in the S corporation. This is because the gain from the sale will increase Tom and Suzie’s cost basis in their S corporation stock. The increase in the cost basis will allow them to use more of the charitable deduction that will flow through to them from the S corporation. Over the years, the S corporation unitrust will make payments to the S corporation. So long as the S corporation was not a prior C corporation, the passive income from the CRUT will not pose any problems for the S corporation.

Tom and Suzie are very happy with the sale of their business and that they are able to provide a very nice gift to their favorite charity. They are also very happy that they now get to take a long needed vacation.

Assessment

There are a number of charitable strategies that can be used when selling a business. Tom and Suzie could have established a charitable gift annuity with their Sub S stock. They also could have used a gift and sale strategy. There are other options available to Tom and Suzie if they chose not to keep the S corporation alive for the 20 year term of the trust. This article is the first in a series that will explore the options of using businesses and business assets to fund charitable gifts. Throughout this series, planning options with C corporations, S corporations, partnerships, LLCs and sole proprietorships will be discussed.

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Filed under: Estate Planning, Financial Planning, Retirement and Benefits | Tagged: "Pass-Through" Taxation, C corp, Charitable Gifts, CRT, CRUT, Gifts of S Corporation Stock, inside basis, IRC Sec. 1361, outside basis, Reg. 1.337(d)-4, S corp, Sec. 1361(c)(6), Sec. 1366(d)(1), Sec. 512(e)(1)(B)(ii). |