By Danielle T. Zaragoza,
Esq., Morrison &
Foerster LLP
Not all charitable gifts are created equal, and a charity is
not required to accept any and all donations of property, especially property
that may be difficult to own or liquidate in furtherance of the charity's
purpose. For instance, before a charity
accepts a contribution of stock in an S corporation, it should be aware of
the income tax consequences of being a shareholder of an S corporation. This article summarizes some of the basic tax
laws related to charities, S corporations and the unrelated business
income tax and suggests that a charity think twice before accepting a
charitable gift of S corporation stock.
Unrelated Business Income Tax
The
unrelated business income tax ("UBIT") applies to most organizations exempt
from tax under section 501(a) of the Internal Revenue Code (the "Code"). These organizations include charitable,
religious, scientific and other organizations described in Section 501(c)
of the Code. Unrelated business income
is the income from a trade or business regularly carried on by a charity that
is not substantially related to the performance by the organization of its
exempt purpose or function. The principal
purpose of the UBIT rules is to prevent a charity from having an unfair
competitive advantage over a taxable organization when a profitable activity is
not directly related to the organization's exempt purpose or function.
S Corporations Generally
S
corporations are corporations that elect to pass their income, losses,
deductions and credits through to their shareholders for federal tax
purposes. Shareholders of S corporations
report the flow-through of income and losses on their personal tax returns and
are assessed tax at their individual income tax rates. This allows S corporations to avoid
double taxation on the corporate income. S corporations are responsible for tax on
certain built-in gains and passive income.
To
qualify for S corporation status, the corporation must meet the following
requirements:
- Be a
domestic corporation
- Have
only allowable shareholders
- includes
individuals and certain trust and estates
- may
not include partnerships, corporations or non-resident alien shareholders
- Have
no more than 100 shareholders
- Have
one class of stock
- Not
be an ineligible corporation-i.e., certain financial institutions,
insurance companies, and domestic international sales corporations.
Charities are Eligible S Corporation Shareholders
- UBIT Liability
Prior
to 1998, if a charity became a shareholder of an S corporation, the
corporation immediately lost its S corporation status and was subject to
many of the disadvantageous provisions of the general corporate income tax
laws, including double taxation on the corporate
income. In 1996, Congress enacted the
Small Business Job Protection Act of 1996 and permitted a charity to be an
eligible shareholder of an S corporation beginning January 1, 1998. This allowed 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. For some potential donors, S corporation
stock may be the most valuable asset owned and it is often the only asset that
they can use for a major charitable gift.
An S corporation's
income is taxed to the shareholders and charities are not exempt from this
provision. The way Congress chose to
implement this provision was to treat a charity's share of the S corporation's
income as unrelated business taxable income.
Section 512(e) of the Code generally provides that a charity that is a shareholder of an S corporation will recognize tax on unrelated business taxable income on its ownership of S corporation stock regardless of whether the S corporation income is generated from active or passive interests. Therefore, a charity that owns S corporation
stock must take into account its share of the S corporation's income,
deductions, or losses in figuring unrelated business taxable income, regardless
of the actual source or nature of the income, deductions, and losses. For example, the charity's share of the S corporation's
interest and dividend income will be taxable, even though interest and
dividends are normally excluded from unrelated business taxable income. The charity must also take into account its
gain or loss on the sale or other disposition of the S corporation stock
in figuring unrelated business taxable income.
Just because a
charity can be an S corporation shareholder, does not mean that it should be an
S corporation shareholder.
Prior to accepting a contribution of S corporation
stock, a charity should evaluate the business of the S corporation and
determine if owning the stock is an attractive investment given the UBIT
burdens associated with owning and selling S corporation stock. Below is a list of factors for a charity to
consider when making that evaluation:
- What is the nature
and profitability of the business?
o
Many S corporations are operating
businesses whose success and failure depends on the skills and management of employees
- Will the charity be
able to sell the stock?
o
The potential market for selling or liquidating
the contributed S corporation stock is usually very restricted and may
include only the corporation (a redemption), the existing shareholders, or
purchasers who have been pre-approved by the existing shareholders. As a result, the charity should be
comfortable holding the S corporation stock as a long term investment.
- What is the donor's
adjusted basis in the stock?
o
The donor's tax basis is important because it
determines the charity's gain or loss upon the sale of the stock and affects
whether cash distributions from the S corporation are taxable or tax-free.
- What is the projected
after-tax income stream the charity can expect as a shareholder in the S corporation?
o
The after-tax income stream will be the cash
distributions from the S corporation less the amount of UBIT the charity
is required to pay.
o
Are the expected distribution amounts sufficient
to pay the UBIT and would there be amounts left over to support the charitable
purpose?
- How often does the S corporation make
distributions? Does the S corporation have a shareholder agreement in
place that mandates cash distributions in amounts sufficient to at least
cover the UBIT liabilities?
o
If UBIT is due, a charity will usually be
required to make estimated quarterly tax payments or may be subject to interest
and penalties.
o
If the S corporation does not make regular
distributions to satisfy the UBIT estimated quarterly tax payments, does the
charity have sufficient liquid assets to make these payments or will it have to
borrow funds to do so?
o
A charity should establish a reserve fund to
satisfy the UBIT in years when the S corporation has taxable income but
does not make cash distributions to its shareholders, which may happen even if
there is a shareholder agreement in place requiring such distributions.
After
considering the above listed factors, a charity may determine that the
financial benefits of being a shareholder of the S corporation do not
outweigh the administrative, filing and unrelated business income tax burdens
associated with owning the particular S corporation stock.
* *
*
Morrison & Foerster's
Trusts and Estates group provides sophisticated planning and administration
services to a broad variety of clients.
If you would like additional information or assistance, please contact
Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.
© Copyright 2012 Morrison &
Foerster LLP. This article is published
with permission of Morrison & Foerster LLP.
Further duplication without the permission of Morrison & Foerster LLP
is prohibited. All rights reserved. The views expressed in this article are those
of the authors only, are intended to be general in nature, and are not
attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be applicable
in all situations and should not be acted upon without specific legal advice
based on particular situations.
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