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 1996 2 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.
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