Tax Traps When Giving S Stock to a Charity

Take-Away: There are several tax traps when S corporate stock is the subject of a gift to charity, particularly if the S stock is used to fund a charitable remainder trust (CRT.) It may be better for the S corporation to use one of its assets as the subject of a gift to charity, as opposed to the gift of S corporate stock to a tax exempt entity.

Background: On a recent bike ride the owner of a closely held business mentioned that due to the recent market collapse and the uncertainties of the future business world, he has decided to sell this corporation. He plans to sell his stock to a long-time key employee. He also mentioned that he planned to gift some of his stock to a charitable remainder trust (CRT) just prior to the anticipate stock sale, claiming a charitable income tax deduction. The CRT would pay 5% of its assets annually to he and his wife with the CRT remainder interest ultimately passing to a charity that he and his wife have supported for many years. Sale of the stock by the CRT would not create any capital gain exposure for the corporation’s owner. When I learned that his corporation is an S corporation,  I cautioned (no doubt ruining the balance of the bike ride and his anticipated ride into retirement) that there were several tax concerns in the implementation of his plan to gift S stock to a CRT and then he and the CRT sell their S corporate shares to the key employee.

Some of the tax traps that need to be considered if S corporate stock is transferred to a CRT follow.

1. UBTI: When a tax exempt entity, like a CRT, owns shares of an S corporation, all of the charity’s share of the S corporation’s income and capital gains, including the capital gains on the CRT’s sale of the S stock, will be considred unrelated business taxable income (UBTI.) The upshot is that the UBTI will be taxable to the charity, in this case the CRT. Moreover, a CRT is not a valid S corporate shareholder. Thus, the transfer of S stock to the CRT will terminate the corporation’s S election, causing the corporation to convert to a C corporation. What is critical is that all income or capital gains a charity (the CRT) receives from an S corporation is deemed by statute to be UBTI, and thus taxable.
2. Characterization as a Pre-Arranged Sale: If the donor enters into an informal agreement or understanding to sell the S stock to his buyer prior to transferring some of the S stock to a charity, like a charitable remainder trust (CRT), and that property is ultimately sold to the buyer, the IRS may recharacterize the transaction as a sale of the stock by the donor personally rather than a sale of its stock by the CRT. If recharacterized, the gain would be taxable to the donor-seller, instead of being a tax-free sale by a tax exempt entity (the CRT). In addition, the donor would have to pay the full capital gain tax out of his own pocket;  he cannot use any of the sales proceeds received by the CRT to pay the capital gain tax.
3.  Valuation Discounts: If the donor transfers some of his S stock to a CRT, the IRS (or the Tax Court) may claim that a valuation discount applies to the value of the S stock given to the CRT. In the past the IRS did not spend much time claiming that the S stock gifted to the CRT was subject to valuation discounts for either (i) lack of control or (ii) lack of marketability, but those good ‘old days’ have are long gone. If a valuation discount is applied to the S stock given to the CRT, that reduces the value of the charitable deduction that the donor initially expected to claim (to offset his capital gain tax exposure on the sale of his own S shares of stock.)
4. Hot Assets: A gift of S corporate stock to a CRT may also present problems if the S corporation has inventory or accounts receivable (often called hot assets.) If that is the case, the donor’s income tax deduction for the contribution of the S corporate stock will be reduced by the donor’s proportionate share of the hot assets, for which the donor will not receive any income tax charitable deduction. [Note, this hot asset rule also applies to LLCs and partnership interests transferred to CRTs.]
5. Debt-Financed Stock: The transfer of debt-financed property to a CRT or donor advised fund (DAF) which includes of a flow-through entity like an S corporation because creates unrelated business taxable income (UBTI) for the CRT on income or gain from the sale in proportion to the percentage of the debt compared to the income or gain received.

Example: If the S corporation is 50% leveraged, then potentially 50% of all income or gain incurred by the CRT will be subject to UBTI.

Grantor Trust: If the donor remains liable on the debt after gifting the S stock to the CRT, the CRT will be treated as a grantor trust for income tax purposes. Consequently, the CRT will not be a qualified tax exempt entity, and the donor will lose the income and gift tax deduction when the S corporate stock was transferred to the CRT. Restated, the donor will be liable for any capital gain that that is triggered when the CRT sells an appreciated asset like the S corporate stock.

6. Private Foundation Rules: The private foundation (PF) excise tax rules apply to CRTs (and also donor advised funds.) That means that the bewildering PF self-dealing prohibition rules apply as well as the PF excess business holding rule applies to a CRT that holds S stock. These rules can pose a problem if the donor decides to continue to hold his S stock as he would be a disqualified person and exposed to the self-dealing prohibitions. Some of these excise taxes, if a situation is not corrected, are punitive in amount.

Conclusion: The strategy of gifting stock to a CRT to reduce capital gains exposure on the sale of the balance of the donor’s stock makes sense. Capital gains are avoided by the donor, and the CRT that sells the stock is tax exempt. In addition, the donor creates a charitable income tax deduction to further reduce income taxes. This all works if the corporation is a C corporation, but not if the stock transferred to the CRT is S corporate stock. Some, but not all, of these problems can be avoided if the S election is dropped prior to the gift to the CRT and its subsequent sale of the gifted stock. In sum, use extreme caution if the plan is to use S stock as the subject of a gift to a CRT.