Roger started a successful business 20 years ago manufacturing and selling sweaters. He and his business partner Daniel own all of the shares in the business, which is organized as an S-corp and valued at $3,000,000. Roger is approaching retirement age and is looking for a way to transfer his $2,000,000 interest to Daniel and also offset the taxable income from the sale with a charitable income tax deduction.The transfer of S-corp stock to a charitable remainder trust (CRT) raises potential issues as well. While a charity is a permissible S-corp shareholder, a charitable remainder trust is not. Sec. 1361(e). If a CRT receives S-corp stock, either through donation or purchase, the S-corp will be reclassified as a C-corp. This will cause the corporation to lose its pass-through taxation status and its income will be subject to double taxation, likely to the chagrin of the remaining shareholders.
He asks his professional advisor about the possibility of selling $1,250,000 of his stock to Daniel and donating the remaining stock to his favorite charity. Roger's advisor warns him that the transfer of $750,000 in S-corp stock to charity will not produce a full $750,000 charitable deduction, but will be reduced by the ordinary income of the corporation. Roger learns that if the corporation were to sell its inventory 15% of the amount realized would be ordinary income. Therefore, Roger's deduction would be reduced by 15% from the $750,000 fair market value to $637,500.
Michael is the sole shareholder in an S-corp he purchased 20 years ago from the founder, who was retiring. Michael's current adjusted basis in the stock is $150,000. The S-corp, which operates a hardware store in town, purchased a plot of land for $70,000 10 years ago with the intent to build an additional store, but those plans never materialized. Michael is now ready to sell his shares to a third party but would like to offset the capital gains from the sale with a charitable income tax deduction.This asset transfer strategy does not come without its share of difficulty. First, the transfer of assets will likely be a better fit for S-corps with few shareholders. An S-corp with the maximum 100 shareholders will have difficulty reaching a consensus regarding a substantial charitable gift of corporate assets. An S-corp with two shareholders, on the other hand, is much more likely to be amenable to the idea of a charitable gift of corporate assets, as a greater percentage of the deduction will flow through to each shareholder.
Michael donates the plot of land, now valued at $150,000, to the local community college, which has its main campus adjacent to the property. Michael takes an income tax deduction of $150,000 for the charitable gift. While under prior law, Michael's outside basis would also be reduced by $150,000, current law only requires him to reduce his outside basis by $70,000. Thus, Michael ends up with an adjusted basis of $80,000.
Later in the same year, Michael finds an entrepreneur ready to operate the local hardware store who purchases all of Michael's S-corp shares for $300,000. Michael realizes $220,000 of gain on the sale, part of which is offset by his $150,000 charitable income tax deduction.
George and his son Hal have owned and operated a small chain of bicycle repair shops for the last 21 years. When George first started his business, he formed a corporation and made an "S election" for the corporation to be treated as an S-corp. Over time, the corporation expanded its footprint to three locations.It is important to note that a CRT funded with S-corp assets should be limited in duration to a term of years rather than for the life or lives of an individual or individuals. In Private Letter Ruling (PLR) 200203034, the Internal Revenue Service (the Service) ruled that a CRT funded by an S-corp that included individuals as successor beneficiaries did not qualify as a trust for federal income tax purposes and thus was not a qualified CRT. The Service based this decision in part on Reg. 1.671-2(e)(4), which treats the corporation as the grantor of the trust if the transfer is for a business purpose. However, if the transfer to the CRT is for personal purposes, the transfer will be treated as a constructive distribution to the shareholders, who will be treated as the grantors of the trust.
George is ready to retire and hand over the business to Hal. They meet with the company's attorney to determine the best exit strategy for George. George would ideally like to reduce his interest in the company in exchange for some extra retirement cash. Hal is on board with the plan but he does not have the means to buy his father's shares. George has heard of other small business owners using charitable solutions to achieve their goals, so he asks the attorney if there are any charitable gift vehicles that will help him and Hal.
The attorney explains that charities may be wary of accepting a gift of S-corp stock, since there will likely be a heavy tax bill attached before the stock can be sold and that a CRT cannot be funded with S-corp stock. George is intrigued, however, when the attorney mentions that the assets of an S-corp may be used to fund a CRT.
George and Hal decide to consolidate their bicycle repair operation by closing the smallest and lowest revenue producing shops of their three locations. They redistribute the newly closed location's inventory and equipment between the two remaining locations. The corporation then establishes a 20-year term charitable remainder unitrust funded with the real estate that formerly housed the repair shop that they closed. Even though the store was small, the real estate was very valuable. In fact, the real property represents roughly one-third of the value of the corporation's total assets. With this arrangement, George and Hal are able to steer clear of any danger of recognized gain.