Prudent tax advisors make use of S-corporations for both wealthy and aspirational clients. The number of S-corporation returns filed with the IRS has grown from nearly 3.3 Million in 2003, to 4.7 Million in 2017, and now to nearly 5.2 Million as of 2019. Using S-corporation stock, as an alternative to cash or property distributed from the S-corp, to accomplish charitable pursuits and mitigate taxes can be a win-win situation for many taxpayers if they focus on the effect this has on the basis in their stock holdings. This article will explain the discreet effects on S-corp stock basis that prove this is a powerful planning tool. The valuation of a private company is extremely complex and should be done by an accredited professional. However, valuation cost is the only significant cost to implement this strategy when compared to a base case whereas the taxpayer would otherwise make the same donation in the form of cash.
The U.S. Tax Court in a memo opinion, Dickinson v. Commissioner, T.C. Memo. 2020-128 (Sept. 3, 2020), respected the form of the taxpayer’s gift to charity in the form of S-corporation stock. The Tax Court order allowed the taxpayer to claim a charitable deduction for the fair market value of the stock and avoided recharacterization as a deemed redemption of stock, followed by proceeds contributed to charity.
The charity involved in this matter was Fidelity Investments Charitable Gift Fund (Fidelity Charitable). In 2019, Fidelity Charitable passed the Gates Foundation as the largest grantmaking organization in the United States with assets in excess of $31 Billion. This foundation is a top choice for many, but certainly not the only Charitable Gift Fund operating in this technical area.
In Dickinson, the Tax Court recited some key facts supporting the taxpayer’s position. The taxpayer obtained approval from the Charity’s board. Secondly, the stock and accounting ledgers showed Fidelity Charitable Fund as the new owner prior to the redemption. And lastly, the taxpayer obtained confirmation letters which explained Fidelity retained the “exclusive legal control over the contributed assets.”
Some key takeaways for practitioners and taxpayers are as follows:
- S-corporation stock can be gifted to a 501(c)(3) charity without busting the S-election.
- Fidelity Charitable Gift Fund has a policy to sell/redeem any securities as soon as they are received.
- Candidates for this planning technique must review their corporate bylaws or LLC operating agreement to confirm no restrictions exist on the transfer or redemption of shares.
- Issues with basis recognition of income and reduction for transfer to charity.
- Memo opinion is not legal precedent, but may be cited in another case. Tax Court Rule 51(f) provides that “Orders shall not be treated as precedent, except as may be relevant for purposes of establishing the law of the case, res judicata, collateral estoppel, or other similar doctrine.”
The advantage of the stock gift and redemption form is subtle and rely on the calculation of shareholder’s basis in S-corportation stock under CFR 1.1367-1(d). Adjustments to stock basis are generally effective at the close of the corporation’s taxable year. However, “if a shareholder disposes of stock during the corporation’s taxable year, the adjustments with respect to that stock are effective immediately prior to the disposition. Rules effectuating the allocation of income amongst shareholders follow a per-share-per-day methodology. The timing of the basis increase allocations results in an advantageous accumulation of shareholder basis in the S-corporation that otherwise wouldn’t exist if the shareholder distributed cash from the entity and contributed it to charity. The taxpayer could utilize this additional basis in stock in several ways, whether it be gain mitigation on sale of the business, or creative estate planning techniques where intervivos gifts are subject to the basis rules for lifetime gifts of property.
The best strategy here would be to minimize the holding period of the charity, which is advantageous for both parties. In the case of Fidelity Charitable, their board of trustees has established governance rules requiring the immediate liquidation of non-public stock. When the stock is redeemed, the percentage ownership of outstanding stock and thus, the following year’s allocation of income is recomputed. Lastly, the practitioner needs to be aware of and comply with the UBTI rules of IRC Section 512 when issuing a K-1 to the charity for their minimal holding period.
The accompanying exhibit shows an illustration with various assumptions to highlight the accumulation of basis as a deferred tax asset using the highest marginal rate (37%). The overarching concept here is it will take multiple gifts and a number of years to accumulate meaningful amounts of additional basis. This strategy is best used in a business with predictable cash flow and earnings profile, such as a real estate management company. A donor-advised-fund established with a charitable gift fund is recommended to allow the taxpayer additional flexibility including the timing of distributions and choice of the ultimate public charitable organization recipient.
Base Case: The taxpayer distributes 20% of taxable income in cash and contributes to charity to mitigate tax liability.
Alternative Case: The taxpayer uses the tax strategy described in Dickinson to achieve their charitable pursuits.
- Taxable Income grows at 5% annually,
- Beginning stock basis is $300,000,
- S-corporation is wholly-owned,
- Valuation costs per year are $5,000, and non-deductible when paid by the corporation.
- Valuation is 6 x Taxable Income with a 30% combined valuation discount,
- Donation targeted amount is 20% of Taxable Income, which equates to an approx. 5% ownership.