Virginia State Bar

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Trusts and Estates

A Section of the Virginia State Bar.

Fall 2003 Newsletter

Newsletter - Trusts and Estates

Volume 19, No. 1

LIFETIME CHARITABLE GIVING USING SCORPORATION STOCK: TRAPS, TRICKERY, AND TROUBLE AHEAD

by Dana G. Fitzsimons Jr.

Introduction

Despite the noticeably higher profile of many C corporations, most corporations doing business today are S corporations. For many clients, S corporation stock represents a large part of the client's net worth, making such stock a tempting candidate for charitable giving. For this reason, advisors should have an understanding and appreciation of the application of the Subchapter S rules in the context of charitable gift planning. This Article will review a handful of the many potential problems surrounding lifetime charitable planning involving gifts of S stock to "public charities." 1 As this Article will attempt to show, for the advisor seeking to further the client's charitable inclinations through gifts of S stock, there awaits a collection of traps, tricks, and trouble to be carefully navigated. This Article will highlight some of the more common problem areas.

Subchapter S

The principal advantage of electing to do business as an S corporation is the opportunity to enjoy the limited liability of a regular, or C corporation, within the framework of a pass-through taxation regime. The principal disadvantage to S corporation status may be the technical complexity of the Subchapter S rules (Code Sections2 1361 et seq.). Of the many Subchapter S requirements that apply to businesses electing S corporation status, in the charitable planning context primary concern is with the rules restricting the number and types of shareholders that an S corporation may have.

An S corporation may not have more than 75 shareholders at anyone time during any taxable year.3 As discussed throughout this Article, the calculation of the number of shareholders of an S corporation can become complicated when trusts are involved.

The Subchapter S rules also restrict who may be a shareholder of S stock. Individuals (other than nonresident aliens) can own S stock4 , as can estates and charitable organizations described in Code Section 501(c)(3).5 Certain types of trusts (the most commonly used of which are considered in this Article) are allowed to hold S stock: grantor trusts,6 so-called "Mallinckrodt" Trusts7 certain testamentary trusts,8 voting trusts,9 qualified subchapter S trusts (QSSTs),10 and electing small business trusts (ESBTs).11

Great care should be taken to ensure that transfers of S stock to charity (or to charitable trusts) do not run afoul of the 75 shareholder limit or result in the transfer of S stock to an ineligible shareholder, either of which will "blow" the Selection.

Outright Gifts of S Stock to a Public Charity

An outright gift of S stock to a public charity may be an attractive option because of its relative simplicity. A public charity is an eligible S shareholder,12 and for purposes of the 75shareholder limit, a public charity is counted as one shareholder. Appreciated S stock can be an especially attractive subject of an outright gift to a public charity because generally the donor can take an income tax deduction based on the fair market value of the stock, and recognition of gain can be avoided on the appreciation of the stock over the donor's basis. Conversely, depreciated S stock is generally best not used for lifetime charitable giving, so as not to waste a potentially valuable capital loss deduction.

To qualify an outright lifetime gift of S stock for the income tax deduction, the donor must transfer his entire interest in the stock to avoid violating the partl.a1 Interest rules.13 For example, no deduction would be allowed if the donor retained the voting rights over the stock.

A "qualified appraisal" is required to substantiate the value of gifts of S stock over $10,000 (along with additional reporting requirements).14 A qualified appraisal must be prepared by a qualified appraiser, who holds himself out as an appraiser and is qualified to appraise the type of assets being valued, and who is not the donor, the charity, or a related party to either.15 The appraisal must be dated no earlier than sixty days before the date of the gift and no later than the date (including extensions) by which the donor must file his income tax return reporting the gift.16

Assuming the S stock is long-term capital gain property (i.e., held by the donor for more than one year), the donor may generally deduct the full market value of the appreciated S stock.17 Gain is not generally recognized on the transfer of appreciated S stock to a qualified charity.18

While there is an unlimited gift tax charitable deduction for the value of the S stock,19 the income tax deduction on gifts to charity is limited to a percentage of the taxpayer's "contribution base" (usually adjusted gross income).20 Generally, the deduction for an outright gift21 of long-term capital gain property, including S stock, to a public charity is limited to 300/0 of the donor's contribution base.22 If an individual's charitable contributions for any year exceed the 30%- limit the excess may be carried forward for up to five years until fully used.23

Even with the limits, outright transfers to qualifying public charities can yield favorable income tax results while reducing the donor's estate for transfer tax purposes and satisfying the donor's charitable objectives. For those clients unwilling to make - an outright disposition, consideration might be given to the availability of using a trust as a vehicle for a gift of S stock to charity. As will be shown below, two common, trust vehicles for charitable giving (charitable remainder trusts and charitable lead trusts) may not be viable or practical options where S stock is involved.

Trusts as Permitted S Shareholders

The most commonly used trusts permitted to hold S stock are trusts structured as grantor trusts and trusts making one of two elections: the election to be treated as a qualified subchapter S trust (QSST) or the election to be treated as an electing small business trust (ESBT).

Grantor Trusts

Generally, a grantor trust is a trust where the grantor includes all of the trust's items of income, deductions, and losses for income tax purposes. Such a trust, where the grantor is treated under Code Sections 671-679 as the owner of the trust for income tax purposes, and the grantor is a U.S. citizen or resident, is eligible to hold S stock.24 For purposes of the 75-shareholder limit, the grantor is treated as the shareholder.25

There are significant disadvantages to transferring S stock to a grantor trust. The grantor will be taxed currently on all of the trust- income attributable to the S stock held in the trust, regardless of whether such income is actually distributed. Additionally, the grantor must have sufficient income to take advantage of any charitable deductions. Great care should be taken when setting up a grantor trust to ensure that the gift into trust is a completed gift, to avoid inclusion of the trust assets in the grantor's estate under Code Section 2036, and to avoid violating the private foundation rules that may apply to the trust.

QSSTs

A QSST is a trust that satisfies the QSST requirements, which require generally that: (1) the trust may have only one income beneficiary at a time, (2) the trust must distribute all of its income annually, and (3) principal distributions made during the life of the income- beneficiary can only be made to the income beneficiary, and if the trust terminates during the income beneficiary's life, the trust must distribute its assets to the income beneficiary. The QSST election must be made separately for the stock of each S corporation held in the trust (as opposed to an ESBT, where one election is made for all S stock in the trust).

A QSST is an eligible S shareholder,26 provided the trust satisfies the definitional requirements of a QSST and the beneficiary makes the necessary election.

For purposes of applying the 75-shareholder limit, the income beneficiary making the QSST election is treated as the shareholder during his life.27

ESBTs

An ESBT election is often preferred over a QSST election for its flexibility because, unlike a QSST, an ESBT can have multiple beneficiaries, accumulate income, and sprinkle income and principal among the beneficiaries.

A trust may qualify to make an ESBT election where the trust does not have beneficiaries other than individuals, estates, certain charities, or certain governmental entities. A public charity can be a beneficiary of an ESBT.28 Additionally, in order to qualify as an ESBT no interest in the trust can have been acquired by purchase,29 and the trustee must make a timely ESBT election.30 Once made, the ESBT election applies to all of the S stock in the trust, and the election is generally irrevocable.31

An ESBT electing trust is an eligible S shareholder.32 For purposes of the 75-shareholder limit, each potential current beneficiary of the trust is treated as a shareholder. A potential current beneficiary is any person who, at any time, is entitled to, or may, receive a distribution of trust income or principal, but doesn't include a future interest.33 If at any time there is no potential current beneficiary, the trust is treated as the shareholder.34 If a potential current beneficiary (or the beneficiary's spouse) owns S stock directly, the potential current beneficiary is not counted twice in applying the 75-shareholder limit. Where any potential current beneficiary of the trust is not an eligible S shareholder, the trust is not eligible to be an ESBT.

The S corporation jeopardizes its S election where the ESBT election is made and one of the potential current beneficiaries of the trust is not an eligible S shareholder. Accordingly, it is important to evaluate the eligibility of every potential current beneficiary of the trust before making the ESBT election.

The class of persons and entities that are eligible beneficiaries of an ESBT include some entities that are not permissible S shareholders (and vice versa).35 It is therefore important to assess each beneficiary of the trust under both the ESBT and S rules before making the irrevocable ESBT election and inadvertently blowing the corporation's S status or violating the ESBT rules.

As discussed below, both the QSST and ESBT elections can be problematic when made for the most common forms of charitable trusts.

Charitable Remainder Trusts

Simply put, if you are considering funding a charitable remainder trust with S stock, don't!

In a charitable remainder trust, the trust instrument provides for either fixed payments or a percentage of the value of the trust as revalued annually to one or more beneficiaries (commonly a spouse or other family members) for a term of 20 years or less or for the lives of the beneficiaries.36 The remainder interest passes to a charity at the termination of the income interest. In a 1992 private letter ruling, the Service concluded that neither a charitable remainder annuity trust nor a charitable remainder unitrust could qualify as a Qualified Subchapter S Trust (QSST) under Code Section 1361(d).37 This ruling makes clear that transferring S stock to a charitable remainder trust will blow the corporation's S election. Charitable remainder trusts are also ineligible to make an ESBT election.38

Charitable Lead Trusts

A charitable lead trust is a split-interest trust under which an annuity or unitrust interest is payable to charitable beneficiaries for a certain term, and upon expiration of that term the remainder interest is payable to non charitable beneficiaries or reverts to the donor.39

In a charitable lead annuity trust ("CLAT), the charity receives a fixed sum annually for a term of years, or for the lives of named persons, of either a fixed dollar amount or a percentage of the initial fair market value of the amount transferred to the trust. In a charitable lead unitrust ("CLUT"), the charity receives annually a fixed percentage of the fair market value of the trust, as revalued annually, for a term of years, or for the lives of named persons. The potentially high cost of annually appraising S stock in a CLUT makes the CLAT typically the more attractive option.40 Additionally, the CLAT's use of an annuity may offer greater leverage for transfer tax purposes when the Code Section 7520 rates are low.

The most common form of CLAT is the qualifying non-grantor trust (to shift the items of income and deductions from the grantor to the trust). In this type of arrangement the income interest is given to a qualified charitable organization in the form of a guaranteed annuity. The grantor does not receive an income tax charitable deduction, rather, the CLAT is entitled to a charitable deduction for amounts of its gross income paid to charity each year.41 The qualifying non-grantor CLAT is used generally to remove future appreciation of the trust corpus from the grantor's estate and to leverage transfer tax exclusions and exemptions.

A split-interest trust with a charitable lead beneficiary (keeping in mind that charitable remainder trusts cannot hold S stock without blowing the S election) is not eligible to make a QSST election because: (1) the charitable lead trust's charitable income beneficiary does not have a "measuring life" as required by the QSST rules and (2) the distribution of the remainder in a CLAT (usually to a family member) may violate the QSST requirement that the trust assets be distributed to the current income beneficiary if the trust terminates "during the life" of the income beneficiary.42

Accordingly, in order to hold S stock the trustee of the non-grantor CLAT must qualify to and make an ESBT election (which, as discussed, below, may result in the loss of the trust's charitable deduction under Code Section 642(c)).43

ESBT Electing CLAT

In 2002 the Treasury Department and the IRS issued final ESBT regulations under Code Sections 1361 and 641, which, in addition to addressing numerous other issues clarified how charitable contributions from an ESBT would be treated.44

The Code and Regulations set up an elaborate taxation scheme for ESBTs, a full discussion of which is beyond the scope of this Article. Basically, for purposes of reporting and computing the ESBT's income taxes, the ESBT is segregated into an "S portion" (consisting of S stock) and a "non-S portion," and the regulations allocate items of income and deductions among the portions. The final regulations create disincentives for charitable contributions by an ESBT.

Where an S corporation in which an ESBT holds shares makes a charitable donation, the regulations limit the deduction available to the ESBT by subjecting the deduction to the limitations of I.R.C. Section 681, regarding unrelated business income, which can be a significant limitation.45

Where the ESBT makes a direct contribution to a charity (such as the annuity payment under a CLAT) of assets other than S stock, the contribution is only deductible to the extent it is paid from the gross income of the non-S portion (which would not include income earned with respect to the S stock).

A transfer of S stock to, charity to satisfy the annuity payment in-kind would not be deductible by the non-S portion because the S stock is allocated to the S portion, and the transfer would therefore not be out of the gross income of the non-S portion. To complete the rather punitive regime under the regulations, a transfer of S stock to charity is also not deductible by the S portion of the ESBT.46

Because in order to protect the corporation's S election a non-grantor CLAT must make an ESBT election (and subject itself to the oppressive regulations), the significant tax disadvantages of using a CLAT to hold S stock must be carefully considered.

Conclusion

A trusted colleague may have summed it up best: when asked for guidance on approaching lifetime charitable giving using S stock, she told me it should be a short article-just advise clients to "pick another asset." In addition to the complexity, in her experience, many charities are not interested in S stock gifts because of the unrelated business taxable income (UBTI) problems for the charity under Code Section 512. While this Article mentions only some of the most basic potential problem areas, closer examination of the relevant Code and Regulations will undoubtedly reveal additional issues to be mindful of. In light of this, the prospect of funding a lifetime charitable gift with S stock seems to be an unattractive proposition.

That being said, if you're faced with a charitably inclined client with only S stock to carry that inclination to fruition, strap yourself in, because it's going to be a rough ride.

Dana G. Fitzsimons Jr. is an associate with the law firm of McGuireWoods LLP in Richmond, Virginia. Mr. Fitzsimons earned his Bachelor of Music degree from Ithaca College, and his JD. from William and Mary. Mr. Fitzsimons would like to thank W Birch Douglass, III and Michele A. W McKinnon at McGuireWoods for their invaluable assistance with the preparation of this Article.

1 "Public charities" are traditionally those § 501 (c)(3) organizations described in Code §§ 170 (b)(l)(A)(i) - (vi) and 509(a)( 1), and typically include churches, educational institutions, and organizations providing medical care or education. The myriad of additional issues that arise when the intended charitable donee is an entity other than a public charity, such as a private foundation, are beyond the scope of this Article. Testamentary charitable planning is also beyond the scope of this Article.

2 Citations to Code Sections are to the Internal Revenue Code of 1986, as amended.

3 I.R.C. § 1361(b)(lXA).

4 I.R.C. § 1361 (b)(I)(B).

5 I.R.C. § 1361(b)(1)(B). A concern that should be addressed by a charity considering holding S stock is that the items of income, loss, deduction, or credit of the S corporation that flow through to the charity and the gain and loss on the sale of S stock are treated as unrelated business taxable income (UBTI) to the charity. I.R.C. Section 512(e)( 1). For an excellent consideration of this and other concerns about donations of S stock from the donor's and the charity's perspectives, see Laura H. Peebles, Charitable Gifts of S Corporation Stock: Problems & Opportunities, The Journal of Gift Planning (2nd Quarter 2002). While repetitive citations are omitted, Ms. Peebles' excellent article was a valuable and frequently referenced source in preparing this Article, and I highly recommend that anyone considering charitable planning with S stock refer to her article for a more detailed discussion of the subject matter.

6 1.R.c. § 136I(c)(2)(A)(i).

7 I.R.C. § 1361 (c)(2)(A)(i); I.R.C. § 678.

8 1.R.C. §,1361(c)(2)(A)(iii).

9 I.R.C. § 1361(c)(2)(A)(iv).

10 I.R.C. § 1361(d).

11 I.R.C. § 1361(c)(2)(A)(v).

12 I.R.C. § 1361(b)(1)(B).

13 See I.R.C. § 251,1 and accompanying regulations.

14Treas. Reg. § 1.170A-13(c)(2)(i) and (ii).

15 Treas. Reg. § l.l70A-13(c)(5).

16Treas. Reg. § 1.170A-13(c)(3).

17 I.R.C. § 170(e)(I). Certain limitations apply where the donated securities are short-term capital gain property.

18This may not be the case where the transfer to charity was for partial consideration, or where the charity sells the stock shortly after receipt pursuant to a pre-arranged agreement.

19 I.R.C. § 2522.

20 I.R.C. § 170(b).

21 Gifts other than an outright gift may be subject to additional limitations and requirements. See, e.g. I.R.C. § 170(b)( 1)(A).

22I.R.C. § J70(b)(1)(B). The donor may be able to deduct up to 50% of his contribution base if he elects to limit the deduction to his basis in the property.

23 I.R.C. § 170(d)(1)(A).

24I.R.C. § 1361(c)(2)(A)(i).

25I.R.C. § 1361(c)(2)(B)(i).

26 1.R.C. § 1361(d)(l).

27 Treas. Reg. § l.l361-1(j)(7)(i). The regulations also detail the application of the 75-shareholder limit after the death of the income beneficiary. See Treas. Reg. §·1.1361I G)(7)(ii).

28Treas. Reg. § l.l361-1(m)(1)(i).

29Treas. Reg. § l.1361-1(m)(1)(iii) (although the trust itself may purchase S stock)

30 Treas. Reg. § l.l361-1(m)(2)(i)

31 The ESBT election may be revoked with the consent of the Commissioner obtained through a request for a private letter ruling. See Treas. Reg. § 1.1361-1(m)(6).

32 I.R.C. § 1361(c)(2)(A)(v).

33 Treas. Reg. § 1.1361-1(m)(4). The 75-sharehoJder limit should be carefully considered where there is a CLAT with several charitable beneficiaries or a class designation. If a class is used, the class may be so broad as to violate the 75shareholder limit. One possibility may be to name a community foundation as the sole charitable income beneficiary, and through the use of a donor-advised fund the charitable gift might be spread amongst several charitable beneficiaries without running afoul of the 75-shareholder limit.

34 I.R.C. § 1361 (c)(2)(B)(v).

35 For example, an I.R.C. § 170(c)(5) cemetery company is a permissible ESBT beneficiary, but is not an eligible S shareholder. Also, a qualified pension trust is a permissible S shareholder, I.R.C. § 1361(c)(6), but is not a permitted ESBT beneficiary because it is not listed in I.R.C. § 170(c). A trust may have a sixty-day period to cure some defects in the beneficiaries that arise. See I.R.C. § 1361(e)(2).

36 See generally Code § 664.

37 PLR 8922014.

38 I.R.C. § 1361 (e)(I)(B)(iii).

39 For an excellent discussion of additional considerations in using CLATs, including CLATs structured as grantor trusts, see Adam J. Wiensch, Esq., Funding Charitable Lead Trusts with S Corporation Stock, Tax Management Estates, Gifts and Trusts Journal, p. 108 (2002). Mr. Wiensch also considers the continuing usefulness of charitable lead trusts under the new taxation regime contemplated by the recent estate tax repeal legislation. While repetitive citations are omitted, Mr. Wiensch's excellent article was a valuable and frequently referenced source in preparing this Article, and I highly recommend that anyone considering planning involving charitable lead trusts and S stock refer to his article for a more detailed discussion of the subject matter.

40 Charitable lead trusts are subject to many of the private foundation rules in I.R.C. §§ 4940-4948, 507, and 508. The requirements and prohibitions of these sections are not considered in this Article but must be carefully reviewed before drafting or administering a charitable lead trust.

41 Code § 642(c).

42 I.R.C. § 1361(d)(3)(A).

43 The trustee should carefully weigh fiduciary considerations when considering whether to make an ESBT election.

44 TD 8994. For an excellent review of the Final Regulations in their historical context, see Jerald David August, et. al., Clarifications Made By ESBT Final Regulations Demonstrate the Need for More Statutory Changes, Journal of Taxation (August 2002).

45 Treas. Reg. § 1.641 (c)-1 (d)(2).

46 Treas. Reg. § 1.641(c)-1, Example 4.