Donations of S-Corp Stock

Public charities have been permitted shareholders of S-Corporations since 1998. Since that time, charitably-inclined business owners have sought to donate shares of their closely-held business stock to charitable organizations. Normally, donating long-term capital gain property to a charity is highly tax efficient because (1) the donor receives a deduction for the fair market value of the donated asset, (2) the donor avoids paying tax on the asset's built-in gain, and (3) the charity, being tax-exempt, also avoids paying tax on any gain from the sale of the asset. In a previous post, I addressed some situations where the charity may some tax.

In the case of S-Corp stock, however, charities pay a lot of tax. Section 512(e)(1)(B)(ii) of the Internal Revenue Code requires that "any gain or loss on the disposition of the stock in the S corporation" is included in unrelated business taxable income (UBTI). Unlike the gain on "virtually every other asset that a charity might own," only the gain on the sale of S-Corp stock is includible in UBTI. See Christopher R. Hoyt, Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems. This is a significant issue because charities typically seek to sell closely-held business interests as quickly as possible, especially stock in S-Corporations.

However, different charities pay different rates of tax on sales of S-Corp stock. Specifically, charities that are trusts pay less tax on gains included in UBTI than do charities that are corporations. This is because trusts are taxed at trust rates, which impose a 20% rate on long-term capital gains, whereas all corporate income, including long-term capital gains, is taxed at corporate rates of around 35%. Moreover, a trust is able to deduct up to 50% of its adjusted gross income for donations to other charities, while corporations are limited to 10%.

This is what makes a Donor Advised Fund at a charity that (1) is a trust and (2) maximizes contributions to other charities, such as Fidelity Charitable, an attractive target for a gift of S-Corp stock. The legal structure of the charity reduces the tax erosion of the gift, while the donor still has the right to advise what organization will ultimately receive the proceeds from the stock sale. Below is a comparison of the post-tax benefits that a corporate charity and trust charity would enjoy from the donation and immediate sale of S-Corporation stock:

	Corporation	Trust
Gain from S-Corp. Shares	1,000,000	1,000,000
Maximum Charitable Deduction	(100,000)	(500,000)
Net Unrelated Business Taxable Income	900,000	500,000
Estimated Tax Rate	35%	20%
Unrelated Business Income Tax	315,000	100,000
Effective Tax Rate	31.5%	10%

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Self-Employment Taxes for LLC Members

In a previous post, I discussed how members of an LLC taxed as a partnership can avoid being liable for self-employment tax on the net income from the business. With the limited exception of Prop. Reg. 1.1402(a)-2, the subject of that post, clear guidance on this issue has been lacking for decades. This month, the IRS created a stir by taking on the issue anew with Chief Counsel Advice memorandum 201436049. Tony Nitti, writing at Forbes, has a great article that describes the backdrop for this new pronouncement in this way:

"IRC Section 1402, like many provisions of the Code, starts off by setting the general rule– i.e., all trade or business income, including a partner’s distributive share of partnership income, is included in self-employment income–before listing a host of exceptions to that general rule. Specific to this discussion, IRC Section 1402(a)(13) provides that the distributive share of partnership income of a limited partner – other than guaranteed payments – is NOT included in self-employment income."

In general, taxpayers who earn active income owe self employment tax on that income, while taxpayers who invest and earn passive income, such as limited partners in a limited partnership, do not pay self employment tax on those earnings. IRC 1402 was passed before LLCs came into existence, and LLCs have confused the issue because all LLC members are legally akin to limited partners.

Most tax practitioners agree that, similar to how S-Corps are treated, only part of the distributive share received by members from properly-structured LLCs ought to be subject to self-employment tax, not all of it. However, with CCA 201436049, the IRS took the position that individuals who were members of an LLC that served as a general partner of an investment limited partnership and received a management fee were subject to self employment tax on the entirety of their distributive share.

CCA 201436049 makes reference to Prop. Reg. 1.1402(a)-2 in a footnote, summarizing the three tests for limited partner treatment: "[A]n individual is treated as a limited partner unless the individual: (1) has personal liability for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership; or (3) participates in the partnership's trade or business for more than 500 hours. [There are] exceptions for certain holders of classes of interest that are identical to those held by limited partners."

With respect to the exceptions: "If the LLC has two classes of members... [and if] at least 20% of the members of the Investor Class do meet all three tests and the managing member is a member of this class," the managing member is treated as a limited partner and his or her distributive share is not subject to self employment tax. John M. Cunningham, "Using LLCs to Protect Family Assets," WealthCounsel CLE, September 14, 2011. The key is to have a properly-drafted operating agreement that clearly creates these distinct classes of membership.

CCA 201436049 stands for the idea that the distributive shares of LLC members who provide services are not wholly exempt from self employment tax simply due to the LLC structure. The proposed regulation, even though not finalized, can probably still be relied upon as a safe harbor. Beyond that, be aware that the IRS appears prepared to argue that more or all of a partnership LLC's distributive shares ought to be subject to self-employment tax.

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Avoid Owning Real Estate in a Corp

Tony Nitti, writing for Forbes, wrote a great article earlier this year that clearly explains Why You Should Never Hold Real Estate In A Corporation. Following is a summary of the primary reasons, contrasted with owning real estate in a partnership:

Capital Contributions: If an individual transfers real property to a corporation in exchange for stock, they must own 80% of the vote and value of the corporation immediately after the transfer; otherwise, a gain must be recognized and tax paid on the difference between the individual's basis in the property and the fair market value. In contrast, "appreciated property can be contributed to a partnership in exchange for a partnership interest [as small as a 1%] without triggering any gain."

Contributions of Property Subject to a Mortgage: Even if a contribution of real property to a corporation is otherwise exempt from gain, if the property is subject to a mortgage, "and the corporation assumes that liability as part of the transfer, the transfer triggers gain to the extent the liability exceeds the tax basis of the property." In contrast, it is "much less likely that a partner contributing leveraged property to a partnership will recognize gain" due to the inside and outside basis rules of partnership taxation.

Sale or Distribution: While it is possible to contribute real property to a corporation without being required to pay tax, the same is not true for getting the property out. If appreciated property is distributed from a corporation, "the corporation recognizes gain as if it had sold the property for its fair market value." The same treatment applies if the property is actually sold by the corporation. Furthermore, withdrawing the sales proceeds from a C-Corporation can result in double taxation to the shareholder. In the case of a distribution from an S-Corp, "the distribution will not be taxed a second time at the shareholder level..., [however the shareholder] cannot take the property out of the corporation without incurring a tax bill." In contrast, "when a partnership distributes property to a partner in a current distribution, generally no gain or loss is recognized by either the partnership or the partner;" only basis adjustments are required.

In addition to the problems listed above, owning real estate within a taxable entity other than a partnership can result in loss limitations, lost step-up in basis of the underlying assets upon the death of a shareholder, and lost step-up in basis for the purchaser of an interest in a corporation owning appreciated assets. It is almost always better to own real estate in a partnership or disregarded entity.

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Federal Tax Classifications for Business Entities

For federal tax classification purposes, a business is classified as either a "business entity," which is any entity recognized for federal tax purposes; or a "disregarded entity," which is any entity not recognized or treated separate from its owner for tax purposes. The most common federal tax business entities include a C-Corporation, S-Corporation, and Partnership. Various rules under the Internal Revenue Code determine how a business is treated for federal tax purposes.

The default tax classification for a corporate entity is a C-Corporation. Alternatively, a corporation can elect to be taxed as an S-Corporation by filing Form 2553 with the IRS and meeting certain requirements.

A single-member limited liability company is the only state-formed entity eligible to be classified as a disregarded entity; this is the default classification. The one exception is where a business is owned equally by a husband and wife in a community property state; this business can also be treated as a disregarded entity. A single-member LLC can also elect to be taxed as a C-Corporation by filing Form 8832 with the IRS; alternatively, it can elect to be taxed as an S-Corporation by filing Form 2553.

The default tax classification for non-corporate, multi-member legal entities (including LLCs and state-law partnerships) is a partnership. A multi-member business may elect to be taxed as a C-Corporation or an S-Corporation in the same manner as a single-member LLC. One of the prerequisites for S-Corporation status is a single class of interest, disregarding differences in voting rights; multi-member LLCs with one class of interest or general partnerships can meet the requirements to be treated as an S-Corporation.

The following chart summarizes these rules:

               State-Law Entity

	Corporation	Single-Member LLC	Multi-Member Eligible Entity
Disregarded	No	Yes	No*
Partnership (Form 1065)	No	No	Yes
C-Corporation (Form 1120)	Yes	Yes	Yes
S-Corporation (Form 1120S)	Yes	Yes	Yes**

*A business owned equally by a husband and wife in a community property state can be treated as a disregarded entity.
**Only certain entities, such as multi-member LLCs with one class of interest and general partnerships, can qualify for S-Corporation status.

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File 1120S instead of Schedule C

Schedule C is part of Form 1040 and is used to report income or loss from a business. “Business” means any continuous activity engaged in for income or profit. Schedule C is also used to report statutory employee wages and expenses, income and deductions of certain qualified joint ventures, and certain income shown on Form 1099-K and Form 1099-MISC. There are two important reasons why reporting business income on Form 1120S is better than reporting business income on Schedule C.

First, is audit risk. The IRS continually tracks the “tax gap,” or the amount of tax liability faced by taxpayers that is not paid on time. A huge portion of the tax gap is attributable to Schedule C under-reporting; this is the reason why the IRS audit efforts focus so heavily on Schedule C. Additionally, claiming several years of losses in a row on Schedule C will increase audit risk with the IRS arguing that the “business” is really a “hobby” and that the losses should be disallowed.

Not only does filing Schedule C cause an audit risk, it also results in paying more self-employment taxes than necessary. On Schedule C, all of the net income from the business is subject to self-employment tax, which is normally around 15 percent. Self-employment tax is in addition to income tax.

By forming a business entity and electing to have that business entity taxed under Subchapter S of the Internal Revenue Code, self-employment tax liability can be reduced. A Subchapter S Corporation (S-Corp) is created when an eligible entity, such as a corporation or limited liability company, elects to be treated according to the rules of Subchapter S of the Code and its regulations.

S-Corp net income is reported on form 1120S and flows through to the personal tax return of its owners, avoiding Schedule C and self-employment tax all together. However, S-Corps must pay a reasonable salary to its owners. Salary is subject to payroll taxes, and payroll taxes are virtually identical in amount to self-employment taxes. However, S-Corps do not need to pay all net income as salary, and any net income not paid as salary avoids both self-employment tax and payroll tax.

In order to form an S-Corp and file Form 1120S, advance planning must be undertaken since a business entity should be formed and Form 2553 should be filed to make the S-Election near the beginning of the tax year. Doing so, however, is likely to result in a smaller overall tax liability at year end.

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Sample Form for S-Election Revocation

While entities taxed as S-Corps are the default recommendation of most business and tax planners, there are a number of benefits derived from being taxed as a C-Corp that should be carefully considered. C-Corps can deduct expenses that other tax entities cannot, such as 100% of the health insurance paid for employees, including shareholders in the corporation, as well as the costs of any medical reimbursement plan. While C-Corps do leave its shareholders open to the notorious double tax, this may not be a problem if profits are low.

If after careful consideration with your CPA, you decide that you would like to revoke the S-Corp status of your closely-held business, the following is a form letter that can be used:


_______________ ____, 20____
Department of the Treasury
Internal Revenue Service
_______________, ____ __________

Re: Revocation of S Corporation Election of _______________, Inc., Taxpayer Identification Number: ____-______________

To Whom It May Concern:

Notice is hereby given, pursuant to Section 1362(a) of the Internal Revenue Code, that _______________, Inc., a corporation incorporated in the State of _______________, with address of _______________, _______________, ____ __________, revokes its S corporation election filed with you on IRS Form 2553 dated _______________ ____, 20____.

The number of shares of the corporation’s stock (including non-voting stock) issued and outstanding at the time of this revocation is __________. The first taxable year for which this revocation is intended to be effective is the corporation’s taxable year beginning _______________ ____, 20____. Required shareholder consents to this revocation of election are attached.

Sincerely,


______________________
President of _______________, Inc.


Shareholders' Consent to Voluntary Revocation of
Election of S Corporation Status
The undersigned, being shareholder(s) of _______________, Inc., a corporation incorporated in the State of _______________, hereby consent to the revocation of its election under Section 1362(a) of the Internal Revenue Code to which this consent is attached. The address of the corporation is _______________, _______________, ____ __________. The corporation’s Taxpayer Identification Number is ____-______________. Each of the undersigned shareholders taxable year ends on December 31.

The undersigned shareholders’ name, address, taxpayer identification number, number of shares owned, and date acquired are as follows:

Shareholder Name:                Address:                         TIN:                      No. of Shares:   Date Acquired:

______________________ ____________________ ______________ ____________ __________________

______________________ ____________________ ______________ ____________ __________________

______________________ ____________________ ______________ ____________ __________________

______________________ ____________________ ______________ ____________ __________________

Signed: ____________________ Title: ____________________ Date: __________________

Signed: ____________________ Title: ____________________ Date: __________________

Signed: ____________________ Title: ____________________ Date: __________________

Signed: ____________________ Title: ____________________ Date: __________________

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