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Saturday, April 27, 2024
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Case Studies |
Death and Taxes - The Madison Era of Giving, Part 3 of 7
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Case:
George Madison, Jr. has definitely become a gift-making machine. Just in the past three months he has gifted $5 million to public charities. George's "ease" into retirement is turning out to be much more exciting than he had ever imagined. Due to the publicity of his two large charitable contributions, George has risen to the top of many gift planners' "people to call upon" list. One such list belongs to Eleanor Jacob, director of development at Education is Power schools. Eleanor consequently called George and asked if she could visit with him. After several visits and trips to the schools, George and Eleanor developed a good relationship. George liked the school's mission and felt he could contribute greatly to its further development. Therefore, George happily pledged a gift of $1 million to help Education is Power upgrade its classrooms and purchase new books for its students.
With respect to funding the outright gift, George already had in mind a particular asset. Many years ago, his son-in-law convinced him to invest $1 million in five gas stations. His son-in-law would run the stations and they would share in the profits. They formed the gas stations as an S corporation for the liability protection and George is the sole shareholder. The value of the business has not changed since inception and George nets about 2% return each year from the five stations.
Question:
George wishes to transfer all of his S corporation stock to Education is Power, thereby fulfilling his $1 million pledge and relieving him of his "poor investment decision." Eleanor is not very familiar with gifts of S corporation stock but she knows there is a red flag associated with them. What issues need to be addressed before this gift gets completed?
Solution:
One of the major tax benefits of being Sec. 501(c)(3) organizations is the privilege to be exempt from income taxation. However, a Sec. 501(c)(3) organization - as well as charitable remainder trusts is subject to income tax on its unrelated business income. Therefore, it is important for charities to refrain from engaging in activities that would subject their proceeds to taxation.
With respect to S corporation stock, the Code is very clear. Sec. 512(e) states that if a Sec. 501(c)(3) holds S corporation stock, any income or gain from such holdings will be unrelated business income. In other words, a charity will have to pay tax on any income distributions it receives while holding the stock and pay tax on any gains it realizes as a result of a sale of the stock. The rate of taxation will be that of a corporation under Sec. 11. Consequently, a charity would end up with a net benefit much less than the fair market value of the stock transferred.
Realizing the tax impact of the proposed gift, Eleanor asked George if another asset could be utilized. Because George wanted to make a net gift of $1 million he recognized the inherent problem with gifting his S corporation stock. George opted instead to transfer some of his C corporation stock, thereby avoiding the whole UBI issue. Eleanor gratefully acknowledged George's flexibility and soon thereafter honored him at a black-tie affair. Not surprisingly, George found his way into another community's hearts (and headlines).
Editor's note: There are other non-tax issues that one must consider before accepting a gift of S corporation stock. Most importantly, a charity must identify who will purchase the stock once the charity is in possession of it. Because there is usually a very limited market for S corporation stock a charity may end up holding the stock for a long period of time. Thus, it is essential to identify potential buyers of the stock. However, the donor and charity must ensure that they do not engage in a prearranged sale, which could cause severe tax problems to the donor.
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