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Saturday, May 4, 2024
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Case Studies |
S Corporation Gifts - Strategies and Hurdles Every Advisor Should Know, Part 4 - Driving S Corp Stock Through Charitable Lead Trusts
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Case:
Tommy Ely, 58, owns and operates eight car dealerships spread throughout the city and surrounding areas. Founded in 1977, Tommy is the sole shareholder of Ely Motorsports, Inc., an S corporation. The eight car dealerships represent mainly high-end, luxury car lines. Specializing in providing unparalleled customer service before, during and after the sale, Ely Motorsports appeals to the affluent and wealthy. Not surprisingly, Ely Motorsports generates over $250 million annually in sales and consistently ranks among the nation's top five best dealerships, a record 12 years in a row.
As a long-time active member of the community, Tommy is frequently invited to charity fundraisers and events. Tommy is also one of the top ten richest people in the city, which probably does not hurt his popularity either. At a recent fundraising function for at-risk youth, Tommy publicly pledged $1 million to the local at-risk youth center.
Tommy is constantly supporting at-risk youth programs in the local community. In fact, Tommy was an at-risk youth himself. Having run away from an abusive home at age fifteen, Tommy actually lived on the streets for a brief time. Fortunately, Tommy was befriended and taken in by volunteers of the local at-risk youth center at the age of sixteen. Through love, support and counseling, Tommy turned his life around and the rest is "car" history. Consequently, the $1 million pledge announcement and lifetime support of at-risk programs was not a surprise to the people who know Tommy's story.
As the sole owner of a highly profitable corporation, Tommy draws quite a substantial annual salary. Tommy's income will nearly double this year because of an extraordinary bonus. Consequently, when taking into account federal and state income taxes, Tommy's combined income tax rate is nearly 50%. Not surprisingly, Tommy wants to significantly reduce his current year's tax liability.
Ideally, Tommy would like to satisfy the $1 million pledge with his S corporation stock. However, the at-risk youth center has expressed some reservations about accepting the S corporation stock. (See Part 3 in this series dealing with the drawbacks for gifts of S corporation stock to charity.)
Question:
In order to satisfy his $1 million pledge, can Tommy create a grantor charitable lead trust with his S corporation stock? Will this achieve Tommy's and the at-risk youth center's objectives? What are the tax benefits and pitfalls to Tommy if he contributes S corporation stock into a grantor charitable lead trust?
Solution:
Prior to 1998, a Section 501(c)(3) charity could not be an S corporation shareholder. Thus, donors could not contribute S corporation stock to charities without adversely affecting the corporation's tax status. However, commencing January 1, 1998, the Code was amended to permit a Section 501(c)(3) charity to be a shareholder of an S corporation. Unfortunately, there was not an amendment to also include charitable remainder trusts (CRT). As a result, a CRT is not a permissible S corporation shareholder. Fortunately, however, a grantor charitable lead trust (CLT) may qualify as a permissible shareholder.
Only certain designated people and entities are eligible S corporation shareholders. The list includes individuals, estates, Section 501(c)(3) charities, certain retirement plans and certain types of trusts. One of those permissible types of trusts are grantor trusts. See 1361(c)(2)(A)(I). As the name suggests, a grantor CLT is a grantor trust. Therefore, it may qualify as a permissible S corporation shareholder.
Accordingly, Tommy can transfer his stock into the grantor CLT without adversely affecting Ely Motorsports' tax status. Equally important, the at-risk youth center does not own the stock now, the grantor CLT does. As a result, the at-risk youth center will simply receive cash distributions each year from the trust. Consequently, this alternative gift plan greatly pleases the at-risk youth center.
Tommy intends to transfer $5 million of S corporation stock into the grantor CLT. The trust will have a 5% annuity payout ($250,000 a year) and a five-year term. Although the trust will distribute $1.25 million over a five-year period, the present value of the income interest is only about $1.1 million. Nevertheless, this planned gift would easily satisfy Tommy's $1 million pledge.
As for Tommy's tax liability this year, the charitable deduction produced is approximately $1.1 million. Thus, Tommy can use this deduction to offset his looming tax liability. The deduction is subject to the 30% of AGI limitation.
Another great advantage of the grantor CLT is the fact that the assets revert back to the grantor. In other words, at the end of the five years, all of the trust assets - approximately $5 million of S corporation stock - will return to Tommy.
One disadvantage of a grantor CLT is the yearly income tax liability attributable to the grantor. Because the trust is taxable to the grantor, each year's trust income will have to be reported by Tommy. The fact the trust makes annual payments to charity does not change this result. Moreover, the trust is not entitled to a charitable deduction for distributions to charity, since Tommy already claimed those future charitable distributions in year one, i.e. the $1.1. million deduction.
Because the minimization of taxable income is one of Tommy's major goals, he cringes at the thought of having to report income each year as a result of the grantor CLT. As an alternative, Tommy may fund the grantor CLT with cash and potentially avoid the downside associated with using S corporation stock. For example, if the trust invested in tax-free bonds, then Tommy would not have to report any taxable income each year.
Consequently, using his personal savings and seven-figure bonus this year, Tommy elects to fund the grantor CLT with $5 million of cash. The charitable deduction and present value of the income stream still remains $1.1 million. In fact, the 30% AGI limitation also still applies despite this being a cash gift, because the tax code views this as a gift "for the use of" rather than "to" charity. To qualify for the 50% AGI limitation, a gift must be "to" charity. See Section 170(b)(1)(A).
In the end, Tommy and the at-risk center win on many accounts. Tommy receives a substantial tax deduction now, helps a cause he cares deeply about and the at-risk center receives a generous (and uncomplicated) gift.
Editor's Note: While not a precedent, the Service approved two similar Sub S scenarios in PLR 199936031 and PLR 199908002. One additional caveat: If the donor dies during the trust term, then it ceases to be a grantor trust. As a result, most counsel in the trust instrument provide that the trust will convert to an electing small business trust (ESBT). See Section 1361(c)(2)(A)(v) and (e). For the tax consequences of a gift of S corporation stock to a non-grantor (family) charitable lead trust, see Part 5 in this series.
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