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Monday, May 6, 2024
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Case Studies |
S Corporation Gifts - Strategies and Hurdles Every Advisor Should Know, Part 7 - The Untouchable Donor's CRT
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Case:
Tommy Ely, 58, owns and operates eight car dealerships spread throughout the city and surrounding area. 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. After attending a recent fundraising function for at-risk youth, Tommy personally decided to give approximately $1,000,000 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 decision to give and the lifetime support of at-risk programs was not a surprise to the people who know Tommy's story.
In determining the best way to fund the $1,000,000 gift, Tommy realized Ely Motorsports owns the perfect asset: highly appreciated investment land. Ely Motorsports frequently buys vacant land for potential new car dealership sites. This particular land holding was purchased six years ago for $500,000 and has since doubled in value. However, Ely Motorsports elected not to build upon this site. Therefore, the property was going to be sold which would result in $500,000 in taxable income.
Question:
Can Ely Motorsports transfer the land into a charitable remainder trust (CRT)? What type of trust is best? What are the tax benefits and pitfalls, if any, associated with an S corporation creating and funding a CRT?
Solution:
S corporations report income, gains, losses and deductions on the corporation's income tax return. However, these items then "flow through" to the individual S corporation shareholders' income tax return. Therefore, if an S corporation makes a charitable contribution, the deduction eventually flows through to the individual shareholder. In many ways, an outright gift of property by the S corporation to charity or a CRT (as opposed to a donor's gift of S corporation stock to charity or a CRT) is the ideal scenario for both donors and charities.
An S corporation is permitted to fund a CRT, but the trust must be for a term of 1 to 20 years since the S corporation does not have a designated life expectancy. See PLR 9340043. The S corporation creates the CRT with corporate assets, and income from the CRT is paid to the S corporation for the specified term of years.
In this instance, Ely Motorsports intends to create a 5% CRT with a ten-year term. Specifically, a FLIP unitrust is selected because the trust is receiving an unmarketable asset. The FLIP provision will provide much-needed flexibility. The ten-year FLIP Unitrust will distribute over $500,000 to the S corporation. Moreover, at the end of the trust term, the at-risk youth center will receive approximately $1.2 million.
Ely Motorsports may transfer the $1 million investment land into the FLIP unitrust and, consequently, receive a $600,000 charitable income tax deduction. Since Tommy is the sole shareholder, the $600,000 deduction would flow through onto Tommy's income tax return just as if he had made the gift himself. Accordingly, the deduction would be subject to the applicable AGI limitations for gifts of appreciated property, i.e., 30% AGI limitation with a five-year carry forward.
With a combined federal and state tax rate of nearly 40%, Tommy's $600,000 deduction may save almost $240,000. Another benefit is the avoidance of $500,000 of capital gains tax. After taking into account federal and state income tax rates, Tommy may bypass nearly $150,000 of capital gains tax.
Two potential disadvantages include a deduction limitation and capital gains recognition. First, under Section 1366(d)(1), the charitable deduction reduces the shareholder's basis in the S corporation stock by the basis to Ely Motorsports of the asset. With a basis of 50% of fair market value, there is a basis of $300,000 in the charitable deduction. Because Tommy's basis in Ely Motorsports stock is approximately $2 million, the full $600,000 deduction flows through. Therefore, in this instance, the $600,000 deduction will not be limited. However, Tommy's basis in Ely Motorsports will decrease by the prorated basis of $300,000 allocated to the charitable deduction. He remaining basis is then $1.7 million.
Second, Reg. 1.337(d)-4 requires recognition of gain at the corporate level if "substantially all" the assets are given to charity or to a charitable remainder trust. "Substantially all" is not specifically defined, but most counsel speculate "substantially all" to mean between 80-85%. Conservative counsel should set the limit at about 65%. Nevertheless, Tommy again is in the clear. With a valuation of over one hundred million dollars, the $1 million gift is not even 1% of the corporation's total assets. Therefore, neither of the two potential tax traps apply to Tommy or Ely Motorsports.
With so many positives, Ely Motorsports proceeds with the FLIP unitrust. The resulting significant tax savings, income stream and substantial gift to the at-risk youth center make this one of Tommy's easiest and best decisions of the year.
Editor's Note: It is important to note that an S corporation CRT should not list any of its shareholders as income beneficiaries or incorporate shareholder's lives when determining the trust duration. In PLR 200203034, the Service rejected such an arrangement. Specifically, the Service ruled that S corporation's transfer to the CRT was only partially for a business purpose. Accordingly, the Service ruled that a portion of the property transferred to the CRT would be treated as constructively distributed to the shareholder.
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