S Corporation Gifts - Strategies and Hurdles Every Advisor Should Know, Part 9 - Gift Annuity for Mentor Creates Comfort and Legacy

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. After attending a recent fundraising function for at-risk youth, Tommy decided to make a major gift to the local at-risk youth center. The gift is to support future expansion of the at-risk youth facilities.

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 continual decision to give and the lifetime support of at-risk programs is not a surprise to the people who know Tommy's story.

Tommy knows a gift to charity will produce a charitable income tax deduction, which will reduce his significant tax liability this year. In addition to the tax savings, Tommy wants to also benefit his mentor and surrogate father, Ben Smalls, who is age 81. Specifically, Tommy likes the idea of giving Ben an income stream for life to make the rest of Ben's life more "comfortable."

Question:

Is there a way Tommy can achieve all of his goals with one plan? Tommy wants to satisfy his goals using his Ely Motorsports shares. Is that a problem? What issues do Tommy and charity need to address?

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. As a result, Tommy may transfer S corporation stock to charity in exchange for a charitable gift annuity (CGA). (Unfortunately, a charitable remainder trust is not a permissible S corporation shareholder.)

Tommy, therefore, decides to create a $1 million CGA for Ben. The annual annuity payout is 7.4% or $74,000. Assuming a cost basis of $200,000, a portion of the $74,000 annuity will be tax-free each year to Ben. In addition, Tommy will receive approximatly a $512,000 charitable income tax deduction. Tommy will need to file a gift tax return, since he is making a gift to Ben. The taxable gift is $488,000, which is the difference between the $1 million stock value and the $512,000 charitable deduction. Fortunately, Tommy will use his $1 million exemption to completely cover the gift to Ben.

After speaking with the charity's advisors, Tommy learns of two potential drawbacks of the plan. First, with respect to S corporation stock, Section 512(e) states that if a 501(c)(3) holds S corporation stock, any income or gain from such holdings will be UBI. 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. Since the at-risk youth center must pay tax on any income or gains, it would naturally receive less than the $1 million when the stock is eventually sold. Accordingly, the at-risk youth center would wish to discount the gift annuity contract value.

Second, a gift annuity funded with appreciated property where the donor is not an annuitant raises a tax problem. Specifically, Tommy will have to realize a portion of the capital gain at the time of the transfer. In this case, Tommy may have to realize approximately $390,000 of capital gain, which would significantly reduce Tommy's charitable deduction.

Because Tommy wants to create a gift annuity of $1 million and enjoy certain tax benefits from the gift, he realizes he must take into account the UBI issue and the realization of capital gain tax. After considering the drawbacks with the current plan, Tommy decides to fund the gift annuity with $1 million of cash instead of his S corporation stock. As a result, Tommy avoids the capital gains issue and receives a significant tax deduction subject to the 50% AGI limitation. Ben also receives a significant amount of tax-free income each year. The at-risk youth center is equally pleased, since it no longer must deal with the UBI-producing asset.

In the end, Tommy completes the plan which benefits Tommy, Ben and the at-risk youth center. A true success in so many ways, Tommy's life and willingness to give truly places him among our nation's best year after year.