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Saturday, April 27, 2024
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Case Studies |
S Corporation Gifts - Strategies and Hurdles Every Advisor Should Know, Part 12 - Family Foundation Gets Behind the Wheel
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Case:
Tommy Ely, 58, owns and operates eight car dealerships spread throughout the city and surrounding areas. Tommy is the sole shareholder of Ely Motorsports, Inc., an S corporation founded in 1977. 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 continually supporting at-risk youth programs in the local community. In fact, Tommy created a family foundation several years ago to accomplish his charitable goals. Surprising to most people, Tommy was an at-risk youth himself. Having run away from an abusive home at age 15, 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 16. Through love, support and counseling, Tommy turned his life around and the rest is "car" history. Consequently, Tommy's lifetime support of at-risk programs is not a surprise to the people who know his story.
Question:
Tommy wants to contribute $1 million to his foundation this year. Specifically, he wants to give approximately 1,000 Ely Motorsports shares to his foundation. What are the tax consequences to a family foundation if it receives S corporation stock? Should Tommy proceed with the current plan or use an alternate asset?
Solution:
Prior to 1998, a Sec. 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 Sec. 501(c)(3) charity to be a shareholder of an S corporation.
Accordingly, public charities and private foundations (e.g., family foundations) are now permissible S corporation shareholders. However, private foundations (PFs) are generally less desirable recipients of S corporation stock than public charities. In particular, PFs are prohibited from engaging in certain enumerated transactions. In this instance, the most relevant and important prohibited transactions are Sec. 4943 transactions, which deal with excess business holdings.
In general, Sec. 4943 imposes an excise tax on the excess business holdings of a PF. The excess business holdings tax is generally triggered when a PF and any disqualified person together own more than 20% of the outstanding voting stock. If such a threshold is met, then Sec. 4943 imposes an initial tax of 10% on the value of the excess business holdings. However, if a PF does not dispose of the excess business holdings by the end of the tax year, a punitive 200% tax on the excess business holding is imposed.
In this case, Tommy owns 100% of the S corporation stock. Therefore, even if he contributed just 5% to his foundation, he would still trigger Sec. 4943 because Tommy and the foundation jointly own more than 20% of the outstanding voting stock. This potential tax liability is not acceptable to Tommy.
There are some important exceptions to Sec. 4943. For instance, in limited situations, the 20% limit may rise to 35%. Unfortunately, this would not resolve Tommy's problem, since he clearly exceeds 35% as well. There is also a 2% de minimus rule that allows PFs to own 2% or less of the outstanding voting stock and 2% or less of the outstanding value of all classes of stock without penalty. Consequently, this exception may alleviate Tommy's present obstacle if his contribution stays within the 2% limits. Last, there is a five-year period in which a PF may dispose of an excess business holding.
Despite the possible exceptions to Sec. 4943, the S corporation route seems unnecessarily burdensome and costly. Furthermore, there are adverse income tax consequences to Tommy and his PF when S corporation stock is contributed. More important, Tommy can easily use other less complicated and more favorable assets to accomplish his charitable giving goals. With little interest in paying more to the government, Tommy greatly prefers this option. Therefore, Tommy simply completes his gift to his family foundation with $1 million of publicly traded securities. Not surprisingly, later that year, Tommy's foundation makes a large grant to the at-risk youth center, thereby continuing to fulfill a lifelong mission of helping at-risk youth.
Editor's Note: While most contributions to private foundations merely receive a cost basis charitable income tax deduction, there is an important exception for gifts of qualified appreciated stock. Pursuant to Sec. 170(e)(5), qualified appreciated stock generally is any stock for which market quotations are readily available on an established securities market. Here, Tommy contributed publicly traded securities that qualify under Sec. 170(e)(5). Accordingly, Tommy's charitable income tax deduction will equal the fair market value on the day that the stocks are contributed (the mean of the high and low sales rule). See GiftLaw Pro Chapter 1.5.1 for more information on the valuation of stocks and other properties.
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