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Sunday, May 5, 2024
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Case Studies |
S Corporation Unitrust
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Case:
Mary Smith, age 50, is the sole shareholder of an S corporation which has a current fair market value of $2 million. The corporation currently holds various business assets and, in addition, a parcel of property valued at $1 million with a cost basis of $200,000. Mary is contemplating selling the real estate but has not done so because of the capital gains taxation. The real estate is leased on a 'net-net-net' basis and the corporation receives a monthly lease payment of $5,000 per month. The property is very marketable, and a number of prospective buyers have expressed interest. Mary has also been approached by her favorite charity to make a substantial gift to an endowment campaign. She feels that the real estate would make a nice gift to the campaign, but she would like to continue to receive income from the property for a period of at least 15 years until she retires. Upon reaching age 65, she would begin to draw her substantial retirement funds.
Question:
Can the real estate, held by the "S" corporation, be used to fund a charitable trust? Should she use "S" corporation stock to fund the trust?
Solution:
One of the primary characteristics of an "S" corporation is that the income and deductions of the corporation flow through to the shareholders. Therefore, the $60,000 per year that the real estate receives in lease income flows through to Mary and is reportable on her personal tax return. Since she would like to continue receiving this income, the probable solution is to transfer the real estate into a term of years unitrust with the "S" corporation as the income beneficiary. By funding a 15-year unitrust with a payout rate of 6%, the income of $60,000 annually will flow through to her and once again, will be taxed on her personal return. As with all charitable trusts, the gain of $800,000 will not be subject to tax should the property be sold by the trust. Also, the charitable deduction of approximately $413,000 created as a result of funding the unitrust will flow through to Mary as well. However, the deduction will flow through only to the extent of her basis in the stock.
Bonus - the unitrust may pay out capital gain. After the trust sells the real estate, it may reinvest in a portfolio of 70% stocks and 30% bonds. This portfolio may distribute largely capital gain-type return to the "S" corporation. The income may then pass through to the shareholders and the capital gain portion will be taxed at a lower rate.
As an alternative, should she consider funding the unitrust with "S" corporation stock? If stock is transferred to a charitable trust from an "S" corporation, the "S" election would be terminated because charitable trusts are not eligible shareholders. Therefore, the "S" corporation would become a regular "C"corporation, thus eliminating the flow through characteristic of income and deductions. Therefore, this would not be a viable alternative should she desire to retain "S" status.
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