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GiftLaw Note: In PLR 9340043 the taxpayer owned stock in a subchapter S corporation. While a charity is a permissible shareholder of Sub S stock, it is subject to unrelated business taxable income on payments. Since a charitable trust is not a permissible shareholder in the subchapter S corporation under IRC Section 1361, it is not possible to transfer the subchapter S stock into the charitable trust. However, it was deemed permissible to create a unitrust for a term of 20 years.

The unitrust is created by the subchapter S corporation with corporate assets and income from the trust is paid to the subchapter S corporation. A corporation is permitted to fund a trust, but the trust must be for a term of 1 to 20 years, since the corporation does not have a designated life.

Under Sec. 1366(a)(1)(A), the charitable deduction contribution flows through to the shareholder, subject to the basis limitation of Sec. 1367(a)(2)(B). In effect, the charitable deduction is limited to the available basis of the shareholder in the subchapter S corporation.

This method can be very useful in liquidation of a subchapter S corporation, provided that the sub S has not previously been a C corporation and is subject to the 25% passive limitation of Sec. 1362(d)(3)(A).
This is in response to your letter dated July 10, 1992, and supplemental information concerning several ruling requests. Specifically, you have requested the following rulings: (1) that A is a permissible donor to the Trust; (2) that the Trust qualifies as a charitable remainder unitrust under section 664(d) of the Internal Revenue Code and that the Trust may pay the unitrust amount to A for a term of 20 years; (3) that the contribution by A of its general partnership interest in B to the Trust does not result in a constructive dividend to C; (4) that the actuarial value of the remainder interest and retained interest be computed; (5) that 12 percent of the actuarial value of the remainder interest shall be subject to the percentage limitations of section 170(b)(1)(A) and (c), and that 88 percent of the actuarial value of the remainder interest shall be subject to the percentage limitations of section 170(b)(1)(B) and (D); (6) that the general partner's pro rata share of the gain from the sale of B's assets to E will be allocated to the Trust; and (7) that for any year in which the Trust qualifies as a charitable remainder unitrust, the Trust will be exempt from taxes imposed by Subtitle A of the Code, unless it has any unrelated business taxable income as defined in section 512 of the Code and applicable regulations, and that no such income results from the transaction involved herein.

We will not issue a ruling on issue (6) because that determination is primarily one fact. See Section 4.02(1) of Rev. Proc. 93-3, 1993-1 I.R.B. 71.

FACTS


The following facts have been represented.

A is a subchapter S corporation within the meaning of section 1361 of the Code. C is A's sole shareholder. A is a general partner holding an approximately 78 percent partnership interest in B, a limited partnership (the partnership). A has been a partner in the partnership for approximately three years.

On October 21, 1992, A formed the Trust and transferred to the Trust its interest in the partnership. Prior to the transfer, the partnership distributed cash, accounts receivable, and any substantially appreciated inventory pro rata to the partners of B. Immediately after the transfer of the partnership interest to the Trust, B sold all its assets to E, a subsidiary of F.

Under the terms of the governing trust instrument, C is named trustee, and his wife, D, is designated the successor trustee if C is unable to serve. Also, under the terms of the governing instrument, A may at any time remove any presently acting or designated trustee or cotrustee or successor cotrustee and name a replacement or successor trustee or cotrustees.

The term of the trust is 20 years, and the unitrust amount is payable to A. The unitrust amount is the lesser of: (a) the income of the Trust for the taxable year as defined in section 643(b) of the Code; or (b) 5 percent of the net fair market value of the assets of the Trust valued as of the first day of each taxable year of the Trust.

At the end of the term of the Trust, the trustee will distribute not less than 12 percent of the remainder interest to organizations then described in section 170(b)(1)(A) of the Code. The trustee will distribute the remaining 88 percent of the remainder interest to a private foundation that will be created on or before the death of the last survivor of C and D. If, at the time the remainder interest is payable, the private foundation is not described in sections 170(c), 2055(a), and 2522(a), then the remainder interest will be distributed to organizations selected by the trustee that meet the requirement of those sections.

QUALIFICATION OF A AS A PERMISSIBLE DONOR


There is nothing in section 664 of the Code or the underlying regulations that would prohibit an S corporation from being a permissible donor to an otherwise qualified charitable remainder unitrust.

QUALIFICATION OF THE TRUST AS A CHARITABLE REMAINDER UNITRUST AND THE TERM OF THE TRUST


Section 664(d)(2) of the Code sets forth the requirements to be a charitable remainder unitrust. Section 664(d)(2)(A) provides that the unitrust amount must be paid "to one or more persons (at least one of which is not an organization described in section 170(c)and, in the case of individuals, only to an individual who is living at the time of the creation of the trust) for a term of years (not in excess of 20 years) or for the life or lives of such individual or individuals."

Section 1.664-3(a)(3)(i) of the Income Tax Regulations provides that the unitrust amount must be payable to or for the use of a named person or persons, at least one of which is not an organization described in section 170(c)of the Code. Section 1.664-3(a)(5)(i) provides that the period for which the unitrust amount is payable begins with the first year of the charitable remainder trust and continues either for the life or lives of a named individual or individuals or for a term of years not to exceed 20 years. Only an individual or an organization described in section 170(c)may receive an amount for the life of an individual.

Section 7701(a)(1) of the Code defines a "person" to include an individual, trust, estate, association, company, corporation, and partnership.

In the present situation, the Trust provides that the unitrust amount is payable for a term of 20 years. Because the term of the Trust is a term of years not to exceed 20 years, the recipient of the unitrust amount may be any person or persons, including a corporation, so long as at least one such person is not a charitable organization. Thus, A is a permissible recipient of the unitrust amount.

The governing instrument of the Trust as submitted contains provisions set forth in Rev. Rul. 72-395, 1972-2 C.B. 340, as modified by Rev. Rul. 80-123, 1980-1 C.B. 205, and Rev. Rul. 82-128, 1982-2 C.B. 71, and clarified by Rev. Rul. 82-165, 1982-2 C.B. 117.

Accordingly, the Trust will qualify as a charitable remainder unitrust, for federal income tax purposes, for any year in which it continues to meet the definition of and functions exclusively as a charitable remainder unitrust. For such year, the Trust will be exempt from taxes imposed by subtitle A of the Code unless it has any unrelated business taxable income as defined in section 512 and the applicable regulations.

CONSTRUCTIVE DIVIDEND TO C


The contribution by A of its partnership interest in B to the Trust does not result in a constructive dividend to C.

ACTUARIAL VALUE OF THE REMAINDER INTEREST


The value of the remainder interest is computed for the contribution made to the Trust on October 21, 1992. With interest at 7.8 percent, an adjusted payout rate of 5 percent times .954353 (equalling 4.772 percent), and with quarterly payments at the end of each quarter for which they are paid, the present worth of the remainder interest in a unitrust which falls in 20 years after the transfer is $0.376130 for each $1.00 of the initial trust corpus.

LIMITATIONS ON CHARITABLE CONTRIBUTION


Section 1366(a)(1)(A) of the Code provides that a shareholder in a subchapter S corporation determines his tax liability by taking into account his pro rata share of the corporation's items of income, loss, deduction, or credit that if separately stated and given separate treatment on his individual income tax return could affect his tax liability. The flush language of section 1366(a)(1) provides that items referred to in section 1366(a)(1)(A) include amounts described in section 702(a)(4). Amounts described in section 702(a)(4) are charitable contributions as defined in section 170(c).

Section 1367(a)(2)(B) of the Code provides that the basis of each shareholder's stock in an S corporation shall be decreased by the items of loss and deduction described in section 1366(a)(1)(A) determined with respect to the shareholders.

In the present case, the amount of the charitable contribution may be affected by the bargain sale rules. To the extent that A is relieved of partnership liabilities by reason of the donation, the transaction will be treated as part sale, part contribution. See Rev. Rul. 75-194, 1975-1 C.B. 80. The rules for computing the sale and the contribution portions in such a case, and for applying the reduction provision in section 170(e)(1), are set forth in the Code and the regulations under sections 170 and 1011(b). See sections 1.170A-4(c)(2)(i); 1.1011-2(a)(3); 1.1011-2(b).

Provided there is no part gift, part sale under the bargain sale rules, the amount of the charitable contribution will be the fair market value of the remainder interest of A's interest in B, reduced in accordance with the applicable provisions of section 170(e) of the Code. C, as the sole shareholder of A, will take this charitable contribution into account pursuant to section 1366(a)(1)(A) and will reduce the basis of C's stock in A by this amount pursuant to section 1367(a)(2)(B). The limitations applicable to individuals set forth in section 170(b) apply in determining C's allowable deduction for the charitable contribution.

Section 170(f)(2)(A) of the Code provides that in the case of property transferred in trust, no deduction shall be allowed for the value of a contribution of a remainder interest unless the trust is a charitable remainder annuity trust or a charitable unitrust (described in section 664) or a pooled income trust (described in section 642(c)(5)).

Section 170(b) of the Code provides percentage limitations for the charitable contribution deductions of individuals. Generally, individuals may deduct contributions to organizations listed in section 170(b)(1)(A) to the extent that the aggregate of such contributions does not exceed 50-percent of the taxpayer's contribution base (generally, adjusted gross income) for the taxable year. Deductions for charitable contributions to organizations other than those listed in section 170(b)(1)(A) are generally limited to 30 percent of the taxpayer's contribution base for the taxable year.

Section 1.170A-8(b) of the regulations provides that to qualify for the 50-percent limit the contributions must be made "to," and not merely "for the use of," a section 170(b)(1)(A) organization

Section 1.170A-8(a)(2) of the regulations provides that a contribution of a remainder interest in property, whether or not the contributed interest is transferred in trust, for which a deduction is allowed under section 170(f)(2)(A) or (3)(A) of the Code, is considered as made "to" the charitable organization except that, if the interest is transferred in trust and, pursuant to the terms of the trust instrument, the interest contributed is, upon termination of the predecessor estate, to be held in trust for the benefit of the organization, the contribution is considered as made "for the use of" the organization.

In Rev. Rul. 79-368, 1979-2 C.B. 109, a charitable organization described in section 170(b)(1)(A) of the Code is designated as the recipient of the remainder interest in a qualified charitable remainder unitrust. Under the terms of the trust, the grantor and surviving income beneficiaries have the power at any time to substitute for the named recipient any other charitable organization described in section 170(c). Thus, the grantor and the surviving beneficiaries have the power to change the recipient of the remainder interest in the trust from an organization that would qualify for the 50-percent limit on contributions under section 170(b)(1)(A) to an organization that would be subject to the lower limit on contributions set by section 170(b)(1)(B). The ruling holds that because of this power the charitable deduction is subject to the lower section 170(b)(1)(B) limit.

The general percentage limits under section 170(b) of the Code are modified, under sections 170(b)(1)(c)and 170(b)(1)(D), if the property contributed is capital gain property.

For this purpose, "capital gain property" is defined in section 170(b)(1)(c)(iv) of the Code as, with respect to any contribution, any capital asset the sale of which at its fair market value at the time of the contribution would have resulted in gain which would have been long-term capital gain. Section 1222(3) provides that the term "long-term capital gain" means gain from the sale or exchange of a capital asset held for more than 1 year, if and to the extent that the gain is taken into account in computing gross income.

Section 741 of the Code provides that in the case of a sale or exchange of an interest in a partnership, gain or loss is recognized to the transferor partner. Such gain or loss is considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items which have appreciated substantially in value). Section 751 provides that to the extent attributable to these items, the sale or exchange of a partnership interest results in ordinary income.

Generally, the amount of a charitable contribution of property, including a charitable remainder unitrust interest, is its fair market value, as reduced under section 170(e)(1) of the Code. Section 1.170A-1(c)(1) and section 1.170A-6(b)(2) of the regulations.

Under section 170(e)(1) of the Code, the amount of a contribution of property is reduced by the amount of gain which would not have been long-term capital gain if the property had been sold at its fair market value. Thus, the amount of a contribution of long-term capital gain property is generally the fair market value of that property. Under section 170(e)(1)(B), however, the amount of a contribution is reduced by the amount of gain which would have been long-term capital gain in two situations: (1) the property is tangible personal property whose use by the donee is unrelated to the donee's exempt purpose or function; or (2) the contribution is to or for the use of a private foundation not described in section 170(b)(1)(E).

With respect to contributions of long-term capital gain property (not described in section 170(e)(1)(B) of the Code) to organizations described in section 170(b)(1)(A), section 170(b)(1)(c)(i) provides generally that the total amount of contributions which may be deducted for any taxable year may not exceed 30 percent of the taxpayer's contribution base for the year. However, under section 170(b)(1)(c)(iii), a taxpayer may elect to have the 50-percent limit apply, if the amount of the contribution is reduced as provided in section 170(e)(1).

With respect to contributions of long-term capital gain property to organizations described in section 170(b)(1)(B) of the Code, section 170(b)(1)(D) provides that the total amount of contributions deductible for any taxable year may not exceed the lesser of (1) 20 percent of the taxpayer's contribution base for the taxable year or (2) the excess of 30 percent of the taxpayer's contribution base for the taxable year over the amount of the contributions of capital gain property to which section 170(b)(1)(c)applies.

Section 57(a)(6)(A) of the Code provides that an item of tax preference for alternative minimum tax purposes includes the amount by which the deduction allowable under section 170(f)(2)(A) would be reduced if all capital gain property were taken into account at its adjusted basis. Section 57(a)(6)(B) defines "capital gain property" the same as does section 170(b)(1)(c)(iv), but excludes any property to which an election under section 170(b)(1)(c)(iii) applies.

Since the Trust in this case qualifies as a charitable remainder unitrust as described in section 664 of the Code, a charitable contribution deduction will be allowed under section 170(f)(2)(A) for the value of the remainder interest, subject to certain reductions and percentage limitations.

In determining these percentage limits, the contribution of the remainder interest in the trust will be considered to have been made "to," rather than "for the use of," charitable organizations because, at the end of the charitable trust term, the remainder interest will be distributed to charitable organizations outright and not in trust. See section 1.170A-8(a)(2) of the regulations. Applying the rationale of Rev. Rul. 79-368, section 170(b)(1)(A) of the Code applies to 12 percent of the remainder interest, since a minimum of 12 percent of the remainder interest must be distributed to section 170(b)(1)(A) organizations. In this regard, the fact that the trustee has the discretion to determine the specific donee or donees within the class of section 170(b)(1)(A) organizations is not relevant. Because it is not possible to determine what portion, if any, of the remainder interest over 12 percent will be distributed to section 170(b)(1)(A) organizations, section 170(b)(1)(B) applies with respect to the other 88 percent of the remainder interest.

The contribution amounts and percentage limits are also affected by the rules of section 170(b)(1)(c)and (D) and section 170(e) of the Code. Under section 741, the contributed partnership interest will be a capital asset at the time of the contribution, and no part of the contributed interest will be attributable to section 751 items that would yield ordinary income had the partnership interest been sold. The partnership interest is long-term capital gain property, as defined in section 1222(3), because A has held the partnership interest for more than one year. Therefore, section 170(b)(1)(c)(i) applies to the 12-percent portion of the remainder interest contributed to section 170(b)(1)(A) organizations and decreases the percentage limit applicable to the charitable contribution of that portion to 30 percent. Section 170(b)(1)(D) applies to the other 88 percent of the remainder interest and reduces the applicable percentage limit for the charitable contribution of that portion of the remainder interest to 20 percent.

The amount of the charitable contribution of the 88-percent portion of the remainder interest will also be reduced under section 170(e)(1)(B)(ii) of the Code, since long-term capital gain property is being contributed to a private foundation. This assumes that the foundation that C and D create qualifies as a private foundation as defined in section 509(a) and is not a private foundation described in section 170(b)(1)(E). Section 170(e)(1)(B)(ii) reduces the amount of the charitable contribution by the amount of any long-term capital gain that would have resulted if the partnership interest had been sold.

For alternative minimum tax purposes, the 12-percent portion of the remainder interest that is being contributed to section 170(b)(1)(A) organizations is subject to the tax preference item under section 57(a)(6) of the Code, since the amount of the contribution of that portion of the remainder interest has not been reduced under section 170(e)(1). The amount of the tax preference item is the amount by which the deduction allowed under section 170 for the 12-percent portion of the remainder interest exceeds the adjusted basis of that portion of the remainder interest. However, if C elects under section 170(b)(1)(c)(iii) to reduce the amount of the contribution of the 12-percent portion under section 170(e)(1) in return for a 50-percent limit, then no tax preference item would exist. No tax preference item exists with respect to the other 88 percent of the remainder interest, assuming that the amount of the contribution is reduced under section 170(e)(1)(B) to the adjusted basis of the contributed property.

UNRELATED BUSINESS INCOME


Section 664(c)of the Code states that a charitable remainder annuity trust and a charitable remainder unitrust shall, for any taxable year, not be subject to any tax imposed by this subtitle, unless such trust, for such year, has unrelated business taxable income (within the meaning of section 512, determined as if part III of subchapter F applied to such trust).

Section 1.664-1(a) of the regulations states that a trust created after July 31, 1969, which is a charitable remainder trust is exempt from all of the taxes imposed by subtitle A of the Code for any taxable year of the trust except a taxable year in which it has unrelated business taxable income.

Section 512(a)(1) of the Code states that the term "unrelated business taxable income" means the gross income derived by any organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less the deductions allowed by this chapter which are directly connected with the carrying on of such trade or business, both computed with the modifications provided in subsection (b).

Section 512(b)(5) of the Code excludes from the calculation of unrelated business taxable income all gains or losses from the sale, exchange, or other disposition of property other than stock in trade or other property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, or property held primarily for sale to customers in the ordinary course of the trade or business. Section 512(c)(1) of the Code states that if a trade or business regularly carried on by a partnership of which an organization is a member is an unrelated trade or business with respect to such organization, such organization in computing its unrelated business taxable income shall include its share of the gross income of the partnership (whether or not distributed).

Section 513 of the Code states that the term "unrelated trade or business" means any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of the purpose or function constituting the basis for its exemption under section 501.

Section 1.513-1(b) of the regulations states that, for purposes of section 513 of the Code, the term "trade or business" has the same meaning it has in section 162, and generally includes any activity carried on for the production of income from the sale of goods or performance of services.

The sale of B's assets, effectuated by the Trust, as general partner, in the circumstances described, does not involve a sale of inventory or property held primarily for sale to customers in the ordinary course of the business of an investment management and advisory company. Therefore, under section 512(b)(5) of the Code, gain on the sale of B's assets will not produce unrelated business taxable income to the Trust.

Since the sale of the partnership assets occurred on October 21, 1992, the same day of the Trust's receipt of its interest in the partnership, the Trust was not the owner of a partnership interest in an unrelated trade or business, which would have produced unrelated business taxable income to the Trust. Therefore, the transaction will not result in the Trust's incurring any unrelated business income tax liability pursuant to section 512(c)(1) of the Code.

The mere continued holding of its partnership interest after the partnership's assets other than office furnishings and equipment have been transferred to the subsidiary of F will not involve the Trust in any income producing activity which could be characterized as trade or business. Therefore, the Trust's mere holding of such partnership interest after the transfer of assets to F's subsidiary, as described previously, will not result in the Trust's incurring any unrelated business income tax liability pursuant to section 512(c)(1) of the Code.

Accordingly, we have concluded that the Trust will not realize any income subject to unrelated business income tax as a result of the transactions described above. No opinion is expressed as to any other provisions of the Trust.

No opinion is expressed as to the federal tax consequences of the formation or operation of the Trust under the provisions of any other section of the Code.

A copy of this letter should be attached to the federal tax return for the tax year that the Trust is formed. A copy of this letter is enclosed for that purpose.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be cited as precedent.

Related Topics On Subchapter S Unitrust

4.14.5  Asset Sale Strategy:    Another strategy for avoiding the rules that require charities to pay tax on S corporation income or sale proceeds and that prevent CRTs from owning S corporation stock is the use of an asset sale. Rather than having a shareholder transfer S corporation stock to charity or a term of years CRT, the S corporation itself contributes assets to charity or to a term of years CRT.



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