One strategy for working around 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 option grant. This strategy was once widely employed but is rarely used today.
The option strategy involves the grant of an option to purchase S corporation stock from an S corporation shareholder to a charity or CRT. The option exercise price is heavily discounted and well below the fair market value of the S corporation stock. The charity or CRT then sells the option to a public charity for the difference between the fair market value of the S corporation stock and the option exercise price. When the purchaser exercises the option, the donor claims a deduction for the difference between the option exercise price and the fair market value paid by the purchaser to the charity or CRT.
The IRS initially approved use of the option strategy, see PLR 9240017, but subsequently withdrew its approval, stating in PLR 9417005 that "[n]o inference should be made from this withdrawal as to the proper tax treatment of the transfer to a charitable remainder trust of an option to purchase property." The IRS indicated at this time that it was reconsidering whether the use of an option grant was permissible.
The IRS demonstrates a distaste for the option strategy by its seeming refusal to issue PLRs approving its use. The basis for their distaste is unclear, but the IRS has put forth various arguments including that the gift of an option is a nondeductible partial interest gift. See PLR 9501004. Various practitioners believe that were the IRS to challenge the option strategy the Tax Court would side with the taxpayer and not with the IRS. The cost and time involved in this potential court battle, however, often dissuades donors from employing the strategy.
Example 4.14.4
Owen Owner wants to transfer S corporation stock worth $100,000 to a CRT. When he learns that a CRT cannot own his S corporation stock he decides to use the option grant strategy to facilitate his gift. Owen grants CRT an option to purchase his S corporation stock for $10. CRT then sells the option to Owls Unlimited, a public charity, for $99,990. Owls unlimited exercises the option for $10 and Owen Owner's S corporation stock is transferred to Owls Unlimited. When Owls Unlimited exercises the option, Owen Owner claims an income tax deduction for that portion of $99,990 - the difference between the $100,000 value of his stock and the $10 option exercise price - that represents the value of CRT's charitable remainder.
Owen Owner knows that if his income tax return is audited the IRS will likely challenge his use of the deduction relating to his use of the option grant strategy. Owen Owner has decided that in this event he is willing to spend the time and money to appeal any adverse ruling he receives from the IRS and litigate the issue in tax court. Owen believes that he would win in Tax Court and have the option grant strategy approved for good.
