As discussed in GiftLaw Pro 4.14.5, it is common for an S corporation to make a direct gift of one or more assets to charity or to a term of twenty years charitable remainder trust (CRT). When this occurs, it is important to consider whether the gifted asset is used in an active trade or business. If it is, both the income from that asset and any gain or loss from the sale of that asset are subject to unrelated business income (UBI) tax.
Charities and charitable trusts are normally tax exempt. However, if they are regularly conducting a trade or business that is not substantially related to the exercise of their exempt purpose, they are subject to unrelated business income tax. Sec. 513(a).
Since a charitable trust will never be able to claim that an active trade or business is related to its exempt purpose, the transfer of active business assets from the S corporation to a charitable remainder trust results in unrelated business income. See Newhall v. Commissioner.
However, there are exceptions to the unrelated business rules. Among the various exceptions are the receipt of rent from real property and the payment of royalties and lease returns. These exceptions require the payouts to be fixed. If the payments are dependent upon earnings and profits, then the trust is in effect a partner and again subject to UBI. Sec. 512(c).
If an active trade or business is involved, transfer of these assets to a CRT could subject the unitrust to a 100% excise tax on the UBI. Sec. 664(c)(2)(A). While the tax may not be large if the asset is sold quickly, many grantors may prefer to avoid the tax on UBI.
To avoid UBI, a donor who plans to contribute active business assets from an S corporation to a CRT can lease those assets to a third party prior to making the contribution. If this lease is in place before the assets are contributed to a CRT, the only income the CRT will ever receive from the assets is fixed rent from the lease. Fixed rent payments are passive income and not taxable UBI. Sec. 512(c)
Therefore, there are two possible solutions for active businesses. First, if there is a buyer "waiting in the wings," then the business interest may be transferred into a charitable trust and sold in an expeditious manner to the buyer waiting in the wings. While it will be essential to avoid a prearranged sale, the time that the business is held in the trust may be just a few days. As a result, there may be a very modest amount of unrelated business income subject to the 100% excise tax.
Alternatively, the grantor may prefer to have the S corporation lease the assets to a third party and completely avoid the UBI excise tax.
Example 4.14.7 A
Saddle Soap, Inc. is an S corporation that uses its assets in the conduct of an active trade or business. Saddle Soap, Inc. wants to contribute 20% of its assets to a CRT. So that the CRT's income won't be UBI, Saddle Soap, Inc. enters into a short-term net lease with Sue Sudsy whereby she leases the assets that will be contributed to the CRT. When Saddle Soap, Inc. contributes the assets to the CRT, the CRT's only income is fixed lease payments - passive income that is not UBI - received from Sue Sudsy.
Who Can Lease the S Corporation Assets?
A CRT is prohibited from engaging in any direct or indirect transaction with a disqualified person. Sec. 4941. This means that a CRT cannot receive lease payments from a disqualified person. It is therefore important for an S corporation to select a non-disqualified person to lease its assets if it plans to employ the lease UBI strategy.
Whether someone is a disqualified person with respect to a CRT is determined by facts and circumstances but generally includes the S corporation itself, anyone who owns more than 20% of the S corporation, a trustee of the CRT or a family member of any disqualified person (not including his or her brothers and sisters). Sec. 4946.
A common choice of person to lease assets from an S corporation is a key employee (but not an officer or director of the S corporation). Legal counsel should be consulted to ensure that the identity of the person who leases assets is not a disqualified person.
Lease Term
If the S corporation plans to sell its assets following their contribution to a CRT, then the term of the net lease can be relatively short. For safety, the short term lease should include additional renewal periods.
Example 4.14.7 B
Noisemakers Inc. is an S corporation that plans to contribute assets to a CRT and subsequently sell all of its assets. The income generated by these assets is income from Noisemakers Inc.'s active trade or business. So that income received by the CRT will not be subject to UBIT, Noisemakers Inc. leases the assets that it plans to contribute to the CRT to Larry Lessee on a short term basis. After Noisemakers Inc. contributes assets to the CRT and concurrent with the expiration of Larry Lessee's lease, Noisemakers Inc. and the CRT jointly sell all of their assets to Polly Purchaser. After the sale, the CRT has cash representing the value of its Noisemakers Inc. assets.
If the S corporation does not plan to sell its assets following their transfer to a CRT, then the term of the net lease should be no shorter than the term of the CRT. This will ensure that no income generated by the assets will be subject to UBIT and disqualify the CRT prior to its termination.
S Corporation Passive Income Limitations
While the use of a lease is effective to transform active income into passive income so as not to trigger application of UBIT it may cause problems for an S corporation. Specifically, the passive investment income of an S corporation that has earnings and profits from previous years as a C corporation may not exceed 25% of that corporation's gross receipts for 3 consecutive years. Sec. 1362(d)(3). This means that any planning with S corporation assets that involves the use of a net lease should occur only after a determination that the passive income generated by the lease will not disqualify the S corporation.
