Unlock the charitable capital in S-Corporation stock in a tax-favored way

By Michael D. Barnes, President of Johnson Trust Company, Johnson Investment Counsel

Many private business owners come to a liquidating event in the lifecycle of their business — sometimes related to succession planning or selling the business — and want to benefit the community that helped the business succeed. 

Often, the business owner can make gifts to charity before the liquidating event in tax-favored ways, but for owners of S-Corporations, taxes to the recipient charity may significantly reduce the remaining gift funds.

Typical scenario:

  • Business owner holds S-Corporation stock which will be liquidated by a sale to a 3rd party, or by a redemption of the stock by the company.
  • Business owner wishes to make a charitable gift of some of the proceeds from selling the S-Corporation stock.
  • Before the sale or redemption is finalized, the business owner transfers some of the S-Corporation shares to a public charity.
  • The business owner and charity sell their respective shares of S-Corporation stock to the 3rd party buyer or to the company.

Key benefits to the business owner:

  • Income tax savings – the business owner can take a charitable income tax deduction for the appraised value of the S-Corporation shares transferred to the charity.
  • Capital gains tax savings – the business owner will avoid the capital gains income on the sale of the shares.
  • Estate tax savings – the shares transferred to charity will not be taxed in the business owner’s estate.

Two key issues:

1. Avoid a step-transaction:

If a business owner has a binding commitment to sell the S-Corporation stock, and prior to closing the sale, gifts the stock to charity, the IRS will likely tax the realized capital gain to the owner by applying the Step-Transaction Doctrine.            

Solution: The charitable gift of stock should be completed as far in advance as possible of the negotiation and signing of a binding Letter of Intent or Purchase Agreement.

2. Reduce unrelated business income tax to the charity:

When a public charity sells S-Corporation stock, the capital gains from the sale of the stock is taxed to the charity as Unrelated Business Taxable Income.

NOTE: Only capital gains from selling S-Corporation stock is taxed to the charity – the sale of C-Corporation stock, LLC units, or other business interests usually is not taxed to the charity.

The capital gain is taxed to the charity based on what kind of entity the charity is:

  • If the charity is a non-profit corporation (a “Corporation Charity”), the capital gain is subject to a corporate tax rate of 21%. 
  • If the charity is a trust (a “Trust Charity”), the capital gain is subject to trust tax rates, which are similar to individual income tax rates and includes capital gains rates of 0-20%. Also, trusts can apply a charitable income tax deduction for income distributed to charity during the trust’s tax year, applicable up to 60% of the trust’s taxable income.

NOTE: Typically, the charity pays the capital gains tax from the gift proceeds, which reduces the funds available to the charity.

Gift plan – to reduce tax on the capital gains:

  1. The business owner gifts the S-Corporation stock to a Trust Charity that is a public charity.
  2. The Trust Charity sells the S-Corporation stock to the 3rd party buyer, or redeems the shares to the company. Upon the sale, the Trust Charity will incur taxable capital gains from the sale of the stock, typically taxed at 20%.
  3. In the Trust Charity’s same tax year (could be a fiscal year), the Trust Charity transfers the sale proceeds to a Corporation Charity that is a public charity.
  4. When the Trust Charity transfers the sale proceeds to the Corporation Charity, the Trust Charity can take a charitable deduction applicable up to 60% against the capital gains income, which effectively reduces the tax rate on the total capital gains to 8%.

Where can you find a Trust Charity?

Many Community Foundations were initially formed as Trust Charities, and later reorganized as Corporate Charities, but kept the Trust Charity in place.

Some public charities sponsored by investment companies or national charities have formed affiliated Trust Charities to facilitate gifts of S-Corporation stock.

This article is intended for informational purposes only. It is important to consult your personal tax adviser prior to any transaction.

Michael D. Barnes is President of Johnson Trust Company, a subsidiary of Johnson Investment Counsel, Inc., an independent wealth management firm with over $16 billion under management. Michael is also President of the Johnson Charitable Gift Fund, a public charity providing donor advised accounts and endowment funds. He is an attorney with over 30 years of experience assisting clients in preserving wealth through wise estate and charitable gift planning. For more information, contact Michael D. Barnes at mbarnes@johnsoninv.com or 513-611-3100.

Johnson Investment Counsel is a Goering Center Sponsor, and the Goering Center is sharing this content as part of its monthly newsletter, which features member and sponsor articles.

About the Goering Center for Family & Private Business

Established in 1989, the Goering Center serves more than 400 member companies, making it North America’s largest university-based educational non-profit center for family and private businesses. The Center’s mission is to nurture and educate family and private businesses to drive a vibrant economy. Affiliation with the Carl H. Lindner College of Business at the University of Cincinnati provides access to a vast resource of business programing and expertise. Goering Center members receive real-world insights that enlighten, strengthen and prolong family and private business success. For more information on the Center, participation and membership visit goering.uc.edu.