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S Corporations and UBI Losses

by Erik Dryburgh

Some of the major accounting firms have created a new “proprietary” gift scheme. It involves a very profitable S Corporation and a charity with large unrelated business income (UBI) losses. Because the promoters will not release any written information regarding the scheme without first securing a signed confidentiality agreement, I have been unable to obtain any of the relevant documents or opinion letters. My understanding of the gift scheme is thus based solely on conversations with clients and colleagues who have been approached with the idea. While I am sure there are nuances and complexities that I am not privy to, the basic structure of the gift is fairly straightforward.

In simple terms, the gift works this way. The owner of the S Corp does a corporate reorganization in which a number of nonvoting shares of stock are created for each existing share of voting stock. The owner then gives the nonvoting shares to a charity. As required by IRC § 170(f)(8), the owner obtains an appraisal of the shares given to charity, which concludes that the shares have quite a low value. This low valuation is due to the lack of voting power and, in some cases, the ability of the voting shareholder to issue more shares and thereby “dilute” the value of the outstanding shares

To give an example, let's assume the S Corp earns $1,000,000 per year, the owner creates nine nonvoting shares for each voting share and the appraiser values the nonvoting shares at $500,000.

The charity is “expected” to hold the shares for a limited period of time, such as five years. During that time, 90% of the income earned by the S Corp is allocated to the charity's interest, and only 10% to the original shareholder. Furthermore, during the five-year period, little to no cash distributions are made from the S Corp. In short, the plan is that the S Corp will generate and retain large amounts of cash, while 90% of the associated income is allocated to the charity.

After the 5-year period has passed, the charity agrees to sell the shares back to the original shareholder for their then-current value. I have been told that the charity is guaranteed that the buy-back value will be at least as much as the value used for the initial deduction (and, I suspect, unlikely to be much more).

Thus, at the end of the day:

  • the owner has a charitable contribution deduction of $500,000 in Year One;
  • the owner pays the charity $500,000 in Year Five; and
  • the owner has sole ownership of the S Corp, which now holds $5,000,000 of essentially untaxed cash.

There is one very important “wrinkle” in the plan. Charities have been eligible to be shareholders of S Corps only since 1998. Further, pursuant to IRC § 512(e), all income allocated by an S Corp to a charity shareholder, as well as any gain on the sale of the S Corp shares themselves, is treated as UBI. This is much different than the rule applicable to holding interests in a partnership; the tax treatment of the income allocated to a charity by a partnership depends upon the nature of the activities conducted by the partnership. Accordingly, the charity in my example will be allocated 90% of the income earned by the S Corp, or $900,000 per year, all of which will constitute UBI, without any cash distributions to help pay the tax.

Why would a charity even consider such a gift? It might if it had an offsetting UBI loss, or a large UBI loss carryforward. In that case, it could absorb the UBI distributed by the S Corp without creating a tax liability. The only benefit to the charity is the hope (or perhaps implied understanding) that it will be bought out in a few years.

This gift scheme is similar to the Charitable Family Limited Partnership (CFLIP). While the promoters are not playing the valuation game of “deduct high, buy low,” the basic concept is similar: The charity is nominally the majority owner of an entity, but has no control and none of the benefits (i.e., cash) of being an owner.

This scheme carries with it many of the same risks and uncertainties as are present in the CFLIP:

  • Is the donor really exhibiting sufficient “disinterested generosity” to evidence a charitable gift?
  • Is the donor really giving true ownership of shares in the S Corp, or perhaps only some bundle of implied understandings and promises (a partial interest at best)?
  • Can the charity substantiate a gift of unrestricted S Corp shares in good faith and without triggering IRC §§ 6700 or 6701 penalties?
  • Can the charity's board of directors fulfill its fiduciary responsibility to make the charity's assets productive without challenging the voting shareholder's decision to not make cash distributions (especially when the S Corp had most likely been making substantial annual cash distributions every year prior to the gift)?
  • Can the board agree to sell the shares without getting its own appraisal (that might be higher than the original owner “understands” he/she will have to pay)?

Not having the opportunity to review one of these transactions in depth, I do not have answers to the above questions. Nonetheless, the promoters themselves acknowledge the existence of substantial risk by offering 50-page opinion letters with staggering price tags. And, although I have not reviewed one of the opinion letters, I suspect that it focuses upon the donor and the donor's tax risks, not the charity and the risks to it and its board of directors.

From my perspective, the “problem” with this gift scheme is also its saving grace. The gift can be made only to a charity that can absorb several years of substantial UBI allocations, and I suspect that there are not many of those from which to choose.

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