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Tuesday July 16, 2024

Article of the Month

C Corporations and Charitable Giving


Introduction


Individuals who want to start a business have several options for structuring their enterprise. As individuals explore the various possibilities, they often weigh factors like tax implications, liability protection and potential for business growth. C corporations, for instance, offer distinct benefits as separate legal entities with limited liability protection. This limited liability protection helps shield personal assets from business debts and obligations which provides some financial security.

Business owners who opt for a C corporation will find it relatively uncomplicated to transfer assets into a C corporation without payment of tax. Sec. 351(a). However, transferring assets out of the C corporation may come with some unintended tax consequences, which prompts a discussion on the different charitable planning strategies to optimize tax outcomes. In this article, we will provide insight into the tax implications of transferring assets out of C corporations and some options to consider for charitably minded business owners.

C Corporation Taxation


When a C corporation is created, a shareholder will transfer assets into the corporation and the corporation assumes the shareholder's cost basis for that asset. In return for the assets received, C corporations typically issue stock to its shareholders, which maintains the same cost basis for the transferred asset. Sec. 358(a). Thereafter, if the C corporation distributes noncash assets to a shareholder, the C corporation must pay taxes on the capital gain of the assets as if the corporation had sold the asset to the shareholder at fair market value. Sec. 311(b).

Another layer of tax will be applied when shareholders receive dividend income from the business. Whether the dividend is taxable to the shareholder depends on the C corporation's accumulated earnings and profits. Distributions of dividends are classified as ordinary or qualified. Ordinary dividends are taxable to the shareholder at ordinary income tax rates. Currently, qualified dividends are taxed at long-term capital gain rates.

As a separate entity, a C corporation will need to file IRS Form 1120 to report its income, gains, losses, deductions and credits. C corporations pay federal taxes at the rate of 21%. Most C corporations will also be required to pay state income taxes. The cumulative federal and state tax rate could approach 30% of taxable income. C corporations and its shareholders can utilize charitable strategies to alleviate some of the tax consequences they would otherwise face.

Charitable Giving to Offset Corporate Income


C corporations are eligible to offset up to 10% of taxable income through charitable contributions. Corporations are permitted to carry over excess charitable contributions for up to five additional years. Charitable deductions are reduced to cost basis if ordinary gain property is contributed, which would include inventory or equipment used in the trade or business. C corporations may take advantage of enhanced deduction limits for certain inventory, scientific property and food inventory.

C corporations that choose to donate inventory to nonprofit organizations to use in the nonprofit's exempt purpose, for the care of the ill, needy or infants are permitted to increase the charitable deduction from cost basis. Reg. 1.170-4A(b)(2)(ii). Scientific property donated by a C corporation to a college, university or tax-exempt research facility also falls under the increased deduction limits. Sec. 170(e)(4). These contributions will be permitted at the lesser of two times the basis or the basis plus one-half of the appreciation. Sec. 170(e)(3)(A). Food inventory may be deductible up to 15% of the C corporation's taxable income. Sec. 170(e)(3)(C). The food inventory must be "apparently wholesome food," meant for human consumption and must meet all the requisite labeling and quality standards. Certain additional documentation will be required for the C corporation to meet the deduction substantiation requirements under each of these code sections.

For noncash asset donations in excess of $5,000, a qualified appraisal will be required to substantiate the charitable deduction. In the case of closely held stock, the qualified appraisal threshold increases to $10,000. Publicly traded stock does not require a qualified appraisal.

Charitable Giving to Bypass Gain


C Corporations and shareholders can bypass capital gains through giving outright to nonprofit organizations or by setting up a charitable remainder unitrust (CRUT). Shareholders can donate their C corporation stock either outright or to a CRUT. If the appreciated stock is held for more than one year, shareholders can receive an income tax deduction based on the fair market value of the donated assets.

Stock Funded CRUT


A CRUT funded with stock is typically the most advantageous method, particularly for corporations positioned for sale, as it provides better tax savings. In a stock funded CRUT, shareholders transfer part or all of their stock into a CRUT for the lives of the shareholders or a term of up to 20 years. Once the stock is transferred, the CRUT assumes ownership or shareholder status in the C corporation and the CRUT's tax-exempt status leads to a capital gain bypass when the CRUT's trustee sells the stock to a new buyer.

The CRUT not only enables a tax-free sale of the asset, but it also provides income to the shareholders for their lifetimes and a charitable deduction. The appreciated property deduction will be limited to 30% of the shareholder's adjusted gross income (AGI) with a five-year carry forward of any excess deduction amounts.

Since using a C corporation to fund a CRUT typically occurs when there is a desire to sell the business to a larger corporation or to have the C corporation redeem the stock, it is likely that the shareholder will want to seek control over the transaction process. In such scenarios, it becomes crucial to steer clear of prearranged sales. A prearranged sale occurs when there is a binding obligation for the tax-exempt entity to sell the shares to a buyer prior to the transfer of the assets to them. Rev. Rul. 78-197, 1978-1 C.B.83. Business owners must be careful not to sign any legally binding agreement prior to the transfer to the trust, otherwise the shareholders will be required to recognize capital gains on the transfer.

In Estate of Scott M. Hoensheid et al. v. Commissioner; No. 18606-19; T.C. Memo. 2023-34, the Tax Court determined the taxpayer transferred stock to a donor advised fund (DAF) after the transaction was virtually certain and the gain had ripened. There was no bypass of capital gain on the gift and the taxpayer did not receive a charitable deduction because the appraisal and appraiser failed to meet the requirements. Hoensheid testified that he intended to gift 1,380 shares during a stockholders meeting held on June 11. However, the documents that established this number did not exist until July 9 or July 10.

Therefore, there was no actual or constructive delivery prior to July 11 or July 12. There was a July 13 email and PDF of the stock certificate sent from the taxpayer's financial advisor to the institution holding the DAF. The Tax Court determined that based on this strong documentary evidence, the actual date for the gift and acceptance of the 1,380 shares by the financial institution was July 13, 2015. The basic timeline is a decision on June 11, 2015, by the three brothers to sell Commercial Steel Treating Corporation (CSTC) to HCI Equity Partners (HCI) and a gift of stock on July 13, 2015, which occurred when the sale was essentially completed, just two days before final closing. Because the sale was a virtual certainty, the gain had ripened and there was no bypass of gain on the gift of stock to the financial institution.

The right to avoid taxation is available if there is not a vested or fixed right to receive income at the time of the transfer. See Rauenhorst v. Commissioner, 119 T.C. 157 (2002); Ferguson v. Commissioner, 174 F.3d 997 (1999). It is possible that a gift transfer does not obligate the nonprofit to sell. In Dickinson v. Commissioner, T.C. Memo. 2020-128, an individual made multiple share transfers to a financial institution and the shares were subsequently redeemed by the corporation. Because the redemption "was not a fait accompli at the time of the gift," the taxpayer was not subject to the "practically certain to occur" realization event. This principle was also relevant in Rauenhorst. The Rauenhorst Court stated that while the courts are not subject to Rev. Rul. 78–197, 1978–1 C.B.83, the Commissioner is precluded from arguing against the IRS position on prearranged sales.

In Ferguson, the shareholders had approved the sale and the gain had ripened, but in Rauenhorst there still was uncertainty as to the sale and the gain had not ripened. The key factors in prearranged sale cases are whether there is a legal obligation to sell by the donee, what actions have already been taken by the parties to effectuate the transaction and if there are remaining unresolved transactional contingencies.
Example A

Samantha and Rachel, two successful entrepreneurs, co-founded a technology company named Technology Innovations Incorporated (TII). Together, they developed cutting-edge software solutions that established them as major contenders in the tech market. A larger company, Big Tech Corp. (BTC) has shown some interest in acquiring TII, and now, after 30 years in business, Samantha and Rachel plan to retire.

Samantha and Rachel are now in negotiations for the purchase of their company. While both parties intend to enter into a contract for the sale of the business, Rachel and Samantha have not signed an agreement.

Concerned with the capital gains tax implications, Rachel and her spouse, Rick, who own 50% of the company, contacted their CPA to discuss the sale of their stock to BTC. Their initial cost basis in the stock was $1 million and the value of the stock is now worth $5 million. If they were to sell their stock to BTC, they would realize very large capital gains taxes.

After exploring their options with their CPA, Rachel and Rick chose to fund a CRUT with their stock. They liked the idea of securing lifetime income for retirement, while supporting their favorite charity and bypassing capital gains tax.

Because Samantha and Rachel have only entered into negotiations and there is no legally binding agreement to sell their stock to BTC, the risk level for a prearranged sale is low. Excited for the plan, Rachel and Rick transfer their stock to the CRUT and BTC thereafter purchases the stock from the trustee. With this plan, the couple will get an annual income of $250,000 for their lives, a tax deduction of over $1.6 million and capital gain tax savings of over $950,000.
Unitrust Bailout

If a business owner is not willing to sell their business to another corporation and instead prefers to give their business to family members, there are strategies that would allow for a family succession plan. A charitable bailout can be used to transfer ownership of the business to children in a tax efficient way.

In this scenario, business owners gift a portion of stock to children outright using their annual exclusions. With two parents and three or more children, a significant value may be transferred over the course of a few years. At the same time, shares of stock are transferred into a CRUT without any binding obligation for the CRUT's trustee to sell the stock. After several weeks, the Corporation offers to redeem the stock. The C corporation then repurchases the shares for cash, effectively absorbing or retiring the shares back into the company. The self-dealing exception under Sec. 4941(d)(2)(F) allows redemptions if all stock of the same class (as the donated stock) follow the same rules and the charity gets paid the fair market value for the stock. The corporation must provide the same opportunity to redeem stock for both the charity and all other shareholders. The CRUT structure would not permit the children to purchase the shares from the trust, even at fair market value. Sec. 4941. Sec. 4946.

Under the right circumstances, the unitrust bailout is a valuable business succession strategy that is tax efficient. It allows shareholders to bypass capital gains on the sale of their stock, secure lifetime income, obtain a tax deduction and facilitate the transition of the business to the next generation. If a C corporation has accumulated earnings taxable under Sec. 531, it can use its accumulated earnings to redeem the shares, which adds an additional benefit to the transaction. Accumulated earnings tax is a 20% penalty that is imposed when a corporation retains earnings beyond the reasonable needs of its business.
Example B

Kate and John are ready to retire. They own a business worth $1.5 million and they want to set up a plan to transfer their business to their children. Their children have been actively involved in the business and hold one third ownership of the business.

With the use of the annual gift tax exemption, Kate and John have gradually given a total of $100,000 worth of stock to the children tax free. They plan to continue giving to their children, but now they wish to secure additional income for their retirement.

They create a two-life CRUT with $500,000 of their shares for their lives. The unitrust would enable them to bypass the capital gains on the $500,000 of stock and receive an income tax deduction of more than $211,000.

Two to eight weeks later, the trustee of the CRUT, sells the shares to the business at a fair market value, using the self-dealing exception under Sec. 4941(d)(2)(F). The business then redeems the shares using its retained cash, which helps avoid an accumulated earnings tax. Over the next five years, Kate and John make additional gifts of their stock to the unitrust which reduces and eventually eliminates their ownership stake, while increasing their income and charitable deductions.

Asset Funded CRUT


A C corporation can establish a CRUT with its own assets. If the C corporation is creating the CRUT, the CRUT's duration is limited to a term of 20 years or less, because a C corporation does not have a life expectancy. While C corporations are eligible for charitable deductions under Sec. 170, they are limited to offset up to 10% of its taxable income. The calculation of corporate taxable income should exclude the charitable deduction, net operating loss carryback and net capital loss carryback. Sec. 170(b)(2). If the asset is considered a long-term capital gain asset, the corporation would be entitled to a deduction based on the fair market value.

For C corporations seeking to terminate their business and liquidate, there is typically a tax on the corporate gain at the corporate rate followed by a second tax on the shareholder at the shareholder's personal tax rate. To avoid such capital gains, corporations may consider distributing all assets to charity or a charitable trust. However, C corporations should proceed with caution when contributing "substantially all" assets to charity or a charitable remainder trust.

Gain recognition at the corporate level is mandatory if "substantially all" of the assets are given to charity or to a charitable remainder trust. Reg. 1.337(d)-4. Although the term "substantially all" is not defined, other sections in the Code interpret the phrase to mean 85%. While these regulations address a variety of tax matters, their consistent interpretations of what is considered "substantially all" may hold significance.

Some professional advisors suggest the percentage to be lower. For example, Sec. 337 refers to "an 80%" ownership threshold for a subsidiary to qualify as a controlled corporation. Because the threshold is uncertain, a conservative percentage of 65% of the assets to charity or a charitable trust would likely comply with Sec. 337, but a donor should consult with their legal and tax professional for counsel.
Example C

David and Lisa founded a small manufacturing business years ago called Start-up Inc. They are now looking to retire and let their children continue operating their business. However, David desires to remain engaged in the company's operations and will do so through a consulting contract even after retirement, offering guidance and support to their children as they take over the business.

The business owns a large parcel of land that was purchased years ago for potential expansion which has increased in value. The land is now worth $1 million, which is quite an increase from the original price of $300,000. Due to changes in the business, the land will no longer be required for their business, and the couple plan to transfer this land to fund a CRUT that will provide them with additional income in their retirement years.

The corporation then transfers the $1 million parcel of land into a 6% unitrust for a term of 20 years. When the trustee sells the property, the corporation bypasses capital gains on $700,000 and saves taxes at the corporate rate. Additionally, the corporation would receive a charitable deduction of over $300,000 which can be used for the next five years.

The CRUT will pay $60,000 of income to the company every year with potential for growth and a portion of the income can be used to compensate David as a consultant to the company. This setup not only ensures steady income for David during retirement years, but it also provides the business with income from the trust and a charitable income tax deduction.

Conclusion


There are several charitable strategies that can be used when selling a business or transferring a business to the next generation. Using outright gifts, CRUTs or charitable bailouts, C corporations and shareholders can align their objectives for exiting their business with their philanthropic efforts, all while realizing tax savings. By understanding the tax implications that come with C corporations and the tax advantages offered by charitable gift strategies, professional advisors will be well equipped to guide and support business owners through their wind-down process.

Published April 1, 2024
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