S shareholder charitable contribution planning opportunities.

One of the changes made by recent S corporation legislation relates to the ability of charitable organizations to become S shareholders. As a result of this change in the law, S shareholders will be able to make contributions of S stock to certain charities, beginning in 1998, without terminating the company's S status. Although this was a fairly exciting change, there are several practical problems that may limit its appeal in the real world. An alternative idea for charitably inclined S shareholders may be to make charitable contributions of shareholder loans, rather than S stock. In many instances, structuring a charitable contribution in the form of a shareholder loan may provide a more tax-efficient result for both the S shareholder and the charity.

One of the practical problems with making contributions of stock to a charity is the potential for generating unrelated business taxable income (UBTI) for the charity. The charity's distributive share of S earnings would generally represent UBTI, unless the S corporation engaged in certain exempt activities. Many charitable organizations are prohibited from earning any UBTI under their organizational charter, or would otherwise be disinclined to assume the administrative burdens of filing Form 990-T, Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)), and making tax payments on earnings from their investments. As a result, there is somewhat of a disincentive for charitable organizations to accept contributions of S stock. In addition, the contributing shareholder is not permitted to treat S stock as a capital asset in determining the treatment of its charitable contribution to the extent of the S corporation's "hot assets."

To avoid these issues, it may be more attractive instead to donate an S shareholder loan, because neither the hot assets rule nor the UBTI issue would come into play. From a valuation standpoint, the charitable contribution of an S shareholder loan may also be more attractive than S stock. Besides being easier to value than stock, the amount of the contribution may be higher for the shareholder/creditor, because the value of a loan may be higher than the value of the stock (particularly if the company is only marginally successful), after taking into account valuation discounting factors traditionally associated with equity interests.

In terms of timing, the charitable contribution of an S shareholder loan may provide the most "bang for the buck" for the shareholder/creditor if it is made after the start-up period of the S corporation's business (i.e., after its operating losses have reduced or eliminated the shareholder's basis in the note), when the operating business has emerged from the start-up period with sufficient financial strength to support a valuation of the shareholder loan at face value. The shareholder/creditor in this situation would actually benefit twice--losses from the S corporation and a charitable deduction--from only one cash outlay, because losses funded by debt and deducted by shareholders need not be recaptured on a subsequent disposition of the note.

These considerations should be kept in mind in planning for the capitalization of an S corporation by the charitably inclined; using shareholder loans to supplement equity may provide significant tax planning opportunities. As a cautionary note, the straight-debt safe harbor of Sec. 1361(c)(5) would not apply to the debt once it is transferred to a charitable organization. Care must therefore be exercised in drafting the debt instrument to avoid the risk that it could be recharacterized as a second class of stock.

From Glenn Dance, CPA, Washington, D.C.