Because of the accumulated earnings tax, a C corporation with significant accumulated earnings can be a problem for a CPA trusted business adviser. Paying the money out as a dividend leads to a second tax the client probably does not want to pay. On the other hand, the longer the company holds the cash and does not use it, the more likely the IRS will impose the accumulated earnings tax.
But if a C corporation owner client is philanthropically inclined and would like to remove the earnings from the company while still maintaining a controlling position of its stock, it may be time to explore a charitable bailout. That’s because this technique can help the donor achieve his or her charitable objectives, avoid capital gains tax, and distribute excess cash that has been accumulated in the corporation tax-free. If the owner’s succession plan involves transferring ownership of the company to his or her children, the owner can also achieve this goal through a charitable bailout.
In a charitable bailout, a corporation’s owner gifts stock in the corporation to a charity, and the corporation then redeems the stock using the corporation’s retained cash. Both the gift of the stock and its redemption are income-tax-free. If the charity is public and if the donor has held the stock for more than one year, the donor is entitled to an income tax deduction for the fair market value of the stock under Sec. 170(b)(1). If the gift is made to a charitable organization that is not a public charity, the income tax deduction is limited to the donor’s basis in the stock under Sec. 170(e)(1).
Stockholders may choose to donate the stock to a charitable remainder trust for redemption. Normally, if a charity is a private foundation or a charitable remainder trust, a redemption would violate the self-dealing rules. However, a “corporate adjustment” exception of Sec. 4941(d)(2)(F) permits redemptions when all stock of the same class as the donated stock is “subject to the same terms” and the charity receives at least fair market value for the stock. To be “subject to the same terms,” the corporation must make a bona fide redemption offer on a uniform basis to the charity and every other stockholder.
Why use charitable bailouts?
The charitable bailout can be very beneficial to all parties involved. It allows a charity to receive cash and a corporation to bail out its accumulated cash while the donor avoids any built-in capital gains tax on the donated stock. The capital gain on the redeemed stock is considered passive income and, as gain from the sale of property, is exempt from the unrelated business income tax (UBIT) under Sec. 512(b).
Charitable bailouts have far better tax consequences than direct donations by a stockholder. If a corporation paid a dividend to the stockholder that the stockholder then contributed to the charity, the stockholder would then owe income tax on the dividend. But, with a charitable bailout, the stockholder can claim the charitable income tax deduction for the donated stock (subject to the 30% and 50% limits of Sec. 170). Though it is the stockholder, not the corporation, who receives credit for the gift, it is the corporation’s cash, not the stockholder’s cash, that is being used. A corporation that has accumulated significant cash will have less cash after a charitable bailout, and thus be less likely to be subject to the accumulated earnings tax.
The charitable bailout technique can also be useful in succession planning. If parents and children all own stock in a C corporation, the parents could reduce or eliminate their ownership stake by contributing their stock to a charitable remainder trust, which stock the company could then redeem. For this strategy to be effective, the children must be stockholders prior to the redemption and the corporation must have sufficient cash to effectuate the redemption. (See IRS Letter Rulings 200720021 and 9338046. Redemption by a note and not cash is a prohibited act of self-dealing).
Potential trouble spots
Advisers and their clients should be aware of several possible pitfalls when using charitable bailouts. One is the imputed prearranged sale doctrine (Rev. Rul. 78-197; Rauenhorst, 119 T.C. 157 (2002); Letter Ruling 200321010). If a stockholder contributes stock in an arrangement in which the charity is compelled to sell the stock, the IRS could take the position that the shareholder had assigned the sale proceeds to the charity, and tax the transaction as if the stock were sold or proceeds distributed to the stockholder. It is worth noting that Rev. Rul. 78-197 states redemption proceeds are taxable as income to the individual stockholder only if the charitable entity is legally bound or can be compelled by corporation to surrender its shares for redemption.
As always, advisers should review state law before recommending a charitable bailout. Also, if the transaction is occurring between related parties, they should be sure to review the charitable organization’s conflict of interest policy.
Note that donor-advised funds, private foundations, and supporting organizations must be mindful of the excess business holdings prohibition and 10% tax under Sec. 4943. This prohibition and tax do not apply to public charities.
In summary, if a client has significant retained earnings in his C corporation and has philanthropic intent, the charitable bailout is a strategy well worth considering.
Patricia M. Annino, J.D., LL.M., a nationally recognized authority on estate planning and taxation, chairs the Estate Planning practice at Prince Lobel Tye LLP.