Doing Well by Doing Good

A recent article posits that the rules regarding the contribution of S-Corporation stock must change because of the fact that such change could open up a host of significant opportunities which will greatly benefit both small the owners of both small and large businesses and charitable organizations. This is even more important of an issue based upon the fact that there are over four million S-Corporations in the US and the fact is that over sixty percent (60%) of the Corporations domiciled in the United States now file a Form 1120S as their tax Return (“The Rules For Gifts of S-Corps Must Change”, Charles J. McLucas Feb 15, 2019, Source URL: https://www.wealthmanagement.com/philanthropy/rules-gifts-s-Corps-must-change).

I wholeheartedly concur with the author’s premise and I believe that those changes and the others which would actually be required, since the two “proposed changes proposed in the article are only a partial solution and are a bit of an oversimplification, are most worthwhile for Congress and the Treasury to consider and enact. However, it is our position that even in the absence of these very beneficial changes, or in the potentially lengthy period that it is likely to be between now and any actual movement with respect thereto, there does exist a very real and practical methodology for achieving many of the most significant of those charitable and tax saving objectives and benefits today.

Over the past thirty plus years of my career as an estate planning attorney, I have counseled a variety of wealthy individuals who are looking for creative means whereby they can accomplish a variety of their philanthropic goals and minimize their income taxes and reduce the wealth transfer tax burdens on themselves and their families. For a very large number of these clients, we have developed charitable planning methodologies and techniques which have allowed them to “do well by doing good.” Many of these individuals have been business owners, real estate owners (or both) and a substantial portion of their wealth is tied up in their business entities and their real estate holdings.

We often find ourselves dealing with people who have large amounts of their net worth tied up in the stock of a business conducted as a C-Corporation. In many of those situations it is common for there to exist is a very significant amount of undistributed profits in that business entity. For those individuals, we have often designed and implemented charitable stock bailout programs whereby the individual causes a portion of his stock to be contributed to a charit1able organization, donor advised fund, pooled income fund, or even a Charitable Remainder Unitrust (“CRUT”) or a Charitable Remainder Annuity Trust (“CRAT”). The CRAT or CRUT will be established to benefit the client first for their lifetime and then to provide a meaningful legacy to charity. The premise of this technique which makes it so attractive, is that it 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.

The CRUT will be established by the client to benefit himself and his spouse for the greater of their individual lives, or a term of years not to exceed twenty years (20). In such a situation, the stock will either be sold by the CRUT/ CRAT to a third-party outside buyer, a more distant family member, key employees, or redeemed by the Corporation. In the traditional model of the bailout scenario, the senior generation member may be hoping to emancipate some of the retained earnings which have been accumulating within the company and do so tax-free while achieving both a philanthropic objective and an estate planning objective. Properly executed, the shareholder can accomplish a succession planning benefit, if that is part of the client’s objectives, by causing his shares to be redeemed while those of the younger generation are not redeemed. Rather, those shares are retained by the younger generation members and they increase their proportion of Corporate control in the process of execution of the transaction.

Notwithstanding the apparent simplicity of the plan set forth in the prior paragraph, there are a variety of rules and regulations which must be respected in order to properly carry out the plan and achieve all of the desired income tax, estate and gift tax and succession planning results. 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 also 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.

Top Tier Query: What is a Charitable Remainder Trust?

A Charitable Remainder Trust (CRT) is an irrevocable agreement in which a donor transfers a set of assets to a trust in exchange for an income interest. The trust is known as a split interest trust under IRC Sec 664. The trust is “split” between an income interest and a remainder interest

which passes to one or more charities. A qualified charitable remainder trust is exempt from income taxation while allowing the donor to claim an income tax charitable deduction. The arrangement permits the tax-free sale of appreciated assets and irrevocably designates the remainder portion of the split interest for the benefit of one or more charitable beneficiaries, including public charities, donor-advised funds, and private foundations.

In its most basic form, the charitable remainder trust is an arrangement between four parties: 1) a donor (taxpayer); 2) a trustee; 3) an income beneficiary; and 4) a charitable remainder beneficiary. It is possible for the donor, trustee, and income beneficiary to be the same person.

The donor enters into a trust agreement with the trustee to transfer certain assets to be managed and maintained by the trustee. In accepting the assets, the trustee agrees to pay an income stream to one or more designated income beneficiaries for the rest of their lives or a designated period of time (term of years). At the expiration of the trust term, the trustee of the charitable remainder trust delivers the remaining trust assets to the charitable remainder beneficiary.

The donor may be an individual, Corporation, partnership, limited liability company (LLC), or trust can be a donor. Alternatively, an individual donor can create a charitable remainder trust during life or at death (testamentary). The transfer to a charitable remainder trust that meets all of the requirements of IRC Sec 664 allows a donor to claim a charitable deduction for income, estate, gift, and generation- skipping transfer (GST) taxes.

The trustee of a charitable remainder trust may be to an individual, including the donor, or an institution such as a bank or charity. When the donor serves as trustee, the donor may outsource investment management and trust administration. In most charitable remainder trusts, the donor and the donor’s spouse will be named for their joint lifetimes as the income beneficiaries of a CRT. Nevertheless, the Internal Revenue Code and Treasury regulations permit any person to be named as an income beneficiary providing one income beneficiary is not a charitable organization.

In most charitable remainder trusts, the donor and the donor’s spouse will be named for their joint lifetimes as the income beneficiaries of a CRT. Nevertheless, the Internal Revenue Code and Treasury regulations permit any person to be named as an income beneficiary providing one income beneficiary is not a charitable organization. For example, the income beneficiary could be an individual, Corporation, partnership, LLC or trust. The treasury regulations provide that if any non-natural person beneficiary could be an income beneficiary, the payout length of that person’s interest may not exceed a term of twenty years. The donor may elect to include one or more charities as co-income beneficiaries in order to provide a currently benefit to the charity.

The charitable remainder interest in a charitable remainder trust may benefit a public charity or a privately-controlled charity (e.g., a private foundation). A third possibility is to split the remainder interest among several charities. The trust may allow a donor retain the power to change the charitable remainder beneficiaries. The donor may choose to name a specific charitable remainder beneficiary immediately, defer the decision until later, name the charitable remainder beneficiary in their will, or grant that power to a child or friend.

Charitable Remainder Trust distributions to income beneficiaries are taxed using a unique four- tier system of accounting. This system utilizes what is sometimes referred to as a “worst -in- first-out” methodology or system for characterizing income distributions in the hands of the income beneficiaries. Each item of income earned by the trust must be separately tracked according to type (e.g. interest, dividends, capital gains, tax-exempt interest, etc.). Then each type of income is “used up” starting with items taxed at the highest rate moving to items that are taxed at the next lower rate. The end result is that ordinary income items, such as interest, are passed out first (Tier I), followed by short-term capital gains, then long-term capital gains (Tier II), tax- exempt interest (Tier Ill), and finally trust principal (Tier IV).

Any earnings within the trust which are in excess of the income beneficiary distributions are retained in the trust in a tax-free environment and combined with future transactions and tracked by type of income on a perpetual basis to prevent a seasoning of the income into a different Tier over time to ensure the proper characterization of future income beneficiary distributions. Note that while the CRT avoids taxation on capital gains realized from the sale of appreciated assets, such gains may be distributed out in a deemed characterization of the future income beneficiary distributions. However, there may be certain methodologies employed which will facilitate maximum efficiency on the distribution characterization front as well.

The donor may use several forms of a charitable remainder trust. The principal distinction between the various forms of charitable remainder trust is the manner in which the trust agreement defines the income interest. The trust must specify that the income interest will be paid as either of the following basic forms of CRT: (a) a fixed payment amount (or annuity) calculated at the outset of the CRT’s existence, referred to as a Charitable Remainder Annuity Trust, or (‘CRAT”) or (b) a fixed percentage of the fair market value of the trust’s assets revalued annually (a Charitable Remainder Unitrust, or CRUT).

The payout in a CRUT may be structured in four or more different ways:

Standard Charitable Remainder Unitrust (SCRUT) -The standard version of a CRUT must pay a fixed percentage of the trust’s assets revalued annually. The percentage must be at least five percent of the trust’s assets. Therefore, as the value of the trust’s assets rises and/or falls on the annual valuation date, payments to the trust beneficiaries will rise and fall.

Net-Income Only Charitable Remainder Unitrust- A NICRUT differs from a standard version of a charitable remainder trust in two key aspects. First, in determining the amount of the payments to the income beneficiaries, the trustee must compare the fixed percentage unitrust amount to the trust’s accounting income as defined under IRC Sec 643 and pay the lesser of these two amounts to the income beneficiaries.

Net-Income with Make-up Charitable Remainder Unitrust (NIMCRUT) – A NIMCRUT differs from a standard version of a charitable remainder trust in two key aspects. First, in determining the amount of the payments to the income beneficiaries, the trustee must compare the fixed percentage unitrust amount to the trust’s accounting income as defined under IRC Sec 643 and pay the lesser of these two amounts to the income beneficiaries. Second, unlike the NICRUT, for each year that the trust’s accounting income is less than the unitrust amount, the difference (or deficiency) is accumulated as an amount that may be “made up” in the future (i.e., the “make-up amount”). Payments of the make-up amount must be made to the extent that the trust’s accounting income in any year exceeds the fixed percentage unitrust amount.

Flip Charitable Remainder Unitrust (Flip-CRUT). The life cycle of a Flip- CRUT is generally characterized by two phases. In the initial phase, a Flip- CRUT acts like a NIMCRUT and only distributes the trust’s accounting income to the income beneficiaries. In the second phase, following the occurrence of a predetermined triggering event, the trust switches, or “flips,” to a standard charitable reminder unitrust and pays out a fixed percentage of the trust’s annual fair market value.

The trustee has only until the end of the tax year in which the triggering event occurs to make any payments pursuant to the make-up provision. The change in the payout method commences on January 1 of the year following the triggering event. Permissible triggering events include: The sale of an unmarketable asset; A date certain; The birth of any person; The death of any person; The marriage of any person; The divorce of any person; or an event outside the control of the trustees or any other persons.

The donor’s tax deduction allowed for a transfer to a charitable remainder trust is equal to the actuarial present value of the remainder interest. The value of the remainder interest is computed by multiplying a remainder factor times the value of the asset transferred. Many inputs impact the computation of the remainder factor. Among the factors are the expected term of the trust, the payout rate, the prescribed federal rate under IRC Sec 7520, and the frequency of the income payments. The remainder interest must be equal to at least ten percent of the fair market value of the property at the time of transfer to the trust.

A Brief History of Subchapter S
Subchapter S was enacted in 1958 to limit the influence of tax considerations on the choice of entity used to own a business and to provide tax relief for small businesses. Prior to the enactment of Subchapter S, business entities could be sole proprietorships, partnerships or Corporations, with tax considerations and commercial law considerations following the choice of entity. Corporations offered limited liability for all owners but weren’t taxed as passthroughs. Sole proprietorships and partnerships offered pass-through tax treatment but, at least for active participants in the business, offered no limited liability protection. The S Corp was proposed in part to allow small businesses to have limited liability under non-tax law and to avoid Corporate- level tax; to let “businesses select the form of organization desired, without the necessity of taking into account major differences in tax consequences.”

Subsequent Amendments
The amendments made between 1958 and 1981 modestly liberalized the rules. Notably, the shareholder limit was raised from 10 to 25, and estates of bankrupt shareholders and certain trusts became eligible shareholders.
In 1982, the Subchapter S Revision Act (SUSRA) made more substantial structural changes to the S Corp regime to “simplify and modify the tax rules relating to eligibility for Subchapter S Status and the operation of Subchapter S Corporations … by removing eligibility restrictions that appear unnecessary and revising the rules relating to income distributions, etc., that tend to create traps for the unwary.” SUSRA is important to the narrative of Subchapter S because it went a long way toward fundamentally changing Subchapter S from the system described above to a true pass-through regime. After SUSRA, S Corp shareholders included their pro rata share of S Corp items on their own tax returns, and the character of all tax items passed through (unless limited by tax basis).

The Small Business Job Protection Act of 1996 also made several changes that broadened the scope of Subchapter S. S Corps gained the ability to own subsidiary Corporations, and a wholly- owned domestic Corporate subsidiary could elect to be treated as a qualified Subchapter S subsidiary, which is an S Corp that is owned by another S Corp. The 1996 legislation also increased the shareholder limit to 75 and allowed certain tax-exempt organizations and electing trusts as shareholders. For most tax-exempt investors, the trade-off was that all income from an S Corp was taxed as unrelated business taxable income (UBTI).

Finally, in 2004 and 2005, the number of permitted shareholders reached 100, and rules were added and amended to treat certain members of a family as a single shareholder.

Legal Requirements to Being and Remaining an S Corporation
A U.S. Corporation can be treated as an S Corporation if:
1) the Corporation files an election to be classified as an S Corporation with the IRS on Form 2553, that has been signed by every shareholder; and
2) the Corporation and each of its shareholders meet the eligibility criteria.

Most U.S. Corporations with 100 or fewer shareholders are eligible to be S Corporations. A few are prohibited because of technical matters concerning the Corporation’s operations or its history that make it ineligible. However, the single most common reason that a Corporation might not qualify as an S Corporation is if it has a shareholder that is not eligible to own S Corporation stock (for example: non-U.S. persons, complex trusts which are not QSSTs or ESBTs, LLCs, partnerships, C-Corporations, etc.). This is what prevented charities from owning such stock until 1998 and continues to prevent charitable remainder trusts and pooled income funds from becoming S Corporation shareholders.

Charities, But Not CRTs, Are Eligible Shareholders

The statutes list the types of shareholders that are eligible to own stock of an S Corporation. See Section 1361. If an ineligible shareholder ever becomes a shareholder, then the S Corporation loses its tax status on that day and becomes a C Corporation. Section 1362(d)(2); Reg. Section

1362-2(b). For example, a Corporation will lose its S Corporation tax status on the date that a Corporation, partnership, or a charitable remainder trust becomes a shareholder because none of them is eligible to be a shareholder. (See Private Letter Ruling 8922014 (Feb. 28, 1989) where a taxpayer attempted to contribute S-Corporation stock to a charitable remainder unitrust).

The 1996 tax legislation added Section 501(c)(3) charities (Section 1361(b)(1)(B) and 1361(c)(7), as added by SBJPA Section 1316(a)), to the list of eligible shareholders. On its face this includes both public charities and private foundations. However, as a practical matter, private foundations will be prohibited from owning stock of most S Corporations because of the Section 4943 excess business holdings tax. A solution for a donor who would like to have a private foundation hold the stock is to establish a Section 509(a)(3) supporting organization instead.

By comparison, the 1996 tax legislation did not add charitable remainder trusts under IRC Section 664 or pooled income funds pursuant to IRC Section 642(c)(3) and 642(c)(5), to the list of eligible shareholders. An S Corporation will lose its tax status on the date that such a trust becomes a shareholder and the Corporation will thereafter be taxed under Subchapter C of the Internal Revenue Code. (See Section 1362(d)(2); Reg. Section 1362-2(b) and PLR 8922014 (Feb. 28, 1989). The only conventional form of deferred charitable giving that S Corporation stock can be used for is a charitable gift annuity, since the charity (an eligible shareholder) will be the owner of the stock. Even if a charitable remainder trust could be an eligible shareholder, the UBIT from the S Corporation could revoke the tax-exempt status of the trust. A charitable remainder trust will lose its tax-exempt status if it has any unrelated business taxable income. Reg. Section 1.664-1(c); Leila G. Newhall Unitrust v. Commissioner, 104 T.C. No. 10 (March, 1995), affirmed 105 F. 3rd 482 (9th Cir. 1997).

There is one type of relatively obscure trust that can own S Corporation stock and can have a charity as a beneficiary: an “electing small business trust” (ESBT). An ESBT is a “sprinkling” or “spray” trust that gives the trustee the ability to give more, or less income to various beneficiaries based on their changing needs and economic circumstances. (Section 1361(c)(2)(A)(v) and 1361(e). A charitable remainder trust will not qualify as an ESBT even if it has lost its tax- exempt status. A tax-exempt trust is not eligible to be an ESBT [Section 1361(e)(1)(B)(ii)] and a charitable remainder trust is tax-exempt under Section 664(d). An ESBT has poor income tax treatment and charities probably should not recommend them to donors for the sole purpose of making a charitable gift.

UBIT Imposed on Taxable Income from S Corporations
The tax laws treat a charity’s share of income from an S Corporation very differently from a partnership or an LLC. The 1996 tax legislation makes a charity subject to UBIT on its share of all income attributable to an S Corporation, including sources that are traditionally tax-exempt to charities, such as interest, dividends, rents and capital gains. (IRC Section 512(e). Even the gain from the charity’s sale of the S Corporation stock is taxable (Sec.512(e). Congress concluded that this treatment was appropriate in light of the history of granting S-Corporations the exemption from the conventional Corporation income tax. A charity will be taxed on its share of an S Corporation’s accounting income rather than the Corporation’s cash distributions. This treatment would make for an unpleasant result where earnings are retained by the S-Corporation for future operations.

Donor’s Perspective: Making A Gift of S Corporation Stock
A donor must first determine whether he or she is willing to give S Corporation stock to a charity. The donor will go through many of the same considerations that he or she would have for a gift of an ownership interest in any type of closely-held business. For example, will the donor be comfortable with a charity having the legal rights of a minority shareholder of a Corporation? Is the stock subject to a transfer restriction that prevents the charity from selling or giving the stock to another party without the shareholder’s approval? (S-Corporations regularly employ restrictive shareholder agreements which preclude transfer to an ineligible shareholder.

The donor needs to be aware that the income tax deduction will likely be less than the appraised value. By way of background, the income tax deduction for a gift of appreciated property must generally be reduced by the amount of “ordinary income” that the donor would have had if the donor had sold the property. The rule generally does not apply to assets that, if sold, would produce a long-term capital gain. That is why wealthy donors generally favor gifts of appreciated stock and real estate: They can deduct the full appreciated value without recognizing any taxable income from the growth in value over time. If a gift consists of both long-term capital gain and ordinary income property, then the deduction is only partially reduced to reflect the ordinary income component

Since the profitable sale of S Corporation stock usually produces a 100% long-term capital gain, most donors would assume that they can deduct the entire appraised value of the stock. However, the tax laws provide that the income tax deduction for a charitable gift of Subchapter S- Corporation stock should be reduced under rules that are analogous to charitable gifts of partnership interests. Thus, if the rental property is owned by an S Corporation, the donor who gave the S Corporation stock to a charity would have to reduce his or her income tax deduction by the proportion of the gain that would be treated as ordinary income if the underlying assets of the Corporation had been sold. This reduction only applies to income tax deductions. By comparison, if the same stock is left to a charity as a bequest at death, the donor could deduct the full fair market value of the stock as an estate tax charitable deduction.

S-Corp Shareholders have long been denied the benefits of the Bailout…Until Now.
In a nutshell, the problem arises from the fact that shareholders of an S-Corp who are charitably inclined are generally prohibited from engaging in or employing any one of the various charitable planning tools which may be utilized by shareholders of regular business Corporations (also referred to as C-Corporations). This preclusion stems from the fact that there are limitations on who (or which entities) are or may be shareholders of an S-Corp. Prior to 1996, the answer was relatively simple in that charities could not be shareholders of S-Corps without causing the termination of the S-election. As a result of legislation passed by Congress and signed into law by President Clinton in 1996, that rule changed, and charitable ownership of S-Corp stock came to be allowed. However, that change was not without its attendant costs on the administrative and tax side of dealing with issues of Unrelated Business Income Tax (“UBIT”), namely: the tax on unrelated business income (“UBI”), which is the imposed upon charitable entities upon the receipt of income attributable to the running of an unrelated trade or business.

For Charitable Remainder Trusts (“CRTs”) that issue is even more problematic as it results in the CRT losing all of its usual tax benefits of tax-free growth and monetization of gain assets without tax inside of the entity. The result is quite harsh and would have effectuated a hardship on the non-charitable beneficiaries of the CRT if the change in the law had allowed the CRT to be an eligible shareholder of the S-Corp. As such, the Treasury staffers wisely decided to make the eligibility limited to organizations which are wholly tax exempt under the provisions of Section 501 of the Internal Revenue Code (“IRC” or “Code”).

Enter the SOCRATES (SM) Option Plan Technique
With all of the issues and difficulties involved in the use of charitable strategies for the S- Corporation and its shareholders, two different planning structures have been developed over the last twenty plus years, namely: 1) the establishment of a charitable remainder trust by the S-Corp as the grantor and providing for the funding thereof with appreciated assets and a sale thereof by the CRT with the retention of the annuity or unitrust payments the S-Corp and then subsequent distribution of the income stream to the shareholders as dividends. Care must be taken to prevent the accidental triggering of the deemed liquidation provisions of Code section 337(d) which was enacted to prevent conversion of Corporations from taxable to tax-exempt entities. As such, the transfer must be of less than substantially all of the assets of the entity into the CRT which is a percentage that may be easier to determine in concept than it is in reality. There are many definitions in the context of Corporate reorganizations under Code Section 368, et seq., with differing percentages under other provisions of the Code.

The S-Corporation Shareholder Grant of a purchase option to either a Charitable Remainder Unitrust (“CRUT”) or a Charitable Remainder Annuity Trust (“CRAT”) (“SOCRATES”)(SM) has been developed and designed to provide an income tax savings and future investment yield enhancement for shareholders of Subchapter S-Corporations (“S-Corps”). The plan is intended to provide a private solution to those people who are charitably inclined and wish to be able to provide substantial benefits to charity, while greatly reducing income and capital gains taxes of the shareholders of the S-Corp upon a monetization/ sale of the shares of the S-Corp. The CRT as option holder will clearly not be deemed to be the holder of the S-Corporation stock for either SCOS or UBTI purposes based upon the IRS’s ruling position, and several cases as well. See for example, Rev. Rul. 70-615, 1970-2 C.B. 169, which provides in pertinent part, that a taxpayer who is the record holder of a small business Corporation’s stock, but who has no beneficial interest in it, is not considered the shareholder.
In the Notice 2004-30 situations, the transferor merely parked the stock with the exempt party during the holding period. The abusive aspects of the transaction allow the original shareholders to allocate 90 percent of the S Corporation’s income to the exempt party while preventing the exempt party from participating in the benefits and burdens of stock ownership to the degree commensurate with the exempt party’s purported stock ownership. Because the exempt party appears to be simply a facilitator without beneficial ownership of the S Corporation stock, the exempt party generally should not be treated as a shareholder for purposes of the allocation of income. Further, any amount received by the exempt party upon exercise of its put right under the redemption agreement should be viewed as a payment for the performance of services as an accommodation party. However, if the exempt party were considered to be a shareholder rather than a mere facilitator or accommodation party, the exempt party would be treated as a shareholder only to the extent of the actual economic benefits it realizes from holding the stock. In the option technique there should be no issue with regard to the S-Corp having either an SCOS violation or an ineligible shareholder and its electing S-Status would not be in jeopardy because until the option is exercised, the CRUT has zero benefits of ownership and could not under prior IRS guidance have shareholder status via which the election conditions would be violated which would cause the election to be terminated. Moreover, the transaction should be respected because it has economic substance other than tax benefits, to wit: it bestows a large economic benefit on the CRT and the charitable remaindermen, not just on the grantor.

SOCRATES Charitable Remainder Trust Option Technique for S-Corporation Stock Procedures
Step 1. Appraise the fair market value of the stock of the company and the interest to go to charity.
Step 2. Establish a charitable remainder Unitrust (type of CRT to be established) for lifetime of the Grantor (and spouse).
Step 3. a. Design and draft Purchase Option document in order to obtain the maximum donation value per share upon which the option has been granted by the shareholder. This will be determined by establishing the lowest strike price per share.

1. The shareholder will grant a “deep in the money call option” to the CRT as a donative or gratuitous transfer (a gift) with the reservation by the donor of all of the respective shares of income, gain or loss, etc. which will be earned and realized and accrued during the pre-exercise and pre-expiration period of the option. The amount will be trued up prior to a closing on the sale of the stock of the company to the third party outside buyer and determined by a defacto “closing of the books” in a manner similar to the procedures established for Code Section 1377 on a buyout of a shareholder in the middle of the tax year. It is our belief that by doing so we are clearly not running afoul of the single class of stock rules (“SCOS” rules).

a. An alternative methodology, which some may find more palatable as far as providing more distance between the S-Corporation, any of its participating shareholder(s) and the CRT(s), is to establish a single member limited liability company (SMLLC) which will be treated as a disregarded entity (a “DRE”) for all federal income tax purposes; have the shareholder grant the option to his or her DRE and then have the shareholder donate the DRE membership interests to the CRT. This will be respected for state law purposes and will not be an action creating a violation of the SCOS.

b. The donative value will be the difference between the strike price and the appraised value. Example: S-Corporation share value $4,000.00/share with option price of $100/share = $3,900.00 donative value per share.

Step 4. a. Charitable option sold to third party outside buyer for $5,000.00 by Trustee of CRT results in $100/share paid to grantor and $4,900 paid to CRT. Trust obtains
$3,900/share return of capital and $1,000/share of long-term capital gain per share.
b. Donor reports a $3,900/share charitable contribution donation multiplied by lifetime present value factor for the remainder interest donated to charity. The deduction is based upon the extent option in the money; the deduction is then reduced by the actuarial net present value of the non-charitable life estate or term of years. Note that the deduction cannot be claimed by the shareholder d/ donor on a tax return until the stock and option are both sold to the third-party buyer. The deduction may likewise be reduced for things like the adjustments under Code Section 1367 for “hot assets” of the S-Corporation prior to the present value calculation.
c. Donor and spouse receive unitrust income payments (or other charities in the case of a sprinkle CRT) for a term of years or the lifetime of one or both of the two grantors.
1. The payout of unitrust income can be deferred by making a NI(M)CRUT trust which is funded with annuities or life insurance (including Private Placement Deferred Variable Annuities (PPDVA) and Variable Universal Life Insurance (PPVUL). It may be possible for the income payments to carry out only the long- term gain by having the sale be made by the PPVUL Policy and by withdrawing money tax free from the policy and passing it out to the CRT for distribution to the next generation.

Selected Issues of Relevance with Respect to the Option Technique
In developing the S-Corporation option technique, some of the primary issues of concern which we have discussed with CPAs and tax attorneys around the country over the past several years, include the following: Single Class of Stock requirements of the Internal Revenue Code (and the applicable Treasury Regulations attendant thereto); preservation of the S-Election without taint of impermissible shareholder ownership (namely: CRT as shareholder versus holder of a bona fide call option); issues of Treasury Notice 2004-30 regarding so called “S-Corporation Tax Shelter”; computation of the charitable deduction as well as the nature and timing thereof (as far as the proper triggering event for claiming the deduction) of the payments; the character of the payments from the CRUT or CRAT and whether the gain on sale of the S-Corp stock to the outside third party is long-term or short-term gain for purposes of the “tiering” rules of IRC section 664 (based upon the applicability of Code section 1015 for determining the tacking of donor holding period in a carryover basis transaction with regard to the stock disposed of as opposed to the option).

S Corporation Tax Shelter: The Abuse Described in Notice 2004-30 as a Listed Transaction
Notice 2004–30, described a situation in which S-Corporation shareholders attempt to transfer the incidence of taxation on this Corporation income or purportedly donating this Corporation nonvoting stock to exempt organization, while retaining the economic benefits associated with that stock. The notice alerts taxpayers in the representatives that these transactions or attacks and witnessing transactions and identifies these transactions and substantially similar transactions, as listed transactions for purposes of section 1.6011-4(b)(2) of the Income Tax Regulations and section 301.6011-2(b)(2) and 301.6012-1(b)(2) of the Procedure and Administrative Regulations. In 2007 the Treasury Department and IRS established Settlement Guidelines in the Internal Revenue Manual describes the transaction, analyzes the law on several issues and then provides a procedure whereby participating taxpayers could remediate their returns and extricate themselves from tax shelter penalties.

The upshot of the Notice and the Settlement Guidelines in law, fact and analysis is that there was no motive other than tax savings and that the savings were achieved by violating the rules with regard to creating a second class of stock with a set of de facto inferior and subordinated rights. Those subordinated rights were the fact that the warrants, which the holders of the voting shares retained in each of the respective participating Corporations, allowed these shareholders to issue to themselves nine (9) shares for each one (1) share which they had previously donated to the charity. In the case of the CRT Shareholder Option grant plan, there is no transfer which is greater than the pledge of the shares to a lender as collateral for a loan. The bank is an impermissible shareholder and the pledge is not considered a second class of stock.

Moreover, the Service in the publication of their Settlement Guidelines (published on April 20, 2007) stated that the essential problem with transactions which were substantially similar to those set forth in Notice 2004-30 cited the Tax Court decision in Palmer as standing for the proposition that the allowance of the tax deduction and the allowance of the transfer of the shares to govern with regard to the incidence of taxability on the sale thereof is predicated upon the bona fides of the donors intent to bestow a financial benefit on the charitable organization which is commensurate with the actual value of the asset or property rights donated to the organization. This was done to enable both the claiming of a deduction and the shifting of the burden of taxation on the S-Corp’s undistributed income to the exempt organizations (thereby allowed to accumulate tax -free in the Corporation) and then redeeming the stock for a fraction of its value at a later point by issuing nine times the amount of stock and having it redeemed by the Corporation using earnings that had previously gone untaxed by virtue of the actual shares being held by the exempt organization.

The transaction in the Notice failed this test. A very large part of the reason for the failure was the fact that “other than with respect to the allocation of income, the parties did not treat the exempt party as owning 90 percent of the S Corporation. For example, in most of the Notice 2004-30 transaction, the exempt party failed to record the nonvoting stock as an asset of the plan.

A number of the S Corporations did not send Schedules K-1 to the exempt party. Because the Notice 2004-30 transactions is a sham, the form of the transaction should be disregarded, and the original shareholders generally should be treated as owning all of the S Corporation stock.” We believe that the result and the decision with respect to these issues would clearly have been different if the economics of this transaction had the bona fide intention of providing a real and meaningful benefit to charity.
In the case of the S-Corp Option, the shareholders remain taxable on the income and the adjustments post exercise take into account all of the 1377 closing of the books allocation of all appropriate income items to those shareholders through the date thereof. The CRUT and the charitable remaindermen benefit by the appropriate portion of the amount value that is paid by the third party outside buyer of the option/ property rights and the stock of the Corporation.

The SCOS rules of Code Section 1361(b)(1)(D) will not apply to the CRT Shareholder option contribution for various reasons ranging from the fact that each or the examples in the applicable Treasury Regulations which pertains to the granting of an option potentially being a SCOS and a violation of the rule (including the rule pertaining to the issuance of an option at a discount of greater ten percent (10%) to fair market value being potentially violative of the SCOS rule) deals with option granted by the S-Corporation. None of the examples in the Regs and none of the private or published rulings on SCOS deal with a donative option being granted to any party. In fact, the reason for that is quite logical when you actually bother to think about it rather than reciting a variety of rote principles, to wit: the reason that SCOS exists is to prevent there from being disparate economics in the capital construct of the Corporation itself and the granting of the option by the shareholder to the CRT or to a charity does nothing to alter the capital structure or ownership of the shares themselves or their rights to participate in the profits of the enterprise.

A recent private letter ruling dealing with Section 1362’s inadvertent termination relief for errors in the operation of an S-Corporation illustrates this issue in a nutshell. In PLR 201904001which was released on January 25, 2019 by the Treasury states the following with regard to an LLC formed between two owners which then elected to be taxed as an S-Corporation:

“X began business on Date 1 and is organized under the laws of State. Between Date 2 and Date 3, X had two owners, and was classified as a partnership for federal income tax purposes. During this time, X’s Operating Agreement provided that current distributions were to be made to the two owners in accordance with their “Ownership Ratios,” while distributions made upon dissolution would be made in accordance with the owners’ “positive Capital Account balances.” Certain distributions (the “LLC distributions”) that X made to the owners between Date 2 and Date 3 caused the owners’ capital accounts to become disproportionate to the owners’ ownership ratios. Effective Date 3, X elected to be classified as an S Corporation, and did not make any changes to its Operating Agreement. As a result of the LLC distributions, the Operating Agreement created a right to nonproportional distributions to X’s owners. This caused X to have multiple classes of stock within the meaning of § 1361(b)(1)(D), thereby causing X’s S Corporation election to be ineffective. On Date 4, X amended its Operating

Agreement to clarify that all liquidating distributions are to be made in accordance with the shareholders’ ownership ratios. X represents that, between Date 3 and Date 4, all distributions were made in accordance with its shareholders’ relative stock ownership, and that all taxable income was also allocated in a pro rata manner. X further represents that X and its shareholders intended for X to be an S Corporation at all times from Date 3 and onward and that X has filed all returns consistent with X’s treatment as an S Corporation since Date 3. X and its shareholders agree to make any adjustments required as a condition of obtaining relief under the inadvertent termination rule as provided in
§ 1362(f).
LAW AND ANALYSIS
Section 1361(a)(1) provides that the term “S Corporation” means, with respect to any taxable year, a small business Corporation for which an election under § 1362(a) is in effect for the year. Section 1361(b)(1) defines a “small business Corporation” as a domestic Corporation which is not an ineligible Corporation which does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, and a trust described in § 1361(c)(2), or an organization described in § 1361(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock. Section 1362(a)(1) provides that, except as provided in § 1362(g), a small business Corporation may elect, in accordance with § 1362, to be an S Corporation. The ineffective election was due to X’s having multiple classes of stock within the meaning of Section 1361(b)(1)(D), caused by its having made nonproportional distributions to its owners, as allowed by its operating agreement, which X didn’t amend at the time of its S-election.

It is our belief that this PLR exemplifies both the Treasury’s willingness to assist where people make errors in the S-Corporation’s operating documents and that the rote application of potentially harsh rules is not the desire of the Service in the context of S-Corporations. It also does serve as a warning to drafters of LLC S-Corporation operating agreements to be careful that they don’t lose sight of the SCOS and pro rata economic issues vis-à-vis each shareholder rather than using either their standard “capital account language” of their operating agreements. Likewise, there is a great likelihood that inadvertent termination relief would be available should the issue ever prove to be decided against the option grant by the shareholder.

Characterization of the Option as a Capital Asset Class of Property Right with a Long – Term Capital Gain Based upon a Carryover of Holding Period in Order to Properly Qualify the Item as Deductible When Option is Sold to Third Party, Exercised or Redeemed

Based upon the weight of authority and published guidance put forth by the Service and the Courts with regard to financial assets and instruments such as put and call options, exchange traded fund assets, straddles and the like, it is our belief that S-Corporation Option will be a capital asset with a long-term holding period and a carryover basis in the hands of the CRUT which is directly tied to the holding period and basis and character of the S-Corporation Stock in the hands of the Shareholder/ Donor. It is our belief that the tax treatment is akin to that existing for an equity option under the exchange traded option rules. When a securities trader has a “holding period” in a capital asset; the holding period is, generally, the period of time over which the trader has held the asset, subject to modification by one or more of the Code’s anti-tax abuse provisions. Generally, a trader’s holding period in an asset begins on the day after he or she acquires it, and the day on which he or she disposes of it is treated as part of the holding period. See IRS Publication 550. If the trader holds a long position in a stock, then when the trader closes out the position depends upon the holding period, STCG-one year or less; LTCG for more than one year. See Internal Revenue Code §§1222(1)-(2) and (3)-(4). Accordingly, we believe that the S-Corporation stock in the case of the CRT Option transaction is properly characterized as IRC Section 1256 property because the stock is a security or financial instrument. Examples of non-1256 property would be coins, stamps, bullion, art collections and collectibles.

An equity option such as our deep in the money donative S-Corp call option, is a stock option. IRS Publication defines an equity option as an option that is valued directly or indirectly by referenced to a single stock. See IRC Sec 1256(g)(6(A). Rev. Rul. 78-182 addresses the taxation of individual calls (on stock) that are capital assets in the hands of the taxpayer.

Based on Rev. Rul. 78-182, if the option holder closes out the call option before it expires, the tax character of the gain or loss as short-term or long-term depends on the holding period of the option. If one or less, the gain or loss is short term. If more than one year, it is long-term. In regard to the capital asset underlying the option, the option holder has a holding period is the time period that the option holder has held the asset. the holding period begins on the day that the capital assets is acquired and ends the day it is disposed of.

If a holder exercises a call option, the holder must add the cost of the call to the basis of the stock the holder received on the exercise. If a holder exercises a put option, the holder must reduce the amount realized on the sale of the underlying stock by the cost of the put when figuring gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on the holding period for the underlying stock (Rev. Rul. 78-182). The method by which an option is exercised, for instance cash settlement or property settlement, does not alter the conclusion that the exercise of a put option is a taxable event for federal income tax purposes. The exercise of a cash settlement option is treated as a sale or exchange of the option. A taxable event occurs upon the closing of a contractual right to purchase or receive securities, regardless of the fact that a right was settled by an offset (Rev. Rul. 88-31; Samueli v. Comm’r, 2011 PTC 33 (9th Cir. 2011), modified by 2011 PTC 58 (9th Cir. 2011; TAM 201214021).

A person who writes (grants) a put or a call does not include the amount received for writing it in income at the time of receipt. Instead, the writer carries it in a deferred account until: (1) the writer’s obligation expires; (2) the writer buys, in the case of a put, or sells, in the case of a call, the underlying stock when the option is exercised; or (3) the writer engages in a closing transaction (Rev. Rul. 78-182; Notice 2003-81; Notice 2007-71).

If a writer’s obligation expires, the amount the writer received for writing the call or put is short- term capital gain. If a writer’s put option is exercised and the writer buys the underlying stock, the writer must decrease the basis in the stock by the amount the writer received for the put. The writer’s holding period for the stock begins on the date the writer buys it, rather than the date the writer wrote the put (Rev. Rul. 78-182).

If a writer’s call option is exercised and the writer sells the underlying stock, the writer must increase the amount realized on the sale of the stock by the amount the writer received for the call when figuring gain or loss. The gain or loss is long term or short term depending on the holding period of the stock (Rev. Ruls. 78-182, 58-234). See generally, Virginia Iron Coal & Coke Co. v. Commissioner (Virginia Coal), 37 B.T.A. 195 (1938), aff’d, 99 F.2d 919 (4th Cir. 1938), and Fed. Home Loan Mortg. Corp. v. Commissioner (Freddie Mac), 125 T.C. 248 (2005), are both instructive regarding options and open transaction treatment. The Board of Tax Appeals also reasoned that continuing open transaction treatment was appropriate because it was uncertain whether the premium payments would ultimately be included in the computation of gain or loss from the sale of the underlying property or would constitute income to the taxpayer in connection with the expiration of the option. Id. See ESTATE OF MCKELVEY v. CIR., 148 T.C. 13 (2017)
Similarly, there are Analogous Holding Period Tacking Issues Relevant to Our SOCRATES Transaction Found in the Internal Revenue Code, Treasury Regulations, Cases, Published Rulings and Private Letter Rulings.

There are a variety to analogous situations throughout the body our income tax laws in which the holding period of assets are deemed be based upon and “tack” to the holding period of the transferor. Most of those situations involve carryover basis types of transactions. In particular, this treatment is actually the general rule with respect to property which is either given by one individual to another or to a trust created by that individual (a gift transaction), the transfer of assets to a Corporation in exchange for its stock in a tax-free in Corporation transaction under Section 351(a), transfers to an entity taxed as a partnership in a Section 721(a) no recognition transaction. Likewise, when assets are donated by an individual to a charitable lead trust (“CLT”), charitable a remainder trust, or to a charity as a part of a pooled income fund gift. Generally, no gain or loss is recognized to the donor on the transfer of property to a pooled income fund. The CLT, CRT or Pooled Income Fund all have a basis and holding period with respect to property transferred to the fund by a donor which is determined under Code Secs. 1015(b) and 1223(2). See Rev. Rul. 2008-41, 2008-30 I.R.B. 170 (2008) which states that Code Sec. 1015(b) provides that, if property is acquired by a transfer in trust (other than by a transfer in trust by a bequest, or devise) after December 31, 1920, the basis shall be the same as it would be in the hands of the grantor, increased by the amount of gain, or decreased by the amount of loss, recognized by the grantor on such a transfer in trust under the law applicable in the year in which the transfer was made.

Section 1.1015-2(a)(1) provides that, if the taxpayer acquired property by such a transfer in trust, this basis rule applies whether the property is in the hands of the trustee or the beneficiary, and whether the property was acquired before, upon, or after termination of the trust and distribution

of the property. Section 1223(2) provides that, in determining the period for which the taxpayer has held property, however acquired, there shall be included the period during which the property was held by another person if, under chapter 1 (Normal Taxes and Surtaxes), the property has, for purposes of determining gain or loss from a sale or exchange, the same basis, in whole or in part, in the taxpayer’s hands as it would have in the hands of the other person.
If, however, a donor transfers property to a pooled income fund and, in addition to creating or retaining a life income interest in the property, receives property from the fund, or transfers property to the fund that is subject to an indebtedness, this nonrecognition rule does not apply to the gain realized by reason of (1) the receipt of that property or (2) the amount of that indebtedness, whether or not assumed by the pooled income fund, which must be treated as an amount realized on the transfer (see Reg. Sec. 1.642(c)-5(a)(3)).
In the context of depreciable real estate, see for example the holding period elements of the Treasury Regulations applicable to Code Section 1250, as follows:
Section 1.1250-4 Holding Period

(a) General . In general, for purposes only of determining the applicable percentage (as defined in section 1250 (1)(C) and (2) (B)) of section 1250 property, the holding period of the property shall be determined under the rules of section 1250(e) and this section and not under the rules of section 1223. If the property is treated as consisting of two or more elements (within the meaning of paragraph (C)(1) of Section 1.1250-5), see paragraph (a)(2)(ii) of Section 1.1250-5 for application of this section to determination of holding period of each element. Section 1250(e) does not affect the determination of the amount of additional depreciation in respect of section 1250 property…….

(c) Property with transferred basis. Under Section 1250(e)(2), if the basis of property acquired in a transaction described in this subparagraph is determined by reference to its basis in the hands of the transferor, then the holding period of the property in the hands of the transferee shall include the holding period of the property in the hands of the transferor. The transactions described in this subparagraph are:
(1) A gift described in section 1250(d)(1).
(2) Certain transfers at death to the extent provided in paragraph (b)(2)(ii) of Section 1.1250-3.
(3) Certain tax-free transactions to which section 1250(d) 3) applies. For application of section 1250 (2) 3) and (e)(2) to a distribution by a partnership to a partner, see paragraph (f)(1) of Section 1.1250-3.
(4) A transfer described in paragraph (e)(4) of Section 1.1250-3 (relating to transaction under section 1081(d)(1) (A)).
(d) Application of transferred-basis and principal residence rules. The determination of holding period under this section shall be made without regard to whether a transaction occurred prior to the effective date of section 1250 and without regard to whether there was any gain upon the transaction. Thus, for example, under paragraph (C) of this section a donee’s holding period for property includes his donor’s holding period notwithstanding that the gift occurred on or before December 31, 1963, or that there was no additional depreciation in respect of the property at the time of the gift.

Conclusion
As we have posited in this article, via the use of real-world financial products and their governing tax principles enable us to use the SOCRATES CRT PLAN for our clients’ best interests. SOCRATES enables us to do what was heretofore thought to be incapable of achievement. As these various underlying authorities (regulations and rulings) highlight, the principles of real-world financial products and engineered financial instruments like derivatives, collars, options, variable prepaid forward contracts, etc. and the tax treatment thereof, provide the astute tax planning attorney with both income and estate tax charitable alternatives in a manner which will benefit S-Corp shareholders and the charitable causes which they support. In fact, the use of the SOCRATES CRT PLAN (SM) will likewise enable the S-Corporation shareholder to engage in a modified Bailout/ Redemption transaction (normally reserved for C- Corporation shareholders) to transfer control of the Corporation from the senior generation to the next generation utilizing Corporate cash to redeem the senior level pf shareholders. Essentially, this transaction can best be described as a charitable leveraged buyout. A powerful tool if properly employed.