The Intersection of IRC Section 642(c) and S Corporations: More Than Meets The Eye?

Analyzing PLR 202423002 for thorny post-mortem S corporation issues and charitable bequests

Intro

In a prior article, I discussed the general principle of eligible S corporation shareholders. With some exceptions, S corporation shareholders usually must be individuals or select trusts.

What we have not yet discussed in that article series is a special carve-out for tax-exempt organizations. Under IRC Section 1361(c)(6), an organization that is both (1) described in IRC Section 501(c)(3), and (2) exempt from tax under IRC Section 501(a), may be an S corporation shareholder. This generally does not include trusts for charities, such as charitable remainder trusts and nongrantor charitable lead trusts. It may be possible, however, for charitable organizations to be beneficiaries of an electing small business trust (ESBT). (See Treas. Reg. 1.1361-1(m)(8)(viii)).

There is, however, one problem that pops up with S corporations where an exempt organization is involved. Although the exempt organization’s ownership of S corporation stock won’t affect the S corporation’s election, it could create headaches for the exempt organization. How?

If we turn our attention to IRC Section 512(e), we find out that the organization’s interest in the S corporation is treated as an interest in an unrelated trade or business.

This article is not a lesson on unrelated trades or businesses, or why they create headaches for exempt organizations. A recent article by S. Mona Reza does a great job of explaining unrelated business taxable income and its effects.

But, there was a recent private letter ruling - PLR 202423002 - which left more questions than answers when it comes to the intersection of UBIT, S corporation stock, stepped-up basis assets, and trusts seeking a charitable deduction.

PLR 202423002

In this private letter ruling, a revocable trust (making an election with the decedent’s estate under IRC Section 645) named a charitable foundation as its sole residuary beneficiary, after reduction for specific gifts and claims against the estate (which were represented to be inconsequential).

The electing revocable trust owned 100% of the stock in an S corporation, which in turn held unimproved land (which the S corporation held as a dealer in real property before the decedent’s death). The trust proposed to:

1. Distribute the unimproved land from the S corporation to the trust in a non-liquidating distribution (which would cause gain recognition to the trust as shareholder under IRC Section 311(b));

2. Sell the land;

3. Distribute the proceeds to the charitable foundation as part of the residuary; and

4. If the sale took place in the same year as the distribution, take a deduction under IRC Section 642(c) for the distribution of the proceeds - thus offsetting the gain passed through from the S corporation under IRC Sections 311(b) and 1366(a).

In this PLR, the trust sought a determination that it would indeed qualify for the deduction under IRC Section 642(c) if successful in selling the property in the same tax year as the deemed gain realization event on the S corporation distribution. Without much analysis of IRC Section 642(c) itself outside of recitation of the applicable requirements, the IRS agreed that the conditions for this deduction would be met - that the sales proceeds would constitute gross income paid or permanently set aside for a charitable purpose under the terms of the revocable trust.

As with many private letter rulings, however, a lot went unsaid. This time, however, the IRS served up a special gift in the form of an analysis of authorities which seemed to not affect their final determination other than to support this caveat by the IRS:

“Except as specifically set forth above, we express or imply no opinion concerning the federal tax consequences of the facts of this case under any other provision of the Code and the regulations thereunder.”

This “gift horse” deals with the UBIT issue mentioned in the introduction to this article.

IRC Section 681

The interesting aspect of the trust-level charitable income tax deduction under IRC Section 642(c) is that, unlike the individual income tax charitable deduction under IRC Section 170, there are generally no limitations on deductibility based on the trust’s adjusted gross income (AGI). It is likely that the pass-through S corporation gain would make up most (if not all) of the trust’s income for the year. However, assuming we could jump through all of the IRC Section 642(c) hoops, there should be a 100% deduction for the trust on the other side. Right?

Unfortunately, the answer is no where UBIT is involved. There is a final, unexpected boss in the form of IRC Section 681(a).

(Visual representation of the final boss of IRC Section 681).

This Code Section generally provides that, even if you qualify for IRC Section 642(c), the amount deductible by the trust may be limited if the trust has “unrelated business income.” This is defined as net amounts which would be treated as unrelated business taxable income to the trust under IRC Section 512 if the trust were instead a tax-exempt organization.

Treas. Reg. 1.681(a)-1 notes the cost of having “unrelated business income” is that, in computing the amount deductible under IRC Section 642(c), the trust will have to apply the individual AGI limitations set forth in IRC Section 170. And while the IRS did not go so far as to cite the rules of IRC Section 512(e) regarding S corporations, it all but served up on a platter the conclusion that the gain passed through from the S corporation would, indeed, be treated as unrelated business taxable income if the trust was an exempt organization.

So, in the PLR discussed above, the trust sought a determination that it would be allowed a deduction for purposes of IRC Section 642(c). But, the trust did not seek a further determination on how much would, indeed, be deductible. Not knowing the type of foundation involved as a charitable beneficiary here, there would likely be either a 30% or 60% AGI limitation under IRC Section 170(b) for the use of cash proceeds after facing the final boss of IRC Section 681.

Corporate Liquidation

The core issue in this analysis is a central flaw for both S corporations and C corporations. After repeal of the General Utilities doctrine, appreciated assets owned by a corporation generally cannot pass to a shareholder without the corporation being treated as if it sold the property for fair market value under IRC Section 311(b). The outcome is corporate-level recognized gain, which is either taxed to the C corporation or passed through to S corporation shareholders.

This presents an interesting conundrum where stepped-up basis stock is involved - especially for an S corporation. While a tax partnership can adjust its “inside basis” in assets to reflect a step-up in “outside basis” with respect to a particular partner’s interest by making an election under IRC Section 754, no such election exists for a C corporation or S corporation.

The outcome is that, in a case like this, stepped-up basis S corporation stock may not avoid income tax in the hands of the recipient unless there is a third party sale. Even then, what we have not yet discussed is the ability of a third-party purchaser of S corporation stock to essentially “force” an inside basis step-up by making an election to instead treat the sale as an asset sale under IRC Section 338(h)(10) for income tax purposes - which changes the character of the transaction and again takes away the benefit of stepped-up basis stock.

What if, however, we were to just liquidate the S corporation? Generally, this would create a situation where (1) we start with stepped-up basis stock, (2) the stock gets a further stepped-up “super” basis from the gain passed through under IRC Sections 311(b) and 1366(a), (3) the shareholder(s) get stepped-up basis assets in exchange for their stock (due to the deemed sale treatment in the previous step), and (4) the shareholder(s) holding stock that started with a stepped-up basis before the liquidation can deduct (as a loss) the positive difference between their super stepped-up stock, and the FMV of the assets distributed on liquidation under IRC Section 331.

Character of loss counts, though, which is why in this case a full liquidation may not have made sense. As noted earlier, the S corporation was treated as a “dealer” with respect to the unimproved land - leading possibly to ordinary income on the distribution to the trust. The proposed transaction from the PLR may have created more bang for the trust’s buck, for reasons we will later discuss when we revisit this liquidation “loophole” to step-up the basis of S corporation assets - especially where ordinary income assets or depreciation recapture are involved.