The IRS has released a revenue ruling that confirms many of our hopes regarding charitable gifts of appreciated property by a Subchapter S corporation. Normally a shareholder's income tax deduction for an S corporation's business losses is limited to the shareholder's basis in the corporation's stock. The IRS has now confirmed that charitable gifts can qualify for better tax treatment. Click through to read Chris Hoyt's analysis.
PGDC Summary by Christopher R. Hoyt:
The IRS concluded that if an S corporation made a charitable contribution in 2006 or 2007 of appreciated property (such as real estate), the shareholder was entitled to claim a charitable income tax deduction that exceeded the shareholder's basis in the stock. This favorable tax treatment was a temporary measure contained in legislation that expired in 2007, but it is one of the "extender" laws (like "Charitable IRA rollover") and there is a good chance that it will be extended into 2008.
The ruling addressed a situation where an individual who owned 100% of an S corporation had a basis of $ 50x in the corporation stock. During 2007, the corporation made a charitable contribution of unencumbered real property, with an adjusted basis of $ 100x and a fair market value of $ 190x. In 2007, the Subchapter S corporation had business profits of $ 30x and a long-term capital loss of $ 25x. The IRS concluded that the shareholder could claim a charitable contribution deduction of $ 154x.
The IRS stated: "Pursuant to section 1366(d)(4), the basis limitation rule in section 1366(d)(1) does not apply to a contribution of appreciated property to the extent the shareholder's pro rata share of the contribution exceeds the shareholder's pro rata share of the adjusted basis of the contributed property. Accordingly, the basis limitation rule of section 1366(d)(1) does not apply to A's pro rata share of the amount of deductible appreciation in the contributed property ($ 90x)."
The IRS then went through a mind-numbing computation to reach a deduction of $154x rather than $190x. Still the good news is that the shareholder can claim a charitable income tax deduction that exceeds the shareholder's basis in the stock. By comparison, if the corporation had a loss from business operations the loss would have been limited by the shareholder's low basis in the stock. The ruling calculated the amount this way: "Accordingly, in 2007, the amount of the charitable contribution deduction that A may claim is $ 154x. This amount is comprised of A's pro rata share of the property's appreciation ($90x) plus the amount of the loss limitation allocated to A's pro rata share of the contributed property's adjusted basis ($ 64x). Under section 1367(a)(2)(B), A's basis in the X stock is reduced to 0 to reflect the $ 16x reduction in basis attributable to the capital loss and the $ 64x reduction in basis attributable to the charitable contribution deduction. Pursuant to section 1366(d)(2), the disallowed portion of the charitable contribution deduction ($ 36x) and the capital loss ($ 9x) shall be treated as incurred by X in the succeeding taxable year with respect to A."
The IRS relied on the example in the Committee Report for the Pension Protection Act of 2006. The Technical Explanation of the Pension Act, Technical Explanation of
H.R. 4, "The Pension Protection Act of 2006," JCX-38-06 page 271,
provides the following illustration of section 1203:
Thus, for example, assume an S corporation with one individual
shareholder makes a charitable contribution of stock with a basis
of $ 200 and a fair market value of $ 500. The shareholder will be
treated as having made a $ 500 charitable contribution (or a
lesser amount if the special rules of section 170(e) apply), and
will reduce the basis of the S corporation stock by $ 200.
(Footnote 306: This example assumes that basis of the S
corporation stock (before reduction) is at least $ 200.)
The full text of the ruling is reproduced below.
Christopher R. Hoyt is a professor of law at the University of Missouri (Kansas City) School of Law and member of the Planned Giving Design Center Editorial Board. He can be reached at hoytc@umkc.edu.
Rev. Rul. 2008-16; 2008-11 IRB 1
Full Text:
ISSUE
If an S corporation makes a charitable contribution of appreciated property in a taxable year beginning after December 31, 2005, and before January 1, 2008, what is the amount of the charitable contribution deduction that a shareholder may claim in circumstances where section 1366(d) of the Internal Revenue Code (Code) limits the shareholder's pro rata share of the S corporation's losses and deductions for the taxable year in which the property is contributed?
FACTS
Individual A is the sole shareholder of S Corporation X. At the beginning of X's 2007 taxable year, A has a basis of $ 50x in the X stock. During 2007, X makes a charitable contribution of unencumbered real property, with an adjusted basis of $ 100x and a fair market value of $ 190x, in a transaction that qualifies under section 170(c). The charitable contribution is not subject to the limitations of section 170(e)(1). In 2007, X has section 1363 taxable income of $ 30x and a long-term capital loss of $ 25x.
LAW
Section 170(a) allows as a deduction any charitable contribution (as defined in section 170(c)) the payment of which is made during the taxable year. The deduction allowable by section 170(a) is subject to the limitations of section 170(b).
Section 1.170A-1(c)(1) of the Income Tax Regulations provides that if a charitable contribution is made in property other than money, the amount of the contribution is the fair market value of the property at the time of the contribution reduced as provided in section 170(e)(1) and section 1.170A-4(a), or section 170(e)(3) and section 1.170A-4A(c).
Section 1363(b)(2) provides that the taxable income of an S corporation shall be computed in the same manner as in the case of an individual, except that the deductions referred to in section 703(a)(2), including the deduction for charitable contributions provided in section 170, shall not be allowed to the corporation.
Section 1366(a)(1)(A) provides that, in determining the tax of a shareholder, there shall be taken into account the shareholder's pro rata share of the corporation's items of income, loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder. Section 1366(a)(1) provides further that the items referred to in section 1366(a)(1)(A) include amounts described in section 702(a)(4). Section 702(a)(4) refers to charitable contributions (as defined in section 170(c)).
Section 1366(a)(1)(B) provides that, in determining the tax of a shareholder, there shall be taken into account the shareholder's pro rata share of any nonseparately computed income or loss.
Section 1366(d)(1) provides that the aggregate amount of losses and deductions taken into account by a shareholder under section 1366(a) for any taxable year shall not exceed the sum of (A) the adjusted basis of the shareholder's stock in the S corporation, and (B) the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder.
Section 1366(d)(2)(A) generally provides that any loss or deduction which is disallowed for any taxable year by reason of section 1366(d)(1) shall be treated as incurred by the corporation in the succeeding taxable year with respect to that shareholder.
Section 1.1366-1(a)(2)(i) and (iii) provides that each S corporation shareholder must take into account separately the shareholder's pro rata share of the S corporation's gains and losses from sales or exchanges of capital assets and the corporation's charitable contributions.
Section 1.1366-1(a)(3) provides that each shareholder must take into account separately the shareholder's pro rata share of the nonseparately computed income or loss of the S corporation.
Section 1.1366-1(b)(1) provides, in part, that the character of any item of income, loss, deduction, or credit described in section 1366(a)(1)(A) or (B) is determined for the S corporation and retains that character in the hands of the shareholder.
Section 1.1366-2(a)(4) generally provides that if a shareholder's pro rata share of the aggregate amount of losses and deductions exceeds the sum of the adjusted basis of the shareholder's stock in the corporation and the adjusted basis of any indebtedness of the corporation to the shareholder, then the limitation on losses and deductions under section 1366(d)(1) must be allocated among the shareholder's pro rata share of each loss or deduction. The amount of the limitation allocated to any loss or deduction is an amount that bears the same ratio to the amount of the limitation as the loss or deduction bears to the total of the losses and deductions.
Section 1367(a)(1)(B) provides that the basis of each shareholder's stock in an S corporation is increased for any period by any nonseparately computed income determined under section 1366(a)(1)(B).
Section 1367(a)(2)(B) provides that the basis of each shareholder's stock in an S corporation is decreased for any period (but not below zero) by the items of loss and deduction described in section 1366(a)(1)(A).
Section 1.1367-1(f) provides that increases in an S corporation shareholder's stock basis that are attributable to income items described in section 1367(a)(1)(B) are made before decreases in such basis that are attributable to items of loss or deduction described in section 1367(a)(2)(B).
Section 1203(a) of the Pension Protection Act of 2006 (Pension Act), P.L. 109-280, 120 Stat. 780 (2006), amended Code section 1367(a)(2) to provide that the decrease in shareholder basis under section 1367(a)(2)(B) by reason of a charitable contribution (as defined in section 170(c)) of property shall be the amount equal to the shareholder's pro rata share of the adjusted basis of such property. The Technical Explanation of the Pension Act, Technical Explanation of H.R. 4, "The Pension Protection Act of 2006," JCX-38-06 page 271, provides the following illustration of section 1203:
Thus, for example, assume an S corporation with one individual
shareholder makes a charitable contribution of stock with a basis
of $ 200 and a fair market value of $ 500. The shareholder will be
treated as having made a $ 500 charitable contribution (or a
lesser amount if the special rules of section 170(e) apply), and
will reduce the basis of the S corporation stock by $ 200.
(Footnote 306: This example assumes that basis of the S
corporation stock (before reduction) is at least $ 200.)
Section 3(b) of the Tax Technical Corrections Act of 2007 (Technical Corrections Act), P.L. 172, 121 Stat. 2473 (2007), added section 1366(d)(4), which concerns the application of the basis limitation rule of section 1366(d)(1) to charitable contributions of appreciated property by S corporations. Generally, under section 1366(d)(1), the amount of losses and deductions which a shareholder of an S corporation may take into account in any taxable year is limited to the shareholder's adjusted basis in his stock and indebtedness of the corporation. Section 1366(d)(4) provides that, in the case of a charitable contribution of property, section 1366(d)(1) shall not apply to the extent of the excess (if any) of (A) the shareholder's pro rata share of such contribution, over (B) the shareholder's pro rata share of the adjusted basis of such property. Thus, the basis limitation rule of section 1366(d)(1) does not apply to the amount of deductible appreciation in the contributed property. See Description of the Tax Technical Corrections Act of 2007, JCX-119-07, pages 2-3.
The Pension Act amendment to section 1367(a)(2) and the Technical Corrections Act amendment to section 1366(d) apply to charitable contributions made by S corporations in taxable years beginning after December 31, 2005, and before January 1, 2008. Charitable contributions made by S corporations in taxable years beginning after December 31, 2007, barring any statutory change, are subject to the law in existence prior to these amendments. The IRS and Treasury Department are considering issuing guidance on the treatment of charitable contributions made by S corporations in taxable years beginning after December 31, 2007.
ANALYSIS
Under the facts of this revenue ruling, X makes a charitable contribution of unencumbered real property with an adjusted basis of $ 100x and a fair market value of $ 190x in a transaction that qualifies under section 170(c). The charitable contribution is treated as a separately stated item of deduction that passes through to A and is deductible in computing A's individual tax liability. Section 1.1366-1(a)(2)(iii).
Pursuant to section 1.1367-1(f), A's $ 50x basis in the X stock is first increased by $ 30x under section 1367(a)(1)(B) to reflect A's share of X's taxable income. A's basis in the X stock is then decreased (but not below zero) by A's pro rata share of the sum of the adjusted basis of the contributed property ($ 100x) pursuant to the flush language of section 1367(a)(2) and by A's pro rata share of X's long-term capital loss ($ 25x) pursuant to section 1367(a)(2)(B). However, A's pro rata share of the aggregate amount of losses and deductions ($ 125x) exceeds A's basis in the X stock of $ 80x. Section 1366(d)(1), accordingly, will limit the allowable losses and deductions to A for X's 2007 tax year.
Pursuant to section 1366(d)(4), the basis limitation rule in section 1366(d)(1) does not apply to a contribution of appreciated property to the extent the shareholder's pro rata share of the contribution exceeds the shareholder's pro rata share of the adjusted basis of the contributed property. Accordingly, the basis limitation rule of section 1366(d)(1) does not apply to A's pro rata share of the amount of deductible appreciation in the contributed property ($ 90x).
Under section 1.1366-2(a)(4), when a shareholder has losses or deductions in excess of the sum of the shareholder's basis in the stock plus indebtedness of the S corporation to the shareholder, the limitation on losses must be allocated pro rata to each item of loss or deduction. In the case of a charitable contribution deduction, the limitation amount allocable to such deduction is determined by reference to the shareholder's pro rata share of the contributed property's adjusted basis pursuant to section 1366(d)(4).
In applying section 1.1366-2(a)(4), the amount of the limitation allocable to a charitable contribution deduction is an amount that bears the same ratio to the section 1366(d) limitation as the shareholder's pro rata share of the contributed property's adjusted basis bears to the total of the shareholder's pro rata share of the corporation's losses and deductions (excluding the charitable contribution deduction attributable to the shareholder's pro rata share of the fair market value of the contributed property over the contributed property's tax basis). Accordingly, the amount of the limitation allocable to A's share of X's charitable contribution deduction is determined by multiplying A's basis in the X stock ($ 80x) by a fraction, the numerator of which is $ 100x (the contributed property's adjusted basis) and the denominator of which is $ 125x (the total of the capital loss and the contributed property's adjusted basis). Thus, $ 64x is allocated to the charitable contribution deduction. The remaining $ 16x is allocated to the capital loss.
Accordingly, in 2007, the amount of the charitable contribution deduction that A may claim is $ 154x. This amount is comprised of A's pro rata share of the property's appreciation ($90x) plus the amount of the loss limitation allocated to A's pro rata share of the contributed property's adjusted basis ($ 64x). Under section 1367(a)(2)(B), A's basis in the X stock is reduced to 0 to reflect the $ 16x reduction in basis attributable to the capital loss and the $ 64x reduction in basis attributable to the charitable contribution deduction. Pursuant to section 1366(d)(2), the disallowed portion of the charitable contribution deduction ($ 36x) and the capital loss ($ 9x) shall be treated as incurred by X in the succeeding taxable year with respect to A.
HOLDING
If an S corporation makes a charitable contribution of appreciated property during a taxable year beginning after December 31, 2005, and before January 1, 2008, the amount of the charitable contribution deduction the shareholder may claim may not exceed the sum of (i) the shareholder's pro rata share of the fair market value of the contributed property over the contributed property's adjusted tax basis, and (ii) the amount of the section 1366(d) loss limitation amount that is allocable to the contributed property's adjusted basis under section 1.1366-2(a)(4). Any disallowed portion of the charitable contribution retains its character and is treated as incurred by the corporation in the corporation's first succeeding taxable year, and subsequent taxable years, with respect to the shareholder.
DRAFTING INFORMATION
The principal author of this revenue ruling is Cynthia D. Morton of the Office of Associate Chief Counsel (Passthroughs & Special Industries). For further information regarding this revenue ruling, contact Cynthia D. Morton at (202) 622-3060 (not a toll-free call).