Charitable organizations receive all types of donations, including cash, personal property, and even business interests. Often times, the charity is so excited about a potential gift that no diligence is completed prior to acceptance, and failure to complete diligence on gifts can turn out to be costly. Take gifts of real property – these are very common and can be financially beneficial to a charity. However, without completing diligence, the charity may find that it now owns a superfund site. Another not-so-obvious example is a donation of stock. Although most donated stock is marketable, certain types of stock, including stock in an S corporation (usually small, family owned corporations), are not. This post explores the implications of a charity accepting gifts of S corporation stock.
Subchapter S corporations can only have certain types of shareholders. Generally, these “permissible shareholders” include individuals (who are not nonresident aliens), estates, certain trusts, and certain exempt organizations. We will focus on the permissible exempt organization shareholder.
Only exempt organizations described in sections 501(c)(3) and 401(a) are permissible exempt organization shareholders – thus, other tax exempt organizations, such as 501(c)(4) or 501(c)(6) organizations, are not eligible to hold stock of an S corporation.
However … 501(c)(3) organizations should beware! Owning S corporation stock is considered an “unrelated trade or business.” What does this mean? In simple terms – the 501(c)(3) organization is treated like all other S corporation shareholders and will pay tax on its share of the corporation’s income, loss, and deductions that pass through to the organization under 1366. That’s right, although the 501(c)(3) organization can generally receive interest, dividends, royalties and rent without paying tax on these items, if these items come from an S corporation – the organization must pay tax! To make matters worse, if the organization sells its S corporation stock, any capital gain will also be subject to tax. Other special rules apply to private foundations and charitable remainder trusts.
The lesson here? It’s often difficult to know whether a gift of stock is stock in an S corporation or a C corporation. Prior to accepting any gift (except cash and other basic gifts), a charitable organization should complete diligence. For example, in anticipation of a gift of stock, the charity should ask for a copy of the corporation’s articles of incorporation and bylaws. Of course, if there is ever a concern, the charity should contact its lawyer. For reference, a sample gift acceptance policy can be found here.