The Pension Protection Act of 2006 (the “PPA”) included a taxpayer-favorable provision that makes charitable contributions of appreciated property through S corporations more appealing. However, this provision is only temporary and is set to expire at the end of the 2007 tax year. Consequently, S corporations and their owners should consider taking advantage of this provision by making charitable contributions prior to the end of the 2007 tax year, which for many taxpayers ends on December 31, 2007.
Charitable Giving through S Corporations and Prior Law
As a general matter, S corporations do not claim deductions for their charitable contributions; rather, like other items of income, loss, deduction or credit, charitable contributions made by an S corporation are reported as contributions on the shareholders’ federal income tax returns. With some exceptions, if a taxpayer makes a charitable contribution of property, the taxpayer is treated as making a contribution equal to the contributed property’s fair market value as of the time of contribution. Thus, if an S corporation (the “contributing corporation”) makes a charitable contribution of property, then (subject to certain limitations) each of the contributing corporation’s shareholders will take into account his or her pro rata share of the contribution for purposes of determining his or her charitable contribution deduction. Essentially, each shareholder is treated as directly making the charitable contribution to the extent of his or her pro rata share. A shareholder’s pro rata share is based on the shareholder’s actual ownership interest in the contributing corporation.
Prior to the enactment of the PPA, the applicable federal tax laws required each shareholder of a contributing corporation making a charitable contribution of appreciable property to decrease his or her tax basis in the stock he or she owned in the contributing corporation by the amount of the shareholder’s pro rata share of the contributed property’s fair market value. For example, assume that Corporation X, an S corporation, is owned 50 percent by A and 50 percent by B and that each of A and B has suffi cient tax basis in his or her Corporation X stock to absorb the amount of any charitable contribution that may flow through from Corporation X. Assume further that Corporation X wants to donate property that it owns to A’s and B’s favorite charity. Corporation X decides to donate property Z. At the time of the donation, property Z has a fair market value of $100 and Corporation X has a tax basis in property Z of $20. Under prior tax law, upon Corporation X’s donation of property Z, $50 worth of charitable contribution would fl ow through to each of A and B, and A and B would each decrease their respective basis in their Corporation X stock by $50.
Under the temporary provision contained in the PPA, the federal tax law now requires each shareholder of the contributing corporation to decrease his or her tax basis in the stock of the contributing corporation by only his or her pro rata share of the contributed property’s adjusted tax basis, as opposed to its fair market value. Returning to the above example, upon the donation of property Z, a $100 contribution would fl ow through to A and B ($50 to each); however, because Corporation X has a tax basis of $20 in property Z as of the time of contribution, A and B are required to decrease their respective basis in their shares by only $10. Both A and B would receive a greater benefi t if, for example, the contributing corporation had a $0 basis in the contributed property because, in that case, neither A nor B would have to decrease his or her stock basis. In the above circumstances, the temporary change in the law allows both A and B to retain more basis in their shares of Corporation X stock. This means that they may have a greater ability to shelter future income that may arise from the sale of their shares and/or utilize additional items of loss or deduction that fl ow through from Corporation X.
Of course, taxpayers who make charitable contributions of property generally are required to substantiate the fair market value of the property by satisfying certain appraisal requirements. Also, as noted above, there are various rules that may limit the amount of charitable deductions an individual can take on his or her individual tax return. Additional rules can apply that may also affect the amount of the actual deduction depending on the type of property being contributed.
As noted above, this taxpayer-favorable provision expires at the end of the 2007 tax year. Therefore, you should contact your tax adviser well in advance of the end of the 2007 tax year if you wish to take advantage of this temporary provision.