Many taxpayers oversimplify the rules surrounding the charitable contribution deduction. Most are aware that contributions to public charities were previously deductible up to 50% of adjusted gross income (AGI), and that for tax years 2018 through 2025, the deduction cannot exceed 60% of AGI. What catches some by surprise is that lower limitations may apply. It is also important to determine the amount deductible prior to the application of any limitations. Is it the adjusted basis? Fair market value? Something in between?
Rules surrounding the pass through of charitable contribution deductions from an S corporation to its shareholders and the corresponding basis adjustments may also surprise taxpayers. This article explores the rules for contributions to public charities by an S corporation.
What Is a Public Charity?
Generally, public charities (nonprivate foundations) are tax-exempt Internal Revenue Code (IRC) section 501(c)(3) organizations that receive support from a broad base of donors. Public charities differ from private foundations, which are 501(c)(3) organizations that receive support from one or a few sources, such as a single family or corporation [IRC section 509(a)]. Different rules may apply to private foundations.
Charitable Contribution Rules for Individuals
Generally, contributions of long-term capital gain (LTCG) property will result in a deduction equal to the fair market value of the property, subject to a 30% of AGI limitation. This rule has not been affected by the Tax Cuts and Jobs Act (TCJA). LTCG property is defined as property that would generate a long-term capital gain if hypothetically sold by the taxpayer on the date of contribution; it is the contribution of a capital asset held for more than one year. The contribution of ordinary income property, which is property that would generate ordinary income if sold, including short-term capital gains, generates a deduction equal to the donor’s adjusted basis of the property contributed, subject to a 50%-of-AGI overall limitation. (The new 60% of AGI limitation only applies to cash contributions to qualifying charities.)
The charitable contribution deduction is determined at the shareholder level, and the treatment of these contributions may differ among shareholders given the limitations based on shareholder AGI.
There are exceptions to these rules; two of the more common exceptions will be reviewed here. First, the contribution of LTCG property that is unrelated to the use of the charitable organization will not generate a full fair market value tentative deduction. For example, if Abigail donates a Picasso to United Way, whose charitable function is not to engage and educate through art, then the taxpayer will only be able to deduct up to her adjusted basis in the artwork, subject to the 50% limitation. Marketable securities are generally not considered unrelated use. Furthermore, if the charity were to sell the donated property immediately after contribution, even if the property is otherwise related to its charitable purpose, the contribution is considered unrelated use. Revisiting the Picasso donation, if Abigail were to contribute it to the Albright-Knox Art Gallery in Buffalo, but the gallery were to sell it off to acquire operating funds, she would again only be eligible for a deduction of her adjusted basis in the Picasso.
The second exception applies to C corporations and is for the donation of inventory, which is normally ordinary income property. If the inventory donation meets certain requirements, the taxpayer may deduct basis plus one-half of the gain of the property, limited to twice the basis.
Basis Adjustment Rules for S Corporation Stock
Under IRC section 1366, an S corporation shareholder reports his pro rata share of S corporation items of separately stated income (deduction) and items of nonseparately stated income (deduction) as reported on Schedule K-1 (Form 1120S). Reporting these items increases (decreases) the shareholder’s basis in the S corporation stock under IRC section 1367. (An S corporation shareholder will increase his basis for tax-exempt income that passes through to his individual return; this adjustment is necessary in order to prevent the tax-exempt income from being taxed at the shareholder level when it is subsequently distributed by the S corporation.)
Among the separately stated deductions are charitable contributions by the S corporation; shareholders must report their ratable share of such contributions. The charitable contribution deduction is determined at the shareholder level, and the treatment of these contributions may differ among shareholders given the limitations based on shareholder AGI. Generally, a shareholder will reduce his basis by the amount of loss and deduction that passes through to him. For example, if an S corporation has a net IRC section 1231 loss of $10,000 that passes through to Brett, he will report the $10,000 loss on his Form 4797 and reduce his basis in his S corporation stock by $10,000. Such is not the case for charitable contribution deductions.
IRC section 1367(a)(2) flush language provides that S corporation shareholders will decrease basis in S corporation stock (or debt after stock basis is reduced to zero) by their pro rata share of the S corporation’s adjusted basis in the property contributed to charity. In Revenue Ruling 2008-16, the IRS clarified that the shareholder’s basis is not reduced by the appreciation of the contributed property. Thus, while the shareholder reduces his stock (and debt) basis by his ratable share of the basis in the contributed property (but not below zero), he will pass through his ratable share of the contributed property’s basis, limited to his basis in S corporation stock and debt, plus his ratable share of all the appreciation on the contributed property. In other words, the deduction is based on the fair market value of the charitable contribution.
The rule that limits the pass-through of the deduction to the stockholder’s basis in S corporation stock and debt does not apply to the appreciation of property contributed to charity by the S corporation. Even when the shareholder begins with zero basis in his S corporation stock (or debt), the appreciation of contributed property will pass through as a charitable contribution. In effect, the deduction is prorated to the portion limited by (and reducing) basis and to the appreciation. This discrepancy in pass-through and basis adjustments first appeared in the Pension Protection Act of 2006 and the Tax Technical Corrections Act of 2007 as a charitable giving incentive. After a few congressional extenders, it was made permanent by the Protecting Americans from Tax Hikes Act of 2015. Without this provision, an inequity may result. If a shareholder’s stock basis were reduced by the appreciation in the contributed property, he could potentially recognize more gain on the subsequent sale of his S corporation stock due to the lower basis. In comparison, the direct contribution of appreciated property to a public charity by an individual does not trigger gain recognition for the donor. Congress amended IRC section 1367 in an effort to prevent such an inequity.
The following example serves to illustrate the rule: Cora owns 100% of Scranton, Inc., an electing S corporation. Her basis in Scranton stock is $10,000 at the beginning of the year. In the current year, Scranton has ordinary income of $7,000 and makes a charitable contribution of LTCG property worth $50,000 and having a $20,000 basis. Scranton has no liabilities and no distributions are made during the year. Cora will first increase her basis in Scranton stock by the $7,000 of ordinary; thus, prior to any loss pass through, Cora has a basis of $17,000 ($10,000 + 7,000). Next, the charitable contribution will pass through as a separately stated deduction. When determining the amount of allowable deduction, Cora will experience a basis limitation. She will not be able to deduct the full $20,000 of the deduction associated with the property’s basis because it is limited to her adjusted basis in Scranton stock of $17,000. As a result, $17,000 of the available $20,000 basis will pass through to Cora on Schedule K-1 (Form 1120S); the excess $3,000 will carry over indefinitely until she has enough stock (or debt) basis to pass it through. Meanwhile, the entire $30,000 ($50,000 − 20,000) in appreciation of the property contributed to charity will pass through to Cora in the year of contribution and is available to be claimed on her personal return. In total, Cora has a potential charitable contribution deduction of $47,000 ($17,000 + 30,000). These taxpayer-friendly rules may be helpful in planning charitable contributions through S corporations.
Contributions by Partnerships
The TCJA also changed the rules relating to the pass-through of charitable contributions of appreciated property made by a partnership and brought them into conformity with the S corporation rules described above. Generally, a partnership will pass through deductions and losses to the extent the partner has basis in his partnership interest, referred to as his “outside basis.” Prior to 2018, the pass-through of charitable contributions was not subject to this limitation. Going forward, under IRC section 704(d)(3)(B), the outside basis limitation applies to the adjusted basis in the appreciated property contributed to a qualifying charity, but not to the appreciation on the contributed property. The appreciation will pass through to the partner in the year of contribution, irrespective of the partner’s outside basis.
A Useful Opportunity
In 2006, Congress gave S corporation shareholders an incentive to contribute to charities in the form of unique basis limitations on the contribution of certain property. In 2015, the provisions were made permanent. Under the TCJA, fewer individuals are expected to itemize their deductions, but for those who do, this benefit remains available when contributing to public charities through S corporations.