Donors considering transferring shares of an S corporation to a Donor-Advised Fund should be aware of the potential tax implications, particularly the triggering of Unrelated Business Income Tax (UBIT). This blog post explains why UBIT becomes a concern and what donors need to understand before making this type of charitable contribution.
Understanding UBIT
Unrelated Business Income Tax (UBIT) is a tax imposed on the income generated from activities that are unrelated to the exempt purpose of a tax-exempt entity, such as a DAF. The rationale behind UBIT is to prevent tax-exempt entities from having an unfair competitive advantage over for-profit businesses when engaging in commercial activities outside their exempt purposes.
S Corporations and DAFs: Where UBIT Comes Into Play
When an S corporation makes a profit, that income is typically passed through to its shareholders, who then report the income on their personal tax returns. This pass-through taxation feature is one of the defining characteristics of S corporations. However, when shares of an S corporation are donated to a DAF, the DAF becomes a shareholder and the rules change.
DAFs, hosted by sponsoring organizations like public charities, are tax-exempt entities. As such, they do not usually pay income tax. However, when a DAF receives pass-through income from an S corporation, this income is considered "unrelated business taxable income" because it arises from an ongoing business that is unrelated to the DAF's charitable purpose. Consequently, the unrelated income triggers UBIT, meaning the DAF must pay taxes on this income, which can diminish the value of the charitable contribution and the funds available for philanthropic grants if the donor does not reimburse the DAF.
Typically, UBIT is applied at 25% of the funds received by the DAF (sale proceeds, operating profits, etc.). However, unlike most DAF hosts, UI Charitable is able to reduce UBIT exposure. UI Charitable established a 501c3 charitable trust in order to accept S-corp donations. If a donation is directed to the UI Charitable Trust rather than into a DAF, it opens up several avenues for reducing UBIT liability:
Donors can lower UBIT by up to 50% by making a significant contribution from the trust to a religious organization, such as a church.
If the donor does not plan on giving to a church, donors can achieve up to a 30% reduction in UBIT by making regular grants from the trust or by transferring funds to a DAF, as donations to a DAF are considered charitable contributions due to its 501c3 status. By doing so, donors can continue to make grants and investments from their DAF as they normally would.
However, it is important to note that the full 21% will be withheld in the trust until the end of the current tax year to ensure sufficient funds are available to cover any incurred UBIT. This strategic approach not only aids in reducing UBIT liability, but also permits the trust to deduct the donations from its taxable income, which includes proceeds from business sales.
The Challenges of Donating S Corp Shares to DAFs
Tax Burden: The imposition of UBIT can significantly reduce the net charitable impact of the donation if the DAF must use part of it to pay taxes.
Valuation and Liquidity: Valuing S corporation shares can be complex, especially for closely held corporations. Moreover, since DAFs are not typically set up to hold and manage business interests, converting these assets into liquid funds for charitable grants can be challenging.
Administrative Complexity: Managing UBIT obligations adds administrative complexity for the DAF sponsoring organization, which must track unrelated business taxable income, file additional tax forms, and ensure compliance with IRS rules.
Considerations for Donors
Before donating S corp shares to a DAF, donors should:
Consult with Tax and Legal Advisors: It is crucial to understand the full tax implications and ensure that such a donation aligns with your philanthropic and financial goals.
Evaluate Alternative Giving Strategies: Consider other charitable vehicles or methods that might be more tax-efficient or better suited to holding business interests.
Discuss with the DAF Sponsor: Engage with the DAF sponsoring organization to understand their policies on accepting business interests and their capacity to manage UBIT compliance.
Conclusion
Donating S corporation shares to a donor-advised fund can be a meaningful way to support charitable causes. However, the potential for UBIT necessitates careful planning and consultation with professionals. By understanding the implications and exploring alternatives, donors can make informed decisions that maximize their philanthropic impact while navigating the complexities of tax regulations.
