S Corporations’ Charitable Contributions of Appreciated Property and Shareholders’ Adjusted Basis in S Stock

Before the Pension Protection Act of 2006, P.L.109-280 (PPA ’06), it was generally understood that an S corporation’s charitable contribution of appreciated property reduced each shareholder’s adjusted basis in stock by the shareholder’s pro-rata share of the charitable deduction, which often was a portion of the contributed property’s fair market value (FMV).This potentially could result in a shareholder’s recognizing gain on the sale of S stock (due to lower basis) related to the S corporation’s charitable contributions. If the shareholder had directly owned and contributed the appreciated property, no indirect gain to the shareholder would have been recognized. Also, the use of FMV was inconsistent with the partnership-partner treatment governed by Rev. Rul. 96-11, which requires that the basis of a partner’s partnership interest be reduced by the partner’s share of the contributed property’s basis.

The PPA ’06 corrected this problem for tax years beginning in 2006 and 2007. (It is hoped that an extension of this treatment will be enacted in 2008 as part of an extenders bill.) PPA ’06 Section 1203(a) amended Sec. 1367(a)(2) to limit the reduction in a shareholder’s basis to the shareholder’s pro-rata share of the S corporation’s adjusted basis of the contributed property, not the FMV. In addition, under Section 3(b) of the Tax Technical Corrections Act of 2007, P.L.110-172, the Sec. 1366(d) basis limitation does not apply to the amount of appreciation in property an S corporation contributes to charity.

Importantly, the PPA ’06 does not change the general shareholder deductibility rule that the deduction is subject to the Sec. 170 contribution limit and, to the extent of the property’s basis, does not change the general shareholder deductibility rule that the deduction is subject to the Sec. 1366(d)(1) basis limitation.

Preparer Actions

S corporations that made charitable gifts of appreciated property in tax years beginning in 2006 or 2007 should supply relevant information to shareholders on Schedules K-1.

Example 1: An S corporation is owned by one shareholder, A, who has an adjusted basis of $1,000 in his S stock. In 2007, the S corporation contributes appreciated property with a basis of $200, an FMV of $500, and a long-term holding period to a Sec. 501(c)(3) charitable organization. The S corporation will reflect on Form 1120S, Schedule K, Shareholders’ Pro Rata Share Items, and A’s Schedule K-1 a separately reported $500 charitable contribution item.This will be deductible on A’s Form 1040, Schedule A, Itemized Deductions, and his adjusted basis in the S stock will be reduced by $200 (the adjusted basis of the gifted property) to $800 ($1,000 – $200).

Example 2: Assume the same facts as in Example 1, except A has a basis in his S corporation stock (after income items and distributions are properly reflected) of $150. The adjustment to his stock basis for the charitable contribution would be $150, so his basis in stock would be $0. A charitable contribution deduction of $500 flows through to A, but because of the Sec. 1366(d) basis limitation, only $450 is currently deductible—the aforementioned $150, plus the $300 of appreciation ($500 – $200). The remaining $50 ($200 – $150) is suspended under Sec. 1366(d)(2).

Example 3: Assume the same facts as in Example 1, except A has a basis in his S corporation stockof $305. A’s basis in his stock is reduced by $200 to $105 and his charitable contribution deduction is $500.

Example 4: Assume the same facts as in Example 1, except A has a basis in his S corporation stock of $0. A currently deducts $300 as a charitable contribution. His basis in the stock remains at $0 and he has a $200 suspended charitable contribution deduction under Sec. 1366(d)(2).

Example 5: Assume the same facts as in Example 1, except the S corporation sells the property valued at $500 to the charity on a bargain sale basis for $400, resulting in a charitable contribution of $100. The bargain sale rules under Sec. 1011(b) require that the adjusted basis of the property be allocated between the sale and the gift by their relative FMVs. The basis of $200 is therefore allocated $40 to gift basis ($100 ÷ $500 × $200) and $160 to the sale ($400 ÷ $500 × $200). Therefore, the charitable contribution deduction would be $100, and the gain on the sale would be $240 ($400 – $160). The adjusted basis of A’s stock would be reduced under Sec. 1366 by $40 and increased by $160 for the gain on sale.