Lots of taxpayers oversimplify the rules surrounding the charitable contribution deduction. Most people are aware that contributions to public charities were previously deductible up to a maximum of 50% of adjusted gross income (AGI), and that for tax years 2018 through 2025, the deduction may not exceed 60% of AGI. What most commonly catches some by surprise is that lower limitations may also apply. It is important to determine the amount deductible prior to the application of any limitations. Is it the adjusted basis? Fair market value? Or perhaps, something in between?
Rules surrounding the pass through of charitable donation deductions from an S corporation to its shareholders and the corresponding basis adjustments might also surprise taxpayers. This article explores some of the rules for contributions to public charities by an S corporation.
What Is a Public Charity?
In general, public charities (like the Giving Center) are tax-exempt Internal Revenue Code (IRC) section 501(c)(3) organizations that receive support from a extensive base of donors. Public charities are different 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 can apply to private foundations.
Charitable Contribution Rules for Individuals
Contributions of long-term capital gain (LTCG) property will produce a deduction equal to the fair market value of the property, which is subject to a 30% of AGI limitation. This rule hasn’t been affected by the Tax Cuts and Jobs Act (TCJA). LTCG property is defined as property that is presumed to generate a long-term capital gain if sold by the taxpayer on the date of contribution; it’s the contribution of a capital asset held for more than one year. The contribution of ordinary income property, property that would generate ordinary income if sold, which includes 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 applies only to cash donations to qualifying charities.)
The charitable contribution deduction is decided at the shareholder level, and the treatment of these contributions might differ among shareholders given the limitations based on shareholder AGI.
There are some exceptions to these rules. First, the contribution of LTCG property that is unrelated to the use of the charitable organization will not generate a full fair market value deduction. For example, if a person decides to donate art, like a Picasso, to United Way, whose charitable function isn’t to engage and educate through art, then the taxpayer will only be able to deduct up to their adjusted basis in the artwork, subject to the 50% limitation. Marketable securities are normally not considered unrelated use. Additionally, if the charity were to sell the donated property immediately after its contribution, even if the property is otherwise related to its charitable purpose, the contribution is considered unrelated use. Looking at the Picasso donation, if the donor were to contribute it to the Albright-Knox Art Gallery in Buffalo, and the gallery decides to sell it off to acquire operating funds, they would again only be eligible for a deduction of her adjusted basis in the Picasso.
Another exception applies to C corporations and is for the contribution of inventory, which is normally ordinary income property. If the inventory donation meets specific requirements, the taxpayer can 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 their pro rata share of S corporation items of separately stated income (deduction) and items of non-separately stated income (deduction) as reported on Schedule K-1 (Form 1120S). Reporting of these items increases (decreases) the shareholder’s basis in the S corporation stock under IRC section 1367. (An S corporation shareholder will increase their basis for tax-exempt income that passes through to their individual return; this adjustment is necessary in order to keep the tax-exempt income from being taxed at the shareholder level when it is subsequently distributed by the S corporation.)
Amid the separately stated deductions are charitable contributions by the S corporation; shareholders have to report their ratable share of such contributions. The charitable donation deduction is determined at the shareholder level, and the treatment of these donations may differ among shareholders given the limitations based on shareholder AGI. Usually, a shareholder will reduce their basis by the amount of loss and deduction that passes through to them. Lets say for example, if an S corporation has a net IRC section 1231 loss of $10,000 that passes through to Brett, they will report the $10,000 loss on their Form 4797 and reduce the basis in their S corporation stock by $10,000. this is not the case for charitable contribution deductions.
IRC section 1367(a)(2) flush language states 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 donated to charity. In Revenue Ruling 2008–16, the IRS defined that the shareholder’s basis is not reduced by the appreciation of the contributed property. Therefore, while the shareholder reduces their stock (and debt) basis by their ratable share of the basis in the contributed property (but not below zero), they will pass through the ratable share of the contributed property’s basis, limited to their basis in S corporation stock and debt, plus their ratable share of all the appreciation on the contributed property. In short, the deduction is based on the fair market value of the charitable contribution.
Rules that limit the pass-through of the deduction to the stockholder’s basis in S corporation stock and debt doesn’t apply to the appreciation of property contributed to charity by the S corporation. Even when the shareholder starts with zero basis in their S corporation stock (or debt), the appreciation of contributed property will pass through as a charitable donation. This means, the deduction is prorated to the portion limited by (and reducing) basis and to the appreciation. This difference in pass-through and basis adjustments first came up in the Pension Protection Act of 2006 and the Tax Technical Corrections Act of 2007 as a charitable giving incentive. After some congressional extenders, it was made to be permanent by the Protecting Americans from Tax Hikes Act of 2015. If a shareholder’s stock basis were reduced by the appreciation in the contributed property, they could potentially recognize more gain on the subsequent sale of his S corporation stock due to the lower basis. The direct contribution of appreciated property to a public charity by an individual doesn’t trigger gain recognition for the donor. Congress amended IRC section 1367 in order to prevent such an inequity.
Here is one example that helps to illustrate the rule: Cora owns 100% of Scranton, Inc., an S corporation. Her basis in Scranton stock is $10,000 at the beginning of the year. In the current year, Scranton has an income of $7,000 and makes a charitable contribution of LTCG property worth $50,000 and has a $20,000 basis. Scranton has no liabilities and no distributions are made during the year. Cora first increases 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 donation will pass through as a separately stated deduction. When figuring out the amount of allowable deduction, Cora will experience a basis limitation. She wont be able to deduct the full $20,000 of the deduction associated with the property’s basis because it’s limited to her adjusted basis in Scranton stock of $17,000. This results in $17,000 of the available $20,000 basis will pass through to Cora on Schedule K-1 (Form 1120S); the $3,000 excess will carry over indefinitely until she has enough stock (or debt) basis to pass it through. At the same time, the entire $30,000 ($50,000 − 20,000) in appreciation of the property donated to charity will pass through to Cora in the year of contribution and is available to be claimed on her personal return. Cora has a potential charitable contribution deduction of $47,000 ($17,000 + 30,000) in total. These taxpayer-friendly rules can be helpful in planning charitable contributions through S corporations.
Contributions by Partnerships
The TCJA has also changed the rules relating to the pass-through of charitable contributions of appreciated property by a partnership and brought them into conformity with the S corporation rules. In general, a partnership will pass through deductions and losses to the extent the partner has basis in their partnership interest, referred to as their “outside basis.” Before 2018, the pass-through of charitable contributions wasn’t subject to this limitation. Under IRC section 704(d)(3)(B), the outside basis limitation applies to the adjusted basis in the appreciated property contributed to an IRS qualified charity, but not to the appreciation on the contributed property. The appreciation will then pass through to the partner in the year of contribution, irrespective of the partner’s outside basis.
A Useful Opportunity
Back 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. And in 2015 the provisions were made permanent. Under the TCJA, fewer people are expected to itemize their deductions, but for those who do, this benefit remains available when contributing to public charities through S corporations.
