Can private foundations own S-corporation stock?

Yes, private foundations are allowed to own shares of S-corporations (S-corps) but with several significant restrictions and drawbacks. First and foremost among these restrictions is that, due to the rules for excess business holdings, private foundations can generally only own a limited percentage of a given S-corp’s voting stock. Furthermore, private foundations should be cognizant of the rules for jeopardizing investments, the limited charitable deduction for S-corp stock donated to private foundations, and the negative impact of unrelated business income tax (UBIT) on S-corp income. Although these rules are navigable, they can lead to unfavorable results for the unwary. Before acquiring or accepting S-corp shares, private foundations should carefully consider whether they can stay within the bounds of these rules and whether S-corp shares are a good investment.

Due to the rules for excess business holdings, private foundation ownership of most privately-held business enterprises (including S-corp stock) is severely limited. The rules dictate that private foundations must, along with their disqualified persons, generally hold 20% or less of the voting ownership of any business enterprise (up to 35% in certain cases where a third party has effective control). If a foundation’s voting ownership exceeds these amounts and the situation is not corrected within a potential grace period, the initial financial penalty is 10% of the value of the holding. The penalty can escalate to 200% if the foundation fails to dispose of the excess holding in a timely manner.

The excess business holding rules can be triggered by the gift or bequest of S-corp stock to the foundation by a benefactor. In fact, this is the most common scenario in which private foundations come to own S-corp stock. Although the potential excess business holding grace period for receiving a gift or bequest can be five years or more, private foundations should still carefully think out a stragety for the S-corp shares before officially receiving them. In some cases a foundation may find the excess business holding rules are too restrictive so the best option is to sell the stock. If the foundation intends to dispose of the stock, it should carefully assess its ability to find suitable buyers. Potential S-corp buyers are typically hard to come by—it sometimes can be very difficult to sell shares at a reasonable price. Before accepting any S-corp stock, a planning meeting with professional business and legal counsel is usually a good idea.  

Another complication is that when S-corp shares are donated to private foundations the charitable deduction for purposes of determining the donor’s income tax liability is limited to the adjusted cost basis of the donated stock. The adjusted basis is oftentimes quite low, especially if the donor has built the business up from the ground using sweat equity. Receiving a deduction that is only equal to cost basis is a very bad tax result. If the stock is instead donated to a public charity (in contrast to a private foundation), the donor can generally take a charitable deduction equal to the fair market value of the stock—this is a much better tax result than being limited to cost basis. Seeing that donating S-corp shares to private foundations produces an inferior tax deduction, this kind of transaction is less appealing. Sophisticated planners might recommend changing the tax status of the business from S-corp to C-corp before the donation occurs but this requires careful deliberation as it is a complex transaction with far reaching tax consequences.

Private foundations should also consider how the rules for jeopardizing investments may relate to ownership of S-corp shares. Private foundations are not allowed to make jeopardizing investments, meaning they should not make investments that jeopardize the foundation’s ability to carry out its charitable mission. This definition is admittedly vague but the sentiment is clear—private foundations should not take undue risk with their investments. Each S-corp is a different business—some S-corps operate in a very aggressive and risky manner while others operate in a very conservative and safe way. Private foundations should be wary of holding any S-corp that could be viewed as exceptionally speculative and uncertain (for example an S-corp that trades in commodity futures using margin). Furthermore, it is conceivable that the IRS could consider too large of an allocation to an S-corp as being a jeopardizing investment, especially if the underlying business strategy is radical or ultra-risky. Private foundations should carefully consider the size of any allocation to an S-corp in the context of their overall asset allocation. There isn’t a magical allocation percentage within a portfolio that is allowable, but if the S-corp holding is greater than 15 to 20% of the foundation’s portfolio, it seems wise to have a serious board discussion about risk and position sizing.

Another significant drawback to private foundations owning S-corps is that any income generated by the S-corp is subject to unrelated business income tax (UBIT). Although private foundations normally only pay a nominal tax of 1.39% on investment income, unrelated business income is taxed at the regular corporate income tax rate of 21%. This relatively high tax rate can have a significant impact on the overall investment return. Also, when a private foundation disposes of S-corp stock, the potential gain is also subject to UBIT. Furthermore, UBIT can force private foundations to file state income tax returns in each state in which the S-corp generated income (foundations normally don’t have to file any state income tax returns). Lastly, if the S-corp has international operations the foundation may be obligated to file headache inducing forms with the IRS relating to international reporting (read expensive compliance costs!).

So, although in general private foundations are allowed to own shares of S-corps there are several significant restrictions and drawbacks. There are, of course, compelling cases where it is a good idea for private foundations to own S-corp stock. However, private foundations need to be careful as they navigate the rules and decide whether owning S-corp shares is a good idea overall.

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