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§ 9.8 S CORPORATION STOCKtaxable income and the charity would like to use the losses to reduce the unrelatedbusiness tax liability. Further, a low basis means a potentially higher gainfrom sale of the S corporation stock, which will trigger a larger amount of unrelatedbusiness income.If the S corporation has losses, there is a second issue: whether the passive losslimitation 243 applies to prevent a charity from deducting an S corporation’s operatinglosses against the corporation’s interest, dividend, and other portfolio income.This issue has not been previously addressed, in that the investment income ofexempt organizations is generally excluded from unrelated business income taxation.244 Because a significant number of S corporations report operating losses,however, the passive loss issue is likely to arise soon. Although arguments can bemade that the passive loss limitation does not apply to unrelated business income,it would be helpful if the IRS clarified the point.Because interest paid on state and local government bonds is normally taxexemptincome to individuals, 245 many partnerships and S corporations invest inthese bonds. However, because unrelated business income is computed withoutreference to regular income tax statutes, and because the unrelated businessincome statute requires an exempt organization to treat all income attributableto an S corporation as unrelated business income, an S corporation’s municipalbond interest attributable to charitable organizations may be subject to the unrelatedbusiness income tax.When a charitable organization engages in an unrelated business that generatesunrelated business income, it can claim a charitable deduction for anamount contributed to an unrelated charity. 246 The question thus arises as towhether an S corporation’s charitable gifts are deductible by the charitable organization/shareholderin the same manner. 247 A related question is whether thereis any reduction in the benefit of the charitable gift if the S corporation makes agift to the charity that owns some of its stock. There certainly is a problem if theS corporation is a subsidiary of the charity, 248 but the tax outcome is unclearwhen the charity owns only a small percentage of the stock. This is another areawhere IRS guidance is needed.The foregoing issues are related to another one: Does S corporation incomeretain or lose its character for unrelated business income purposes? This issue ismost important for charitable trusts, in that they might be able to pay only thelong-term capital gains tax 249 instead of a 39.6 percent tax rate if an S corporation’slong-term capital gains keep their character, rather than being reclassifiedas ordinary income.By way of background, the character of a shareholder’s pro rata share of incomeof an S corporation is determined as if the shareholder had directly engaged in the243 IRC § 469.244 IRC § 512(b)(1).245 IRC § 103.246 IRC § 512(b)(10) (corporations); IRC § 512(b)(11) (trusts).247 IRC § 512(e)(1)(B)(i) states: “All items of income, loss, or deduction taken into account under section1366(a) . . . shall be taken into account in computing the unrelated business taxable income” of a tax-exemptorganization” (emphasis added).248 See § 3.1(a).249 See § 2.16(a). 299