In the first issue of Owner to Owner, we discussed the benefits of making taxable gifts of privately-held business interests before the value of the business increases. In doing so, a business owner gives assets to his beneficiaries that will continue to appreciate while effectively removing the value of the assets and the future appreciation from his estate. In this issue, we will discuss the benefits of making gifts of privately-held business interests to charity. Charitable gifts of business interests accomplish the dual goals of benefiting a particular cause or organization while reducing the business owner’s current income and future estate taxes. While the benefits of such gifts are similar to the benefits associated with making gifts to individuals, the ideal timing for charitable gifts is very different than that of taxable gifts to individuals.
Timing Charitable Gifts of Business Interests
One important reason to make gifts of business interests to individuals before those interests increase in value is to remove any future appreciation on those assets from the business owner’s estate. Making taxable gifts of highly appreciated assets uses more of one’s lifetime gift tax exemption (currently $5.43 million), if any remains, and if not, incurs gift tax. At the same time, the beneficiary who receives the gift of highly appreciated business interests also receives the same low basis that the interests had in the hands of the business owner. Therefore, the beneficiary will be faced with paying capital gains tax on those interests when they are sold or redeemed.
On the other hand, gifting highly appreciated assets to charity can be extremely tax efficient. Depending on the structure of the charitable organization, a business owner may be able to take an income tax charitable deduction on the full fair market value of the business interest when he gifts an appreciated interest in his business to charity. The business owner thereby avoids realizing capital gains on the disposition of the business interest while providing a greater benefit to the charitable organization. In addition, the value of the gifted interest and all future appreciation on the interest are removed from the business owner’s estate. If and when the charity later sells or redeems the stock, the tax-exempt charity will not be required to pay any capital gains tax and will be able to use the full value of the gift to support its charitable purposes.
To illustrate the potential value of giving business interests directly to charity, consider the example of entrepreneurs John and Sam from our last article. John and Sam initially contributed $2 million each to their company, Startup Co., in return for 50% of the shares. Ten years later, Startup Co. is worth $40 million. Both Sam and John are philanthropically inclined and desire to give back to their favorite charities. John decides to sell a 10% interest in Startup Co. and donate the proceeds to Charity A, a public charity (not a private foundation). John sells the interest for $4 million*. Because he is in the highest tax bracket, John must pay capital gains tax of 23.8% on the appreciation upon sale, which equates to $856,800 in capital gains tax. He then donates the remaining $3,143,200 in cash to Charity A and takes an income tax charitable deduction for the same amount. At the same time, Sam decides to give a 10% interest in Startup Co. to Charity B, a public charity. Even though Sam’s tax basis in the interest is only $400,000, his gift will result in an income tax charitable deduction at the full fair market value of $4 million*. If Charity B later sells or redeems the interest for $4,000,000, it will not be required to pay any tax in association with the transaction. Sam’s decision to give the 10% interest in Startup Co. directly to Charity B maximizes his income tax charitable deduction and results in Charity B receiving $856,800 more than Charity A receives from John.
* For purposes of this illustration, we have not assumed any valuation discounts.
Obtain a Qualified Appraisal
If a business owner intends to make contributions of interests in the business with a value of $5,000 or greater, he must obtain a qualified appraisal, as defined by the Internal Revenue Code. The appraisal must be prepared no earlier than 60 days before the date of contribution to charity and no later than the due date of the business owner’s income tax return claiming the charitable deduction. The appraisal must be attached to the business owner’s tax return for the year of the gift and must include a description of the business interests contributed and the fair market value of the interests on the date of the contribution.
In our prior article on taxable gifts of business interests, we discussed the valuation discounts that often apply to gifts of interests in privately-held businesses. Discounts for lack of control and lack of marketability can reduce the value of a gift. Therefore, valuation discounts are desirable for taxable gifts but undesirable for charitable gifts because they may reduce the value of the income tax charitable deduction. Discounts vary based on the character of the property contributed and the circumstances surrounding the contribution. If a business owner previously made taxable gifts of interests in the business to family members and took significant discounts on the gifts, those valuation discounts could reduce the charitable deduction he may be able to take on later gifts to charities.
Choosing the Right Charitable Beneficiaries for Gifts of Privately-Held Business Interests
The value of the income tax charitable deduction and the potential constraints associated with gifts of privately-held business interests depend on the character of the recipient charity. In the previous example, John and Sam made gifts to public charities. While a business owner may wish to make a gift of interests in his business to a private foundation, the charitable deduction he receives for that gift will be limited to 20% of his adjusted gross income (“AGI”), as compared with 30% of AGI for gifts to a public charity or donor-advised fund. More importantly, the value of the charitable deduction will be limited to the owner’s cost basis in the property. For many business owners, their cost basis in the business is very low. If Sam had gifted his 10% interest in Startup Co. to a private foundation instead of a public charity, the value of his income tax charitable deduction would have been limited to his cost basis, or $400,000. While the value of the gift to the private foundation would have been the same ($4 million), the tax benefit to Sam would have been greatly reduced.
The following chart compares the deduction limitations for gifts to public charities, donor-advised funds and private foundations.
In addition to the deduction limitations, private foundations are subject to prohibitions on self-dealing and excess business holdings, among other restrictions. Restrictions on self-dealing are designed to prevent a variety of transactions between private foundations and disqualified persons (substantial contributors, foundation officers and family members, among others). Prohibitions on excess business holdings prevent a private foundation and its disqualified persons from holding, in the aggregate, more than 20% of the voting stock of an incorporated business. Similar restrictions apply to unincorporated businesses, including partnerships and joint ventures. Running afoul of the private foundation rules can results in two layers of punitive tax: an initial excise tax of 5-10% and an additional excise tax of 200% if the violation is not corrected within the taxable period in question.
While donating privately-held business interests to a public charity is often more tax efficient for the business owner and subject to fewer restrictions than gifts to private foundations, many public charities may feel ill equipped to accept complex, illiquid assets. In these situations, a donor-advised fund can be a good alternative. A donor-advised fund is a program managed by a public charity that allows a donating individual to open an account held at the fund to receive a gift of the donating individual’s cash, securities, privately-held business interests or other property. The donor surrenders ownership of anything put in the fund, but retains control over how the account is invested, and how it distributes money to charities. Contributions of privately-held business interests to a donor-advised fund are deductible at fair market value. In addition, many charitable organizations with donor-advised fund programs are experienced in evaluating and accepting complex assets. Once a business owner contributes business interests, which can later be sold or redeemed, to a donor-advised fund, the business owner can support any number of private foundations and public charities through distributions of cash from the donor-advised fund.
One timing pitfall should be noted. If, at the time of the charitable contribution, an agreement is in place for the impending sale of the business, the transaction may be treated as an anticipatory assignment of income and the business owner may be forced to pay capital gains tax on the interests he gave to charity before the sale. Similarly, if a business owner contributes business interests to charity subject to an agreement that the business will thereafter redeem the charity’s interest, the business owner may also be required to pay capital gains tax on the gifted interests. As long as the charity is under no obligation to sell or redeem the shares, the transaction should not be treated as an anticipatory assignment of income.
Legal Structure of Business Also Affects Charitable Gifts
Not only does the classification of the charity affect the value and logistics of charitable gifts of business interests, but the legal structure of the business also impacts the effects of such gifts. While a detailed discussion of various types of businesses is beyond the scope of this article, a business owner and his advisers should carefully consider potential issues before considering charitable gifts of business interests. While charitable contributions of C corporation stock are generally fairly straightforward, contributions of S corporation stock or partnership interests may result in unrelated business taxable income to the charity. Gifts of interests in partnerships or LLCs may result in phantom income to the business owner if the business has outstanding debt or receivables. Finally, shareholder or partnership agreements may further restrict charitable gifts of business interests. However, business owners are often able to negotiate amendments to these agreements permitting charitable gifts.
If you are about to write a check to support your favorite charity, you should consider other alternatives. You want to do good, but you could do it better. If the value of your business has appreciated significantly, gifting appreciated business interests instead of cash can maximize the benefits to you as well as the charity. Talk to your Brown Brothers Harriman Wealth Planner about the options available to you.
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1 Deduction may be carried forward for five years.
2 Gifts of property with a holding period under 12 months (short-term capital gain property) are limited to basis.