Owners of family businesses are often looking to support charitable causes, while also seeking to obtain the most tax efficient outcome from such donations. Generally, a charitable contribution of appreciated property allows a donor to deduct the value of property without having to report the inherent appreciation as income. Many recognize this as a reason to give gifts of appreciated stock or other property to charity instead of cash or other liquid assets. The challenge for a family business owner, though, is that most of her investments consisting of appreciated property are usually in the business, and not in publicly traded stocks or other liquid assets.
This does not mean, however, that she has to miss out on the opportunity to donate appreciated property – it is absolutely possible to structure gifts of her own closely held stock so as to maximize the benefit to both her and the receiving charity (and avoid adverse tax outcomes). It just requires the owner and her advisors to do some careful planning and consideration of the many issues that this sort of gift would present. For example:
- If she owns her own corporation, her stock is probably valued substantially higher than her tax basis, especially if she built the business up with her own “sweat” equity. By making a donation to a public charity (and not a private foundation), she could likely deduct the full fair market value of her closely held stock, as opposed to just her cost basis (which may be minimal).
- Making a gift to charity of stock in her own company means she all of a sudden has a new shareholder in her company. This raises the question of whether she is agreeable to bringing in an “outsider” in this role. One way to overcome this concern would be for the company to redeem – or buy back – the stock after the gift is made. Unfortunately, though, in order to get all the benefits and still comply with applicable tax rules, there cannot be such an arrangement in place at the time of the gift.
- She might be thinking of making a gift to charity in anticipation of a sale or merger of her company because such a donation would eliminate the realization of capital gains tax on the gifted portion of the stock. However, she must gift the stock before entering into any documentation evidencing the intention to sell or merge the company. Further, if the charity is going to hold on to the stock after the sale, a buy-sell agreement should be part of the transaction to control who may become a subsequent shareholder, and to deal with governance issues.
Special Considerations with S Corporation Stock
A large number of family businesses operate as S corporations, largely due to the “pass through” nature to the owner of the tax attributes of the company. However, with an S corporation, the rules for making charitable gifts of the stock become much more complex and additional consideration and planning needs to be performed.
While S corporations are now eligible to have charities as shareholders, there are two marked differences from the general analysis provided above.
- First, the amount of the charitable deduction she might claim is reduced by any portion of the value of the stock that is attributable to appreciated assets owned by the S corporation that would generate ordinary income upon their sale. For example, if part of the value of the business is made up of equipment that has been depreciated below its fair market value, the amount of the charitable deduction she can claim must be reduced by the donated stock’s percentage share of the ordinary income that would have been recognized by the company if it sold all the equipment. As such, she may not get a charitable deduction equal to the full appraised value of the stock.
- Second, a charity receiving S corporation stock must pay tax on its share of any income that flows through the S corporation to the charity. Further, unlike virtually every other asset that a charity might own, the gain from the sale of S corporation stock will be subject to taxation to the charity. This necessitates the charity having enough cash to pay these tax obligations, making the charity somewhat dependent on distributions from the S corporation.
However, with an S corporation, the rules for making charitable gifts of the stock become much more complex and additional consideration and planning needs to be performed.
As one might imagine, these considerations may dissuade an owner from making charitable gifts of stock in her closely held business if it is an S corporation, and may cause a charity to refuse to accept any such gift of the stock. There are, however, a few methods that might resolve these issues to everyone’s satisfaction.
- If she is considering selling her business to a larger C corporation, and wants to first make a charitable gift of a portion of the business to a charity in order to avoid having to realize gain on part of the sale, she could consider terminating the business’ S corporation status and becoming a C corporation prior to the charitable gift. The purchasing C corporation would not be an eligible S corporation shareholder anyway, and by making such transition in the form of the business, she could then deduct the full appraised value of the stock and the charity would not recognize any tax upon the sale.
- Alternatively, instead of gifting the S corporation stock, which may create the above-described unfavorable tax results, she could consider causing the S corporation to make a direct gift of some of its underlying assets. Her S corporation’s financial transactions and tax attributes flow through to her, as shareholder, and so if the S corporation makes a simple cash or asset gift to a charity, the charitable income tax deduction will be passed through to her. As long she has sufficient basis in her stock to deduct the gift, there is no need for her to contribute stock to obtain a charitable tax deduction when the company’s gift can produce these same tax benefits. The charity would also benefit from the gift by the company since it will not have to pay tax on the income produced from the donated assets.
Clearly, there are multiple considerations for an owner who would like to donate S corporation stock to a charity. With some sound advance planning, though, it may be possible to obtain optimal tax efficiency for both the owner and the charity.
Note: On March 1, at the DWT offices in Seattle, Washington, the author and Matt Loftin, a DWT estate planning attorney, and Keith Baldwin, a DWT corporate transactions attorney, will participate in a panel presentation sponsored by the Association of Washington Business on “12 Most Common Mistakes to Avoid in Selling Your Business.” Join Matt and Keith in their discussion on how to develop a thoughtful process to address all issues surrounding the most important phase of your business life. You can register for the presentation by clicking here.
Matt Loftin counsels individuals, families, and businesses on a broad range of trust and estate matters, including business planning. He advises clients on tax-efficient wealth and property transfers made during lifetime and at death through the utilization of client-specific planning techniques, including charitable planning, business-succession planning, and special needs planning. In addition, Matt represents personal representatives, executors, and trustees in the administration of trusts and estates. Matt can be reached via email at [email protected] or directly by phone at 425.646.6118.