According to The Chronicle of Philanthropy, 12 of the 50 most generous donors in 2014 are from the technology industry, and a stunning number of them are under age 40. The amount contributed by tech entrepreneurs increased tenfold from 2010 to 2014 and accounted for nearly half of all donations made by the top 50 philanthropists in 2014. Charitable giving is no longer an afterthought for young tech clients, but an integral part of their wealth planning, and the challenges can be extraordinary.
Typical Client Characteristics
These clients are typically in their 20s or 30s. While they may be single or married, their family aspirations usually aren’t fully realized. They may not have children but plan to have them, or they may have one or more young children. They often have modest current net worth but tremendous “upside potential.” It isn’t uncommon for these clients to have $1 million or $2 million of net worth but own shares and options in a startup company that have the potential to catapult their net worth to $30 million or more in a year or two.
To Give or Not to Give?
The first consideration for young clients is whether they wish to make any significant charitable gifts given their present circumstances. Some of the factors they might consider in deciding whether to make significant charitable transfers include:
- Current and anticipated wealth level
- Needs of children or anticipated children born or adopted later, including support and schooling
- Anticipated living expenses, including possible changes in lifestyle
- Possible need for new business opportunities and startups
- Possible gifts to other family members
- Tax benefits of charitable gifts
- Possible “rainy days”
Selecting the Assets to Give
Tech industry clients often hold a concentration of private company stock and options. As a result, it’s important to understand the rules of charitable giving generally and how those rules apply to their unique assets.
Charitable giving tax rules—background. The Internal Revenue Code permits donors to claim an income tax deduction for contributions to eligible charities.
When appreciated assets are contributed, the amount deductible is generally limited to the donor’s basis (that is, no deduction is allowed for the appreciation component). But, when a sale of the asset would produce long-term capital gains (LTCGs), a full fair market value (FMV) deduction is allowed for contributions to public charities, but generally limited to basis for contributions to private foundations (PFs).
In addition, all contributions in a given calendar year are subject to a limitation based on a donor’s adjusted gross income (AGI). Contributions to a public charity will generally be limited to 50 percent of the donor’s AGI for the year. Contributions to a PF will generally be limited to 30 percent of AGI. The limitations are further reduced if the donor is contributing appreciated assets that would, if sold, be taxed as LTCGs. When appreciated assets are contributed, the limitations are reduced from 50 percent to 30 percent for public charities, and from 30 percent to 20 percent for PFs. Unused deductions may be carried forward for five years.
Giving stock options. There are two types of stock options: (1) incentive stock options (ISOs) and (2) nonqualified stock options (NSOs).
ISOs are special. They aren’t taxed when issued or exercised. Rather, the client is taxed when the shares obtained from exercising the options are sold. If the client holds the underlying shares for longer than two years from the date the options were granted and for longer than one year from the date the options were exercised, a sale of the shares will trigger LTCGs. Therefore, a contribution of those shares to a public charity would result in an FMV charitable contribution deduction. If the client hasn’t held the shares long enough, a sale of the shares will trigger ordinary income, and any deduction for contribution of those shares would be limited to basis.
NSOs are stock options that don’t qualify as ISOs. While an NSO may be transferable, it’s usually not advantageous to give them to charity. When the options are exercised, the client will need to include in gross income the difference between the FMV of the shares and the exercise price. This is so even if the client transfers the options to charity, and the charity later exercises them. As a result, the tax implications to the client will be the same as if the client had exercised the NSO and subsequently transferred the shares to charity. The client will have ordinary income, the shares will receive a tax basis equal to FMV and the client will receive an equal and offsetting deduction for completing a gift of the shares to charity.
As a result of these rules, clients generally don’t make gifts of stock options (whether ISOs or NSOs) to charities during the client’s lifetime. However, it’s very common to exercise options and contribute the underlying shares.
Giving stock. Tech industry clients often own stock in a private company. Specifically, the client might hold:
- Founder’s shares from the initial formation of the company
- Shares received as compensation
- Shares purchased that don’t represent compensation
- Shares from the exercise of options
The first consideration in contemplating a gift of private company stock is whether any restrictions apply to the shares that would prevent transfer. If the shares can’t be transferred due to restrictions imposed by the company, the client’s options will be to wait until the restrictions expire, seek a modification of the restrictions or give other assets.
The next consideration is whether any part of the contribution will be limited due to ordinary income or short-term capital gains potential. In essence, we need to know that any ordinary income potential in the stock has been cleared by taking the stock into income and that any capital gains potential in the stock will qualify for LTCGs treatment. If the shares are “founder’s shares,” they’ll generally be capital assets and will have a tax basis close to zero. If the shares were purchased, and weren’t compensation, they’ll have a basis equal to the purchase price paid for the stock, and there’ll be no ordinary income potential. If the shares were obtained on the exercise of an option, they’ll generally have a tax basis equal to the exercise price plus any gross income recognized on exercise.
Once the planner has ascertained that the shares are capital assets, the next step is to determine if the shares have been held long enough to qualify for LTCGs on a sale. If the shares qualify for LTCGs treatment on a sale, contributing those shares to a public charity will give rise to an FMV charitable contribution deduction (subject to AGI limitations). Otherwise, a deduction for a contribution of the shares will be limited to basis.
Timing of Gifts
In general, the client will want to time a charitable gift to take place in a calendar year when they will have substantial income or capital gains to offset with the deduction.
If the taxable event is an upcoming company transaction, extra caution is necessary to avoid the assignment of income doctrine. Under this judicial doctrine, when a taxable event is deemed to have been complete enough prior to the contribution of shares, the client will remain taxable on the gains from the sale even though the sale is ultimately consummated by the charity, and the charity gets the money. The application of this doctrine hinges on whether the charity is legally obligated to proceed with the sale after receiving the shares.
Selecting the Donee
Once the client has decided to make a contribution and selected the asset to give, the next step is to select the appropriate donee. The client’s choices will include charitable remainder trusts (CRTs), charitable lead trusts (CLTs), PFs and public charities including donor-advised funds (DAFs).
CRTs. CRTs make sense for a client who wishes to defer the income tax on the sale of low basis stock in exchange for a modest contribution to charity and accompanying income tax deduction. The client will typically set up a charitable remainder unitrust (CRUT) and contribute the low basis stock. The trust instrument will typically provide that the client will receive an annual payout equal to 5 percent of the value of the trust from year to year for a period not to exceed the life or lives of the donors or 20 years. At the end of the trust, an amount calculated to equal 10 percent or more of the initial contribution passes to one or more public charities. The sale of appreciated stock by the CRUT won’t be immediately taxable, but payments back to the client will be subject to income tax when received, and the payments will carry out the highest tax items first.
CLTs. CLTs can make sense for clients who would like to make a transfer to children or others over time, minimize the gift tax associated with the gift and benefit charity along the way. The client contributes assets to the CLT, and the CLT is obligated to make annual payments (usually a guaranteed annuity amount) to the charity for a period of years, after which the remainder passes to children or other non-charitable beneficiaries. The CLT may be structured to yield an income tax deduction up front for the charitable payments, but the trade-off is the trust must be structured as a grantor trust, and thus all income and gains over the coming years will be taxed to the client.
PFs. PFs may appeal to clients who are in need of a current-year income tax deduction but would like to select the ultimate charitable recipients over time. PFs can be structured as trusts or corporations. They’re generally required to distribute 5 percent of their net assets each year to public charities or other qualified recipients. Due to the complexity and expensive ongoing maintenance costs, these are generally unattractive to all but the wealthiest clients, and even those will often opt for a DAF instead.
DAFs. DAFs compete with PFs when the client wishes to obtain a current deduction while retaining the ability to select the ultimate charitable recipients later. These are offered by community foundations and, increasingly, by financial institutions (through affiliated public charities). While the client doesn’t have an absolute right to select charitable beneficiaries, the client has the ability to advise the sponsor as to desirable beneficiaries, and these recommendations are generally followed. Due to their simplicity and excellent tax benefits, DAFs have become very popular in recent years.
This is an adapted version of the authors’ original article in the October issue of Trusts & Estates.