Successfully founding and running a business not only creates personal financial stability and prosperity, but also provides entrepreneurs who are so inclined with an excellent opportunity to share their wealth. Mindfully giving to charitable organizations that support causes they care about provides these organizations with important resources to continue their work or begin new projects. Making charitable gifts can also be a useful tax-planning strategy to capture tax deductions against business income and to avoid capital gains tax on highly appreciated assets.
Startup founders and executives commonly receive stock options (ISOs and NQSOs) and restricted stock units as part of their overall compensation package. As the company continues to grow, the value of the company stock can increase substantially, creating wealth – and a considerable tax bill. With vesting, bonuses, and other events that trigger income, there may be years where a founder’s income is higher than usual. Proactively implementing charitable giving strategies that capitalizes on higher income years can reduce the larger tax bill and meet the founder’s charitable giving objectives at the same time.
Donating Appreciated Non-Cash Assets
Non-cash assets – which include business interests, private equity interests, securities, or real estate – are excellent candidates for a charitable donation if their value has appreciated significantly and they’ve been held by the taxpayer for more than one year. By donating these assets directly to charity, one can avoid paying taxes on the investment’s appreciation, while generously providing for their charity of choice.
Please note that donating appreciated non-cash assets to charity has complex tax, legal, and administrative implications that should be executed with the support of the entrepreneur’s wealth advisor, attorney, and accountant.
Charitable Remainder Trusts and Charitable Lead Trusts
For entrepreneurs who have a considerable amount of company stock and are looking to diversify without incurring a major tax bill, one attractive strategy is the Charitable Remainder Trust (also known as a CRT). A CRT is an irrevocable trust that can be funded with company stock and distributes income to a beneficiary over a specific term; the assets remaining in the trust at the end of the term are then passed to charity. This strategy would be a good fit for an entrepreneur who wants to benefit charity, but would still like to maintain access to a portion of the sale proceeds for personal spending.
Here’s a hypothetical scenario using a CRT when one receives highly appreciated shares from an IPO. The entrepreneur will transfer their shares of the highly appreciated stock to a CRT, receive a tax deduction when the contribution is made, and then sells the shares within the CRT. Due to the tax treatment of the CRT, the sale of the company stock within the CRT is not a taxable event to the entrepreneur. The proceeds can then be deployed into a diversified portfolio, minimizing business and market risk for the pool of assets. The entrepreneur can now begin receiving annuity payments from the CRT and can space out the total tax due over a number of years.
A Charitable Lead Trust (CLT) works similarly, but in reverse – instead of the entrepreneur receiving annuity payments, with the remainder passing to charity at the end of the trust term, a qualified charity (or charities) will receive payments annually, with a beneficiary of the donor’s choosing (usually family) receiving the remainder proceeds at the end of the specified term.
If the entrepreneur would like to fund a personal charitable portfolio over time instead of all at once, a CLT can be used to accomplish this goal. If the CLT is a grantor trust (where the grantor is paying the trust’s taxes), the donor will receive a charitable deduction based on the current value of the future payments that will be made to charity (and is dependent on the type of charity receiving the benefit). After funding the CLT, annual payments can be made to either a donor-advised fund or a family foundation each year to meet charitable goals.
It’s important to note that a CLT is subject to income taxes, similar to any other non-charitable trust. If the trust is a grantor trust, its income will appear on the grantor’s income tax return. If it is a non-grantor trust, the trust itself is responsible for its own taxes, and careful planning must be done to ensure the trust has adequate cash to cover its taxes, as well as its annuity payments.
Both types of trusts are subject to complex IRS rules, and have complex administrative requirements, so anyone considering either of these trusts as a part of their charitable planning should work closely with a trusted advisor to execute.
Pairing Liquidation with Donating Appreciated Stock Directly to Charity
Another option for entrepreneurs looking to diversify a heavily concentrated position is to pair liquidation with donating the appreciated stock directly to charity. If the individual doesn’t want to donate all of the assets to charity – but still wants to incorporate charity in the process – one solution would be to pair in-kind stock donations with sales. This is to avoid paying taxes on the appreciation of the donated shares and to receive a tax deduction offsetting income generated from the sales. By doing so over time (instead of all at once), the exposure to market risk may be mitigated; they may also benefit from redeploying the sales proceeds into the market over time (also known as dollar-cost averaging).
Let’s review another hypothetical scenario involving an entrepreneur’s liquidity event due to an acquisition of his or her business. The entrepreneur seeks guidance to understand their financial position after the transaction, as well as to identify how much they could give to charity to meet their giving goals while preserving assets needed for personal use.
With the help of their advisers, the entrepreneur develops a sound framework around the anticipated net worth of their estate after proceeds are received, the estimated tax liability resulting from the transaction, the sustainable annual spend rate based on their new net worth, and the impact a charitable gift to their donor-advised fund would have on each of these data points. An adviser can help with recommended donation amounts by testing the impact of $1m, $5m, and $10m gifts (for example) on the entrepreneur’s sustainable annual spending rate, the sustainable grant rate from their donor-advised fund using the new assets, and the overall tax savings per gift amount. With proper planning and analysis, the entrepreneur in this example could end up being able to donate the maximum $10m gift while saving a substantial amount in taxes.
It’s important to note that the timing of a transaction like this needs to be thought through relative to the actual liquidity event. Having a trusted advisor who will work closely with your company, accountant, and attorney to holistically review all aspects of a transaction and its impact on an entrepreneur’s financial position is a crucial step.
Using a Donor-Advised Fund or Private Foundation
Donor-Advised Fund (DAF)
If the entrepreneur isn’t sure about which causes or organizations to support, they can open and fund a donor-advised fund (DAF). A DAF is a charitable account sponsored by a public charity, to which a donor can make gifts of cash, securities, private assets, or restricted assets, and receive a charitable deduction in return. Assets other than cash are typically liquidated once they’ve been deposited into the donor-advised fund, and at that time, the donor has a wide range of options in terms of how to invest the cash. Once the account is funded, the donor can make grant recommendations to the sponsoring charity for gifts to another public charity of their choosing. Once the sponsoring charity approves the grant, a check for the requested grant amount is sent to the charitable organization chosen. It’s important to understand that while a donor may recommend grants to the sponsoring charity, the charity ultimately holds the right to approve or deny the grant.
There are currently no minimum grant requirements for a donor-advised fund and the administrative process is relatively straightforward and low-cost. Grants paid from a DAF may also be sent anonymously to the chosen charity if the donor wishes not to reveal their identity. These features make DAFs a popular charitable giving vehicle among high-net-worth entrepreneurs and investors.
Private Foundation
An alternative to using a DAF for charitable giving is a private foundation. A private foundation is a charitable giving vehicle set up similarly to a trust, with a grantor and trustees. The trustees are responsible for making grants to charity from the foundation, filing tax returns, and deciding how the foundation’s portfolio is invested. Private foundations are excellent charitable giving vehicles for those who wish to incorporate their family members in the family’s philanthropy, even allowing the trustees to receive a salary for their work related to the foundation.
It’s important to note some key differences between a private foundation and a DAF. Private foundations are more expensive to create and manage, primarily due to legal costs associated with creating the foundation, tax costs associated with filing tax returns each year, and excise taxes on income (1-2%) due each year at the time of filing. A private foundation’s tax returns are also public, meaning that any grants paid during the year are readily available for others to view, along with the names of trustees and the investments in the foundation’s portfolio. Deductions for gifts of cash or appreciated securities to a private foundation are also subject to lower AGI income limits, meaning that a donor receives a lower charitable deduction than they would by giving to a donor-advised fund.
Whether an entrepreneur chooses to create and fund a DAF or a private foundation is ultimately a personal choice which should incorporate charitable giving objectives and overall estate plan. A trusted advisor can walk through the specific pros and cons of each to help one make a fully informed decision.
Next Steps
With an increased need for resources on behalf of charitable organizations worldwide and evolving tax law changes, entrepreneurs may want to begin building mindful charitable giving strategies today. As a trusted advisor to entrepreneurs and executives, Lake Street’s team of professionals are ready to help, reach out to us today.
IMPORTANT DISCLOSURES AND DISCLAIMERS
This hypothetical case study is provided for illustrative purposes only and does not represent work we’ve done on any client of Lake Street Advisors nor is it intended to be representative of any client experience. Instead it is meant to provide an illustration of Lake Street Advisors approach to planning and tax strategies we believe would be appropriate given the facts and circumstances of the hypothetical case presented.
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